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OPTIMAL CAPITAL BUDGETING

THE COST OF CAPITAL

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INTRODUCTION BUDGETING

We have already discussed the capital structure of a firm as well as Capital budgeting and risk

We have also discussed the capital budgeting techniques

Through the discussions, we have mentioned cost of capital including the following

The importance of cost of capitalThe cost of capital : cost of debt; preferred stock;

retained earningsThe Weighted average cost of capital (WACC

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Factors affecting WACCFactors affecting cost of capitalI do not indent to repeat any of these

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BUDGETING

A budget is defined as a financial implementation tool. What is being implemented is the project identifiedThe project should be the best after FORCASTINGNeed to differentiate budgeting and forecastingForecasting is the process of evaluating various

options of implementing a particular project. The best forecast becomes the budgetBUT a budget is better defined as a set of activities for

implementation

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CRITICS

Critics of the budgeting process dismiss it and say:Takes too long to prepare.Doesn't help us run our business.Budgets are out-of-date by the time we get them.Too much playing with the numbers.Too many iterations / repetitive tasks within the

processBudgets are cast in stone in a constantly changing

business environment

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Too many people are involved in the budgeting process.

Unable to control budget allocations.By the time budgets are complete, I don't

recognize the numbers.Budgets do not match the strategic goals and

objectives of the organizationIntroduction of a slack

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BUDGETING IS IMPORTANT

Financial Planning is a continuous process that flows with strategic decision making

The Operating Plan and the Financial Plan will both support the Strategic Plan.

we have to take into account numerous factors before we can finalize our budgets

Budgeting should be flexible, allowing modification when something changes

For example, the following will impact budgeting:

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Life cycle of the businessFinancial conditions of the businessGeneral economic conditionsCompetitive situationTechnology trendsAvailability of resourcesBudgeting should be both top down and bottom

up; i.e. upper level management and middle level management will both work to finalize a budget

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We can streamline the budgeting process by developing a financial model.

Financial models can facilitate "what if" analysis so we can assess decisions before they are made

This can dramatically improve the budgeting process.

One of the biggest challenges within financial planning and budgeting is how do we make it value-added

Budgeting requires :

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clear channels of communication, support from upper-level management, participation from various personnel, and predictive characteristicsBudgeting should not strive for accuracy, but should

strive to support the decision making processIf we focus too much on accuracy, we will end-up

with a budgeting process that incurs time and costs in excess of the benefits derived

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The challenge is to make financial planning a value-added activity that helps the organization achieve its strategic goals and objectives

NOTE Budgeting is most useful when done as an integral part of an organizations strategic analysis

Strategic analyses consider how an organization combines its own capabilities with the opportunities in the marketplace to accomplish its overall objectives.

The following questions may be asked:

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What are the overall objectives of the organization?Are the markets for its products local, regional,

national or global? What trends will affect its markets? How do the economy, its industry and its competitor affect the organization?

What forms of organizational and financial structure serve the organization best?

What are the risks of the alternative strategies and what are the organizations contingency plans if its preferred plan fails

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WHO IS INVOLVED

Need for a budget committee consisting ofTop managementCost center/line managers (budget owners)The budget clerk (the accountant-keeps the

time schedule and records events)

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THE PROCESS

Zero based budgeting (ZBB)Also referred to as priority based budgeting It requires that all activities are justified and

prioritized before decisions are taken relating to the amount of resources to be allocated to each activity.

It is a method of budgeting, which requires each cost element to be specifically justified as though the activities to which the budget relates were being undertaken for the first time

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Without approval the budget allowance is zero. It is an attempt to overcome the disadvantage of

incremental budgeting by treating each budget period as though it were independent of past periods

It is cost benefits exercise which:Asks fundamental questions about existing cost levels

and the way in which existing operations are carried out.Examines the existing budget modelCritically evaluates the viability of cost centers in the

future.

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Incremental budget Also referred to as traditional budgeting method It is a method of budget setting in which the prior

period budget is used as a base for the current budget

set by adjusting the prior period budget to take account of any anticipated changes in activity levels and inflation.

The disadvantage of this approach is that it perpetuates any past inefficiency

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It may however be appropriate in cases such as staff salaries, which may be estimated on the basis of current salaries plus an increment for inflation.

