Financial Policy and

Planning chapter 6(capital

budgeting)
Financial Objectives and Shareholders
Wealth

Investors maximize their wealth by
selecting optimum investment and
financing opportunities, using financial
models that maximizes expected returns in
absolute terms at minimum risk
Objective of Financial Management
RISK AND RETURN TRADE-OFF

To implement investment and financial
decisions using risk adjusted wealth
maximizing criteria, which satisfy the firms
owners placing them in an equal, optimum
financial position
Functions of Strategic Financial
Management
Investment Decisions
Dividend Decisions
Financing Decisions
Portfolio Decisions

In our real world, each of the above is designed to
maximize the shareholders wealth using the
market price of an ordinary share as a
performance criterion.
The Investment and Finance Decisions
Investment Policy selects:
1- An optimum portfolio of investment
opportunities that
2- Maximize expected net present value (ENPV)
3- At minimum risk

The Investment and Finance Decisions
Finance Policy identifies:
1- Potential fund sources (equity and debt,
long or short) required to sustain
investment
2- Evaluates the risk adjusted returns
expected by each of the sources and
3- Selects the optimum mix that will minimize their
overall Weighted Average Cost of Capital (WACC)

Importance of WACC in Wealth
Maximization
A firms WACC represents the overall cut-off rate
that justifies the financial decision to acquire
funding for an investment proposal (as we shall
discover, a zero NPV).

In an ideal world of wealth maximization, it
follows that if corporate cash profits exceed
overall capital costs (WACC) then NPV will be
positive, producing a positive EVA. Thus:

Importance of WACC in Wealth
Maximization
If management wish to increase shareholder
wealth, using share price, then it must create
positive Earning Value (EVA) as the driver.

Negative EVA is only acceptable in the short
term.
Importance of WACC in Wealth
Maximization

If share price is to rise long term, then a
company should not invest funds from any
source unless the marginal yield on new
investment at least equals the rate of return
that the provider of capital can earn elsewhere
on comparable investments of
equivalent risk.

Importance of WACC in Wealth
Maximization

Thus objective of finance is represented by the
maximization of shareholders welfare
measured by share price, achievable through
the maximization of the expected net present
value (ENPV) of all companys prospective
capital investments.

Capital Project
A capital project is defined as an asset
investment that generates a stream of receipts
and payments that define the total cash flows of
the project. Any immediate payment by a firm for
assets is called an initial cash outflow, and future
receipts and payments are termed future cash
inflows and future cash outflows, respectively
Dividends or Futures Capital Gains
If ENPV is positive, a projects anticipated future
net cash inflows should enable a firm to repay
cheap contractual loans with accumulated
interest and provide a higher return to
shareholders. This return can take the form of
either current dividends, or future capital gains,
based on managerial decisions to distribute or
retain earnings for reinvestment
Dividend or Futures Capital Gain
Managements minimum rate of return on
incremental projects financed by retained
earnings should represent the rate of return that
shareholders can expect to earn on comparable
investments elsewhere.
Otherwise, corporate wealth will diminish and
once this information is signaled to the outside
world via an efficient capital market, share price
may follow suit.
Dividend payment vs Profit Retention
Companys retained profits for new capital
projects represent alternative consumption and
investment opportunities foregone by its
shareholders, the corporate cut-off rate for
investment is termed to be the opportunity cost
of capital.
Dividend payment vs Profit Retention
If management vet projects using the
shareholders opportunity cost of capital as a
cut-off rate for investment, then

It should be irrelevant whether future cash flows
paid as dividends, or retained for reinvestment
As a consequence, dividends and retentions are
perfect substitutes and dividend policy is
irrelevant.
A firm is considering two mutually exclusive capital projects of
equivalent risk, financed by the retention of current dividends. Each
costs 500,000 and their future returns all occur at the end of the
first
year.
Project A will yield a 15 per cent annual return, generating a cash
inflow of 575,000, whereas Project B will earn a 12 per cent return,
producing a cash inflow of 560,000.
All individuals and firms can borrow or lend at the prevailing market
rate of interest, which is 14 per cent per annum.
Managements investment decision would appear self-evident.
- If the firms total shareholder clientele were to lend 500,000
elsewhere at the 14 per cent market rate of interest, this would
only compound to 570,000 by the end of the year. -It is
financially more attractive for the firm to retain 500,000 and
accumulate 575,000 on the shareholders behalf by investing in
Project A, since they would have 5,000 more to spend at the
year end.

