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WEIGHTED AVERAGE generally used since firms seldom use

equal amounts of debt and equity capital sources.


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