Topics
1) Capital Budgeting
2) Cost of Capital
3) Measures of Leverage
4) Dividends and Share Repurchases
5) Working Capital Management
6) Financial Statement Analysis
Capital Budgeting
Introduction
The Capital Budgeting Process is the process of identifying and evaluating capital projects, i.e., projects
where the cash flow to the firm will be received over a period longer than a year. Capital budgeting
usually involves the calculation of each projects future accounting profit by period, the cash flow by
period, the present value of the cash flows after considering the time value of money, the number of
years it takes for a projects cash flow to pay back the initial cash investment, an assessment of risk, and
other factors.
5 Key Principles of Capital Budgeting
1) Decisions are based on cash flows, not accounting income (Incremental cash flows are to be
considered, not sunk costs)
2) Cash flows are based on opportunity costs
3) The timing of cash flows is important
4) Cash flows are analyzed on an aftertax basis
5) Financing costs are reflected in the projects required rate of return
Net Present Value (NPV)
The NPV is the sum of present values of all expected incremental cash flows if a project is undertaken.
The discount rate used is the firms cost of capital. For a normal project with an initial cash outflow,
flowed by a series of cash inflows (after tax), the NPV is given by:
For independent projects, the NPV decision rule is to accept projects with positive NPVs and to reject
projects with negative NPVs.
Simple Example
The Table shows the expected net aftertax
cash flows of two projects, A and B. Discount
Rate (Required rate of Return) = 10%
NPV of A = 2000 + 1000/(1.1)^1 + 800/(1.1)^2 + 600/(1.1)^3 + 200/(1.1)^4 = INR 157.64
NPV of B = 2000 + 200/(1.1)^1 + 600/(1.1)^2 + 800/(1.1)^3 + 1200/(1.1)^4 = INR 98.36
Both projects A and B have positive NPVs, so both can be accepted. But, if only one project is to be
chosen and if other factors are kept constant, then Project A should be chosen because it has a positive
NPV.
Advantage of the NPV Method: It is a direct measure of the expected increase in the value of the
firm/project
Disadvantage of the NPV Method: The project size is not measured. For example, an NPV of INR 100 for
a project costing INR 10,000 is good, but the same NPV of INR 100 is not so good for a project costing
INR 10,000,000
Internal Rate of Return (IRR)
The IRR is the discount rate which makes the present values of a projects estimated cash inflows equal
to the present value of the projects estimated cash outflow. It is the discount rate at which the NPV of a
project is equal to 0.
If IRR > the required rate of return, accept the project
If IRR < the required rate of return, reject the project
Continuing with the above example used for NPV:
Project A: 0 = 2000 + 1000/(1 + IRR
A
)^1 + 800/(1 + IRR
A
)^2 + 600/(1 + IRR
A
)^3 + 200/(1 + IRR
A
)^4
Project B: 0 = 2000 + 200/(1 + IRR
B
)^1 + 600/(1 + IRR
B
)^2 + 800/(1 + IRR
B
)^3 + 1200/(1 + IRR
B
)^4
Using trialanderror methods, financial calculators or Excel, the IRR for Project A = 14.49% and the IRR
for Project B = 11.79%. Both can be accepted as the IRRs for both projects > 10%.
Year Project A (INR) Project B (INR)
0 2000 2000
1 1000 200
2 800 600
3 600 800
4 200 1200
Advantage of the IRR Method: It measures profitability as a percentage, showing the return in each
Rupee invested. One can comment on how much below the IRR the actual project return could fall (in
percentage terms) before the project becomes economically unfeasible
Disadvantages of the IRR Method: The possibility of producing rankings of projects which may differ
from the NPV rankings (either due to cash flow timing differences or due to differences in project size)
and the possibility of Multiple IRRs for the same project or no IRR
Payback Period
The Payback Period is the number of years it takes to recover the initial cost of an investment.
Continuing with the same example:
Payback Period = Full years until recovery + (Unrecovered Cost at the beginning of last year/Cash flow during last year)
Payback Period (Project A) = 2 + (200/600) = 2.33 years
Payback Period (Project B) = 3 + (400/1200) = 3.33 years
Since the Payback Method does not take into account the time value of money and cash flows beyond
the payback period, project decisions cannot be based solely on this method. However, this method is a
good measure of project liquidity.
Discounted Payback Method
This method uses the present values of the projects estimated cash flows. It must be greater than the
Payback Period without discounting.