Conversely, no one benefits if the firm invests in Project B, whose
value grows to only 560,000 by the end of the year.
Management should pay the dividend.
But suppose that part of the companys clientele is motivated by a
policy of distribution. They need a dividend to spend their proportion
of the 500,000 immediately, rather than allow the firm to invest this
sum on their behalf.
Armed with this information, should management still proceed with
Project A?
Project evaluation
Projects should only be accepted if their post-tax
returns at least equal the returns that shareholders can
earn on an investment of equivalent risk elsewhere.

Projects that earn a return less than this opportunity
rate should be rejected.

Project yields that either equal or exceed their
opportunity rate can either be distributed or retained.

The final consumption (spending) decisions of
individual shareholders are determined independently
by their personal preferences, since they can borrow or
lend to alter their spending patterns accordingly.

What is Capital Budgeting
The financial term capital is broad in
scope. It is applied to non-human
resources, physical or monetary, short or
long.
Similarly, budgeting takes many forms
but invariably comprises the detailed,
quantified planning of a scarce resource
for commercial benefit
Capital Investment Requirements
Diversification defined in terms of new products,
services, markets and core technologies which do not
compromise long-term profits.
Expansion of existing activities based on a comparison
of long-run returns which stem from increased
profitable volume.
Improvement designed to produce additional revenue
or cost savings from existing operations by investing in
new or alternative technology.
Buy or lease based on long-term profitability in
relation to alternative financing schemes.
Replacement intended to maintain the firms existing
operating capability intact, without necessarily
applying the test of profitability
Project Evaluation Methods
Pay Back (PB)
Accounting Rate of Return (ARR)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Project Evaluation Methods
Payback (PB) is the time required for a stream of cash flows
to cover an investments cost. The project criterion is
liquidity: the sooner the better because of less uncertainty
regarding its worth. Assuming annual cash flows are
constant, the basic PB formula is given in years by:

PB = I
0
/C
t



PB = payback period
I
0
= capital investment at time period 0
Ct = constant net annual cash inflow defined by t = 1

Managements objective is to accept projects that satisfy
their preferred, predetermined PB
Short-termism is a criticism of management today, motivated by liquidity, rather than
profitability, particularly if promotion, bonus and share options are determined by next
years cash flow (think sub-prime mortgages).But such criticism can also relate to the
corporate investment model. For example, could you choose from the following using
PB?

Cash flows Year 0 Year 1 Year 2 Year 3
Project A (1000) 900 100 -
Project B (1000) 100 900 100

The PB of both is two years, so rank equally. Rationally, however, you might prefer
Project B because it delivers a return in excess of cost. Intuitively, I might prefer
Project A (though it only breaks even) because it recoups much of its finance in the
first year, creating a greater opportunity for speedy reinvestment. So, whose choice is
correct?

Unfortunately, PB cannot provide an answer, even in its most sophisticated forms.
Apart from risk attitudes, concerning the time periods involved and the size of
monetary gains relative to losses, payback always emphasizes liquidity at the expense
of profitability

Project Assessment Methods
The formula to calculate payback period of a project
depends on whether the cash flow per period from the
project is even or uneven. In case they are even, the
formula to calculate payback period is:

Payback Period = [Initial Investment /Cash Inflow per
Period]

When cash inflows are uneven, we need to calculate
the cumulative net cash flow for each period and then
use the following formula for payback period:
Payback Period = A +[ B/ C] In the above formula,
A is the last period with a negative cumulative cash
flow;
B is the absolute value of cumulative cash flow at the
end of the period A;
C is the total cash flow during the period after A


Project Assessment Methods
Accounting rate of return (ARR) therefore, is frequently used with
PB to assess investment profitability. As its name implies, this
ratio relates annual accounting profit (net of depreciation) to
the cost of the investment. Both numerator and denominator
are determined by accrual methods of financial accounting,
rather than cash flow data.
ARR = P
t
- D
t
/ [(I
0
- S
n
)]

