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Corporate Finance - I

© EduPristine CFA - Level – I 1

Agenda

Reading 35: Capital Budgeting

Reading 36: Cost of Capital

© EduPristine CFA - Level – I

Capital Budgeting(Study Session 11 – Reading 35)

2


Coverage of the topic – Capital Budgeting

1. Meaning and process of Capital Budgeting

2. Types of Projects

3. Basic Principles

4. Techniques of Capital Budgeting

5. Other Concepts

a) Projects with unequal life

b) Capital Rationing

c) NPV & stock price

3


Meaning and process of capital budgeting

Capital Budgeting ( Process of identifying and evaluating Capital Projects )

Refers to planning for proposed capital outlays and financing of these outlays

Evaluating Projects for which cash flows will be received over a period longer than a year

Decision should be consistent with the goal of maximizing shareholder value

Capital project

Project involving huge sum of money outflow to purchase a capital asset (Long-term asset for use)

Typical cash flow pattern – Outflow at initial level followed by a stream of Cash Inflows in the future

4


The Capital budgeting Process

Generating IdeasStep 1

•Generate ideas from inside or outside of the company

Analyzing Individual ProposalsStep 2

•Collect information and analyze the profitability of alternative projects

Planning the Capital BudgetStep 3

•Analyze the fit of the proposed projects with the company’s strategy

Monitoring and Post AuditingStep 4

•Compare expected and realized results and explain any deviations

5


Examples of Capital Projects

Different e.g. of Capital Projects

1. Replacement projects: replacing old equipment with new one (cash flows can be predicted with more certainty)

2. Expansion projects: expanding current production capacity (comparatively requires more analysis to determine the cash flows)

3. New Product or services: introducing new product or service (more rigorous analysis is required to find out cash flows, carries more risks)

4. Regulatory, safety and environmental: Required by government or some external party. May generate no revenue.

5. Other projects: Risky projects difficult to analyze by usual method (R&D) or pet projects of someone in the company (CEO buying a private jet)

6


Basic principles of capital budgeting

1. Evaluation of decisions is based on cash flows, not accounting income

2. Cash flows are analyzed on an after-tax basis because shareholders get benefit from profit after tax only

Cash flows After Tax is NOT EQUAL to Net Income. (PAT from Income Statement)

3. Evaluation is based on Incremental Cash Flows

Difference between the cash flows with project & cash flows without the project under consideration. This cash flows should be taken for analysis & not the total cash flows

4. Timing of cash flows affects decisions because of time value of money

Earlier cash flows are more valuable than future cash flows

5. A project must earn equal to or more than its opportunity Cost to be accepted (like a benchmark)

Opportunity Costs is the profit that would have earned through the next best project

E.g. :Investment in Stocks Vs. Interest income in an FD

7


Basic principles of capital budgeting (Contd.)

6. Sunk Costs do not play any role in Capital Budgeting

It is the cost which cannot be recovered (whether the project is selected or not)

E.g.: money paid to market research firm for determining demand for a new product, Purchase price of the old machinery which is now contemplated to be replaced.

7. Externalities MUST be considered while evaluating a project

It is the effect of the investment on other aspects besides the investment itself:

It can be a negative impact or a Positive Impact

Cannibalization: One product of a company eating over the share of another product of the same company e.g. Maruti Suzuki’s Alto model’s sale being impacted due to the launch of A-Star model

8. Financing costs (like interest rate) are not considered as a part of the cash flows because they are already considered in project's hurdle rate (required rate of return)

9. Pattern of Cash Flows

a) Conventional Cash flow – One initial outflow followed by a series of inflows

b) Nonconventional Cash Flows – Cash flows can flip from positive to negative after the initial outflow

8



10. Role of Depreciation

Depreciation is a non-cash expense hence does not play any active role in determining CF

However, since it’s a tax deductible expense, it leads to tax saving

Reduced tax outflow is deemed to a cash inflow

Two approaches to calculate CFAT

1. CFAT = PBDT *(1 - T) + Dep x T

2. CFAT = PAT + Dep

11. Gain or Loss on Capital Asset

Whenever a capital asset is sold, gain / loss is calculated

Gain (or Loss) = Scrap or Sale value - Book Value (on the date of Sale)

This capital gain (or loss) is taxable thus results into additional taxes (or tax savings)

Net Cash Flow in case of:

1. Gain = Sale Value – additional taxes

2. Loss = Sale value + Tax Savings (deemed inflow)

9



12. Working Capital Adjustment

In case a new capital asset is purchased, there is a change warranted in the operational or working capital requirement also.

