Review of chapters 9-12
The material in chapters 9-12 addresses the following issues:
• How does a firm decide on which projects to undertake/invest in (capital
• What considerations should a firm take when it decides on how much debt
and equity to have in its capital structure?
In order for firms to make an informed decision about projects that it has available to them, they need to understand the tools that can be used to evaluate projects and how to apply these tools. In the capital budgeting context, projects are any investment that a firm is considering that will generate cash inflows (or reduce cash outflows) for a period of more than one year, such as a new plant, new product, new equipment, etc.
Projects can be independent, in which case each project is evaluated individually and if it meets the acceptance criteria will be implemented. Or projects can be mutually
exclusive, in which case the selection of one (or more) projects will result in the rejection of one (or more) projects. With mutually exclusive projects, the firm must be able to rank the projects available. Many firms face capital rationing constraints (i.e., not enough
capital to undertake all acceptable projects), because they cannot invest in all projects
that are acceptable. In these cases, firms must also be able to rank the projects available.
The following is a matrix of evaluation tools, their strengths and drawbacks, the inputs required to evaluate projects, and their decision rules.
Tool Strengths Drawbacks Inputs Decision rule
Payback It is simple and intuitive. The appropriate Incremental If the project’s
period payback period is a cash flows payback period is
It is biased towards subjectively determined less than the
liquidity, i.e., short-term number. maximum
It ignores the time payback period,
It adjusts for uncertainty value of money. the project is
of later cash flows. acceptable.
It ignores cash flows
beyond the cut-off date.
It is biased against
Discounted It is biased towards The appropriate Incremental If the project’s payback liquidity, i.e., short-term payback period is a cash flows discounted period projects. subjectively determined payback period is
number. Required rate less than the
It adjusts for uncertainty It ignores cash flows of return maximum
of later cash flows. beyond the cut-off date. acceptable
It is biased against the project is
long-term projects. acceptable.
Net Present It accurately assesses the Absolute (dollar) Incremental If the NPV > 0, the Value value of a project to a returns are more cash flows project is
firm. difficult to understand acceptable.
for some managers. Required rate
It incorporates all cash of return
flows, cash flow riskiness It is biased towards
and time value of money larger projects. If
in its calculation. projects can be
replicated (or are
scalable) this may
result in incorrect
rankings of projects.
Internal It is closely related to It may result in Incremental If the IRR > Rate of NPV, and generally leads multiple answers or no cash flows required rate of Return to identical accept/reject answers with non- return, the project
decisions. conventional cash Required rate is acceptable.
flows. of return
It is easy to understand
and communicate It may lead to incorrect
(percentage returns). decisions in
It is not biased towards mutually exclusive
selecting smaller or larger projects as it assumes
projects. cash flow are
reinvested at the IRR.
Difficult to calculate by
Profitability It is closely related to The actual value is less Incremental If PI > 1, the Index NPV, and generally leads meaningful than a cash flows project is
to identical decisions. percentage return (such acceptable.
as IRR). Required rate
It is easier to understand of return
and communicate than
It is not biased towards
selecting smaller or larger
Evaluation Tool calculations:
Payback period: number of years it takes to recoup the initial investment. To calculate this, we subtract the cash flow generated in each year from the initial investment until it is recovered. In the last year, we divide the initial investment still to be recouped by the cash flow generated in that year.
Discounted payback period: number of years it takes to recoup the initial investment. To calculate this, we subtract the present value of the cash flow generated in each year from the initial investment until it is recovered. In the last year, we divide the initial investment still to be recouped by the present value of the cash flow generated in that year.
n CFtNPV，，Net Present Value: t(1？r)，0t
represents the incremental cash flow generated by the project in year t and r CFt
represents the required rate of return for the project.
nInternal rate of return: CFt0，，t (1？IRR)，0t
In most cases, the IRR can only be solved using a spreadsheet or a financial calculator. With any other type of calculator it requires trial and error.
Present Value of BenefitsProfitability Index: PI， Present Value of Costs
The present value of benefits is the present value of cash inflows of the project. The present value of costs is the present value of cash outflows of the project. If the project has conventional cash flows (initial cash outflow and subsequent cash inflows only), the PI can also be calculated as:
PI = (NPV + Initial investment) / Initial investment
NPV will always tell you how much value a project adds to the firm. The PI will always provide you with the correct ranking of projects. If ranking is not required, NPV is the best method to use. If ranking is needed and the projects are of different size (different initial investment), PI is the best method. For most managers, IRR tends to be the most meaningful measure because it describes the project value in terms of percentage returns.
Evaluation tool inputs:
For every tool that we may use, we need to know how to calculate the incremental cash flows that the project generates. For all except the payback period we also need to know how to calculate the required rate of return for the project:
Incremental cash flows: The relevant cash flows of the project are those that are
incremental to the firm IF the project is accepted. This means that we should not include sunk costs (costs that would be incurred even if the project is not accepted). We
should include erosion costs (lost cash flows from another product because a new product is introduced), and opportunity costs (the lost cash flows from equipment
disposed because of the new project or land/factory that could have sold).
