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Finance 1 > Cost of Capital and Capital Budgeting Techniques (LECTURE 6) > Flashcards

Cost of Capital and Capital Budgeting Techniques (LECTURE 6) Flashcards

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1
Q

CAPITAL ASSETS

A

Capital assets are long-term assets used to:

  • Generate future revenues or cost savings.
  • Provide distribution, service, or production capacity

Tangible: land, building, machinery, etc.
Intangible: copyrights, patent, etc.

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2
Q

Quantitative elements of capital budgeting.

A
  • Accounting rate of return
  • Payback period
  • Discounted payback period
  • Net Present Value (NPV)
  • Profitability Index (PI)
  • Internal Rate of Return (IRR)
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3
Q

Qualitative elements of capital budgeting.

A
  • Employee morale, safety, and responsibility
  • Corporate image
  • Social responsibility
  • Market share
  • Growth
  • Strategic planning
  • Sustainability
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4
Q

COST OF CAPITAL

A

The cost of capital represents the overall cost of financing to the firm.
The cost of capital is normally the relevant discount rate to use in analysing an investment.

The overall cost of capital is weighted average of the various sources, including debt, preference share, and shareholders’ equity:

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5
Q

WEIGHTED AVERAGE COST OF CAPITAL

A 
WACC = Weighted Average Cost of Capital
WACC = After tax costs x weights
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6
Q

Sources of long-term capital?

A
  • Long-Term Debt
  • Preference Share
  • Equity: Retained Earnings or New Shares
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7
Q

Calculating the weighted Average Cost of Capital

A

WACC or Cost of Capital = (Cost of Debt x Weight) + (Cost of Preference Shares x Weight) + (Cost of Equity x Weight of Equity)

Cost of Debt = Kd
Cost of Preference Shares = Kp
Cost of Equity = Ke

K0 = WdKd + WpKp + WeKe

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8
Q 
WEIGHTING EXAMPLE:
Bonds: 40
Pref. Stock: 100
Shares: 100
Ret. Earn.: 160
Total L&E: 400
What is weight of each component?
A

Bonds: 40/400 = 10%
Pref. Shares: 100/400 = 25%
Equity: 260/400 = 65%

WACC calculation:
If after-tax cost of debt to a company is 8%:
Kd = *%

If cost of preferred stock to a company is 10%:
Kp = 10%

If cost of equity to a company is 12%:
Ke = 12%

WACC = (8x0.10) + (10x0.25) + (12x0.65) = 11.1%

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9
Q

What are capital budgeting techniques?

A
  • Payback period
  • Discounted payback period
  • Accounting rate of return
  • Net Present Value
  • Internal Rate of Return
  • Profitability Index
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10
Q

THE PAYBACK PERIOD METHOD

A

How long does it take the project to “payback” its initial investment?

Payback Period = number of years to recover initial costs

  • Minimum acceptance criteria set by management
  • Ranking criteria set by management
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11
Q

Example of Payback Period Method 1

A 
Cash Flows Project A:
Time 0: (£10,000)
Time 1: £5,000
Time 2: £0
Time 3: £0
Payback: 2 Years
Cash Flows Project B:
Time 0: (£15,000)
Time 1: £15,000
Time 2: £0
Time 3: £0
Payback: 1 Year
Cash Flows Project C:
Time 0: (£10,000)
Time 1: £0
Time 2: £0
Time 3: £20,000
Payback: 2.5 Years
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12
Q

Example of Payback Period Method 2

A

Paid back between years 2 and 3.
-£5,000 cumulative cash flows in year 2 and £15,000 in year 3.

Payback Period = 2 + 5,000/20,000 = 2.25 years

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13
Q

Disadvantages of PPM

A
  • Ignores the time value of money
  • Ignores cash flows after the payback period
  • Biased against long-term projects
  • Requires an arbitrary acceptance criteria
  • A project accepted based on the payback criteria may not have a positive NPV
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14
Q

Advantages of PPM

A
  • Easy to understand

- Biased toward liquidity

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15
Q

THE DISCOUNTED PAYBACK PERIOD

A

How long does it take the project to “payback” its initial investment, taking the time value of money into account?
Same as PPM except work out present value of cash flows.

Decision rule: Accept the project if it pays back on a discounted basis within the specified time.

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16
Q

Disadvantages of Discounted Payback Period

A

By the time you have discounted the cash flows, you might as well calculate the NPV.
Similar disadvantages as PPM.

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17
Q

AVERAGE ACCOUNTING RETURN

A

Measure of accounting profit relative to book value:

AAR = Average Net Income / Average Book Value of Investment

Similar to return on assets measure.

Ranking and minimum acceptance criteria set by management.