E.g. A bigger machinery will

• Need more stock of Raw material – Additional Raw Material

• Will have more WIP at any point in time - Additional WIP

• Will produce more finished output - Additional finished goods

• Overall, more investments will have to be made in the Working capital

Adjustments required are:

1. Treat the ADDITIONAL working capital as cash out flow at To (as part of the initial cash flow)

2. Treat the same amount as cash inflow at the end of the project (as part of the terminal value)

10


Different Types of Project

1. Mutually Exclusive Projects

One Project in a set of projects can only be selected

Acceptance of one would imply rejection of the other

Compete directly with each other

a) Either old machinery can be repaired or can be replaced by a new machinery

b) Purchase of a laptop – Either Dell or HP

2. Independent Projects

Projects which can be selected irrespective of the other project

Acceptance of one DOES NOT mean rejection of the other

DO NOT Compete directly with each other

a) Entering a new market – South Africa and Egypt – BOTH can be done at the same time

b) Purchase of CDs – Moser Baer and Sony – BOTH can be done at the same time

11


Techniques of Capital Budgeting

The methods which are used to evaluate the project based on its cash flows are known as techniques of capital budgeting

There are four main techniques of capital budgeting

1. Payback Period (PBP)/(DPBP)

2. Net Present value (NPV)

3. Profitability Index (PI)

4. Internal Rate of Return (IRR)

Each technique has a different mathematical construct to evaluate the project, each will have its own limitations and advantages vis-à-vis other techniques

Due to difference in basic construct, the evaluation result may be DIFFERENT

12


Tech 1– Payback Period (PBP)

It is the time period taken to recover the initial cost of an investment

Decision Criteria: Shorter the PBP, better is the project

It is more widely used in industries where the lifecycle of the project is very short

Used when investor is more interested in capital preservation rather than earning interest

Limitations

• Cash flows post the PBP are not considered

• Time Value of money is ignored

Example

Payback Period For A

= 2 + (3000-2700)/900 = 2.33

Payback Period For B

= 3 + ( 3000-2700)/1500 = 3.20

[ NOTE : - Payback Period is a good measure of liquidity . Also, since PBP ignores terminal or salvage value , It is a poor measure of Profitability ]

13

Project A Project B

Year CFAT Year CFAT

1 1,500 1 600

2 1,200 2 900

3 900 3 1,200

4 600 4 1,500

Initial Investment - 3,000

PBP 2.33 3.20


Tech 1 - Improved – Discounted PBP

The discounted payback method uses the present value of the project's estimated cash flows

It is the number of years it takes a project to recover its initial investment in present value terms

It is always greater than the payback period without discounting

Example

Payback Period For A

= 2 + (3000-2483)/756 = 2.68

Payback Period For B

= 3 + ( 3000-2375)/1188 = 3.53

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Project A Project B

Year CFATDiscounted

CF @ 6% Year CFATDiscounted

CF @ 6%

1 1,500 1415 1 600 566

2 1,200 1068 2 900 801

3 900 756 3 1,200 1008

4 600 475 4 1,500 1188

Initial Investment - 3,000 ; Cost of capital is 6%

DPBP ? ?


Solution:

Answer for example on Payback Period (PBP) and Discounted PBP

15


Tech 2 – Net Present Value

As the name suggest, it is the NET difference between the present value of Cash inflows and present value of cash outflows discounted at the required rate of return.

NPV = PVCI – PVCO

As a conventional pattern of cash flow, PVCI can be expressed as:

Where

• CFt = after tax cash flow at time t

• k =required rate of return for project

Decision criteria

16

n

tt

t

n

n

k

CF

k

CF

k

CF

k

CFPVCI

02

2

1

1

)1()1(....

)1()1(

IF…. DECISION

NPV > 0 The project may be accepted.

NPV < 0 The project should be rejected.

NPV = 0The Company is indifferent in accepting or rejecting the project. The project does not add any value to shareholder.


Project A Project B

Year CFAT Year CFAT

1 12,000 1 22,000

2 14,000 2 20,000

3 16,000 3 16,000

4 20,000 4 14,000

5 22,000 5 12,000

Cash Flows 84,000 84,000

Initial Investment – 60,000

After tax Cost of Capital is 10%

NPV ? ?

Example 1

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Formula -

Applying the above formulae we get : -

NPV of Project A = 1820.91

NPV of Project B = 5563.20

18


Example 2

Choosing the correct rate of discount is crucial for effective project evaluation process

19

Project C

Year CFAT

1 10,000

2 11,000

3 10,500

4 14,000

5 12,500


WACC is 6%, NPV = ?

WACC is 10%, NPV = ?


Solution:

Answer 1:

Answer 2:

20

NPV Project A Project B

1,820.91 5,563.20

After Tax Cost of Capital NPV

6% 469.96

10% (4,605.67)


Tech 3 – Profitability Index (PI)

PI is the INDEXED return earned by the project over its Initial cash outflow

PI is the present value of a project's future cash flows divided by the initial cash outlay.

Decision criteria;

• If PI > 1.0, accept the project

• If PI < 1.0, reject the project

Example

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Project A Project B

Year CFAT PV Year CFAT PV

1 1,500 1,415 1 600 566

2 1,200 1,068 2 900 801

3 900 756 3 1,200 1,008

4 600 475 4 1,500 1,188

Initial Investment - 3,000 ; Cost of capital = 6%

PI = ?

