Finn Theory & Practice 11-12

Chapter 11

Capital

A firmโ€™s sources of financing to fund its assets

  • Preferred Stock

  • Long-term Debt

  • Common Stock

Capital Structure: The relative proportions of debt, equity, and other securities that a firm has outstanding

Cost of Capital: Reflects the average riskiness of all the securities the firm has issued

  • Indicates how the market views the risk of those assets

The return to an investor (required return) is the same as the cost to the company (cost of capital)

  • A firm must earn at least the required return to compensate investors for the financing they have provided

Cost of Capital can be helpful for:

  • Capital budgeting decisions

  • Financing decisions

  • Operating decisions

Cost of Debt

The required return that lenders require on the companyโ€™s new debt

  • Estimated by computing the Yield-to-Maturity (YTM) on the existing long-term debt

  • YTM: Return bond purchasers would earn if they held the debt to maturity and received all the payments as promised

๐‘ช๐’๐’”๐’• ๐’๐’‡ ๐‘ซ๐’†๐’ƒ๐’• = ๐‘นD = ๐’€๐‘ป๐‘ด

Debt and Equity are not equal in the eyes of the firm

  • We need to consider TAX

  • We are concerned with after-tax cash flows

  • Debt gets a tax advantage (interest paid on debt is tax-deductible)

  • This reduction in taxes reduces the Cost of Debt

  • Equity does not have tax advantage (dividends are not tax deductible)

๐‘ฌ๐’‡๐’‡๐’†๐’„๐’•๐’Š๐’—๐’† ๐‘ช๐’๐’”๐’• ๐’๐’‡ ๐‘ซ๐’†๐’ƒ๐’• = ๐‘นD โˆ— (๐Ÿ โˆ’ ๐‘ปC)

where TC is the Corporate Tax Rate

Capital Structure Weights

Weights of each source of funds

  • Always use the target weights (if not available, use market values)

  • A firmโ€™s market value is the sum of the market value of each capital

  • MV of Firm = MV of Debt + MV of Equity + MV of Preferred Stock

  • V = D + E + PS

    • D = # of outstanding bonds * market price of each bond

    • E = # of outstanding common stock * market price of each common stock

    • PS = # of outstanding preferred stock * market price of each preferred stock

  • The capital structure weights must always add up to 100%

  • WD: % financed with Debt

  • WE: % financed with Equity

  • WPS: % financed with Preferred Stock

The Weighted Average Cost of Capital (WACC)

  • WACC represents the overall return the firm must earn on its existing assets to maintain the value of the firm

    • The required return on the firmโ€™s assets, based on the marketโ€™s perception of the risk of those assets

    • Do not find the dollar amount; it should be a percentage

    • Decrease debt, increase equity, tax goes up, tax savings will be less

  • ๐‘พ๐‘จ๐‘ช๐‘ช = [WD โˆ— RD โˆ— (๐Ÿ โˆ’ TC)] + [WE โˆ— RE]

  • ๐‘พ๐‘จ๐‘ช๐‘ช = [WD โˆ— RD โˆ— (๐Ÿ โˆ’ TC)] + [WE โˆ— RE] + [WPS โˆ— RPS]

Factors that influence a companyโ€™s WACC

Uncontrollable Factors:

  • Market conditions (especially interest rates)

  • The market risk premium

  • Tax rates

Controllable Factors:

  • Capital structure policy

  • Dividend policy

  • Investment policy

    • Firms with riskier projects generally have a higher cost of equity

Divisional/Project Costs of Capital

Can we use WACC as the appropriate discount rate for different divisions or for specific

projects to make a decision?

  • The WACC reflects the risk and the target capital structure of the firmโ€™s existing assets as a whole

  • Using the WACC as a discount rate is only appropriate for projects/divisions that have the same risk as the firmโ€™s current operations

  • Divisions and different projects often require separate discount rates because of the relative risk of each division

If a single WACC was used for every division:

  • Riskier divisions would get more investment capital

  • Less risky divisions would lose the opportunity to invest in positive NPV projects

Project Risk Differentiation

How can we calculate the appropriate discount rates?

The Pure Play Approach

  • Find one or more companies that specialize in the product or service that we are considering

  • Compute (or research) the beta for each company and take the average of the betas

  • Use that beta along with the CAPM to find the appropriate return for a project of that identical risk

The Subjective Approach

  • Consider the projectโ€™s risk relative to the firm overall

  • If the project has more risk than the firm, use a discount rate greater than the WACC

  • If the project has less risk than the firm, use a discount rate less than the WACC

Floatation costs increase the cost

Beta increases, the company is riskier, the cost of equity goes up, WCA would go up

Chapter 12

Capital Budgeting

The process of identifying, evaluating, and selecting long-term investments that contribute to the firmโ€™s goal of maximizing ownersโ€™ wealth

Why is it so important?