Incremental cash flow calculations: NOTE: These steps (1-3) will be provided exactly
as presented below in the formula sheet.
1. Initial Cash Flows (in year 0):
; Initial capital investment (outflow)
; Purchase price of new asset
; Installation costs necessary to place asset into operation
; Working capital investment (outflow)
; Change in net working capital =
Change in current assets – change in current liabilities
2. Operating Cash Flows (yearly):
Project OCF = Project EBIT – Taxes + Depreciation
Where EBIT = Revenues – COGS (or operating expenses) – Depreciation
And taxes are based on EBIT
3. Terminal Cash Flows (in the last year of the project):
; After-tax sale of capital asset (inflow)
Cash flow from asset sale:
Sale price – (Sale price – Book value) * tax rate
; Working capital recoup (inflow)
Depreciation for the purposes of project evaluation is calculated using the appropriate MACRS schedule. The cost of the asset to be depreciated includes the initial purchase price of the asset and installation costs.
If the project is one where an old equipment is being replaced, we must also include the following relevant cash flows: Cash flow from the sale of the old equipment (in year 0) and cash flows lost because we have discontinued using the old equipment (these will be operating cash flows and will be calculated exactly like the OCF calculations for the new equipment.
It is a standard assumption that the working capital investment (made in year 0) will be completely recouped in the last year of the project.
Required rate of return (cost of capital) for project:
When determining the appropriate required rate of return for a project, the critical question that must be answered is whether the project’s risk is similar to that of the rest of the firm. We can answer this by looking at the project specifics.
If the project is similar to what the firm does and the firm only operates in that one area, then the overall firm WACC can be used as the required rate of return for the project.
If the firm has multiple divisions with different risk or the project is in an area that is new to the firm, then we need to determine a project-specific WACC. Here we can rely on the pure play approach to determining the project risk. The pure play approach
requires finding a firm that operates in just one line and it is the same line as the project being considered. Once we obtain such a firm, we need to get the firm’s beta and recalculate the cost of equity (Re). All other components of the WACC remain the same.
We need to determine the costs of each form of capital that the firm employs (debt, common equity, preferred stock) and the weights of each form of capital:
Cost of common equity is calculated using the CAPM:
DPSR，Cost of preferred stock: PSPPS
Cost of debt (before-tax) (R) is the Yield to Maturity (YTM) of the firm’s bonds. It can d
be calculated using the information of currently outstanding bonds or bonds to be issued. With a financial calculator, we can calculate this exactly. Without one, we can use the following equation to obtain an approximation of the YTM.
'$1000？P 0C？ nR，d' 1000P？0 2
The weights of each form of capital can be calculated using book values (obtained directly from the balance sheet) or market values.
BV of common equity = Common Stock + Retained Earnings
BV of debt = Long-term Debt
BV of preferred stock = Preferred Stock
The market value of equity is the current stock price * shares outstanding. The market value of PS is the current preferred stock price * shares outstanding
The market value of debt is more difficult to obtain because a firm typically has numerous debt issues. We would need to find the price and bonds issued for each issue or look at company filings to obtain this information. For the purpose of the exam, this would be given to you.
Once we have the costs and weights, we can calculate the project WACC:
Capital structure is the mix of the various types of debt and equity capital maintained by a firm. The more debt capital a firm has in its capital structure, the more highly financially leveraged the firm is considered to be.
To determine whether adding increasing debt (relative to equity) will add value to the firm, we must evaluate its impact on the earnings per share (EPS) of the firm. Earnings
per share is calculated as Net Income / # of shares of common stock outstanding.
The reason why we want to measure its impact on EPS is because an increase in EPS typically means an increase in dividends for the firm. With our stock valuation models, an increase in dividends will increase the stock price of the firm. This means that owners’ wealth is increased.
Simple decision rule based on financial leverage: If the after-tax cost of debt is less than the return on equity (net income / common equity), then adding debt will increase EPS.
Increasing financial leverage will increase the risk and return of the firm.
There are theories that can be used to explain why firms may choose a certain capital structure or why capital structure may not be important.
Pecking order theory: Because of asymmetric information and the cost of issuance, firms prefer internal financing first (no issuance costs), debt financing second (no negative implication from the announcement) and equity financing last (suggests the firm’s stock price is overvalued. Firms will therefore have a capital structure that is consistent with this theory. Only when they cannot borrow more (increase debt) will they issue equity.
M&M theories: With no taxes, capital structure is irrelevant. It does not matter what the mix of debt and equity is, the value of the firm remains the same. With corporate taxes, 100% debt is optimal because of the interest tax shield debt provides.
Static theory of finance:This theory builds on the M&M theory with taxes. When the
possibility of bankruptcy and its associated costs are also considered, the optimal capital structure is at the point where the additional tax-shield benefit of taking on one more dollar of debt (marginal benefit) is equal to the cost of bankruptcy (marginal cost).