00

1CF

NPV

CF

flowscashfutureofPVPI

If NPV is >0, PI >1

If NPV is <0, PI <1


Solution:

22

Project A Project B

Year CFAT PV Year CFAT PV

1 1,500 1,415 1 600 566

2 1,200 1,068 2 900 801

3 900 756 3 1,200 1,008

4 600 475 4 1,500 1,188

Initial Investment - 3,000

PI =3714/3000 1.24 =3563/3000 1.19


Tech 4 – Internal Rate of Return (IRR )

It is the annualized effective compounded rate or return that can be earned on the capital invested

• It is the MWR (Discounted Cash Flow Application)

Mathematically, IRR is the discount rate that makes the present value of the expected incremental after-tax cash inflows just equal to the initial cost of the project

In equation form, this is expressed as: PV (Cash Inflow) = PV (Cash Outflow)

Decision Criteria:

• If IRR > the required rate of return, accept the project

• If IRR < the required rate of return, reject the project

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n

n

IRR

CF

IRR

CF

IRR

CFCFNPV

)1(....

)1()1()(0

2

2

1

10


Example 3

24

Project A Project B

Year CFAT Year CFAT

1 12,000 1 22,000

2 14,000 2 20,000

3 16,000 3 16,000

4 20,000 4 14,000

5 22,000 5 12,000

Cash Flows 84,000 84,000


NPV ? ?

IRR ? ?


Solution:

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Project A Project B

NPV 1,820.91 5,563.20

IRR 11.06% 14.01%

n

n

IRR

CF

IRR

CF

IRR

CFCFNPV

)1(....

)1()1()(0

2

2

1

10


NPV Profile

NPV Profile is the graph that shows a project’s NPV as a function of various discount rates.

• NPV on Y-axis and Discount Rate on X-axis.

The discount rate where NPV is 0 is the IRR

When discount rate = 0, NPV reflects the undiscounted difference between Inflows and outflows

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A

BCrossover Rate

IRR of A

IRR of B

NPVA preferred

over B

B preferred over A

Rate

A is preferable B is preferable

A’s cash inflows are farther from To

compared to B’s cash inflows.

As a result, the impact of rate hike is

more prominent in case of A’s NPV

compared to B’s NPV


IRR vs NPV

For conventional projects, the NPV and IRR will agree on whether to invest or not to invest.

NPV and IRR may give conflicting results for different project sizes: Choose NPV

NPV is theoretically the best method. Its main weakness is that it does not include any consideration to the size of the project . For example, an NPV of $10 is great for project costing $100 but not so great for a project costing $10000.

Key Advantage of IRR is that it measures profitability as a percentage, showing the return on each dollar invested .

Limitations of IRR

• IRR might give conflicting project ranking as compared to NPV for mutually exclusive project.

• Multiple IRR or No IRR problem ( there may be more than one discount rate that will produce an NPV equal to zero )

• IRR assumes yearly returns are invested at the IRR which may not be possible most of the times

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Ranking conflicts: NPV vs. IRR – Points to remember

The NPV and IRR methods may rank projects differently.

If projects are independent, accept if NPV > 0 produces the same result as when IRR > r.

If projects are mutually exclusive, accept if NPV > 0 may produce a different result than when IRR >r.

The source of the problem is different reinvestment rate assumptions

Net present value: Reinvest cash flows at the required rate of return

Internal rate of return: Reinvest cash flows at the internal rate of return

The problem is evident when there are different patterns of cash flows or different scales of cash flows.

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CONFLICTING PROJECT RANKINGS

YEAR PROJECT – A PROJECT - B

0 -$2000 -$2000

1 1000 0

2 1000 0

3 1000 0

4 1000 0

5 1000 8000

NPV 1790 2967

IRR 41% 32%

REQUIRED RATE OF RETURN = 10%

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Preference of Capital Budgeting Methods

Gist :

1) In terms of consistency with owners’ wealth maximization, NPV and IRR are preferred over other methods.

2) Larger companies tend to prefer NPV and IRR over the payback period method.

3) The payback period is still used, despite its failings.

4) The NPV is the estimated added value from investing in the project; therefore, this added value should be reflected in the company’s stock price.

30


Other Concepts - Projects with Unequal lives

When the options that are being evaluated are of different tenure (project life), we need to make an adjustment

The objective of this adjustment is to make like-to-like comparison between both the projects removing the impact of unequal lives .

Methods that can be used:

A. Least common multiple of lives approachExample: Project Eagle of 6 years and Project Bird of 3 years. Since LCM of both the projects complete duration is 6, calculate NPV/IRR from Project Eagle as usual and for Project Bird assume the project restarts at the end of 3rd year. So in effect Project Bird will have to be repeated twice for a like to like comparison with Project Eagle

B. Equivalent Annual Annuity Approach – Simpler approachStep 1: It basically calculates the sequence of annual payments (annuities) that is equal to the project’s NPV. Step 2: The project which has higher annuity is selected

31


Other Concepts – NPV and Share Price

NPV is the addition to shareholders wealth (at To) by taking an action and discounting its CFs using WACC

Wealth of the shareholders is measured by the share price

Therefore by Fundamental Analysis, NPV is addition in the Market capitalization at To

The value of the company is the value of existing investments plus the NPV of all future investments.