Continuing with the same example:
Year Project A (INR) Project B (INR)
Net Cash Flow Cumulative NCF Net Cash Flow Cumulative NCF
0 2000 2000 2000 2000
1 1000 1000 200 1800
2 800 200 600 1200
3 600 400 800 400
4 200 600 1200 800
Year Project A (INR) Project B (INR)
Net Cash Flow Discounted
NCF
Cumulative
DCNF
Net Cash Flow Discounted
NCF
Cumulative
DCNF
0 2000 2000 2000 2000 2000 2000
1 1000 910 1090 200 182 1818
2 800 661 429 600 496 1322
3 600 451 22 800 601 721
4 200 137 159 1200 820 99
Discounted Payback Period (Project A) = 2 + (429/451) = 2.95 years
Discounted Payback Period (Project B) = 3 + (721/820) = 3.88 years
This method addresses the concern of discounting cash flows at the projects required rate of return,
but it still does not consider cash flows beyond the discounted payback period.
Profitability Index (PI)
This is the Present Value of a projects future cash flows divided by the initial cash outlay. It is closely
related to the NPV.
PI = (PV of future cash flows/Initial Investment) = 1 + (NPV/Initial Investment)
If PI > 1.0, accept the project, else, if PI < 1.0, reject the project.
Cost of Capital
Introduction
A firm must decide on how to raise capital for its various projects, to funds its business and for growth.,
dividing it among common equity, debt and preferred stock. The optimum mix which produces the
minimum overall cost of capital will maximize the value of the firm. Debt, preferred stock and common
equity are referred to as the capital components of the firm. The cost of each of these components is
called the component cost if capital.
k
d
: Cost of Debt The rate at which the firm can issue new debt. It can also be considered as the yield to
maturity on existing debt (pretax component)
k
d
(1
t): Aftertax cost of Debt t is the firms marginal tax rate
k
p
: Cost of preferred Stock
k
e
: Cost of Equity The required rate of return on common stock
WACC: Weighted Average Cost of Capital It is the cost of financing the firms assets. WACC is the
average of the costs of the above sources of financing, each of which is weighted by its respective use in
the given situation.
WACC = (w
d
)[k
d
(1
t)] + (w
p
)(k
p
) + (w
e
)(k
e
)
where, w
d
= percentage of debt in the capital structure, w
p
= percentage of debt in the capital structure,
w
e
= percentage of debt in the capital structure
Simple Example
Suppose Company As target capital structure is as follows: w
d
= 0.45, w
p
= 0.05, w
e
= 0.50. Beforetax
cost of debt = 8%, cost of equity = 12%, cost of preferred stock = 8.4%, marginal tax rate = 40%
WACC = (w
d
)[k
d
(1
t)] + (w
p
)(k
p
) + (w
e
)(k
e
)
WACC = (0.45)(0.08)(1 0.40) + (0.05)(0.084) + (0.50)(0.12) = 0.0858 = 8.58%
The weights in the calculation of WACC should be based on the firms target capital structure (the
proportions the firm aims to achieve over time). The assumption here is that the firm would stick to the
same capital structure throughout the life of the project
The Optimal Capital Budget
In the figure above, the intersection of the investment opportunity schedule with the marginal cost of
capital curve identifies the amount of the optimal capital budget. The firm should undertake projects
whose IRRs are greater than the cost of funds as this will maximize the value created.
It is useful to view graphically how WACC alters as leverage changes. The classic figure below shows how
WACC is high at low levels of leverage (debt), it reaches an optimum at the idealized WACC before
rising quickly into the territory where financial distress (risk of bankruptcy) becomes a major factor.
Cost of Debt
The aftertax cost of debt is the interest rate at which firms can issue new debt net of the tax savings
from the tax deductibility of interest.
Aftertax cost of debt = Interest Rate Tax savings = k
d
k
d
(t) = k
d
(1 t)
Cost of Preferred Stock
k
p
= Preferred Dividends (D
ps
)/Market Price of Preferred Stock (P)
Cost of Equity
The cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to
compensate for the risk they undertake by investing their capital. Two methods have been discussed
below to calculate the Cost of Equity: the Capital Asset Pricing Model (CAPM) and the Dividend Discount
Model.
Capital Asset Pricing Model (CAPM)
The most commonly accepted method for calculating cost of equity comes from the Capital Asset Pricing
Model (CAPM): The cost of equity is expressed formulaically below:
k
e
or r
e
= r
f
+ (r
m
r
f
) *
where: k
e
or r
e
= the cost of equity or the required rate of return on equity, r
f
= the risk free rate, r
m
=
expected return on the market portfolio, (r
m
r
f
) = the equity market risk premium, = beta coefficient =
unsystematic risk of the firm
The Risk Free Rate (r
f
) is the amount obtained from investing in securities considered free from credit
risk, such as government bonds from developed countries
Beta (): This measures how much a company's share price reacts against the market as a whole. A beta
of 1 indicates that the company moves in line with the market. If the beta is in excess of 1, the share is
exaggerating the market's movements; less than 1 means the share is more stable. Occasionally, a
company may have a negative beta, which means the share price moves in the opposite direction to the
broader market
Equity Market Risk Premium (r
m
r
f
): It represents the returns investors expect to compensate them for
taking extra risk by investing in the stock market over and above the riskfree rate
Dividend Discount Model Approach
If dividends are expected to grow at a constant rate, g, then the current value of the companys stock is
given by this model.