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Kaizen Budgeting Kaizen is the Japanese term for continuous

improvementKaizen budgeting is a budgetary approach that

explicitly incorporates continuous improvement during the budget period into the resultant budget number

This may be achieved by continuous cost reduction.

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TYPES of Budget

Sales budget-literally the first budgetWhat products are going to be soldWhat is the maximum size of the marketWhat portion of the market can be capturedWho is going to the sell the products In what geographical areas are the products going to be

soldWhen will the products be soldWhat price will be charged for each unitHow many units will be sold

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The production budgetGeneral and administrative budgetThe cash budgetThe capital expenditure budgetThe master budget

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BUDGET STATEMENTS

Budget Balance sheetBudget Profit and lossBudget cash statement (EXAMPLE)

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ADVANTAGES OF BUDGETING

Motivation to workers particularly line managersApproval for expenditure hence saves timeThere is better management, coordination of

work and communicationManagers are continuously thinking about the

future strategic directionHolds managers to account since it clearly defines

areas of duty and responsibilityVariance analysis enhances control

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scarce resources are efficiently and effectively applied

Managers are able to pick and focus on priority areas accordingly

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MARGINAL COST OF CAPITALThe marginal cost of capital (MCC) is the cost of the last

dollar of capital raised, essentially the cost of another unit of capital raised.

As more capital is raised, the marginal cost of capital rises. A company’s cost of capital will remain unchanged as new

debt, preferred stock and retained earnings are issued until the company’s retained earnings are depleted.

Once retained earnings are depleted, the company will determine to access the capital markets to raise new equity

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This effectively raises the company’s WACCPleas refer to the WACC (and the formula of

computation)Again remember the factors affecting the WACC

of a firm as follows:FACTORS A FIRM WILL NOT CONTROL

The level of interest ratesMarket risk premiumTaxation rates

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FACTORS A FIRM WILL CONTROLCapital structure policyDividend policy Investment policy

MCC VERSUS WACCThe marginal cost of capital is simply the weighted

average cost of the last dollar of capital raised.As mentioned previously, in making capital decisions, a

company keeps with a target capital structure.

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There comes a point, however, when retained earnings have been depleted and new common stock has to be used

When this occurs, the company’s cost of capital increases. This is known as the "breakpoint" and can be calculated as follows:

Breakpoint for retained earnings = retained earnings

wce

WHERE wce WEIGHT FOR COMMON EQUITY

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EXAMPLE

Assume a company expect to earn KSH50 million next year. Assume further that the said company’s payout ratio is 30%. Lets assume wce = 55%?

REQUIREDWhat is the company’s breakpoint on the

marginal cost curve, SOLUTIONbreakpoint = KSH50 million (1-0.3) = SH63.6 million

0.55

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LETS REVIST THE OPTIMAL CAPITAL STRUCTURE

This simply means that managers should choose a capital structure that maximises the shareholder’s wealth.

This process may involve a trial capital structure, based on the market values of the debt and equity, and then an estimation of the wealth of the shareholders under this particular capital structure.

The idea is to repeat the process until an optimum capital structure is determined

FIVE STEPS HERE INCLUDE:

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1. Estimate the interest rate the entity will pay2. Estimate the cost of equity3. Estimate the weighted average cost of capital4. Estimate the free cash flows and their present

value, which is the value of the firm5. Deduct the value of the debt to find the

shareholders’ wealth, which is what we want to maximize

NOTE: FURTHER READING PG 504-513 MAIN TEXT

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THE INVETMENT OPPORTUNITY SCHEDULE

The concept behind the IOS is very similar to that of the MCC schedule

The MCC schedule represents the cost of capital faced by the firm (ranking from the cheapest to the most expensive)

The IOS represents the projects that are available to the firm (ranking them from the most desirable to the least desirable).

In order to construct the IOS, the firm needs to first estimate the IRR of each of the project it is considering.

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Once that is accomplished, the financial manager can plot the IOS, which is a chart of the IRRs of the firm’s projects arranged from the highest IRR to the lowest IRR

FOR EXAMPLELets say a firm is interested in five independent

projects, and the financial information regarding those projects is presented in the following table.