If a project has an NPV of $250 Mn and the current value of the company is $5,000 Mn (100 Mn outstanding shares), the total market cap will increase by $250 Mn.

• Share price should increase by $2.5 ($250 Mn divided by 100Mn)

• New share price will be $50 + $2.5 = $52.5

3232

Because of speculations and other forces prevailing in the capital market,the above relation might not hold true at all time


Other Concepts – Capital rationing

Firms/Companies have fixed amount of capital to allocate amongst capital projects

Capital rationing is the allocation of this fixed amount of capital among the set of available projects such that the selection will maximize shareholder’s wealth

Project’s with negative NPVs are to be discarded irrespective of availability of capital

1. Hard capital rationing – funds allocated to the manager of capital project cannot be increased

2. Soft capital rationing – manager of capital project is allowed to increase allocated capital budget provided they can justify to senior management of creating shareholder value on that additional capital

3333

Profitability Index is used to rank projects on the basis of their relative returns


Other Concepts – Project Sequencing

Project Sequencing

Sequenced through time so that investing in a project creates the option to invest in future projects.

Example: A chemical company can first select a project of establishing the chemical plant & then to use the excess heat of chemicals it can establish a chemical power plant

34


Question Set 1

1. Which of the following is least accurate about discounted payback period?

A. It ignores terminal value

B. It is shorter than regular payback period

C. It is the time taken by the present value of cash flows to equal the initial investment

2. Which of the following statements is least accurate?

A. If NPV for a project is negative then its IRR can be positive.

B. Cash flows in capital budgeting should include opportunity costs.

C. Discounted payback period is smaller than normal payback period.

3. A company X bought a machinery for $100 and expects to give the following cash inflow: Year 1: 50, Year 2: 40, Year 3: 10, Year 4: 15The Required rate of return is 4%. Calculate the Payback Period and Discounted Payback Period.

A. 3 and 3.47

B. 3.47 and 3

C. 3 and 4

35


Question Set 1 (Contd.)

4. Sigma Tech has a net worth of $4 million and Global Inc has a net worth of $500 million. Which of the following methods of capital budgeting is most likely to be used by these companies?

A. Sigma should use the NPV method

B. Global should use the discounted payback method

C. Sigma should follow the discounted payback method

36


Solutions (Q.Set1)

1. Solution: BIt is always greater than regular payback period

2. Solution: CIf the cost of capital >IRR then NPV can be negative whatever is the value of IRR.Cash flows should include opportunity costs.Discounted payback period is larger than normal payback period because future cash flows are discounted and their PV is less than undiscounted value.

3. The correct answer is 3 and 3.47.

4. Solution: CSigma is a smaller company as compared to Global, hence is more likely to follow the discounted payback method.

37


Question Set 2

1. In the capital budgeting process, three of the major steps are:

A. Analyze the project proposal, create firm wide capital budget and monitor decisions.

B. Analyze the project proposal, raise capital and monitor project performance.

C. Analyze the project proposal, create firm wide capital budget and raise capital

2. Which of the following costs is least likely to be used in capital budgeting analysis?

A. Fees paid to a marketing research firm to estimate the demand for a new product prior to a decision on the project.

B. Cannibalization of its existing product market due to the launch of another product by a firm.

C. The tax saving affect of depreciation cost.

3. Which of the following is true about Cannibalization:

A. It’s a positive externality

B. It’s a negative externality

C. It’s not an externality

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4. With regards to capital budgeting, an appropriate estimate of the incremental cash flows from a project is least likely to include:

A. Interest Costs

B. Externalities

C. Opportunity Costs

5. The effects that the acceptance of a project may have on firm’s other cash flows is known as:

A. Opportunity Cost

B. Externalities

C. Sunk Cost

39


Solutions (Q.Set2)

1. Solution: ACapital budgeting has 4 steps. In none of the steps capital is raised in capital budgeting process.

2. Solution: AFees paid to a marketing research firm to estimate the demand for a new product prior to a decision on the project is a sunk cost and should not be included in the capital budgeting analysis.

3. The correct answer is It’s a negative externality.

4. The correct answer is Interest Costs.

5. Solution: BOpportunity Cost: Cash flows that a firm will lose by undertaking the projectSunk Cost: Costs that cannot be avoided, even if the project is not undertaken

40


Question Set 3

1. Calculate the NPV, IRR of the Hisar Project

A. 5,882.79, 10.64%

B. 882.79, 20.64%

C. 882.79, 10.64%

2. A company is considering two projects A and B which are mutually exclusive. The cross over rate in the NPV profile of both the projects is 8.5%. If internal rate of return (IRR) for project A and B is 13% and 15% respectively then which of the following statements is correct?

