Domain IV − Financial Management − Section A.4 Capital Budgeting Flashcards
Capital Structure
refers to a firm’s combination of the two major sources of funds:
- Debt capital is funds obtained through borrowing: Short‐term debt, Long‐term debt
- Equity capital is funds from: Stock issues to the general public, Additional paid‐in capital, Operational revenues and retained earnings, Venture capital, Liquidating assets
Short‐term Debt
typically finances current needs for cash or inventory at times when cash requirements exceed available funds. These sources must be repaid within one year. The sources of short‐term funds are:
- Trade Credit provides a short‐term source of funds resulting from purchases made on credit or open account.
- Unsecured Bank Loans are borrowed short‐term funds for which the borrower does not pledge any asset as a collateral. (i.e. promissory note, line of credit, revolving credit agreement).
- Commercial Paper is the purchase of commercial paper by firms with excess funds in order to earn interest.
- Secured Short‐term Loans require the owner to pledge collateral such as accounts receivable or inventory. (i.e. field warehousing arrangement, warehouse receipts, chattel mortgages, repurchase agreement).
- Factoring is selling of accounts receivable below their face value to a factor.
- Bankers’ Acceptances are drafts drawn on deposits at a bank guaranteed by the bank for payment at maturity.
Long‐term Debt
usually needed to finance major purchases and/or investments. Types of long‐term debt include:
- Long‐term Loans are loans that can be repaid over periods of one year or longer. (i.e. term loans or lease).
- Bonds are certificates of indebtedness sold to raise long‐term funds for governments or corporations.
Common Stock
is stock providing owners voting rights but only a residual claim to company assets.
• Common stock may be sold at either a par or no‐par value basis and may be quoted at book or market value:
i. Par Value is the value printed on the stock certificates of some companies.
ii. Non‐Par Value shares may be issued to reduce the state taxes on incorporation and to avoid the use of the arbitrary par value basis.
iii. Book value is the residual value of a corporation (assets – liabilities – preferred stock) divided by the number of common stocks to find the value of each stock.
iv. Market value is the market price at which a stock is currently selling.
• Pre‐emptive rights provide the common shareholders with the right of buying shares of new issuances in proportion to their existing ownership.
Preferred Stock
is stock providing owners preferential dividend payment and first claim to assets after debts are paid (but before common shareholders), however, usually lacking the voting rights.
For payments of dividends, preferred stock may be:
- Cumulative preferred stock stockholders must be paid a dividend for each year before common stockholders can be paid. All cumulative dividends in arrears need to be paid prior to paying dividends to common shareholders.
- Noncumulative preferred stock need only be paid on the current year’s dividends before common stockholders receive their dividends.
Additional Paid‐In Capital
are funds paid to the company other than stocks that may be from the excess over par from stock issuances and/or other contributions to the organization.
Operational Revenues and Retained Earnings
are the cumulative earnings of the company since inception that were not distributed to the shareholders as dividends.
Capital budgeting
is the process of planning expenditures on assets whose cash flows are expected to extend beyond one year. Effective capital budgeting can improve both the
timing of asset acquisitions and the quality of assets purchased.
Net present value (NPV)
ranks investments using the net present value of the future net cash flows of the project discounted using the marginal cost of capital.
• Hurdle Rate is the target rate of return set by management on its investments. Projects selected should provide a rate of return equal to or greater than the hurdle rate.
=> When selecting amongst two or more projects, the project with the higher positive NPV should be selected.
=> When selecting amongst mutually exclusive investment projects, all projects with positive NPV should be selected depending on the availability of investment funds for the initial cash outflows.
Internal Rate of Return (IRR)
calculates the expected rate of a project by calculating the discount rate (k) that equates the present value of future cash inflows and outflows to zero.
=> Projects with IRRs more than the hurdle rate are accepted whereas projects with IRRs less than the hurdle rate are rejected.
Profitability index
is the ratio of the present value of net future cash inflows to the present value of the net initial investment.
=> To be accepted under the profitability index method, a project should have an index greater than one. The higher the profitability index the better, other factors being constant.
Payback Period
is the period of time required for the net revenues of an investment to recoup the costs of the investment.
- It is equal to the year before full recovery plus the unrecovered cost at start of year divided by the cash flow during the year.
- The lower the payback period, the better.
The Accounting Rate of Return (ARR)
is the ratio of the additional accounting return (above the expected or required returns) divided by the average investment.
- The ARR measures the return in terms of accrual accounting rather than cash flows.
The cost of capital to a firm :
is the weighted average of the cost of the various components of capital that the firm uses.
• The components are: debt, preferred stock, common equity
• The weighted average cost of capital would thus be the sum of the following:
- Debt (D) % × after‐tax cost of debt.
- Preferred stock (PS) % × cost of preferred stock.
- Common equity (CE) % × cost of common equity.
• The weighted average cost of capital is minimized when the firm is at its optimal capital structure. The optimal capital structure is the mix of debt, preferred shares, and common shares that minimizes the weighted average cost of capital.
Taxes
are payments made to the government by individuals and corporations representing one of the major sources of government financing.
- Value‐Added Tax is a tax levied on the value a firm adds to a good or service. The amount is usually measured as the difference between the value of a firm’s sales and its cost of sales.
- Income tax is a tax levied on a firm’s income (i.e., total revenues less total expenses). (i.e. corporate tax, personal income tax).
- Capital Gains Tax is a tax levied on a firm’s capital gains that are the result of a profit on capital assets.
- Property Tax is a tax levied on property ownership.
