Five Key Principals of Capital Budgeting

1) Decisions are based on incremental cash flows. Sunk costs are not considered.

2) Cash flows are based on opportunity cost

3) Timing of the cash flows is important

4) Cash flows are analyzed on an after-tax basis

5) Financing costs are reflected in the required rate of return, not in the incremental cash flows

2) Cash flows are based on opportunity cost

3) Timing of the cash flows is important

4) Cash flows are analyzed on an after-tax basis

5) Financing costs are reflected in the required rate of return, not in the incremental cash flows

Payback Period

Number of years it takes to recover the initial cost of the project. Ignores time value of money and any cash flows beyond the payback period

Discounted Payback Period

Number of years it takes to recover the initial investment in present value terms. Still ignores the cash flows beyond the discounted payback period.

Profitability Index

Present Value of a project’s future cash flows divided by the initial cash outlay

A positive NPV project

should increase the company’s stock price by the project’s NPV per share

WACC =

(weight of debt)(cost of debt(1-tax rate)) + (weight of ps)(cost of ps) + (weight of common equity)(cost of common equity)

Weights/Proportions used in WACC calculations

are target proportions and are calculated using market values

Three Cost of Equity Capital Calculations

1) CAPM Approach

2) Discounted Cash Flow Approach

3) Bond Yield Plus Premium Approach

2) Discounted Cash Flow Approach

3) Bond Yield Plus Premium Approach

CAPM Approach =

RFR + Beta(R of market – RFR)

Discounted Cash Flow Approach for Cost of Equity =

((Dividend 1)/(Initial Price)) + g

Bond Yield Plus Risk Premium Approach =

current market yield on the firm’s long-term debt + risk premium

Cost of Preferred Stock =

Dividend / Price

Cost of Debt =

average market yield on the firm’s outstanding debt issues

Marginal Cost of Capital Curve

upward sloping if a firm’s WACC can increase as it raises larger amounts of capital

Investment Opportunity Schedule

downward sloping if the firm ranks its potential projects in desending IRR order

Optimal Capital Budget

amount of capital investment required to fund all projects for which the IRR is greater than the marginal cost of capital

Pure-Play Method

project beta is estimated based on the equity beta of a firm purely engaged in the same business as the project. Must be adjusted for any difference between the capital structure (leverage)

Country Risk Premium=

(sovereign bond yield – T Bond Yield) * (std. dev of developing country index / std. dev. of sovereign bonds in US currency)

Required Return on Equity Securities =

RFR + Beta ((Expected return on the Market) – RFR + CRP)

Flotation Costs

Underwriting costs, and should be included as an addition to the initial outlay for the project when calculating NPV or IRR

Business Risk

resulut of Sales Risk and Operating Risk

Financial Risk

additional risk common shareholders have to bear because the firm uses fixed cost sources of financing

DOL =

(% change in EBIT) / (% change in Sales)

Degree of Operating Leverage

Degree of Operating Leverage

DOL at particiular level of Sales, Q, =

Q(P-V) / Q(P-V) – F

or

(S – TVC) / (S – TVC – F)

or

(S – TVC) / (S – TVC – F)

There is no operating leverage IF

fixed costs are zero

DFL =

(% change in EPS) / (% change in EBIT)

Degree of Financial Leverage

Degree of Financial Leverage

DFL at a particular level of sales =

(EBIT) / (EBIT – interest expense)

There is no financial leverage IF

interest costs are zero

Degree of Total Leverage (DTL) =

DOL * DFL

DTL =

(S – TVC) / (S – TVC – F – I)

Breakeven Point

Quanity of sales a firm must achieve to just cover its fixed and variable costs

Quantity Breakeven Point =

(total fixed costs) / (price – variable cost per unit)

If sales are greater than the breakeven quantity

the firm with the greater operating leverage will generate a large profit

Financial leverage reduces net income by the interest cost but

increases return on equity because the reduced net income is generated with less equity and more debt

Cash Dividends

reduce the company’s assets and market value of the equity. The stock price drops by the amount of the per share dividend. Therefore, it does not change the shareholder’s wealth

Liquidating Dividend

A company goes out of business and distributes the proceeds to shareholders. These are taxed as a return of capital

Dividend Payment Chronology

Declaration Date, Ex-Dividend Date, Holder-of-Reocrd Date, Payment Date

Ex-Dividend Date

First day the stock trades without the dividend (two business days before the record date)

Holder-of-Record Date

Date on which shareholders must own the shares in order to receive the dividend

Stock Dividends, Stock Splits, and Reverse Stock Splits

change the number of shares outstanding, but the share price changes proportionally, so a shareholder’s wealth and ownership stake are not affected

Reverse Stock Split

Replace “old” shares with a smaller number of “new” shares

Liquidity Drag

forces that delay the collection of cash, such as slow payments by customers and obselete inventory

Adjustable-Rate Preferred Stock

Dividend rate that is reset periodically to current market yields, offers corporate holders a tax advantage because a percentage of the dividends received is exempt from federal tax

% Discount from Face Value =

(face value – price) / (face value)

Discount-Basis Yield =

((face value – price)/ (face value)) * (360/days)

or

(% discount) * (360/days)

or

(% discount) * (360/days)

Money Market Yield =

((face value – price) / (price)) * (360/days to maturity)

or

HPY * (360/days to maturity)

or

HPY * (360/days to maturity)

Bond Equivalent Yield =

((face value – price) / (price)) * (365/days to maturity)

or

HPY * (365/days to maturity)

or

HPY * (365/days to maturity)

Aging Schedule

shows amounts of receivables by the length of time they have been outstanding

Weighted Average Collection Period

Average days outstanding per dollar of receivables

2/10 net 60

2% discount for paying an invoice within 10 days that is due in full after 60 days

Cost of Trade Credit =

(1 + (percent discount / (1 – percent discount)) ^ (365/days past discount) -1

Uncommitted Line of Credit

Non-binding offer of credit

Committed Line of Credit

Binding offer of credit to a certain maximum amount for a specific time period. Requires a fee

Revolving Line of Credit

Most reliable line of credit, typically for longer terms

Lines of Credit are primarily by

large, financially sound companies

Banker’s Acceptances

used by firms that export goods and are a guarantee from the bank of the firm that has ordered the goods, stating that a payment will be made upon receipt of the goods. The exporting company can then sell this acceptance at a discount in order to generate funds.

Blanket Lein

Gives the lender a claim to all current and future firm assets as collateral additional to specific named collateral

Factoring

The actual sale of receivables at a discount from their face value