A. At required rate of return of 10% only project A should be accepted.

B. At required rate of return of 10% both projects should be accepted.

C. At the required rate of return of 8% only project A should be accepted

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Zentec Limited - Hisar project (in Lacs)

Year CFAT

1 3,000

2 2,000

3 2,000


After tax Cost of Capital is 10%



3. During capital budgeting cannibalization effect of an existing product line due to the launch of a new product is an example of:

A. Externalities

B. Sunk Costs

C. Opportunity Costs

4. Sigma Corporation is planning to launch a new product in the market for which it has paid Xylus Consultants a fee of $4000 to do a market survey to gauge the demand for the product. The new product is expected to cause a 5% decline in the market share of its existing brands. Also the facilities for the manufacturing of the project could earn a lease rent of $1500 per month, if the project were not to be undertaken. Which of the following regarding the project cash flow is least likely true?

A. The cash flows should not take into account the consultants fee

B. The loss in lease rent is relevant to the decision making

C. The loss of sale of existing product is irrelevant to the decision making

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Solutions (Q.Set3)

1. B. 882.79, 20.64%

2. C. Since both the projects are mutually exclusive hence only one of them can be accepted.

For required rate of return > 8.5 %( but less than 15%) project B should be accepted

For required rate of return < 8.5% project A should be accepted.

3. A. Externalities are the effects the acceptance of a project may have on other cash flows of the firm.

An example of negative externality is cannibalization effect of an existing product line due to the launch

of a new product.

4. C. The cost of cannibalisation should be considered in the incremental cash flows

43


Cost of Capital(Study Session 11 – Reading 36)

44


Coverage of the topic - Cost of Capital

1. Context for Cost of Capital

2. Different Components of Capital

3. Cost of individual Components of Capital

4. Weighted average cost of capital (WACC)

5. Marginal cost of capital (MCC)

6. Other Topics

A. Calculating βeta for the project

B. Country equity risk premium (CRP)

C. Treatment of floatation costs

45


Context for cost of capital

Three main decision to be taken by a Finance Manager

• Financing Decision: How to raise most optimum finance

• Investment Decision: How to make most optimum investments

• Dividend Decision: How to distribute profits in the most optimum manner

Financing and Investing decisions are independent: there is no one to one relationship between every action of both decisions

In evaluating investing decisions, there is need for an opportunity cost against which the returns from the project / asset can be compared with

• This opportunity cost is genesis of Cost of Capital

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Common Objective: To maximize

Shareholders’ wealth


Cost of Capital - Meaning

Different ways to understand the meaning of cost of capital:

1. The rate of return that the suppliers of capital, bondholders and owners, require as a compensation for their contribution of capital

2. The cost to finance assets of the firm

3. The minimum rate which the assets of the firm must earn to add to shareholders wealth

4. The opportunity cost which is used as a benchmark to evaluate capital projects

5. WACC reflects the average risk of projects that make up the firm

47


Different Components of Capital

Three main components of capital

Equity share (Common equity)

Preference Share (preferred Stock)

Debt (Bank loan, Debenture or Bonds)

48

Source of capital Amount of return Certainty of payment

Equity Not certain Not certain

Preference Certain Not certain

Debt Certain Certain

1

2

3

Investor’s risk


Cost of Capital

Costs of Capital

Cost of Debt

Yield to Maturity

Debt Rating

Cost of Preferred

Equity

Return on Preferred Stock

Variations because of

Callability etc.

Cost of Common

Equity

Capital Asset Pricing Model

Dividend Discount

Model

Bond Yield plus Risk Premium

49


Cost of debt capital (Kd)

A. Company perspective

Interest rate at which firms can issue new debt (Kd) (This is generally used for perpetual debt)

B. Investor’s perspective: Investor’s YTM on existing debt (Most preferred)

The Yield to Maturity (YTM) is the annual return that an investor earns on a bond if the investor purchases the bond now and holds it until maturity.

YTM is the IRR from point of view of the investor

YTM is to be used for calculation purposes and not coupon rate

C. Alternate perspective: Debt Rating Approach

To be used only when current market price of debt is uncertain and can not be used to estimate YTM

Compare the ratings and maturity of the debt to arrive at Kd (Matrix pricing)

Impact of taxes

Interest expense on debt capital is an allowable expenditure for tax purposes >> results into tax savings

After-tax cost of debt = interest rate - tax savings = Kd - Kd(t) = Kd(1 - t)

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Debt of PriceMarket

ExpenseInterest Kd


Issues in Estimating the Cost of Debt

1. Fixed Rate Debt vs. Floating Rate Debt

Estimating the cost of a floating rate security is difficult because the rate of interest is fluctuating over the life of the debt – it depends not only on the current yields but also on future yields.

The analyst may use the current term structure of interest rates and term structure theory to assign an average cost to such instruments

2. Debt with Embedded Options

Problem in valuing bonds with call, conversion or put options.

Options affect the value of debt

a) Callable bonds have higher yields than similar non-callable bonds

b) Putable bonds have lower yields than similar non-putable bonds.