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PRO1 PRO 2 PRO 3 PRO 4 PRO5 KSH KSH KSH KSH KSH

Outlay 250,000 100,000 100,0000 120,000 200,000 IRR 34.54% 39.03% 33.87% 14.28% 16.41%Payback 2.21 1.5 1.83 3.5 4.33

Using this information, the projects can be arranged from the highest IRR to the lowest IRR as follows:

Projects 2, 1, 3, 5 and 4

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IRR 39.03

34.54

33.87

16.41

14.28

100,000 350,000 450,000 650,000 770,000 NEW CAPITAL

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EXPLANATIONS

From the IOS above, we know that if the firm decides to undertake all five projects, it will need an investment budget of $770,000

However, the firm does not know if this is advisable because it does not know if all the projects will be able to generate a high enough return (i.e. IRR) to cover the cost of raising the new capital)

In order to make the correct decisions, the firm needs to combine its IOS with its MCC schedule to determine which project it should undertake and which project it should reject.

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CAPITAL RATIONING

The act or practice of limiting company's investmentCapital rationing occurs when a company's

management places a maximum amount on new investments it can make over a given period of time

The two methods of capital rationing are : forbidding investments over a certain amount or increasing the cost of capital for such investmentsCapital rationing is most common when a company's

previous investments have not performed well.

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THE DIVIDEND POLICY

What is dividend?A dividend is the distribution of profits to a

company's shareholdersThe primary purpose of any business is to create

profit for its owners, and the dividend is the most important way the business fulfils this mission.

When a company earns a profit, some of this money is typically reinvested in the business and called retained earnings, and some of it can be paid to its shareholders as a dividend

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Paying dividends reduces the amount of cash available to the business, but the distribution of profit to the owners is, after all, the purpose of the business.

Some companies pay "stock dividends" rather than cash dividends, in which case shareholders receive additional stock shares.

The amount of the dividend is determined every year at the company's annual general meeting, and declared as either a cash amount or a percentage of the company's profit

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The dividend is the same for all shares of a given class (that is, preferred shares or common stock shares)

Once declared, a dividend becomes a liability of the firm.

When a share is sold shortly before the dividend is to be paid, the seller rather than the buyer is entitled to the dividend

At the point at which the buyer is not entitled to the dividend if the share is sold, the share is said to go ex-dividend

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This is usually two business days before the dividend is to be paid, depending on the rules of the stock exchange

When a share goes ex-dividend, its price will generally fall by the amount of the dividend.

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HOW DIVIDEND DETERMINED

The dividend is calculated mainly on the basis of the company's un-appropriated profit and its business prospects for the coming year

It is then proposed by the Executive Board and the Supervisory Board to the annual general meeting

At most companies, however, the amount of the dividend remains constant.

This helps to reassure investors, especially during phases when earnings are low, and sends the message that the company is optimistic with respect to its future performance.

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Some companies have dividend-reinvestment plans.

These plans allow shareholders to use dividends to systematically buy small amounts of stock often at no commission

Dividends are not yet paid in gold certificates although this idea has been discussed by mining companies such as Goldcorp.

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WHY COMPANIES AVOID DIVIDEND PAYMENT

Companies have often avoided paying dividends for several reasons:

To reinvest to grow: Company management and the board believe that it is important for the company to take advantage of opportunities before it, and reinvest its recent profits in order to grow, which will ultimately benefit investors more than a dividend payout at present.

Double taxation: When dividends are paid, shareholders in many countries, including the United States, suffer from double taxation of those dividends: the company pays income tax to the government when it earns any income, and then when the dividend is paid, the individual shareholder pays income tax to the government on the dividend payment.

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-This is often used as justification for retaining earnings, or for performing a stock buyback, in which the company buys back stock, thereby increasing the value of the stock left outstanding. The shareholder pays no income tax on this transaction.

Microsoft is an example of a company which has historically been a proponent of retaining earnings; it did so from its IPO in 1986 until 2003, when it declared it would start paying dividends. By this point Microsoft had accumulated over $43 billion in cash, and there had been increasing irritation from stockholders who believed this large pile of cash should lie in their hands and not in the company's, YET Microsoft had no conceivable good reason to have that much money sitting in the bank!.

