Post on 28-Dec-2015
CAPITAL BUDGETING INITIAL INVESTMENT
PLANNING HORIZON
TERMINAL VALUE
REQUIRED RATE OF RETURN
NET CASH FLOWS
RETURNS TO ASSETS OR RETURNS TO EQUITY? IF THE OBJECTIVE IS TO MEASURE THE
PROFITABILITY OF THE ASSETS COMMITTED TO THE INVESTMENT,
NET CASH FLOWS ARE THE PROJECTED AFTER-TAX CASH FLOWS WITHOUT DEDUCTION OF CHARGES FOR INTEREST OR LOAN PAYMENTS.
THE DISCOUNT RATE USED IS THE WEIGHTED AVERAGE COST OF CAPITAL.
BASED ON THE ASSUMPTION THAT THE FIRMS LEVERAGE OR OVERALL FINANCIAL STRUCTURE DETERMINES THE FINANCING COST OF THE INDIVIDUAL INVESTMENT AND THAT THE FINANCING ARRANGEMENTS FOR THE INDIVIDUAL INVESTMENT DO NOT SUBSTANTIALLY INFLUENCE THE FIRM’S OVERALL COST OF CAPITAL
IF THE OBJECTIVE IS TO MEASURE THE PROFITABILITY OF THE EQUITY CAPITAL COMMITTED TO THE INVESTMENT,
NET CASH FLOWS ARE THE PROJECTED AFTER-TAX CASH FLOWS WITH THE DEDUCTION OF CHARGES FOR INTEREST AND PRINCIPAL ON LOAN PAYMENTS.
THE DISCOUNT RATE USED IS THE FIRM’S COST OF EQUITY CAPITAL.
THIS APPROACH EXPLICITLY ACCOUNTS FOR EACH INVESTMENT’S METHOD OF FINANCING.
BASED ON THE ASSUMPTION THAT THE INVESTMENT’S FINANCING COSTS MAY STRONGLY INFLUENCE THE FIRM’S LEVERAGE AND COST OF CAPITAL.
INITIAL INVESTMENT
THE INITIAL EQUITY THE INVESTOR COMMITS TO THE INVESTMENT.
ALL COSTS NECESSARY TO MAKE THE INVESTMENT ARE INCLUDED.
IF FINANCING IS USED, THE INITIAL INVESTMENT WILL BE LOWER.
NET CASH FLOWS
REFERS TO CASH FLOWS
INCLUDES ALL CASH INFLOWS AND CASH OUTFLOWS ON AN AFTER TAX BASIS
OUTFLOWS INCLUDE: OPERATING EXPENSES CAPITAL EXPENDITURES INCOME TAXES FINANCING (UNDER THE RETURN-TO-
EQUITY APPROACH)
TERMINAL VALUE
THE RESIDUAL VALUE OF ASSETS INVOLVED IN THE INVESTMENT.
ONLY THE EQUITY PORTION OF ANY SALE OF ASSETS SHOULD BE INCLUDED.
ANY OUTSTANDING DEBT WOULD BE REPAID WHEN THE ASSETS ARE SOLD.
DISCOUNT RATE
THE DISCOUNT RATE USED IS CONSIDERED TO CONTAIN THREE COMPONENTS:
REAL RISK FREE RATE OF RETURN RISK PREMIUM ANTICIPATED RATE OF INFLATION
Comparison of ROA and ROEROA ROE
Initial Investment Total amount of the investment
Only the equity invested
Terminal Value Total residual value of the assets
Equity portion after repayment of any outstanding debt
Discount Rate Weighted average cost of capital
Cost of equity capital
Net Cash Flows After tax net cash flows to the investment
After tax net cash flows including the servicing of debt
WHAT GOES INTO THE DISCOUNT RATE? THE DISCOUNT RATE SHOULD
REFLECT THE COST OF CAPITAL OR THE COST OF FUNDS USED TO FINANCE THE BUSINESS.
AN INVESTMENT IS NOT ACCEPTABLE UNLESS IT GENERATES A RETURN SUFFICIENT TO COVER THE COST OF FUNDS.
THE DISCOUNT RATE CONTAINS THREE COMPONENTS:
REAL RISK-FREE RATE RISK PREMIUM INFLATION EXPECTATIONS
WEIGHTED AVERAGE COST OF CAPITAL THE COST OF CAPITAL IS WEIGHTED
BY THE PROPORTION OF EACH TYPE OF CAPITAL (DEBT AND EQUITY) IN THE CAPITAL STRUCTURE OF THE FIRM.