ARR = average accounting rate of return
P
t
= annual post-tax profits before depreciation
Dt = annual depreciation
I
0
= original investment at cost
S
0
= scrap or residual value

The ARR is then compared with an investment cut-off rate
predetermined by management
ARR - Example
Example 1: An initial investment of $130,000 is expected to
generate annual cash inflow of $32,000 for 6 years.
Depreciation is allowed on the straight line basis. It is
estimated that the project will generate scrap value of
$10,500 at end of the 6th year. Calculate its accounting rate
of return assuming that there are no other expenses on the
project.

Solution
Annual Depreciation = (Initial Investment Scrap Value)
Useful Life in Years
Annual Depreciation = ($130,000 $10,500) 6 $19,917
Average Accounting Income = $32,000 $19,917 = $12,083
Accounting Rate of Return = $12,083 $130,000 9.3%

The Concept of Required Rate of Return
for a Project
Given an unbiased estimate of cash flows of a project, at what
rate should we discount the cash flows of the project?
Cash flows should be discounted at the required rate of
return
the rate of return that similar risk class investments are providing in
the market or
the minimum rate of return that a project must earn to justify
investment of resources
Required rate chosen to discount the cash flows and to
compute the NPV must be appropriate to the risk of the
project.
What if we choose a required rate of return that is
too high for the project given its riskiness?
We will end up rejecting some good projects,
because with a high discount rate the NPV will either be
very low or sometimes even negative, because we are
unnecessarily using a very conservative discount rate.
By rejecting good projects, the firm will compromise its
competitiveness and market value
What if we choose a required rate of return that is
too low for the project given its riskiness?
We will end up accepting some bad projects,
because with a low discount rate the NPV will either be
high and positive, because we are unnecessarily using a
very low discount rate.
By accepting bad projects, the firm will increase the
risk of its cash flows.
This will compromise its competitiveness and market
value
Weighted Average Cost of Capital
Choosing the right discount rate also know as
required rate of return for a project is critical for its
success
Use a weighted-average cost of capital
A weighted-average of the cost of each component
of capital used to fund the project, where weights
represent the proportion of each component in the
total capital for the project
An optimal cost of capital is the cost at which value
of the firm is maximum
For an all equity firm
Whenever a firm has excess cash, it can take one of
the two actions.
On the one hand, it can pay out the cash immediately as
dividend or
it can invest extra cash in a project, paying out the future
cash flows of the project as dividends
A firm should invest money in the project only if the
project provides a return higher than the required
rate of stockholders.
Stockholders required rate is the opportunity
cost of not receiving dividend or the return
they would forgo by not receiving the
dividend, which will be the rate which similar
risk class investments are providing in the
market

Required Rate of Return = r
f
+ (r
market
r
f
)
Market rate of return minus the risk free rate equals
market risk premium
If we multiply market risk premium by the beta of the
security, it is known as the security risk premium
Required rate of return equals risk free rate of return
plus security risk premium
How do we compute beta? = (
i,m
)/
2
m
Beta equals covariance between the security and the
market divided by the variance of the market

Cost of Capital with Debt
If a firm uses both debt and equity to finance its
investments, we need to use overall cost of capital as
the discount rate
r
wacc
= (S/V r
s
) + (D/V r
D
(1-T
c
))
Where
r
wacc
= the weighted average cost of capital
S = market value of equity
D = market value of debt
V = total market value of the firm (D+S)
r
s
= cost of equity
r
D
= cost of debt
T
c
= corporate tax rate
Example of WACC
Debt to equity ratio = 0.25
Beta of common equity = 1.15
Beta of debt = 0.3
Market risk premium = 10%
Risk free rate = 6%
Corporate Tax Rate = 35%
What is the overall cost of capital?

Rs = 6 + (10) 1.15 = 17.5%
rD = 6 + (10) 0.3 = 9%

Rwacc = (0.8 17.5) + (0.2 9 (1 0.35)) = 15.17%