Take investment if the AAR exceeds some specified return level.

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18
Q

Disadvantages of Average Accounting Return

A
  • Ignores the time value of money
  • Uses an arbitrary benchmark cut-off rate
  • Based on book values, not cash flows and market values
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19
Q

Advantages of Average Accounting Return

A
  • The accounting information is usually available

- Easy to calculate

20
Q

What are the 3 discounted cash flow methods?

A
  1. Net Present Value (NPV)
  2. Profitability Index (PI)
  3. Internal Rate of Return (IRR)

and Discounted Payback Period

21
Q

THE NET PRESENT VALUE

A

= Initial Investment (usually negative) + PV of future CF’s

NPV = -CF0 + CF1/(1+K0)^1 + CF2/(1+K0)^2 + CF3/(1+K0)^3 … CFn/(1+K0)^n

22
Q

How do you estimate NPV?

A
  1. Estimate future cash flows: how much? and when?
  2. Estimate discount rate
  3. Estimate initial costs

Minimum acceptance criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV

23
Q

Why use NPV?

A
  • NPV uses cash flows
  • NPV uses all the cash flows of the project
  • NPV discounts the cash flows properly
24
Q

How do you work out NPV?

A

NPV = -CF0 + CF1/(1+K0)^1 + CF2/(1+K0)^2 + … for every year

Work out PV of each cash flow.
Add PV of all cash flows together.

25
Q

What does it mean if NPV = 0?

A

Actual rate of return equals desired rate of return.

26
Q

What does it mean if NPV > 0?

A

Actual rate of return is great than desired rate of return.

27
Q

What does it mean if NPV

A

Actual rate of return is less than desired rate of return.

28
Q

MUTUALLY EXCLUSIVE PROJECTS

A

Only one of several potential projects can be chosen, e.g. acquiring a new machine.

Rank all alternatives, and select the best one (highest NPV).

29
Q

INDEPENDENT PROJECTS

A

Accepting or rejecting one project does not affect the decision of the other projects.

Must exceed a minimum acceptance criteria.

30
Q

THE PROFITABILITY INDEX

A

Benefit-Cost Ratio:
PI = Total PV of Future Cash Flows / Initial Investment

Minimum Acceptance Criteria:
Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI

31
Q

How do you work out the profitability index?

A

Work out present value of all cash flows then divide by the initial investment.

32
Q

Disadvantages of the profitability index.

A

-Depends on the scale of the project.

33
Q

Advantages of the profitability index.

A
  • May be useful when available investment funds are limited
  • Easy to understand and communicate
  • Correct decision when evaluating independent projects
34
Q

THE INTERNAL RATE OF RETURN

A

IRR: the discount rate that sets NPV to zero

Minimum Acceptance Criteria: Accept if the IRR exceeds the required return

Ranking Criteria: Select alternative with the highest IRR

35
Q

How do you work out IRR?

A

NPV = -CF0 + CF1/(1+K0)^1 + CF2/(1+K0)^2 + CF3/(1+K0)^3

Set to zero:

0 = -CF0 + CF1/(1+IRR)^1 + CF2/(1+IRR)^2 + CF3/(1+IRR)^3

Work out PV at one discount rate then at another, one is above zero, other is below. Then use interpolation to find discount rate where NPV is equal to zero.

IRR = L+(PV+)/(PV+)-(PV-)

IRR is the x-axis intercept of NPV set against discount rate.

36
Q

Advantages of IRR?

A

Easy to understand and communicate.

37
Q

Disadvantages of IRR?

A
  • IRR may not exist, or there may be multiple IRRs
  • Does not distinguish between investing and borrowing
  • Problems with mutually exclusive investment
38
Q

Problems with mutually exclusive investment?

A

The scale problem

The timing problem

39
Q

How do you distinguish between borrowing and lending?

A

Standard investment project: negative cash flow first, positive cash flow later.

IRR criterion: accept if IRR > benchmark

Lending project: positive CF are followed by negative ones

IRR criterion: accept if IRR

40
Q

NPV vs. IRR

A

NPV and IRR will generally give the same decision.

EXCEPTIONS:
-Non-conventional cash flows - cash flow signs change more than once

  • Mutually exclusive projects
  • Initial investments are substantially different
  • Timing of cash flows is substantially different
41
Q

Which techniques use time value of money?

A

NPV, PI, IRR

42
Q

Which techniques provide specific rates of returns?

A

IRR

43
Q

Which techniques use cash flows?

A

Payback, NPV, PI, IRR

44
Q

Which techniques consider returns during life of the project?

A

NPV, PI, IRR

45
Q

Which techniques use discount rate?

A

NPV, PI

Finance 1 (7 decks)

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