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Safaricom- the largest telecommunication and riches company south of the Sahara has ‘increased’ its dividends payout to 2cents per share! Mockery on stockholders?

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PAYMENT PROCEDURESDeclaration date- the date directors meet and declare

dividendHolder-of-record date- the date records are compiled and

closed for dividend purposes. For example say that date is January 5th- if the company is notified of the sale before January 5th, 5pm, then the new owner is paid dividend. If notification to sale is received on January 6th, the previous owner is paid the dividend

Ex-dividend date- the securities industry has set up a convention under which the right to the dividend remains with the stock until two business days prior to the holder-of-record date.

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Payment date- the date the company mails out the checks to the holders of record, usually the payment date

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FACTORS INFLUENCING DIVIDEND PAYMENTS

Constraints on dividend paymentInvestment opportunitiesAvailability and cost of alternative sources of

capitalEffects of dividend policy on rs (required rate

of return on equity)MORE PAGE 567-568

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TYPES OF DIVIDENDS

Cash dividends-the most commonStock dividends- a ratable distribution of additional

shares of stockProperty (in kind) dividend: Distributed in the form of

assets by the issuing company or a subsidiary company.Other types of dividend: Warrants and financial assets

having market value are also distributed in the form of dividends.

Liquidating Dividends – a distribution of capital assets to shareholders.

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OTHER MATTERS

Stock Splits – each of the outstanding shares is broken into a greater number of shares.

Redemption of Shares – a corporation's exercise of the right to purchase its own shares.

Acquisition of Shares – a corporation's repurchase of its own shares.

Scrip/Bonus issue- Allocation of additional shares to existing shareholders in proportion of shares held- from retained earnings or share premium/reserve account

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LEGAL RESTRICTIONS

Dividends – dividends may be paid only if the following tests are satisfied:Cash Flow Test – a corporation must not be or become

insolvent (unable to pay its debts as they become due in the usual course of business).

Balance Sheet Test-Means company should not mess up with approved capital structure varies among the States and includes the earned surplus test (available in all States), the surplus test, and the net assets test (used by the Model and Revised Acts).

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Legal Restrictions on Liquidating Distributions – States usually permit distribution in partial liquidation from capital surplus unless the company is insolvent.

Legal Restrictions on Redemptions of Shares – in most States, a corporation may not redeem shares when insolvent or when such redemption would render it insolvent

Legal Restrictions on Acquisition of Shares – restrictions similar to those on cash dividends usually apply.

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DIVIDEND THEORIES

Dividend irrelevance theory- M&M Merton Miller and Franco Modigliani argue that a firm’s value is determined only by its basic earnings power and its business risk

This argument effectively meant that a firm’s value is determined only by the income produced by its assets, AND NOT HOW THIS INCOME IS SPLIT BETWEEN DIVIDENDS AND RETAINED ESRNINGS

Thus dividend is irrelevant

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Bird-in-the-Hand theory- this theory argues in favour of dividends

Proponents argued that the required rate of return on equity rs decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which are supposed to result from retaining earnings than they are of receiving dividend payments.

Thus dividend payment is preferred

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Tax-preference theory- this theory deals with tax reasons that make investors prefer low to higher dividend payments namely:

Capital gains have lower tax than dividends-in Kenya capital gains are tax exempt

Capital gains tax is not paid until the stock is soldStocks held until death attract no capital gains tax at allThese reasons make investors prefer to have

companies retain profits

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The signalling hypothesis- it is a general business observation that AN INCREASE IN DIVIDEND PAYOUT is often accompanied by an INCREASE IN THE PRICE OF THE STOCK and a dividend cut leads to a stock price decline

This may help to conclude that investors prefer dividends to capital gains

Clientele effect-dividend payout is affected by clientele needs accordingly

For example retired people, pension funds and university endowment funds may prefer dividend payouts because they are in LOW TAX BRACKETS

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On the centrally, individuals at their peak earnings may prefer capital gains because they are at the HIGHEST TAXATION brackets.

KENYAAre Kenya dividend policies any different?

