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Capital Budgeting
I. Overview
Capital budgeting.
Because capital budgeting decisions are long-term and relatively inflexible.
Using a ranking procedure.
- To determine the asset cost or net investment.
- Calculate the period estimated cash flows.
- Relate the cash-flow benefits to their cost by using the method to evaluate the purchase.
- Rank the investments and choose the best.
Present value and future value (time value of money).
Breakeven time.
Payback period.
Net present value (NPV).
Internal rate of return (IRR).
Profitability or excess present value.
The degree of financial leverage (DFL).
Financial leverage.
Operating leverage.
The degree of operating leverage (DOL).
Degree of financial leverage times the degree of operating leverage.
The cost of capital.
The weighted-average cost of capital.
The cost of debt.
The cost of retained earnings.
Because of stock floatation costs.
The cost of preferred stock.
Capital asset pricing model (CAPM) and the dividend growth model.
II. General Concepts
Discounted cash flow model
- Future operating cash savings.
- The disposal prices of the current and future assets.
- The tax effects of future asset depreciation.
Because it affects cash payments for taxes or income taxes that must be paid.
The minimum desired rate of return set by the entity or management.
The discount rate used in the analysis.
Profitability index method.
When a project’s returns exhibit low variability and negative correlation.
Discount each cash flow using a discount rate that reflects the degree of risk.
Sensitive analysis.
- Increase the estimated cash inflows.
- Increase the discount rate.
- The initial investment in the new equipment.
- Any required investment in working capital.
- Current disposal price of the new equipment.
- Current disposal price of the old equipment.
- Operating costs of old equipment.
- Operating cost of the new equipment.
III. Payback
The payback period.
Advantages
- It is simple.
- It is easy to understand.
Disadvantages
- It ignores the time value of money.
- It does not consider returns return after the payback period.
The bailout payback period.
It measures the risk based on the shorter the period, the lower the risk.
IV. Cost of Capital
The purpose is to minimize the weighted-average cost of capital and maximizes the entity’s value reflected in its stock price.
The financial structure includes short-term debt plus long-term accounts.
(Note: Financial structure includes all of the accounts on the credit side of the balance sheet.)
The capital structure consists of equity and long-term debt.
The marginal cost of capital.
Because the lower-cost sources of funds are used first.
An optimal capital budget is achieved.
The output should increase until marginal cost equals marginal revenue.
- Expected market earnings.
- The current US Treasury bond yield.
- Beta coefficient.
Beta coefficient.
When DFL increases, fixed interest charges and risk increase.
As a result, the variability of the returns to equity holders increases.
Thus, the standard deviation of return on equity increases.
The degree of financial leverage (DFL).
The higher the dividend payout ratio, the sooner retained earnings are exhausted, and external financing must be obtained.
The dividend growth model R= D/P+G is rewritten to P=D/(R-G).
When investors have a lower rate of return on equity, the denominator is smaller, which translates into higher market value.
The cost of new debt minus the interest rate times the firm’s marginal tax rate or the tax savings.
Because when the nominal interest rate increases, the rate of return on equity also increases. Thus, the denominator under P=D/(R-G) is larger, which translates into a lower market value.
- Current dividend per share.
- The expected growth rate in dividends per share.
- Current market price per share of common stock.
- It must be estimated.
- It exists but is not specially stated.
- It is the result of a process designed to recognize economic reality.
- An imputed cost may not require a dollar outlay formally recognized by the accounting system, but it is relevant to the decision-making process.
Increase in the cost of debt and equity as the debt-to-equity ratio increases.
- Lower-cost capital sources are used first. Additional projects must then be undertaken with funds from higher-cost sources.
- Similarly, the risk is increased because the most profitable investments are made initially, leaving the less profitable investments for the future.
V. Net Present Value
The net present value.
- Ability to perform sensitivity analysis.
- It is easily adapted for risk by adjusting the discount rate.
- It does not provide the true rate of return for an investment.
If investors desire no risk, that is, a certain rate of return, the risk-free rate is used in calculating NPV.
It can be used when there is no constant rate of return required for each period year.
It increases the present value of the depreciation tax shield.
he projects should be accepted with an NPV greater than zero or a positive NPV.
The profitability index (present value index).
The profitability index (present value index).
Because the profitability index is based on the NPV method, it results in the same decision as the NPV in the absence of capital rationing.
VI. Internal Rate of Return
- The discount rate in which the NPV of the cash flows is zero.
- The breakeven borrowing rate for the project in question.
- The yield or effective rate of interest quoted on long-term debt and other instruments.
- Emphasis on cash flows.
- Recognition of the time value of money.
- The NPV criterion is that the NPV is positive, and the criterion is that the desired rate of return is less than the IRR.
- When the desired rate of return is less than the IRR, the NPV is positive.
- When it exceeds the IRR, the NPV is negative.
- Accordingly, when two projects are independent, the NPV and IRR criteria always result in the same accept or reject decision.
- The investment cost is lower.
- Cash inflows are received earlier in the life of the project.
- Lager cash inflows.
- The project has a shorter payback period.
When multiple projects have unequal lives, and the investment size for each project is different.
It implicitly assumes that the firm is able to reinvest project cash flows at the project’s internal rate of return.
Because it determines the total present value for each feasible combination project when an investor invests in projects that generate the most dollars of the limited resources available and the size and returns from the possible investments.