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INVESTOR-SUPPLIED ITEMS: debt, preferred shares, & ordinary

share are called Capital component.

COST OF DEBT (Kd) minimum rate of return required by suppliers of

debt.

Before tax cost of debt interest rate a firm must pay on its new

debt.

After tax cost of debt should be used to calculate WACC

FORMULA: After-tax cost of debt=Interest rate(1-Tax rate)

COMPUTING COST OF A NEW BOND ISSUE

1. Determine net proceeds from sale of each bond

Net proceeds of bond sale=Market price Flotation cost

2. Compute the before tax cost of bond

NPd=I(PVIFAKD,N)+PN(PVIFKD,N)

I= annual interest payment in pesos

PVIFA= Present value interest factor of annuity

Pn= Par/ principal repayment req. in period N

Kd= before tax cost of new bond issue

n= length of holding period of bond in yr

t= time period in yrs

PVIF= present value interest factor of a single

3. Compute the after-tax cost of debt using the ff. equation:

Kdt= after-tax cost of debt

Kd= before-tax cost of debt

T= marginal tax rate

PREFERRED SHARE(Kp) a hybrid security that has characteristics

of both debt & equity. Formula: Kp=Dp / NPp

Where: Dp= Annual div per share on preferred share

NPp= Net proceeds from sale of preferred

ORDINARY EQUITY SHARE does not represent a contractual

obligation to make specific payments thus making it more difficult to

measure its cost than the cost of bonds/preferred.

Cost of existing ordinary equity share is same as the cost of

retained earnings.

Cost of new O.E share and R.E are similar but not equal.

A. COST OF EQUITY

1. Capital Asset Pricing Model(CAPM) most widely used method

for estimating cost of ordinary equity.

Steps:

1.1. Estimate risk free rate (rRF) (Generally use 10 yr Treasury

bond)

1.2. Estimate stock beta coefficient (bi) & use it as an index of

the stock risk.

1.3. Estimate expected market risk premium.

1.4. Substitute preceeding values in CAPM equation to

estimate required rate of return on stock question.

Formula:

Rs=rRF + (RPm)bi or rRF (rm rRF)bi

2. Bond Yield Plus Risk Premium Approach

Generalized risk premium/bond-yield-plus-risk premium

required rate of return on shareholders equity.

Formula: Ks=Kd + rp

Where: kd= base rate of long term bonds/bond yield

rp=risk premium

3. Dividend Yield Plus Growth Rate Approach

Formula: Ks= D1/Po + g

Where: D1=div expected to be paid @ the end of yr.1

Po=Current stock price

g= Expected dividend growth rate

4. Discounted Cash flow (DFC) Approach method of estimating

cost of equity.

Formula: Ks= D1/Po + expected g

5. Earnings Price Ratio Model simplistic technique used to

estimate cost of ordinary equity, w/c is based on inverse of the

firms price-earnings ratio.

Formula: Ks=E/Po

Where: E= Current earnings per share

Po= Current market price of O.E share

B. COST OF NEW ORDINARY EQUITY SHARES or Constant

growth Model for new O.E shares is generally used in measuring

cost of new ordinary equity share.

Underpricing it occurs when new O.E share sells below the

current market price of outstanding O.E share in order to

attract investors & compensate dilution of ownership.

Underwriting fee covers the cost marketing new issue

C. COST OF RETAINED EARNINGS R.E should be cost-free

bcoz they represent money that isleft-over after dividends are

paid.

R.E. BREAKPOINT tot amount of capital that can be raised before

new shares must be issued.

PROBLEMS TO CONSIDER W/ ESTIMATES OF COST OF

CAPITAL:

1. Privately owned firms

2. Measurement problems

3. Capital structure weights

4. Cost of capital for projects of differing risk

Formula: WACC=(% of debt)(After-tax Cost of Debt)+(% of

Preferred share)(Cost of preferred share)+(% of ordinary

Equity)(Cost of O.E)

WACC measures specific cost of capital of each long term financing

source.