Analysts may use the YTM method if future bonds to be issued with embedded options are similar to bonds already traded in the market.

Else, the YTM can be adjusted to reflect the embedded options.

51


Issues in Estimating the Cost of Debt (Contd.)

3. Non-rated Debt

If the company does not have any outstanding debt or the company does not have rated bonds then yields on the existing debt is not available (YTM model fails)

In such case: Researchers arrive at a synthetic debt rating based on financial ratios.

Not accurate since information about the particular bond issue are not captured by the synthetic rating.

52


Cost of non-callable, nonconvertible preferred stock (Kps)

A. Company perspective

It is the cost that a company has committed to pay preferred stockholders as a preferred dividend when it issues preferred stock (Kp)

B. Investor’s perspective: Investor’s YTM on existing Preferred Stock (Only for Comparison purpose)

The Yield to Maturity (YTM) is the annual return that an investor earns on a Preference share if the investor purchases the share now and holds it until maturity.

YTM is the IRR from point of view of the investor

YTM is to be used for calculation purposes and not coupon rate of dividend

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Stock Preferred of PriceMarket

Dividends PreferredKps

Impact of taxes

Preference Dividend is NOT an allowable expenditure for tax purposes >> DOES NOT resultinto tax savings


Cost of equity capital (Ke)

Ke can be calculated by three Approaches:

1. Capital asset pricing model (CAPM)

2. Dividend discount model (DDM)

3. Bond yield plus risk premium

54

Answer will be different by all three approaches

Impact of taxes

Common Dividend is NOT an allowable expenditure for tax purposes >> DOES NOT resultinto tax savings


1. Capital asset pricing model (CAPM)

Where:

is the returns sensitivity of stock returns to changes in the market return

E(Rm) is the expected return on the market (index)

[ E(Rm)– Rf]is the expected market risk premium (compensation for extra risk taken)

Beta: is the measure of systematic risk [ Formulas not reqd. ]

Important points

1. Historical Equity Risk Premium: Equity risk premium observed over a long period of time is a good indicator of the expected equity risk premium.

2. Limitations:

• The level of risk of the stock index may change over time

• The risk aversion of investors may change over time

• Estimates are sensitive to the method of estimation and the historical period covered.

55

fmf RRER )(Re

Beta = Covariance (Equity & Market)Variance (Market)

= Coefficient of Correlation X Std deviation (Equity)Std deviation (Market)


2. Dividend discount model (DDM)

Where:

D1 : is the dividend expected after one year

Po is the market price of the common share today

G = sustained (constant) growth expected in dividends

G = (retention rate) x (return on equity) = (1 - payout rate) x (RoE)

56

GP

0

1e

DR



Analysts often use an ad hoc approach to estimate the required rate of return on equity

This is done by adding a risk premium (3-5% - for investing in equity compared to debt) to market yield on the same firm’s long term-debt

Example: Bond MF v/s Equity MF

Note: Bond yield is before tax (if after tax cost of firm is given, convert it to before tax)

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premiumrisk Equity yield bond eR


Calculating Weighted Average of Cost of Capital

WACC = Wd* Kd (1-t) + Wps* Kps + We* Ke

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Cost Weight age

Debt Kd Wd

Preferred Stock Kps Wps

Equity Stock Ke We


Methods of Calculating Weights used in WACC

Preference of weights should be:

1. Market values of Target Capital Structure

2. Market Values of the Current Capital structure

3. Industry averages as the target capital structure

4. Book Values of the Current Capital structure

The weights used in the WACC should be adjusted for

1. Historical trends

2. Any announcement by the company to alter its capital structure

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EXAMPLE – WACC

Suppose the Oxford Company has a capital structure composed of the following, in billions:

If the before-tax cost of debt is 9%, the required rate of return on equity is 15%, and the marginal tax rate is 30%, what is Widget’s weighted average cost of capital?

Solution:

WACC = [(0.20)(0.09)(1 – 0.30)] + [(0.8)(0.15)]

= 0.0126 + 0.120

= 0.1325, or 13.25%

Interpretation:

When the Oxford Company raises €1 more of capital, it will raise this capital in the proportions of 20% debt and 80% equity, and its cost will be 13.25%.

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Debt €10

Common equity €40


Marginal Cost of Capital - Coverage

1. Basic Explanation

2. Optimal Capital Budget

3. Break points

4. MCC Schedule

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Marginal Cost of Capital - Basic Meaning

MCC is the cost of incremental capital raised by the firm

In other words, what it would cost to raise additional funds for the potential investment project.

Examples of MCC -

A company wants to raise capital for an expansion plan for setting up new factory.

Although the existing debt is at 12%, any additional debt can be raised at 14%.

New shares will involve an issue cost of $ 2.5 per share.

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Optimal Capital Budget

The Optimal Capital Budget is that amount of capital raised and invested at which the marginal cost of capital is equal to the marginal return of investing (Similar to MC = MR in Economics)

1. Investment Opportunity Schedule – Returns to a company’s investment opportunities are generally believed to decrease as the company makes additional investments as represented by the Investment Opportunity Schedule.