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HYBRID FINANCING

Preferred stockWarrantsConvertiblesWarrants versus convertiblesOutstanding convertiblesCalling convertiblesInnovative new hybrids

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PREFERRED STOCKThis is a hybrid stockBecause the owner of a preferred stock receives a promise

to pay a stated dividend , usually every quarter for an infinite period.

Preferred stock is similar to bonds in some aspects (receives a known streams of payments) and to common stocks in other aspects (the issuer does not have the same legal obligation to pay investors as do issuers of bonds)

It imposes a fixed charge and therefore increases the firm’s financial leverage

Pays preferred dividend

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TYPES These stocks having contractual rights superior to those of

common stock and they include:

Dividend Preferences – must receive full dividends before any dividend may be paid on common stock

Liquidation Preferences – priority over common stock in corporate assets upon liquidation.

Adjustable rate preferred stock- don't pay fixed dividend instead dividend tied to the rate of Treasury securities

Market auction preferred stock- holders have the right to auction their shared every seven weeks

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ADVANTAGES OF PREFERRED STOCK

In contrast to bonds, the obligation to pay preferred dividends is not firm, and passing a preferred dividend can not force a firm into bankruptcy

By issuing preferred stock, the firm avoids the dilution of common equity that occurs when common stock is issued

Since preferred stock sometimes has no maturity, and since preferred sinking fund payments, if present, are typically spread over a long period of time, preferred issues reduce the cash flow drain from repayment of principal that occurs with debt issues

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DISADVANTAGES

Preferred stock dividends are not normally deductible to the issuer, hence the after-tax cost of preferred is typically higher than the after-tax cost of debt. However, the tax advantage of preferreds to corporate purchasers lowers its pre-tax cost and therefore its effective cost

Although preferred dividend can be passed, investors expect them to be paid, and firms intend to pay the dividend if conditions permit. Thus preferred dividends are considered to be fixed cost. Therefore their use, like debt, increases financial risk and consequently the cost of common equity.

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WARRANTS

This is a certificate issued by a company that gives the holder the RIGHT to buy a stated number of shares of the company’s stock at a specified price for some specified length of time

If all taken, they cause dilution to the earnings per share of common equity

MORE PG 672-677

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CONVERTIBLESThese are bonds or preferred stocks that, under specified

terms and conditions, can be exchanged for (or converted into) common stock at the option of the holder.

They do not bring in any additional funds for the firm- like warrants do-

But they are just a replaced on the balance sheet by common stock

They too however cause dilution to earnings per share on common equity

MORE PG 677-687 MAIN TEXT

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DIFFERENCE BETWEEN WARRANTS AND CONVERTIBLES

Warrants are usually issued privately- most convertibles are issued publicly

Warrants can be detached and thus can be sold separately- convertibles , both the bonds and options are bundled together and can not be sold separately

Warrants may be issued on their own and necessarily in conjunction with other securities- convertibles are not

Warrants are exercised for cash- convertibles are notA package of bonds and warrants may be taxed differently-

thus there are tax differences between warrants and convertibles accordingly.

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INNOVATIVE HYBRID FINANCING

A hybrid debt security is a form of debt security, which is blended with derivatives like swap, forward or option.

Previously, the most popular type of hybrid security was the convertible debenture or convertible bond

In the earlier part of 1980s, nevertheless, a unique category of hybrid securities achieved a lot of recognition, specifically in the United States.

The hybrid securities are usually fundamental tools that are utilized for handling risk

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EMERGING ONES

Hybrids for handling commodity risk: Oil-indexed bond, which was issued by Standard Oil in the year 1986. This blended a zero coupon bond along with a call option on oil with similar maturity period

Hybrids for handling foreign exchange risk: Dual currency bond, which was issued by Philip Morris Credit in the year 1985. The coupon payments were disbursed in Swiss francs and the principal was disbursed in United States Dollar.

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Hybrids for handling interest rate risk: Inverse floating rate notes. The Student Loan Market Association or Sallie Mae issued this hybrid security in the year 1986. They were also known as yield curve notes. These notes can be broken down into two portions, i) a plain vanilla interest rate swap and ii) a variable rate bullet repayment note

Hybrids for diminishing the differences between bondholders and stockholders: Variable rate, rating sensitive note. This was issued by Manufacturer Hanover in the year 1988