P
0
= D
1
/(k
e
g)
where: P
0
= the current value of the companys stock, D
1
= next years dividend, k
e
= required rate of
return on equity or cost of equity, g = the firms expected constant growth rate (g = (Retention
Rate)(Return on Equity ROE)). Rearrange the terms to solve for k
e
WACC Example
Question: Monetrix Inc. (a listed firm) is considering a project in the Financial Education business. It has
a D/E ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield of 14%. The equity beta is
0.966. The riskfree rate is 5% and the expected return on the market portfolio is 12%. Calculate the
appropriate WACC to evaluate the project.
Solution
Project Cost of Equity = 5% + 0.966(12%  5%) = 11.762%
Cost of Debt = 14%, Cost of Preferred Stock = 0%, Weight of preferred stock = 0
As D/E = 2, w
d
= 2/3, w
e
= 1/3
Therefore, WACC = 1/3(11.762%) + 2/3(14%)(1 0.40) = 9.52%
Measures of Leverage
Introduction
Leverage, in general, refers to the amount of fixed costs a firm has. These fixed costs may be fixed
operating expenses (such as building or equipment leases) or fixed financing costs (such as interest
payments on debt. Greater leverage leads to greater variability of the firms aftertax operating earnings
and income. Leverage increases the risk and potential return of a firms earnings and cash flows.
Business Risk: Refers to the risk associated with the firms operating income and is the result of
uncertainty about a firms revenues and the expenditures necessary to produce those revenues. It is the
combination of the firms sales risk and operating risk (the additional uncertainty about operating
earnings caused by fixed operating costs).
Financial Risk: Refers to the additional risk that a firms common stockholders must bear when a firm
uses fixed cost (debt) financing. The fixed expenses, in this case, are in the form of interest payments.
The use of financial leverage increases the level of ROE and it also increases the rate of change of ROE.
The use of financial leverage increases the risk of default, but it also increases the potential return for
equity shareholders.
Degree of Operating Leverage (DOL)
It is defined as the percentage change in operating income (EBIT) that results from a given percentage
change in sales.
To calculate a firms DOL for a particular unit level of sales, Q:
where: Q = quantity of units sold, P = price per unit, V = variable cost per unit, F = fixed costs
The DOL is highest at low levels of sales and declines at higher levels of sales.
Degree of Financial Leverage (DFL)
It is interpreted as the ratio of the percentage change in Net Income (or EPS) to the percentage change
in EBIT. For a particular level of operating earnings, DFL is calculated as DFL = EBIT/(EBIT Interest)
Degree of Total Leverage (DTL)
It combines the Degree of Operating Leverage and Financial Leverage. DTL measures the sensitivity of
EPS to the change in sales.
Breakeven Quantity of Sales
The level of sales that a firm must generate to cover all its fixed and variable costs is called the
breakeven quantity. At this quantity, revenues = total costs, implying that net income is 0.
The Contribution Margin, which is the difference between the price and the variable cost per unit, is
used to cover the fixed costs.
Breakeven Quantity of Sales = (Fixed Operating Costs + Fixed Financing Costs)/(Price Variable Cost per unit)
Dividends
A dividend is a pro rata distribution to shareholders that is declared by the companys board of directors
and may or may not require approval by shareholders.
1. Dividend Policy
The decision to pay out earnings versus retaining and reinvesting them.
Dividend policy issues include:
a. High or low dividend payout?
b. Stable or irregular dividends?
c. How frequently to pay dividends?
d. Announce the dividend policy?
2. Theories of Dividend Policy
3 theories of dividend policy:
1. Dividend irrelevance: Investors dont care about dividend payout.
2. Birdinthehand: Investors prefer a high payout.
3. Tax preference: Investors prefer a low payout.
3. Signaling Hypothesis
Investors view dividend increases as signals of managements view of the future.
Since managers hate to cut dividends, they wont raise dividends unless they think the
raise is sustainable.
However, a stock price increase at time of a dividend increase could reflect higher expectations for
future EPS, not a desire for dividends.
4. Clientele Effect
Different groups of investors, or clienteles, prefer different dividend policies.
Firms past dividend policy determines its current clientele of investors.
Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who
have to switch companies.
5. Residual Dividend Model
Find the retained earnings needed for the capital budget.
Pay out any leftover earnings (the residual) as dividends.
Capital budget = $800,000
Target capital structure = 40% debt, 60% equity
Forecasted net income = $600,000
How much of the forecasted net income should be paid out as dividends?
