Corporate Finance

Dr Nguyen Dinh Dat

The content

Chapter 1: Introduction to Corporate Governance and Other ESG

Considerations

Chapter 2: Capital Budgeting

Chapter 3: Cost of Capital

Chapter 4: Measures of Leverage

Chapter 5: Working Capital Management

Chapter 2: Capital Budgeting
I. Introduction
II. The Capital Budgeting Process
III. Basic Principles of Capital Budgeting
IV. Investment Decision Criteria
I. Introduction
What is capital budgeting?
Capital budgeting is the process that companies use for decision-
making on long-term projects.
Why is capital budgeting important?
Capital budgeting is important because:
• It helps decide the future of many corporations. Most capital
investments require huge investments that are not easy to reverse.
• It can be adopted for many other corporate decisions such as
investment in working capital, leasing, and mergers and acquisitions.
• Capital budgeting decisions are consistent with the management goal
of maximizing shareholder value.
II. The Capital Budgeting Process
• There are 4 steps in Capital Budgeting Process

Analyzing Planning Monitoring

Generating ideas individual and capital and post-
proposals budgeting audit
The capital budgeting process
• Step 1- Generating ideas is the most important step in the process.
Investment ideas can come from anywhere within the organization or
outside.
• Step 2 - Analyzing individual proposals is to gather information to
forecast cash flows for each project and then computing the project’s
profitability. Output of this step is a list of profitable projects.
The capital budgeting process
• Step 3 - Planning and capital budgeting is to answer these questions
Do the profitable projects fit in with the company’s long-term
strategy? Is the timing appropriate? Some projects may be profitable
in isolation but not so much when considered along with the other
projects. Scheduling and prioritizing of projects is important.

• Step 4 - Monitoring and post-audit: Post-audit helps in assessing how

effective the capital budgeting process was. How do the actual
revenues, expenses, and cash flows compare against the predictions?
Categories of Capital Budgeting Process

Capital budgeting projects may be divided into the following categories:

• Replacement projects: these are projects where the firm must either:
replace worn out equipment or invest in new equipment that is expected
to lower current production costs and/or increase current sales.
• Expansion projects: these are projects where the firms are constructing a
new plant or expanding capacity of the existing one.
• New products and services: these are projects where the firms are
diversifying current business operations to maintain a competitive edge.
Categories of Capital Budgeting Process

Mandatory projects: these would be projects that are required by the government
or by the regulatory authority

Other projects: Pet projects of senior management or high-uncertainty projects like

R&D projects that are difficult to analyze using the traditional methods.
III. Basic Principles of Capital Budgeting
1. Decisions are based on cash flows
2. Timing of cash flows is vital

-100 300 Project 1

-100 300. Project 2

3. Cash flows are based on opportunity costs.
4. Cash flows are analyzed on an after-tax basis.
5. Financial costs are ignored.
Independent Versus Mutually exclusive Projects

• Independent projects are projects that are unrelated to each other

and allow for each project to be evaluated based on its own
profitability.

• Mutually exclusive means that only one project in a set of possible

projects can be accepted and that the projects compete with each
other.
Project sequencing
• Sometimes projects can only be executed in a sequence.

Project A Project B Project C

Unlimited funds versus Capital Rationing
• Unlimited funds refers to the financial situation in which a firm is able
to accept all independent projects that provide an acceptable return.

• Capital rationing refers to the financial situation in which a firm has

only a fixed number of dollars available for capital expenditures, and
numerous projects compete for these dollars.
4. Investment Decision Criteria
Analysts use several important criteria to evaluate capital
investments. There are four main methods:
- Net present value (NPV)
- Internal rate of return (IRR)
- Payback and discounted payback period
- Profitability index (PI)
Net Present Value (NPV)
• Net present value is the present value of the future after tax cash
flows minus the investment outlay.

Decision rule:
For independent projects: If NPV > 0, accept.
If NPV < 0, reject.
For mutually exclusive projects:
Accept the project with higher and positive NPV.
Example:
• Compute NPV for projects A and B given the following data:
• Cost of capital: 10%
• Expected net after tax cash flows
Year Project A (in $) Project B (in $)
0 -1,000 -1,000
1 500 100
2 400 300
3 300 400
4 100 600
Example:
• = 78.82

= 49.18
Internal Rate of Return (IRR)
IRR is the discount rate that makes the present value of future cash flows equal to
the investment outlay. In other words, IRR is the discount rate which makes NPV
equal to 0.
Decision rule:
For independent projects:
If IRR> required rate of return (or cost of capital), accept the project.
If IRR< required rate of return (or cost of capital), reject the project.

