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CAPITAL BUDGETING. INITIAL INVESTMENT PLANNING HORIZON TERMINAL VALUE REQUIRED RATE OF RETURN NET CASH FLOWS. RETURNS TO ASSETS OR RETURNS TO EQUITY?. IF THE OBJECTIVE IS TO MEASURE THE PROFITABILITY OF THE ASSETS COMMITTED TO THE INVESTMENT,

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capital budgeting
CAPITAL BUDGETING
  • INITIAL INVESTMENT
  • PLANNING HORIZON
  • TERMINAL VALUE
  • REQUIRED RATE OF RETURN
  • NET CASH FLOWS
returns to assets or returns to equity
RETURNS TO ASSETS OR RETURNS TO EQUITY?
  • IF THE OBJECTIVE IS TO MEASURE THE PROFITABILITY OF THE ASSETS COMMITTED TO THE INVESTMENT,
  • NET CASH FLOWS ARE THE PROJECTED AFTER-TAX CASH FLOWS WITHOUT DEDUCTION OF CHARGES FOR INTEREST OR LOAN PAYMENTS.
  • THE DISCOUNT RATE USED IS THE WEIGHTED AVERAGE COST OF CAPITAL.
slide3
BASED ON THE ASSUMPTION THAT THE FIRMS LEVERAGE OR OVERALL FINANCIAL STRUCTURE DETERMINES THE FINANCING COST OF THE INDIVIDUAL INVESTMENT AND THAT THE FINANCING ARRANGEMENTS FOR THE INDIVIDUAL INVESTMENT DO NOT SUBSTANTIALLY INFLUENCE THE FIRM’S OVERALL COST OF CAPITAL
slide4
IF THE OBJECTIVE IS TO MEASURE THE PROFITABILITY OF THE EQUITY CAPITAL COMMITTED TO THE INVESTMENT,
  • NET CASH FLOWS ARE THE PROJECTED AFTER-TAX CASH FLOWS WITH THE DEDUCTION OF CHARGES FOR INTEREST AND PRINCIPAL ON LOAN PAYMENTS.
  • THE DISCOUNT RATE USED IS THE FIRM’S COST OF EQUITY CAPITAL.
slide5
THIS APPROACH EXPLICITLY ACCOUNTS FOR EACH INVESTMENT’S METHOD OF FINANCING.
  • BASED ON THE ASSUMPTION THAT THE INVESTMENT’S FINANCING COSTS MAY STRONGLY INFLUENCE THE FIRM’S LEVERAGE AND COST OF CAPITAL.
initial investment
INITIAL INVESTMENT
  • THE INITIAL EQUITY THE INVESTOR COMMITS TO THE INVESTMENT.
  • ALL COSTS NECESSARY TO MAKE THE INVESTMENT ARE INCLUDED.
  • IF FINANCING IS USED, THE INITIAL INVESTMENT WILL BE LOWER.
net cash flows
NET CASH FLOWS
  • REFERS TO CASH FLOWS
  • INCLUDES ALL CASH INFLOWS AND CASH OUTFLOWS ON AN AFTER TAX BASIS
slide8
OUTFLOWS INCLUDE:
    • OPERATING EXPENSES
    • CAPITAL EXPENDITURES
    • INCOME TAXES
    • FINANCING (UNDER THE RETURN-TO-EQUITY APPROACH)
terminal value
TERMINAL VALUE
  • THE RESIDUAL VALUE OF ASSETS INVOLVED IN THE INVESTMENT.
  • ONLY THE EQUITY PORTION OF ANY SALE OF ASSETS SHOULD BE INCLUDED.
  • ANY OUTSTANDING DEBT WOULD BE REPAID WHEN THE ASSETS ARE SOLD.
discount rate
DISCOUNT RATE
  • THE DISCOUNT RATE USED IS CONSIDERED TO CONTAIN THREE COMPONENTS:
    • REAL RISK FREE RATE OF RETURN
    • RISK PREMIUM
    • ANTICIPATED RATE OF INFLATION
what goes into the discount rate
WHAT GOES INTO THE DISCOUNT RATE?
  • THE DISCOUNT RATE SHOULD REFLECT THE COST OF CAPITAL OR THE COST OF FUNDS USED TO FINANCE THE BUSINESS.
  • AN INVESTMENT IS NOT ACCEPTABLE UNLESS IT GENERATES A RETURN SUFFICIENT TO COVER THE COST OF FUNDS.
slide13
THE DISCOUNT RATE CONTAINS THREE COMPONENTS:
  • REAL RISK-FREE RATE
  • RISK PREMIUM
  • INFLATION EXPECTATIONS
weighted average cost of capital
WEIGHTED AVERAGE COST OF CAPITAL
  • THE COST OF CAPITAL IS WEIGHTED BY THE PROPORTION OF EACH TYPE OF CAPITAL (DEBT AND EQUITY) IN THE CAPITAL STRUCTURE OF THE FIRM.
slide15
THERE ARE TWO TYPES OF CAPITAL INVESTED IN A BUSINESS:
  • DEBT CAPITAL
  • EQUITY CAPITAL
  • COST OF DEBT
  • COST OF EQUITY
cost of debt
COST OF DEBT
  • The cost of debt is the interest expense associated with the debt capital used in the business.
  • Since interest is a tax deductible expense, the cost of debt should be calculated on an after-tax basis.
after tax cost of debt
After-Tax Cost of Debt
  • ATCD = Cost of Debt * (1-marginal tax rate)
  • Example:
    • Cost of debt is 7.5%
    • Marginal tax rate of 20%
  • ATCD = 0.075 * (1 – 0.2)
  • ATCD = 0.075 * 0.8 = 0.06 or 6.0%
cost of equity
COST OF EQUITY
  • The cost of equity is not as easy to determine as the cost of debt.
  • It involves the concept of opportunity cost and a consideration of the relative risk versus debt capital.
  • The cost of equity to a business should be higher than its cost of debt because equity holders take on more risk than debt holders and therefore expect a higher return.
risk return relationship
Risk – Return Relationship