Calculate portion of capital budget to be funded by equity.
Of the $800,000 capital budget, 0.6($800,000) = $480,000 will be funded with equity.
Calculate excess or need for equity capital.
There will be $600,000  $480,000 = $120,000 left over to pay as dividends.
Calculate dividend payout ratio (DIV / NIAT)
$120,000 / $600,000 = 0.20 = 20%.
(
(
(



.

\




.

\

=
budget
capital
Total
ratio
equity
Target
 Income Net Dividends
Stock Repurchases
A repurchase of stock is a distribution in the form of the company buying back its stock from
shareholders.
1. Reasons for Repurchases:
As an alternative to distributing cash as dividends.
To dispose of onetime cash from an asset sale.
To make a large capital structure change.
2. Advantages of Share Repurchases
Stockholders can tender (sell) or not.
Helps avoid setting a high dividend that cannot be maintained.
Repurchased stock can be used in takeovers or resold to raise cash as needed.
Income received is capital gains rather than highertaxed dividends (sometimes).
Stockholders may take as a positive signalmanagement thinks stock is undervalued.
3. Disadvantages of Share Repurchases
May be viewed as a negative signal (firm has poor investment opportunities).
IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.
Selling stockholders may not be well informed, hence be treated unfairly.
Firm may have to bid up price to complete purchase, thus paying too much for its own
stock.
4. Stock Dividends vs. Stock Splits
Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10
shares for each 100 shares owned.
Stock split: Firm increases the number of shares outstanding, say 2:1. Sends
shareholders more shares.
Both stock dividends and stock splits increase the number of shares outstanding, so the
pie is divided into smaller pieces.
Unless the stock dividend or split conveys information, or is accompanied by another
event like higher dividends, the stock price falls so as to keep each investors wealth
unchanged.
But splits/stock dividends may get us to an optimal price range.
5. Reasons for Stock Dividends or Stock Splits
Theres a widespread belief that the optimal price range for stocks is $20 to $80. Stock
splits can be used to keep the price in this optimal range.
Stock splits generally occur when management is confident, so are interpreted as
positive signals.
On average, stocks tend to outperform the market in the year following a split.
6. Conclusions
Share repurchases have a positive effect on share prices.
Dividend initiations have a positive effect on share prices.
Dividend increases have a positive effect on share prices.
Working Capital Management
1. Overview
Working Capital:
Assets/liabilities required to operate business on daytoday basis
Cash
Accounts Receivable
Inventory
Accounts Payable
Accruals
Shortterm in natureturn over regularly
2. Types of Working capital
1. Gross working capital = Current assets
a. Gross Working Capital (GWC) represents investment in current assets
2. Net working capital = Current assets Current liabilities
3. Cash Conversion Cycle
The length of time between a companys payments and cash inflows.
Cash Inventory Receivables Payables
Conversion Conversion Collection Deferral
Cycle Period Period Period
= +
Inventory Conversion Period the average time required to convert materials into finished
goods and then to sell the finished goods.
Inventory
Inventory Conversion Period
Sales per day
=
Receivables Collection Period (a.k.a. Days Sales Outstanding) the average length of time
required to convert the firms receivables into cash post sale.
Receivables Receivables
Days Sales Outstanding
Average Sales Per Day Annual Sales/365
= =
Payables Deferral Period the average length of time between the purchase of materials and
labor and the payment of cash for the materials and labor.
Payables
Payables Deferral Period
Purchases per day
=
Financial Statement Analysis
1. Activity Ratios
Inventory Turnover = Cost of Goods Sold Average Inventory
Receivables Turnover = Sales Average Receivables
Fixed Asset Turnover = Sales Average Fixed Assets
Asset Turnover = Sales Average Total Assets
[365 / Turnover] is days outstanding.
More Turnover is it always good / bad
Payables Turnover = Purchases Average Payables
2. Liquidity Ratios
Current Ratio : It is the relationship between the current assets and current liabilities of a
concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000
respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
Example :
Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000
Current Ratio = > 3,00,000/1,00,000 = 3 : 1
Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1
3. Solvency Ratios
Debt = Shortterm debt + Longterm debt
Total capital = Debt + Equity
Debt to Equity = Debt/Equity
Interest coverage ratio = EBIT / Debt interest
4. Profitability Ratios
Gross Profit Margin = Gross Profit / Net sales
Net Profit Margin = Net Profit / Net sales
Return on Total Capital = EBIT/Total Capital
5. Valuation Ratios
EPS = Net profit / No of Outstanding shares
P/E Ratio = Market Price per share/ EPS
PEG Multiple = PE / Growth Rate
Dividend Payout Ratio = Dividend / Net Income
Dividend Yield (%) = (Dividend amount per share *100) / Market price of share
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