For mutually exclusive projects:

Accept the project with higher IRR (as long as IRR > cost of capital)
Example
Compute IRR for projects A and B given the following data.
Cost of Capital = 10%, Expected Net After Tax Cash Flows

Year Project A (in $) Project B (in $)

0 -1000 -1000

1 500 100

2 400 300

3 300 400

4 100 600
Example:
Project A:
Payback Period
The payback period is the number of years it takes to recover the
initial cost of the investment.
Example: 2 projects with an initial cash outlay of $20,000 with
following free cash flows.
Project A Project B

Year Cash Flow Cash Flow

1 $ 8000 $10,000

2 4000 10,000

3 3,000

4 5,000

5 10,000
Payback Period
The payback period is the number of years it takes to recover the
initial cost of the investment.
Example: 2 projects with an initial cash outlay of $20,000 with
following free cash flows.
Project A Project B

Year Cash Flow Balance Cash Flow Balance

1 $ 8000 ($ 12,000) $10,000 ($ 10,000)

2 4000 (8,000) 10,000 0

3 3,000 (5,000)

4 5,000 0

5 10,000 12,000
• Advantages:
- Easy to calculate
- Easy to explain
- Indicator of project liquidity. A project with a small payback period is
more liquid than one with a longer payback period as the initial
investment is recovered more quickly.
• Drawbacks:
- Does not consider cash flows after payback period.
- It does not consider the time value of money as the cash flows are not
discounted at the project’s required rate of return.
- Does not consider the risk of a project.
Discounted Payback Period
Discounted payback method uses the present value of the estimated
cash flows; it gives the number of years to recover the initial
investment in present value terms.

Example: Compute the payback period and the discount payback

period assuming a rate of 10%.
Year 0 1 2 3 4

Cash flows -800 340 340 340 320

Solution:
Year 0 1 2 3 4
Cash flows -800 340 340 340 340

Cumulative -800 -460 -120 200 560

Cash flows
Discounted -800 309.1 280.99 255.45 232.22
Cash flows
Cumulative -800 -490.9 -209.91 45.54 277.76
Discounted
Cash flows

Payback period = Last year with negative cumulative cash flow + unrecovered cost at the
beginning of the next year/ cash flow in the next year.
120
Payback period = 2 + = 2.35 years
340
209.91
Discounted payback period = 2 + = 2.82 years.
255.45
• Drawbacks of discounted payback method:
• Does not consider any cash flows beyond the payback period.
• Poor measure of profitability as there may be negative cash flows after the
• discounted payback period which may result in a negative NPV.
Profitability index
Profitability Index is the present value of a project’s future cash flows
divided by the initial investment.

Investment decision rule for PI:

Invest if PI>1.
Do not invest if PI<1.
Difference between PI and NPV
• Consider two projects A and B. Project A has an initial investment of
$1 million and an NPV of 0.1 million. Project B has an initial
investment of $1 billion and an NPV of 0.2 million. If projects A and
B are mutually exclusive, then project B would be chosen because
of higher NPV. But, if you consider the profitability index, it gives a
different picture.
• PI of project A = 1 +0.1/1 = 1.1
• PI of project A = 1 +0.1/1000 = 1.0002
• Based on PI, project A is more profitable than project B.
NPV Profile
NPV profile is a graph that plots a project’s NPV for different rates.
The NPV is shown on the y-axis with the discount rates on the x-axis.
Given the data below, create the NPV profile for project X.
Year 0 1 2 3 4

Project -400 160 160 160 160

Discount rate NPV ( in $ million) Discount rate NPV ( in $ million)

0 ? 0 240

5 ? 5 167

10 ? 10 107

22 ? 22 0
NPV profile

There are two important points on the graph:

1- The point where the profile goes through the Y-axis (240) is the NPV of the project when the
discount rate is 0. This is equal to the sum of the undiscounted cash flows.
2- The point where the profile goes through the X-axis (22) is where the discount rate is equal
to the IRR of the project.
Crossover
• Draw the NPV profiles for projects X and Y.
Year 0 1 2 3 4

Project X -400 160 160 160 160

Project Y -400 0 0 0 800

Discount Rate (in %) NPV for Project X NPV for Project Y

0 240 400

5 167.35 258.16

10 107.17 146.41

15 56.79 57.4

18.92 22.82 0

20 14.19 -14.19

21.86 0 -37.22
Crossover
Ranking conflicts between NPV and IRR
• For single and independent projects with conventional cash flows,
there is no conflict between NPV and IRR decision rules. However,
for mutually exclusive projects the two criteria may give conflicting
results.
• What is a conventional cash flows?

