8/12/2019 Principels of Capital Investment -
1/35
Financial Policy and
Planning chapter 6(capitalbudgeting)
8/12/2019 Principels of Capital Investment -
2/35
Financial Objectives and Shareholders
Wealth
Investors maximize their wealthby
selecting optimum investment and
financing opportunities, using financial
models that maximizes expected returnsinabsolute terms at minimum risk
8/12/2019 Principels of Capital Investment -
3/35
Objective of Financial Management
RISK AND RETURN TRADE-OFF
To implement investment and financialdecisions using risk adjusted wealth
maximizing criteria, which satisfy the firms
owners placing them in an equal, optimum
financial position
8/12/2019 Principels of Capital Investment -
4/35
Functions of Strategic Financial
Management
Investment Decisions
Dividend Decisions
Financing Decisions
Portfolio Decisions
In our real world, each of the above is designed tomaximize the shareholders wealth using the
market price of an ordinary share as a
performance criterion.
8/12/2019 Principels of Capital Investment -
5/35
The Investment and Finance Decisions
Investment Policy selects:
1- An optimum portfolio of investment
opportunities that
2- Maximize expected net present value (ENPV)
3- At minimum risk
8/12/2019 Principels of Capital Investment -
6/35
The Investment and Finance Decisions
Finance Policy identifies:
1- Potential fund sources (equity and debt,
long or short) required to sustaininvestment
2- Evaluates the risk adjusted returns
expected by each of the sources and3- Selects the optimum mix that will minimize their
overall Weighted Average Cost of Capital (WACC)
8/12/2019 Principels of Capital Investment -
7/35
8/12/2019 Principels of Capital Investment -
8/35
Importance of WACC in Wealth
Maximization
If management wish to increase shareholder
wealth, using share price, then it must create
positive Earning Value (EVA) as the driver.
Negative EVA is only acceptable in the short
term.
8/12/2019 Principels of Capital Investment -
9/35
Importance of WACC in Wealth
Maximization
If share price is to rise long term, then a
company should not invest funds from any
source unless the marginal yield on new
investment at least equals the rate of return
that the provider of capital can earn elsewhereon comparable investments of
equivalent risk.
8/12/2019 Principels of Capital Investment -
10/35
8/12/2019 Principels of Capital Investment -
11/35
Capital Project
A capital project is defined as an asset
investment that generates a stream of receipts
and payments that define the total cash flows ofthe project. Any immediate payment by a firm for
assets is called an initial cash outflow, and future
receipts and payments are termed future cashinflows and future cash outflows, respectively
8/12/2019 Principels of Capital Investment -
12/35
Dividends or Futures Capital Gains
If ENPV is positive, a projects anticipated future
net cash inflows should enable a firm to repay
cheap contractual loans with accumulatedinterest and provide a higher return to
shareholders. This return can take the form of
either current dividends, or future capital gains,based on managerial decisions to distribute or
retain earnings for reinvestment
8/12/2019 Principels of Capital Investment -
13/35
Dividend or Futures Capital Gain
Managements minimum rate of return on
incremental projects financed by retained
earnings should represent the rate of return thatshareholders can expect to earn on comparable
investments elsewhere.
Otherwise, corporate wealth will diminish andonce this information is signaled to the outside
world via an efficient capital market, share price
may follow suit.
8/12/2019 Principels of Capital Investment -
14/35
Dividend payment vs Profit Retention
Companys retained profits for new capital
projects represent alternative consumption andinvestment opportunities foregone by its
shareholders, the corporate cut-off rate for
investment is termed to be the opportunity cost
of capital.
8/12/2019 Principels of Capital Investment -
15/35
Dividend payment vs Profit Retention
If management vet projects using the
shareholders opportunity cost of capital as a
cut-off rate for investment, then
It should be irrelevant whether future cash flows
paid as dividends, or retained for reinvestment
As a consequence, dividends and retentions areperfect substitutes and dividend policy is
irrelevant.
8/12/2019 Principels of Capital Investment -
16/35
A firm is considering two mutually exclusive capital projects of
equivalent risk, financed by the retention of current dividends. Each
costs 500,000 and their future returns all occur at the end of the
firstyear.
Project A will yield a 15 per cent annual return, generating a cash
inflow of 575,000, whereas Project B will earn a 12 per cent return,producing a cash inflow of 560,000.
All individuals and firms can borrow or lend at the prevailing marketrate of interest, which is 14 per cent per annum.
Managements investment decision would appear self-evident.