THERE ARE TWO TYPES OF CAPITAL INVESTED IN A BUSINESS:
DEBT CAPITAL EQUITY CAPITAL
COST OF DEBT COST OF EQUITY
COST OF DEBT The cost of debt is the interest expense
associated with the debt capital used in the business.
Since interest is a tax deductible expense, the cost of debt should be calculated on an after-tax basis.
After-Tax Cost of Debt ATCD = Cost of Debt * (1-marginal tax
rate) Example:
Cost of debt is 7.5% Marginal tax rate of 20%
ATCD = 0.075 * (1 – 0.2) ATCD = 0.075 * 0.8 = 0.06 or 6.0%
COST OF EQUITY The cost of equity is not as easy to
determine as the cost of debt. It involves the concept of opportunity cost
and a consideration of the relative risk versus debt capital.
The cost of equity to a business should be higher than its cost of debt because equity holders take on more risk than debt holders and therefore expect a higher return.
Cost of Equity - Calculation Capital Asset Pricing Model (CAPM) is
used where a firm is traded on the equity markets (stock market).
Formula: Cost of equity capital = Risk free rate +
Beta (Market risk premium)
But what about firms not traded on a stock exchange? The calculation of equity costs for a business not
traded on an exchange (ie. an agribusiness or farming operation) is problematic, since the beta and market risk premium is not apparent.
Therefore, a substitute method would be:Cost of Equity = Risk free rate + equity risk premium
Where the equity risk premium is based on the owners required rate of return to accept the risk of ownership.
WEIGHTED AVERAGE COST OF CAPITAL Kc = wd Kd + we Ke
Where: Kc is the weighted average cost of capital
wd is the proportion of assets financed with debt
Kd is the cost of debt capital
we is the proportion of assets financed with equity
Ke is the cost of equity capital
DEPRECIATION AN ACCOUNTING PROCEDURE BY
WHICH THE PURCHASE COST OF A DEPRECIABLE ASSET IS PRORATED OVER ITS PROJECTED ECONOMIC LIFE
REFLECTS THE ANTICIPATED DECLINE IN THE ASSETS VALUE OVER TIME
DEPRECIATION IS USED IN THE CALCULATION OF CASH FLOWS TO CALCULATE THE TAXABLE INCOME AND INCOME TAX LIABILITY.
DEPRECIATION IS A NON-CASH EXPENSE, THEREFORE, NOT DEDUCTED FROM THE NET CASH FLOW
Income Taxes and Capital Budgeting
The payment of income taxes constitutes a cash flow, therefore, income taxes should be accounted for in capital budgeting.
An after-tax cash flow should be estimated using projected before-tax cash flows and deducting tax liabilities.
Calculation of After-Tax Cash Flows Net before-tax cash flows are calculated as
the net of revenues less related production expenses.
Additional deductible expenses in the calculation of income taxes include: Depreciation (non-cash expenses) Interest paid on any business loans
Calculation of After-Tax Cash Flows Under the Return on Asset Method
(Before Tax Net CF – Depreciation) = Taxable Income
Taxable Income *Marginal Tax Rate = Tax Due
After Tax CF = Before Tax Net CF – Tax Due
Year Before Tax CF
Depr Taxable Inc
Inc Tax
After Tax CF
1 20,000 13,000 7,000 1,400 18,600
2 25,000 13,000 12,000 2,400 22,600
3 35,000 13,000 22,000 4,400 30,600
4 50,000 13,000 37,000 7,400 42,600
5 50,000 13,000 37,000 7,400 42,600
Calculation of After-Tax Cash Flows Under the Return on Equity Method
(Before Tax Net CF – Depreciation - Interest) = Taxable
Income
Taxable Income *Marginal Tax Rate = Tax Due
After Tax CF = Before Tax Net CF – Tax Due – Principal and Interest on
Loan
Year Before Tax CF
Depr Interest Expense
Taxable Inc
Inc Tax
Loan Payment
After Tax CF
1 20,000 13,000 10,200 -3,200 -640 30,452 -9,812
2 25,000 13,000 8,479 3,521 704 30,452 -6,156
3 35,000 13,000 6,611 15,389 3,078 30,452 1,470
4 50,000 13,000 4,584 32,416 6,483 30,452 13,065
5 50,000 13,000 2,386 34,614 6,923 30,452 12,625