• The reason for conflict is due to differences in cash flow patterns

and differences in project scale.
Example (Ranking conflict due to differing
cash flow patters)
• The cash flow associated with project X and project Y is shown
below:
Year 0 1 2 3 4

Project X -400 160 160 160 160

Project Y -400 0 0 0 800

1. Which project do you select according to the NPV rule using a rate
of 10%?
2. Which project do you select according to the IRR rule?
3. Show the NPV profile for both projects.
 NPV (in $ millions) IRR (in %)

Project X 107.17 21.86

Project Y 146.4 18.92

1. Based on the NPV rule, the project with the highest NPV, project Y
is selected.
2. Based on the IRR rule, the project with the highest IRR, project X is
selected.
3. Whenever NPV and IRR rank two mutually exclusive projects
differently, we must always choose the one with the higher NPV – in
this case, project Y.
Reasons for going with NPV instead of IRR:

• IRR incorrectly assumes that intermediate cash flows can be

reinvested at the IRR rate. Just because project X gives a return of
21.86%, it does not mean the intermediate cash flows can be
reinvested at that rate.
• NPV uses a realistic discount rate assumption of 10%. It is the
opportunity cost of funds. You can easily find other projects to
invest that will give a return of 10%. Hence it is safe to assume that
the intermediate cash flows can be reinvested at this rate. The NPV
assumes that cash flows are reinvested at the required rate of
return.
The Multiple IRR Problem and No IRR Problem
If a project has unconventional cash flows, it can have multiple IRRs,
i.e., there are more than one discount rates that will produce an NPV
equal to zero. The NPV profile of a project with multiple IRRs
intersects the x-axis at more than one point.
Zero IRR
Some projects do not have an IRR, i.e. there is no discount rate that
results in a zero NPV.
Comparison between NPV and IRR
NPV IRR

Advantages Advantages

Direct measure of expected increase in value of the firm. Shows the return on each dollar invested.

Theoretically the best method. Allows us to compare return with the required rate.

Disadvantages Disadvantages

Does not consider project size. Incorrectly assumes that cash flows are reinvested at IRR
rate. The correct assumption is that intermediate cash
flows are reinvested at the required rate.

Might conflict with NPV analysis.

Possibility of multiple IRRs or no IRR for a project.

Relationship between NPV and Stock Price
- The value of a company can be measured as the existing value plus
the present value of its future investments. NPV is a direct measure
of the expected change in the firm’s value from undertaking a
capital project.
- A positive NPV project should cause a proportionate increase in a
company’s stock price. But, if the project’s profitability is less than
expectations, then the stock price may be negatively impacted.
Example
A company is undertaking a project with an NPV of $500 million. The
company currently has 100 million shares outstanding and each share
has a price of $50. What is the likely impact of the project on the stock
price?
Chapter 3: Cost of Capital
The content
• What is cost of capital?
• Methods to estimate the cost of capital
• Why estimating the cost of capital accurately is important?
What is cost of capital?
Cost of capital is the rate of return that the suppliers of capital require
as compensation for their contribution of capital.

lend money to contribute money

ABC
Lenders return (cost) Company
return (cost) Owners

There are two main sources of capital: Debt and Equity.

Debt is the money which come from lenders. When a lender lends
money to the company, obviously, he is expecting a return. The return
the lender expects is a cost to the company.
Equity is the money which contribute by owners. Owners are also
expecting a return. From the company’s perspective that would be the
cost.
• The company invests in a given project if the return is greater the
cost of capital.
• Riskier projects will require a higher cost of capital.

• The cost of capital is the rate of return expected by investors for

average-risk investment in a company.
• One way of calculating this cost is to determine the weighted
average cost of capital (WACC), which is also called the marginal
cost of capital.
(It is called marginal because it is the additional or incremental cost a
company incurs to issue additional debt or equity)
Weighted average cost of capital (WACC)

Three common sources of capital are common shares, preferred

shares, and debt.
Example
ABC company has the following capital structure: 30 percent debt, 10
percent preferred stock, and 60 percent equity. The before-tax cost of
debt is 8%, cost of preferred stock is 10%, and cost of equity is 15%. If
the marginal tax rate is 40%, what is the WACC?

WACC = (0.3) (0.08) (1 - 0.4) + (0.1) (0.1) + (0.6) (0.15) = 11.44%

Taxes and The Cost of Capital
•
Example: Debt = 100, interest rate = 10%, tax rate = 40%.

