Chapter 10, 11, 12 - Cost of capital, Basics of capital Budgeting, Cash Flow Estimation and Risk Analysis

capital budgeting

analysis of potential additions to fixed assets, long-term decisions that involve large expenditures

1. estimate cash inflows/outflows

2. assess the riskiness of CFs

3. Determine the appropriate cost of capital

4. Use capital budgeting tooks

5. Make decision to accept/reject the project

Payback

the length of time required for an investment’s CFs to cover its costs

Strengths - liquidity measure - breakeven calculation; easy to understand/compute

Weakness - doesn’t consider TVM, no clear accept/reject criteria since it only conveys when the firm will recover the investment, does not consider CFs after payback period, does not account for the differences in size among projects

discounted payback

the length of time required for an investments’ CFs, discounted at the investment cost of capital, to cover its costs

S - liquidity measure, easy to understand/compute, considers TVM

W - no clear accept/reject, does not consider CFs after payback, does not account for differences in size among projects

independent projects

projects with CFs that are not affected by the acceptance of other projects (can accept if more than one project)

Mutually exclusive projects

can only accept the best or most profitable project

Net present value (NPV)

PV of project’s FCF discounted at the WACC

S - considers TVM, uses all CFs, tells us how much a project contributes to shareholder wealth hence it is the best criteria, clear accept reject criteria - independent (accept if NPV>0) - mutually exclusive - (accept project with highest NPV>0)

Internal Rate of Return (IRR)

the discount rate that forces a project’s NPV to equal zero; makes PV of future CFs to equal initial cost

S - considers all CFs, TVM, easy interpretation - rate of return, clear accept/reject criteria - independent (accept if IRR>WACC) - ME - accept project with highest IRR>WACC

W - not appropraite for mutually exclusive projects (NPV and IRR may conflict) - reinvestment rate consumption

Multiple IRRs

occurs with nonnormal CFs

Modified IRR (MIRR)

discount rate at which the PV of a project’s cost (outflows) is equal to the PV of its terminal value (FV of inflows) found by compounding the cash inflows at the firm’s WACC

S - assumes CFs are reinvested at WACC, avoids the multiple IRR problem, clear accept reject criteria - independent - accept if MIRR>WACC ME - accept project with highest MIRR>WACC

W - decision conflicts can still arise when examining mutually exclusive projects

NPV profile

a graph showing the relationship between a project’s NPV and firms cost of capital

crossover rate

the cost of capital at which the NPV profiles of two projects cross and the projects NPVs are equal

WACC - weighted average cost of capital

a weighted average of the component costs of debt, preferred stock, and common equity

Optimal Capital Structure

the % of debt, PS, and CE that will maximize the firms stock price

new common equity is raised in two ways

retained earnings - cost is an opportunity cost - stockholders can use the payments as dividends and earn a return on an alternative investment

issue new common stock - floatation costs- fees paid to an investment bank to issue

3 methods to estimate the cost of CE

CAPM, bond yield plus risk premium approach, discounted cash flow

Project’s NPV

PV of its discounted FCFs

Incremental CFs

CFs that will occur if and only if the firm takes a project

Sunk costs

cash outlay that has already been incurred and cannot be recovered regardless of whether the project is accepted or not - not an incremental CF bc incurred in the past (only consider FCFs) so not relevant in capital budgeting analysis

opportunity cost

the best return that could be earned on assets the firm already owns if those assets are not used for the new project - should be accounted for in analysis

externalities

effects of the project on the other parts of the firm or the environment - should be accounted for in the analysis

negative within firm externalities

cannibalization - the situation when a project reduces CFs that the firm would otherwise have earned (e.g. new products compete with old ones)

positive within firm externalities

complimentary - new project which increase the CFs in the old operation when new project is introduced

environment externalities

positive or negative effects on the environment which might be accounted for in CFs even if those effects are difficult to quantify

stand-alone risk

project’s risk assuming it is the only project a firm has and the firm is the only stock held by investor, diversification is ignored, measured by variability of project expected return (SD)

corporate/within firm risk

project’s risk when it is one of many projects of the firm (some diversification)

market/beta risk

riskiness of project as seen by a well-diversified investor who recognizes - the project is only one of the firm’s assets, firm’s stock is only one part of their portfolio (measured by beta)