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1 Corporate Finance Capital Budgeting Cost of Capital Measures of Leverage Dividends and Share Repurchases Working capital management Corporate Governance of Listed Companies Slide 1
2 Capital Budgeting Slide 2
3 Capital Budgeting Capital budgeting is the process that companies use for decision making on capital projects with a life of a year or more. Capital budgeting process Idea generation Analyzing project proposals Planning the capital budget Monitor decisions & conduct postaudit Basic principles of Capital budgeting Use after tax cash flows for decisionmaking Based on incremental cash flows consider opportunity cost consider externality/cannibalization do not consider sunk cost Financing costs are ignore, due to reflected in the project s required rate of return Timing of the cash flows is important Slide 3
4 Capital Budgeting Capital projects Capital project types Replacement projects maintain the business Replacement projects cost reduction Expansion projects New products & markets Mandatory projects safety and environmental Others Project interaction Independent vs mutually exclusive projects Project sequencing Unlimited funds vs capital rationing Slide 4
5 Methods to evaluate project Net Present Value (NPV) Internal Rate of Return (IRR) Payback / Discounted payback period NPV = present value of expected cash inflows less the present value of cash outflows IRR = the discount rate which gives NPV = 0 Number of years to recover the investment cost Accept if NPV > 0 Reject if NPV < 0 Accept if IRR > required rate of return for a project Payback period has many flaws; should use NPV or IRR Average Accounting Rate of Return (AAR) Profitability Index (PI) AAR Average netincome Average bookvalue PV of future cash flows PI Initial investment NPV 1 Initial investment AAR based on accounting data, not cash flow; also ignore time value of money Accept if PI > 1 Reject if PI < 1 Slide 5
6 NPV Profile Definition: NPV profile show a project s NPV graphed as a function of various discount rates. NPV Undiscounted future cash flow initial investment outlay Or the sum of all the undiscounted cash flow $120 P r oject A: 200,80,80,80,80 10% Discount rate(%) Convex from the origin NPV declines at a decreasing rate as the discount rate increases. IRR IRR is the discount rate that makes the PV of future cash flows equal to investment outlay. When can we accept this project? Slide 6
7 NPV Profile NPV $200 Project B: 200,0,0,0,400 Mutually exclusive projects IRR A=10%> IRR B=8% NPV A=NPV B when discount rate is 6% $120 Project A: 200,80,80,80,80 6% Crossover rate 8% 10% IRRs Discount rate(%) If required rate of return 5%< crossover rate 6%, then NPV and IRR criterion have conflicts. Project B realizes its cash payoffs later than project A. Project B s NPV profile is more steeper than project A. Slide 7
8 IRR problems Multiple IRR problem Example: Time CF 2,000 10,00012,000 2 IRRs for this example: 100% and 200% NPV Positive NPV 0 Negative NPV Discount rate 100% 200% No IRR problem Example: Time CF NPV 0 Discount rate No IRR ie no discount rate that gives NPV= 0 Slide 8
9 NPV and IRR Conflict in ranking when using NPV and IRR Single project and independent projects: NPV and IRR will agree on whether to invest or to not invest. Mutually exclusive projects: NPV and IRR may result in conflicting rankings, due to: Projects have different timing of cash flows The projects (CF 0 ) are different sizes Different reinvestment rate assumptions: IRR uses project IRR vs NPV uses cost of capital NPV is the preferred choice for ranking mutually exclusive projects NPV: money amount NPV: different sizes NPV: even cash flow & noneven cash flow NPV: increase shareholders wealth Slide 9
10 Example Two mutually exclusive projects have the following cash flows ( ) and internal rates of return (IRR): Project IRR Year 0 Year 1 Year 2 Year 3 Year 4 A 27.97% 2, ,645 B 28.37% 2, ,051 3,175 Assuming a discount rate of 8% annually for both projects, the firm should most likely accept: (2013 mock morning) A. Both projects. B. Project A only. C. Project B only. Slide 10
11 Cost of Capital Slide 11
12 Cost of Capital Cost of capital for a company Return demanded by investors given the risk level of the company Cost of capital = Weighted average cost of capital (WACC) WACC = marginal cost of capital (MCC) as it reflects the cost on additional capital WACC w k d d (1 t) w k p p w e k e How to calculate weight? Interest cost on debt capital is tax deductible; the after tax cost of debt is k d (1 t) target capital structure company s current market weighted capital company s capital structure trends averages of comparable companies capital structures Slide 12