-If the firms total shareholder clientele were to lend 500,000elsewhere at the 14 per cent market rate of interest, this would
only compound to 570,000 by the end of the year. -It isfinancially more attractive for the firm to retain 500,000 andaccumulate 575,000 on the shareholdersbehalf by investing inProject A, since they would have 5,000 more to spend at the
year end.
8/12/2019 Principels of Capital Investment -
17/35
Conversely, no one benefits if the firm invests in Project B, whose
value grows to only 560,000 by the end of the year.Management should pay the dividend.
But suppose that part of the companys clientele is motivated by apolicy of distribution. They need a dividend to spend their proportion
of the 500,000 immediately, rather than allow the firm to invest thissum on their behalf.
Armed with this information, should management still proceed with
Project A?
8/12/2019 Principels of Capital Investment -
18/35
Project evaluation
Projects should only be accepted if their post-taxreturns at least equal the returns that shareholders canearn on an investment of equivalent risk elsewhere.
Projects that earn a return less than this opportunity
rate should be rejected.
Project yields that either equal or exceed theiropportunity rate can either be distributed or retained.
The final consumption (spending) decisions ofindividual shareholders are determined independentlyby their personal preferences, since they can borrow orlend to alter their spending patterns accordingly.
8/12/2019 Principels of Capital Investment -
19/35
What is Capital Budgeting
The financial term capital is broad inscope. It is applied to non-humanresources, physical or monetary, short or
long. Similarly, budgeting takes many forms
but invariably comprises the detailed,
quantified planning of a scarce resourcefor commercial benefit
8/12/2019 Principels of Capital Investment -
20/35
Capital Investment Requirements Diversificationdefined in terms of new products,
services, markets and core technologies which do notcompromise long-term profits.
Expansion of existing activities based on a comparisonof long-run returns which stem from increasedprofitable volume.
Improvementdesigned to produce additional revenueor cost savings from existing operations by investing innew or alternative technology.
Buy or leasebased on long-term profitability in
relation to alternative financing schemes. Replacement intended to maintain the firms existing
operating capability intact, without necessarilyapplying the test of profitability
8/12/2019 Principels of Capital Investment -
21/35
Project Evaluation Methods
Pay Back (PB)
Accounting Rate of Return (ARR)
Net Present Value (NPV)
Internal Rate of Return (IRR)
8/12/2019 Principels of Capital Investment -
22/35
Project Evaluation MethodsPayback (PB) is the time required for a stream of cash flowsto cover an investments cost. The project criterion isliquidity: the sooner the better because of less uncertaintyregarding its worth. Assuming annual cash flows areconstant, the basic PB formula is given in years by:
PB = I0/Ct
PB = payback period
I0 = capital investment at time period 0
Ct = constant net annual cash inflow defined by t = 1
Managements objective is to accept projects that satisfytheir preferred, predetermined PB
8/12/2019 Principels of Capital Investment -
23/35
Short-termism is a criticism of management today, motivated by liquidity, rather than
profitability, particularly if promotion, bonus and share options are determined by next
years cash flow (think sub-prime mortgages).But such criticism can also relate to thecorporate investment model. For example, could you choose from the following using
PB?
Cash flows Year 0 Year 1 Year 2 Year 3
Project A (1000) 900 100 -
Project B (1000) 100 900 100
The PB of both is two years, so rank equally. Rationally, however, you might prefer
Project B because it delivers a return in excess of cost. Intuitively, I might prefer
Project A (though it only breaks even) because it recoups much of its finance in the
first year, creating a greater opportunity for speedy reinvestment. So, whose choice is
correct?
Unfortunately, PB cannot provide an answer, even in its most sophisticated forms.
Apart from risk attitudes, concerning the time periods involved and the size of
monetary gains relative to losses, payback always emphasizes liquidity at the expense
of profitability
Project Assessment Methods
8/12/2019 Principels of Capital Investment -
24/35
The formula to calculate payback period of a projectdepends on whether the cash flow per period from theproject is even or uneven. In case they are even, the
formula to calculate payback period is:
Payback Period = [Initial Investment /Cash Inflow perPeriod]
When cash inflows are uneven, we need to calculatethe cumulative net cash flow for each period and thenuse the following formula for payback period:
Payback Period = A +[ B/ C] In the above formula,Ais the last period with a negative cumulative cashflow;Bis the absolute value of cumulative cash flow at theend of the period A;
Cis the total cash flow during the period after A
8/12/2019 Principels of Capital Investment -
25/35
Project Assessment MethodsAccounting rate of return(ARR) therefore, is frequently used with
PB to assess investment profitability. As its name implies, this
ratio relates annual accounting profit (net of depreciation) tothe cost of the investment. Both numerator and denominatorare determined by accrual methods of financial accounting,rather than cash flow data.