TWO MAJOR SCHEMES IN COMPUTING WACC:

1. Historical Weights based on the firms existing capital

structure.

Optimal Capital Structure combination of debt & equity that

simultaneously maximizes the firms market value & minimize

WACC.

1.1. Book value weights measure actual proportion of each

type of permanent capital in firms structure based on

accounting values.

1.2. Market value weights measure the actual proportion

permanent capital in firms structure @ current market

prices.

2. Target Weights are based on firm's desired cap. Structure.

CHAP.28: CAP BUDGETING

STRATEGIES ASSET ALLOCATION PROCESS usually more

involved than just deciding whether to buy a particular fixed assets.

CAPITAL BUDGETTING PROCESS is a system of interrelated

steps for making long term investment decision.

STEPS IN CAPITAL BUDGETING:

1. GENERATING PROJECT PROPOSALS

1.1. Capital Budgeting decision:

Replacement decisions to continuous current operations

Replacement to effect cost reduction

Expansion into new products/market

Expansion of existing products/markets

Equipment selection decision

Safety & environmental projects

Merger

Other projects

1.2. 2 Broad Categories:

Independent capital investment projects/ Screening

decision:

- Investment in long-term assets

- New product development

- Undertaking large scale advertising campaign

- Introduction of computer

- Corporate acquisitions

Mutually exclusive capital investment projects/ preference

decision:

- Replacement against renovation od equipment

- Rent/ lease against ownership of facilities

- Manual bookkeeping system against computerized

- Preventive maintenance against periodic overhaul of

machineries.

- Purchase of machineries from an outside supplier

against assembly of machinery by company staff.

2. COLLECTING RELEVANT INFO ABOUT OPPORTUNITIES

Capital Budgeting dynamic process bcoz firms changing

environment may affect desirability of current/ proposed

investment.

3. ESTIMATING CASH FLOWS

Net Cash Flow the difference between inflow & outflow of

cash that result from firms undertaking a project.

Cash flows of a Project fall into 3 CATEGORIES:

3.1. NET INITIAL INVESTMENT

Net Investment net initial cash outlay needed to

acquire a specific investment project.

Initial cash outflows include purchase price of new

asset, outlays & transportation.

Initial cash Inflows include proceeds from disposal

of existing assets

3.2. NET OPERATING CASH FLOWS/RETURN

incremental changes in a firms cash flows that result

from investing in a project.

3.3. NET TERMINAL CASH FLOW

4. EVALUATING PROJECT PROPOSALS

5. SELECTING PROJECTS

3 MAJOR FACTORS:

1. Project type

2. Availability of funds

3. Decision criteria

6. IMPLEMENTING & REVIEWING PROJECTS

Implementation stage involves developing formal

procedures for authorizing expenditures of funds for

capital projects.

Post-audit final aspect of the capital budgeting process

Main purpose of Post-Audit

1. Improve forecast

2. Improve operations

FORECASTING RISK(Estimation risk) possibility that a bad

decision will be made bcoz of errors in the projected cash flows.

METHOD OF ESTIMATING & MEASURING RISK:

1. Scenario Analysis basic form of what-if analysis.

2. Sensitivity analysis process of changing one or more

variables to determine how sensitive a project returns

3. Simulation Analysis a combination of scenario and sensitivity

analysis.

4. Beta Estimation this approach to risk measurement involves

the concepts of CAPM.

- Systematic Risk Principle it states that the reward of

bearing risk depends only on that assets systematic risk.

When performing a new P.V analysis, the ff. should be

observed:

If a MARKET-BASED COST OF CAPITAL is used to

discount cash flow, then cash flow should be adjusted

upwards.