  • Analysis of potential projects

  • Long-term decisions

  • Large expenditures

  • Difficult/impossible to reverse

  • Determines the firmโ€™s strategic direction

Decision Rule Criteria

  • Adjust for the time value of money

  • Adjust for risk

  • Provide information about creating value for the firm

  • Consider all cash flows

  • Allow to rank projects

Net Present Value (NPV)

The measure of the difference between the market value (benefit) of an investment and its cost

  • Estimate NPV by using Discounted Cash Flow (DCF) valuation techniques

  • NPV measures the contribution of a particular investment to the firmโ€™s wealth

    • NPV is the dominant method, always prevailing over others

  • The Net Present Value (NPV) Rule is

    • Accept any investment that has a positive NPV (NPV > $0)ย ย ย ย 

    • Reject any investment that has a negative NPV (NPV < $0)

Internal Rate of Return (IRR)

On an investment, the required return is the return that results in a zero NPV when it is used as the discount rate.

  • Most important alternative to NPV

  • Based on the estimated cash flows and independent of interest rates

  • Intuitively appealing

The Internal Rate of Return (IRR) Rule is

  • Accept any investment if the IRR is greater than the required return

  • Reject any investment if the IRR is less than the required return

Try to find a single rate of return (internal) that summarizes the merits of a project

  • Only depends on the cash flows, not on rates offered elsewhere

NPV vs. IRR

  • Non-Conventional Cash Flows

    • Cash flow sign changes more than once

    • Multiple rates of return problem

  • Mutually Exclusive Projects

    • Taking one investment prevents the taking of another

    • The scale of investments is substantially different

    • The timing of cash flows is substantially different

    • Will not reliably rank projects

  • NPV or IRR:

  • IRR approach assumes that the firm reinvests intermediate cash inflows at a rate equal to the projectโ€™s IRR

  • NPV approach implicitly assumes that the firm can reinvest intermediate cash inflows at the cost of capital (more realistic)

  • Whenever there is a conflict between NPV and another decision rule, always use NPV

Profitability Index

  • Measures the benefit per unit cost, based on the time value of money

    • Present value of the future cash flows divided by the initial investment (very similar to NPV)

    • Also called the benefit-cost ratio (the value created per dollar invested)

Decision Rule

  • Accept the project if the profitability index is more than 1

  • Reject the project if the profitability index is less than 1

Payback Period

The time it takes to generate cash inflows sufficient to recover the initial cost of the investment

  • Based on the notion that an investment pays back the initial investment quickly is good

  • Estimate the cash flows from the project

  • Subtract the future cash flows from the initial cost

Decision Rule

  • Accept the project if the payback period is less than the preset limit

  • Reject the project if the payback period is more than the preset limit

Payback Period ignores the time value of money

Discounted Payback Period finds the point in time at which the project reaches a zero NPV

  • Find the PV of each cash flow

  • Use the discounted cash flows to find the Payback Period

Modified Internal Rate of Return (MIRR)

Controls for some problems with IRR (such as multiple rates)

Discounting Approach

  • Discount future cash outflows to the present and add to the initial cash outflow

Reinvestment Approach

  • Compound all future cash flows to the end

Combination Approach

  • Discount future cash outflows to the present and add to the initial cash outflow

  • Compound all future cash inflows to the end

MIRR will be a unique number for each method

Mutually Exclusive Projects (Unequal Lives)

Different lives?

Replacement Chain (Common Life)

  • Repeat (replicate) each project in the future so that they will both terminate in a common year

  • Calculate NPV using the adjusted cash flows for both projects

Equivalent Annual Annities (EAA)

  • Convert the unequal annual cash flows of a project into a constant cash flow stream (an annuity) whose NPV is equal to the NPV of the initial stream

  • Do for both projects and compare the annuities

Several potentially serious weaknesses

  • If inflation occurs, then replacement equipment will have a higher price, and both sales prices and operating costs will probably change

  • Replacements that occur down the road would probably employ new technology, which in turn might change the cash flows

  • Difficult to estimate the lives of most projects

Economic Life vs. Physical Life

Projects are normally evaluated under the assumption that the firm will operate them over their full physical lives

  • May be better to terminate a project before the end of its potential life (EX, because of high maintenance costs)

Economic Life

  • The number of years a project should be operated to maximize its Net Present Value (often less than the maximum potential life)

To find the economic life

  • Consider all cash flows (including salvage value from the sale of assets

  • Find the projectโ€™s NPV under different assumptions about how long it will be operated

Analyzing The Project

Sensitivity Analysis

  • Determines how the NPV changes as a single underlying assumption is changed, holding the other assumptions constant

Break-Even Analysis

  • Determines the level of an input that causes the NPV of the investment to equal zero

  • Can also perform Accounting Break-Even analysis (determine the level of a particular parameter for which a projectโ€™s EBIT is zero)

Scenario Analysis

  • Determines how the NPV changes as several underlying assumptions are changed simultaneously