2. Marginal Cost of Capital: As the firm raises morecapital - the cost of capital increases:

A. Cost of debt rises to account for theadditional financial risk and

B. Cost of new equity is higher thanretained earnings due to floatation costs.

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Marginal Cost of Capital

Investment Opportunity Schedule

Project IRRCost of Capital%

New Capital raised($)

Optimal Capital Budget


Break Points

Break points occur when the cost of any one of the components of a company's cost of capital changes.

Example:

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Amount of new

Debt ($ Mn.)Kd(1-t)

Amount of new

Equity ($ Mn.)Ke

0-99 5.0% 0-199 7.00%

100-199 5.5% 200-399 8.50%

200-299 6.5% 400-599 11.00%

Capital Structure of 60% Equity and 40% Debt

structurecapitaltheincomponent newtheofWeight

changescapitalofcostscomponent'thewhichatcapitalofAmountPointBreak


The Marginal Cost of Capital Schedule

MCC schedule depicts the WACC at different levels of additional financing

MCC schedule typically has an upward slope because financing cost increase as the requirement for additional financing increases:

• Kd rises as the existing debt may have a covenant that restricts the company from issuing debt with similar seniority as existing debt

• Ke rises as debt increases, there is increased risk for the equity shareholders (financial leverage)

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Amount of New Capital

WACC


Using WACC (or MCC) in Capital Budgeting

If we chose to use the company’s WACC as discount rate in the calculation of the NPV of a project, we assume the following:

a) The project has the same risk as the average-risk project of the company

b) The project will have a constant target capital structure throughout its useful life.

Companies may use an ad-hoc or a systematic approach for adjusting the WACC to evaluate new projects with risks different than risk of companies existing projects.

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Other Topics – 1. Beta and Cost of Capital for a Project

Project: A new venture by an existing company which is in addition to its other businesses.

Beta (total systematic risk) is a combination of:

1. Operating risk

2. Financial risk

Risk (and Beta) of a new project can be very different than overall Risk (and Beta) of the firm.

There is a need to evaluate risks (Beta) specific to the particular project in order to estimate the discount rate (WACC) to evaluate that particular project.

Since each project is not represented by a publicly traded security, it is difficult to calculate the Project Beta.

In order to estimate Beta for the Project - Pure Play Method is USED.

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Pure-Play Method

1. Identify company/group of companies comparable to the project i.e. engaged ONLY in business similar to that of the new project

2. Un-lever the beta in step 1 since the benchmark company will have a different financial structure which also impacts Overall asset’s Operational risk. (All figures on RHS are for the benchmark company)

3. Re-Lever: Now once you have adjusted the beta, then again reload the beta with financial risk of company evaluating the project.(All figures on RHS are for the main subject company)

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Beta (Asset) = Beta (Equity)Equity

Equity + Debt (I – T)

Beta (Equity) = Beta (Asset or Project)Equity + Debt (1 – T)

Equity


Using comparables to estimate beta - Flow

Select a ComparableEstimate the Beta for

the Comparable

Un-lever the Comparable’s Beta to

Estimate the Asset Beta

Lever the Beta for the Project’s Financial

Risk

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Practice Question on Pure-Play method

1) Consider the following information for the Company - A and its comparable, Company - B:

What is the asset beta and equity beta for the Company - A based on the comparable company information and a tax rate of 40% for both companies?

Solution

asset = 1.4 {1 [1 + (1 – 0.4)(100 200)]} = 1.4 × 0.76923 = 1.0769

equity = 1.0769 [1 + (1 – 0.4)(10 40)] = 1.0769 × 1.15 = 1.2384

The beta of the Company - A is 1.2384

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Company - A Company - B

Debt €10 €100

Equity €40 €200

Equity beta ? 1.4


Practice Question on Pure-Play method

2) Acme Inc. is considering a project in the food distribution business. It has a D/E ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield of 14%, Balfor, a publicly traded firm that operates only in the food distribution business, has a marginal tax rate of 30%, a D/E ratio of 1.5 and an equity beta of 0.9. The risk-free rate is 5% and the expected return on the market portfolio is 12%. Calculate Balfor’s asset beta, the project’s equity beta, and the appropriate WACC to use in evaluating the project.

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Solution:

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Other important points on Project Beta

Calculation of Beta

1. Arriving at a beta for a publically traded company (to be used under Pure Play Method) is easy

2. For companies which are not publically traded, estimating a beta requires making proxy by using the information on the project or company combined with a beta of a publically traded company.