If the REAL COST OF CAPITAL is used in the analysis,

there is no need to adjust the cash flows upward

CHAPTER 29: INVESTMENT PROPOSALS

TECHNIQUES IN CAPITAL BUDGETING

A. DISCOUNTED CASH FLOW (TIME-ADJUSTED)

APPROACH

1. Net Present Value

2. Internal rate of return

3. Profitability index

4. Discounted Payback Period

B. NON-DISOUNTED CASH FLOW (UNADJUSTED)

APPROACH

1. Payback Period

2. Bailout Payback Period

3. Payback Reciprocal

4. Accounting Rate of Return (BV rate of return)

STEPS IN COMPUTATION OF IRR

A. CASH INFLOWS ARE EVENLY RECEIVED

1. Compute PV factor by dividing Net Invest by Annual

Cash Returns

2. Trace PV factor in table for PV of P1 received

annually using the life of project as point of reference

3. Column that gives the closets amount to PV factor is

the Discounted rate of return

4. Get the exact Discounted rate of return, interpolation

is applied.

B. CASH INFLOWS ARE NOT EVENLY RECEIVED:

1. Compute Ave. Annual Cash Return by dividing the sum

of returns to be received during the life of project by

total economic life of the project

2. Divide Net Investment by Ave. Annual Cash Returns to

get the PV factor.

3. Refer to table PV of P1 received annually to determine

rate that will give closest factor to computed PV factor.

4. Use step 3.

5. Add PV of annual returns & compare with net

investment

6. If result in step 4 does not give equality of PV of returns

& net investment try another rate

7. Interpolate to get exact discounted rate of return.

ADVANTAGES OF USING PV INDEX

1. Consider the magnitude & timing of cash flows

2. Provides an objective criterion for decision making w/c

maximizes shareholder wealth

3. Provides a relative measure of return per peso of net

investment.

DISADVANTAGE OF USING PV INDEX Conflict may arise with

NPV when dealing w/ mutually exclusive investment

ADVANTAGES OF PAYBACK PERIOD METHOD

1. Easy to compute and understand

2. Used to measure the degree of risk associated w/ a project

3. Generally, the longer the payback period the higher the risk

4. Used to select projects w/c provide a quick return of invested

funds

DISADVANTEGES OF PAYBACK PERIOD METHOD

1. Does not recognize the time value of money

2. Ignores the impact of cash inflows after the payback period

3. Does not distinguish between alternatives having different

economic lives

4. Conventional payback computation fails to consider salvage

value

5. It does not measure profitability only the relative liquidity of

investment

6. There is no necessary relationship between a given payback

& investor wealth maximization so an investor would not

know what an acceptable payback is.

ADVANTAGES OF USING THE ARR

1. Easily understood by investors acquainted with financial

statements

2. Used as a rough preliminary screening device of investment

proposals

DISADVANTAGES OF USING THE ARR

1. Ignores the time value of money by failing to discount the

future cash inflows and outflows

2. Does not consider the timing component of cash inflows

3. Different averaging techniques may yield inaccurate answers

4. Utilizes the concepts of capital & income primarily designed

for the purpose of financial statement preparation & which

may not be relevant to the evaluation of investment

proposals.

SELECTION PROBLEMS

1. Accept Reject Decision

2. Mutually Exclusive Project Decision

a. Sophisticated or Advanced capital budgeting techniques:

Difference in expected economic lives of the

project

Substantially difference in net investments (size) of

the projects

Difference in timing of cash flows

Difference in reinvestment rate assumptions in

discounted cash flow techniques

b. NPV is considered the superior technique. Reasons:

NPV method provides correct rankings of mutually

exclusive investment projects, whereas other DFC

techniques sometimes do not.

NPV implicitly assumes that the operating cash

flows generated by the project are reinvested at the

firms cost of capital w/c approx. the opportunity

cost for reinvestment

3. Capital Rationing Decision

SCENARIOS OF CAPITAL RATIONING

1. Projects are Divisible and Constraint is a Single Period One

2. Projects are Indivisible and Constraint is a Single Period

One

3. Projects are Divisible and Constraint is Multi-period One

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