13 Components of cost of capital Common equity E(R ) R CAPM Dividend discount model k k e D P 1 0 g Bond yield plus risk premium e i k F d β [E(R i m ) R risk premium F ] Preferred stock k p D P p p Debt k d = pretax cost k d (1 t) = post tax cost k d = interest rate on new debt YTM method Debt rating methodmatrix pricing Slide 13
14 Common equity CAPM Using pure play method to calculate a Beta 1. Select the comparable publicly company 2. Estimate comparable s beta 3. Unlever the comparable s beta get the asset beta 4. Lever the asset beta to reflect the debt/equity ratio of the subject company the Project beta 5. Use the project beta to calculate the cost of equity for the project 6. Use the cost of equity to calculate WACC *Pure play method: using a comparable publicly traded company s beta and adjusting it for financial leverage. Comparable company: similar business risk, same industry Slide 14 Asset (unlevered) beta: ASSET EQUITY 1 11t Use the comparable company s debttoequity ratio and t is its marginal tax rate. Company (Project) beta: P ROJECT ASSET 1 1 t ' use the subject firm s debttoequity ratio and t is the subject firm s tax rate D E D' E'
15 Common equity CAPM Country risk premium To adjust for country risk, a country risk premium is added to the market risk premium in the CAPM k = R f + β[r m r f + CRP) annualized of equity index CRP = sovereign yield spread annualized of sovereign bond market in terms of developed market currency Selecting suitable cost of capital to value project Cost of capital for a project should reflect the riskiness of the future cash flows For an average risk project, the cost of capital of the project is the company s WACC If the project risk is lower (or higher) than average risk, use a lower (or higher) discount rate than the company s WACC Slide 15
16 The optimal capital budget Project return Cost of capital(%) MCC and IOS Investment opportunity schedule(ios) Marginal cost of capital (MCC) Optimal capital budget New capital raised The firm should undertake all the projects with IRRs greater than the cost of funds. This will maximize the value created. Slide 16
17 Marginal cost of capital Marginal cost of capital The MCC schedule shows the WACC for the different amount of capital. The MCC is upward sloping due to Additional capital raised at higher cost due to debt covenants New capital raised differs from the target capital structure. Breakpoint the amount of capital at which the cost would change Flotation costs Wrong way adjust cost of capital Right way adjust flotation costs as an initial cash outflow, because flotation costs are a cash flow at the initiation of the project NPV = PV of cash inflows cost of project flotation cost Slide 17
18 Example The following information is available for a company: Bonds are priced at par and they have an annual coupon rate of 9.2% Preferred stock is priced at $8.18 and it pays an annual dividend of $1.35 Common equity has a beta of 1.3 The riskfree rate is 4% and the market premium is 11% Capital structure: Debt = 30%; Preferred stock = 15%; Common equity = 55% The tax rate is 35% The weighted average cost of capital (WACC) for the company is closest to: (2012 mock morning) A.11.5%. B. 13.4%. C.14.3%. Slide 18
19 Leverage Slide 19
20 Leverage Leverage is the use of fixed costs in a firm s operations: operating vs. financial fixed costs Business risk Uncertainty of the company s operating income due to variability of sales and production costs Business risk combines both sales risk and operating risk. Sales risk is the uncertainty relating to sales price and sales quantity; Operating risk is the risk relating to the operating cost structure. Higher fixed operating cost relative to variable operating costs means higher operating risk. Degree of operating leverage (DOL) Slide 20 % EBIT Q P V DOL % S QP V F Financial risk Financial risk increases when the firm takes on more fixed obligations eg. debt and longterm lease. Degree of financial leverage (DFL) measures the effect of a change in operating income on net income. % NI QP V F DFL % EBIT QP V F C Degree of total leverage (DTL) Combines both the effect of operating leverage and financial leverage % NI QP V DTL = DOL DFL % S QP V F C
21 Leverage Firm characteristics and leverage Firms with high fixed costs of production have high operating leverage Firms with high proportion of debt financing have high financial leverage Firms with high fixed costs and high debt have high total leverage Breakeven points: Breakeven points Operating Breakeven points: PQ Q BE BE VQ BE F C P V F C Interest PQ Q OBE OBE VQ OBE F P V F V: variable cost per unit, F: fixed operating costs PV: contribution margin Slide 21
22 Example A firm is uncertain about both the number of units the market will demand and the price it will receive for them. This type of risk is best described as: (2013 mock morning) A. sales risk. B. business risk. C. operating risk. Slide 22
23 THANK YOU Slide 23
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