Challenges in estimating beta of comparable company’s equity

1. Beta is estimated using historical returns.

2. Affected by which index is chosen to represent the market return

3. Adjustment needs to be made for the (believed) tendency of beta to revert towards 1 over time

4. Beta of small-capitalized firms may need to be adjusted upward to reflect risk inherent in small firms that is not captured by usual estimation methods

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Other Topics – 2. Country equity risk premium (CRP)

Context:‘β’ does not adequately capture the country risk of an emerging / developing market

We need to add a country risk premium (CRP) to the market risk premium

Risk of investing in a developing country is measured by the sovereign yield spread i.e. the difference in yields between the developing country’s government bonds (denominated in local currency) and Treasury bonds of similar maturity

The above compensates only the bond risk. This is adjusted for the equity market risk by adjusting it for the relative risk of equity markets to the bond markets

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Consider Sovereign = Government

What is developing is a relative term

currency developedIn marketbond

sovereignofDeviationStandardAnnualized

currency DevelopingIn Country developingofindex

equityofDeviationStandardAnnualized

spreadyieldSovereignCRP

Ke = Rf + ß [E(Rm) – Rf + CRP]


Example

Facts of the case:

Pakistan’s 10 year G Sec Bond Yield = 16%

India’s 10 year G Sec Bond yield = 10%

Annualized SD of Pakistan stock market index = 40%

Annualized SD of rupee denominated 10 year Pakistan’s G Sec bond= 15%

Project Beta = 1.25

E(Rm) = 15% and Rf = 8%

Calculate Ke for investing in Pakistan.

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Solution:

Country Risk Premium:

=(16% - 10%) * (40%/ 15%) = 16%

Cost of Equity:

= 8% + 1.25(15% - 8% + 16%) = 36.75%

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Other Topics – 3. Floatation costs

Charges / Fees paid for raising external equity capital

This fees is paid to the investment bankers to the issue for their services to help in capital raising

Amount of flotation costs

• Floatation costs for equity can range from 1.5% to 1.8% based on the country of the issue and other factors.

• For debt and preferred stock: usually below 1% - the floatation costs are not included in the costs since its very low

Treatment of Floatation Costs

• Either Increase the initial cost of the project (Better Method) or

• Incorporate floatation costs into the cost of capital (Not Preferred)

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Question

Facts of the case:

Cash Outlay: $4 Million

Annual after tax cash flows : $1.5 Million for 4 years

Tax rate : 40%

Before tax cost of debt: 7.5%

MV of Equity: $35

Expected Dividend next year ; $4

Growth rate : 6%

Capital Structure is 40:60 (Debt: Equity)

Flotation Cost of equity: 4.5%

Calculate WACC and NPV.

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Solution – Preferable method

Out of the $4 Million cash outlay, 60%, that is $2.4 Million is Equity and $1.6 is Debt

Adjusting the 4.5% floatation costs to this cast outlay, we have $4M + $2.4*4.5% = $4.108M

Using DDM, 35=4/(re-0.06) => re = 17.42%

Given rd is 7.5%

WACC = 0.6*17.42%+0.4*7.5%*(1-0.4)

= 12.25%

=0.3778 Million

79

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Questions

1. If Debt Outstanding is 20 Crs

Common Equity stock outstanding is 40 Crs

Preferred Stock Outstanding is 30 Crs

Calculate Wd, Wps and We

A. 0.22, 0.33, 0.44

B. 0.33, 0.22, 0.44

C. 0.44, 0.22 ,0.33

2. Kd = 8%, Kps = 9%, Kce = 10.5%, Wd = 35%, Wps = 15%, Wce = 50%, Tax rate = 40%

Calculate WACC:

A. 9.40%

B. 8.28%

C. 7.74%

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Question

3. A stock whose market price is $60 is expected to declare a dividend of 60%(Face value $10). What is the Cost of Equity if the dividends are projected to grow at a rate of 5%?

A. 65%

B. 15%

C. 5%

4. If the difference between the yields of Govt. bonds in India (developing country) denominated in Rupee and the treasury bonds of USA having same maturity, increases. What will be the effect on the cost of equity of a firm in India.

A. Increases

B. Decreases

C. No Impact

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Solution

1. A. 0.22, 0.33, 0.44

2. B. 8.28%

• Answer A takes before tax cost of debt

• Answer C takes after tax cost of debt and Preferred stock

3. B. 15%

• Answer A takes 60% dividend on market price instead of face value

• Answer C subtracts g instead of adding it to (D1/P0)

4. A. Increases

• There is a positive relation between Sovereign yield risk and CRP

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Five Minute Recap

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Categories of Projects :

Replacement projects

Expansion projects

New Product or services

Regulatory, safety and

environmental projects

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Internal Rate of Return :

It is the discount rate that equates the

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Required interest rate on a security = nominal risk free rate + default risk premium + liquidity premium + maturity risk premium

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incomenetAverage

:(APR)return of rate accounting Average

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IRR of A

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A preferred over B

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WACC = Wd *[(Kd(1-t)] + Wps*Kps + We*Ke

structurecapitaltheinntnewcomponetheofWeight

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Cost of Equity Capital Approaches:

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fmf RRER )(Re

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DR

premiumrisk yield bond eR

The cost of preferred stock (Kps) is:

Stock Preferred of PriceMarket

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corporate finance - i -...

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