Principels of Capital Investment -

8/12/2019 Principels of Capital Investment -

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Financial Policy and

Planning chapter 6(capitalbudgeting)


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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


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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


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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.


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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


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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)


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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.


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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.


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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


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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


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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.


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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.


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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.


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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.


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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?


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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.


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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


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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


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Project Evaluation Methods

Pay Back (PB)

Accounting Rate of Return (ARR)

Net Present Value (NPV)

Internal Rate of Return (IRR)


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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


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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


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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


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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


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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%


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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.


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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


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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


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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


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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.


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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


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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


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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


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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%

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Principels of Capital Investment -