ARR = Pt- Dt/ [(I0 - Sn)]
ARR = average accounting rate of returnPt = annual post-tax profits before depreciation
Dt = annual depreciationI0 = original investment at costS0 = scrap or residual value
The ARR is then compared with an investment cut-off rate
predetermined by management
8/12/2019 Principels of Capital Investment -
26/35
ARR - Example
Example 1:An initial investment of $130,000 is expected togenerate annual cash inflow of $32,000 for 6 years.Depreciation is allowed on the straight line basis. It isestimated that the project will generate scrap value of$10,500 at end of the 6th year. Calculate its accounting rate
of return assuming that there are no other expenses on theproject.
SolutionAnnual Depreciation = (Initial Investment Scrap Value) Useful Life in YearsAnnual Depreciation = ($130,000 $10,500) 6 $19,917Average Accounting Income = $32,000 $19,917 = $12,083Accounting Rate of Return = $12,083 $130,000 9.3%
8/12/2019 Principels of Capital Investment -
27/35
The Concept of Required Rate of Return
for a Project Given an unbiased estimate of cash flows of a project, at what
rate should we discount the cash flows of the project?
Cash flows should be discounted at the required rate ofreturn
the rate of return that similar risk class investments are providing inthe market or
the minimum rate of return that a project must earn to justifyinvestment of resources
Required rate chosen to discount the cash flows and to
compute the NPV must be appropriate to the risk of theproject.
8/12/2019 Principels of Capital Investment -
28/35
What if we choose a required rate of return that is
too high for the project given its riskiness?
We will end up rejecting some good projects,
because with a high discount rate the NPV will either bevery low or sometimes even negative, because we are
unnecessarily using a very conservative discount rate.
By rejecting good projects, the firm will compromise its
competitiveness and market value
8/12/2019 Principels of Capital Investment -
29/35
What if we choose a required rate of return that istoo low for the project given its riskiness?
We will end up accepting some bad projects,
because with a low discount rate the NPV will either behigh and positive, because we are unnecessarily using avery low discount rate.
By accepting bad projects, the firm will increase therisk of its cash flows.
This will compromise its competitiveness and marketvalue
8/12/2019 Principels of Capital Investment -
30/35
Weighted Average Cost of Capital
Choosing the right discount rate also know asrequired rate of return for a project is critical for itssuccess
Use a weighted-average cost of capital
A weighted-average of the cost of each componentof capital used to fund the project, where weightsrepresent the proportion of each component in thetotal capital for the project
An optimal cost of capital is the cost at which valueof the firm is maximum
8/12/2019 Principels of Capital Investment -
31/35
For an all equity firm Whenever a firm has excess cash, it can take one of
the two actions.
On the one hand, it can pay out the cash immediately as
dividend or it can invest extra cash in a project, paying out the future
cash flows of the project as dividends
A firm should invest money in the project only if the
project provides a return higher than the requiredrate of stockholders.
8/12/2019 Principels of Capital Investment -
32/35
Stockholders required rate is the opportunity
cost of not receiving dividend or the return
they would forgo by not receiving the
dividend, which will be the rate which similarrisk class investments are providing in the
market
8/12/2019 Principels of Capital Investment -
33/35
Required Rate of Return = rf+ (rmarketrf)
Market rate of return minus the risk free rate equalsmarket risk premium
If we multiply market risk premium by the beta of the
security, it is known as the security risk premium
Required rate of return equals risk free rate of returnplus security risk premium
How do we compute beta? = (i,m)/2m
Beta equals covariance between the security and themarket divided by the variance of the market
8/12/2019 Principels of Capital Investment -
34/35
Cost of Capital with Debt
If a firm uses both debt and equity to finance itsinvestments, we need to use overall cost of capital asthe discount rate
rwacc= (S/V rs) + (D/V rD (1-Tc))
Where rwacc= the weighted average cost of capital
S = market value of equity
D = market value of debt
V = total market value of the firm (D+S)
rs= cost of equity
rD= cost of debt
Tc = corporate tax rate
8/12/2019 Principels of Capital Investment -
35/35
Example of WACC Debt to equity ratio = 0.25
Beta of common equity = 1.15
Beta of debt = 0.3
Market risk premium = 10%
Risk free rate = 6%
Corporate Tax Rate = 35%
What is the overall cost of capital?
Rs = 6 + (10) 1.15 = 17.5%
rD = 6 + (10) 0.3 = 9%
Rwacc = (0.8 17.5) + (0.2 9 (10.35)) = 15.17%
Top Related