Return

Risk

Premium

Risk Free

Rate

Risk

cost of equity calculation
Cost of Equity - Calculation
  • Capital Asset Pricing Model (CAPM) is used where a firm is traded on the equity markets (stock market).
  • Formula:
  • Cost of equity capital = Risk free rate + Beta (Market risk premium)
but what about firms not traded on a stock exchange
But what about firms not traded on a stock exchange?
  • The calculation of equity costs for a business not traded on an exchange (ie. an agribusiness or farming operation) is problematic, since the beta and market risk premium is not apparent.
  • Therefore, a substitute method would be:

Cost of Equity = Risk free rate + equity risk premium

Where the equity risk premium is based on the owners required rate of return to accept the risk of ownership.

weighted average cost of capital1
WEIGHTED AVERAGE COST OF CAPITAL
  • Kc = wd Kd + we Ke
  • Where:
    • Kc is the weighted average cost of capital
    • wd is the proportion of assets financed with debt
    • Kd is the cost of debt capital
    • we is the proportion of assets financed with equity
    • Ke is the cost of equity capital
depreciation
DEPRECIATION
  • AN ACCOUNTING PROCEDURE BY WHICH THE PURCHASE COST OF A DEPRECIABLE ASSET IS PRORATED OVER ITS PROJECTED ECONOMIC LIFE
  • REFLECTS THE ANTICIPATED DECLINE IN THE ASSETS VALUE OVER TIME
depreciation methods
DEPRECIATION METHODS
  • STRAIGHT LINE
  • DECLINING BALANCE
  • SUM OF THE YEAR’S DIGITS
slide25
DEPRECIATION IS USED IN THE CALCULATION OF CASH FLOWS TO CALCULATE THE TAXABLE INCOME AND INCOME TAX LIABILITY.
  • DEPRECIATION IS A NON-CASH EXPENSE, THEREFORE, NOT DEDUCTED FROM THE NET CASH FLOW
income taxes and capital budgeting
Income Taxes and Capital Budgeting
  • The payment of income taxes constitutes a cash flow, therefore, income taxes should be accounted for in capital budgeting.
  • An after-tax cash flow should be estimated using projected before-tax cash flows and deducting tax liabilities.
calculation of after tax cash flows
Calculation of After-Tax Cash Flows
  • Net before-tax cash flows are calculated as the net of revenues less related production expenses.
  • Additional deductible expenses in the calculation of income taxes include:
    • Depreciation (non-cash expenses)
    • Interest paid on any business loans
calculation of after tax cash flows under the return on asset method
Calculation of After-Tax Cash Flows Under the Return on Asset Method

(Before Tax Net CF – Depreciation) = Taxable Income

Taxable Income *Marginal Tax Rate = Tax Due

After Tax CF = Before Tax Net CF – Tax Due

calculation of after tax cash flows under the return on equity method
Calculation of After-Tax Cash Flows Under the Return on Equity Method

(Before Tax Net CF – Depreciation - Interest) = Taxable Income

Taxable Income *Marginal Tax Rate = Tax Due

After Tax CF = Before Tax Net CF – Tax Due – Principal and Interest on Loan