Calculation of net income assuming interest is tax-deductible Calculation of net income assuming interest is not tax-
(Normal situation) deductible

Revenue: 100 Revenue 100

Operating expenses 50 Operating expenses 50

Interest 10 EBT 50

EBT (earnings before tax) 40 Tax expense (40%) 20

Tax expense (40%) 16 Interest 10

Net income 24 Net income 20

Weights of the Weighted Average
• WACC =
Book Value Market value

Debt 20 20

Equity 20 80

• Weights should be based on:

- Market values.
- Target capital structure.
In the absence of explicit information about a firm’s target capital
structure, one may estimate it using one of the following approaches:
• Current capital structure based on market value weights for the
components (most common method).
• Trend in the firm’s capital structure or statements made by
management regarding capital structure policy.
• Average of comparable companies’ capital structures as the target
capital structure.
Example:
• You gather the following information about the capital structure
and before-tax component costs for a company. The company’s
marginal tax rate is 40 percent. What is the cost of capital?
• Use the market value to calculate the weights of each component.
Applying the Cost of Capital to Capital Budgeting and
Security Valuation
Costs of the different Sources of Capital
• Each source of capital has a different cost because of differences in
risk, and potential value as a tax shield. Three primary sources of
capital are:
✔ Debt
✔ Preferred Equity
✔ Common equity
Cost of Debt
Cost of debt is the cost of financing to a company using debt
instruments such as taking a bank loan or issuing a bond.
Two methods to estimate the before-tax cost of debt are:
• The yield to maturity (YTM) approach
• Debt-rating approach
Yield to Maturity Approach

YTM is the annual return an investor earns if the bond is purchased

today and held until maturity. It is the rate at which the present value
of all future cash flows equals the market price of the bond.
Example

A company issues a 10-year, 8% semi-annual coupon bond, par value is equal to

1000. Upon issuance, the bond sells for $980. If the marginal tax rate is 30%, what is
the after-tax cost of debt?
N = 20
PV = -980;
FV = 1000;
PMT = (0.08/2) * 1000 = 40
Compute I/Y = 4.15 %
Annual I/Y = 4.15 x 2 = 8.30 = before-tax cost of debt
After-tax cost of debt = 8.30 x (1 - 0.3) = 5.8%
Debt Rating Approach

• Use the debt rating approach when a reliable current market price
for a company’s debt is not available.
• Estimate before-tax cost of debt based on comparable bonds
▪ Similar rating
▪ Similar maturity
• Use the company’s marginal tax rate to determine after-tax cost.
Cost of Preferred Stock
• The cost of preferred stock is the cost that a company has
committed to pay to preferred stockholders in the form of
preferred dividend. Unlike common dividend which is variable,
preferred dividend is usually fixed and paid before common
shareholders.
• The cost of preferred stock can be computed as:
Example

A company issues preferred stock with par value $100 that is currently
valued at $125 per share. The preferred dividend is $5 per share. The
marginal tax rate is 33 percent. What is the cost of preferred stock?

Cost of preferred stock = 5/125 = 4%.

Cost of Common Equity

Cost of common equity, or cost of equity, is the rate of return required

by a company’s common shareholders. It is the return expected by
investors for the risk they undertake.

Three commonly used methods to estimate the cost of equity are:

• Capital asset pricing model

• Dividend discount model

• Bond yield plus risk premium method

Capital Asset Pricing Model (CAPM) Approach

The cost of equity is equal to the risk free rate plus a premium for
bearing the security’s market risk. The premium is the beta for the
security multiplied by the equity risk premium.
Example

In a developing market, the risk-free rate is 10% and the equity risk
premium is 6%. The equity beta for a given company is 2. What is the
cost of equity using the CAPM approach?

re = 0.1 + 2 [0.06] = 22%

Dividend Discount Model (DDM) Approach

Present value of a perpetuity: Assume an investment gives a cash

flow of $10 at the end of each period forever. This is called a
perpetuity, as the cash flow continues forever. If the discount rate is
5%, the present value of this infinite cash flow can be calculated as
10/0.05 = 200.
 Present value of a growing perpetuity
The cash flow for every successive period grows at a rate of 2%. $10
in period 1, $10.2 in period 2, $10.404 in period 3, and so on. The
present value of a growing perpetuity can be computed as:
The dividend discount mode
• The dividend discount model states that the intrinsic value of a
financial asset, such as a stock, is the present value of future cash
flows (dividends).
The dividend discount model
• Gordon growth model is one example of a DCF model. It is also
called the constant growth dividend discount model. If the
dividends grow at a constant growth rate g, then the price of the
stock can be written as:
Example
You have gathered the following information about a company and the market:
Current share price = 30
Most recent dividend paid = 2
Expected dividend payout rate = 40%
Expected ROE = 15%
Equity beta = 1.5
Expected return on market = 15%
Risk free rate = 8%

Using the DCF approach, what is the cost of retained earnings?

Bond Yield plus Risk Premium Method

• In this method, we add a risk premium to the yield on the firm’s

long-term debt. The assumption here is that the return on a
company's equity will be greater than the return on the company's
bond, as equity is riskier than the bond.
• re = bond yield + risk premium