Capital Budgeting
Finance 100
Prof. Michael R. Roberts
Copyright © Michael R. Roberts
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Topic Overview
How should capital be allocated?
» Do I invest / launch a product / buy a building / scrap / outsource... » Should I acquire / sell / accept offer for company or division? » How should the capital budgeting process be organized?
Which choices should I make?
» make or buy » which distribution channel » should I test market a product
Copyright © Michael R. Roberts
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Discounted Cash Flows (DCF) A Tool for Rational Decision Making
What can be an object of capital budgeting procedures?
» There must be a choice - choose a base case and an alternative. (Do nothing/status quo)
Identify incremental cash
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Using the WACC to Value a Project (Cont.)
What is the value of the project, including the tax shield from debt ?
What is the project NPV ?
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NPV Rule Synopsis
Step 1: Determine the free cash flow of the investment Step 2: Compute the WACC Step 3: Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC
» The WACC can be used throughout the firm as the companywide cost of capital for new investments that are:
– of comparable risk to the rest of the firm, and – that will not alter the firm’s debt-equity ratio.
NPV Rule: If NPV > 0, accept; if NPV < 0, reject
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What Does a Positive NPV Mean?
Consider a project with the following cash flows: Time 0 1 2 3 CF -100 -50 30 200 and a discount rate of 10% had an NPV of 29.6 @ 10%. So what? This project profile implies an NPV of
NPV = −100 + −50 30 200 + + = 29.6 2 1.10 1.10 1.103
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What Does a Positive NPV Mean? (Cont.)
Suppose the only shareholder can borrow and lend at the same rate (i.e., perfect capital markets)
Year Project Cash Flow Loan Cash Flow Interest Balance of account Payment to shareholder
* She is considering the cash flow paid to all the equity or debt holders. So she cannot use the equity cost of capital.
Free cash flows of the project for next five years can be calculated by adding depreciation values and subtracting changes in working capital from net income. In 2010, there will be a cash outflow of $2.2 million as capital expenditure. In 2011, there will be an additional one time cash outflow of $300,000 as an advertising expense. Using net free cash flow values for next five years and discount rate for discounting, NPV for the project comes out to be $2907, 100. The rate of return at which net present value becomes zero i.e.
NPV analysis uses future cash flows to estimate the value that a project could add to a firm’s shareholders. A company director or shareholders can be clearly provided the present value of a long-term project by this approach. By estimating a project’s NPV, we can see whether the project is profitable. Despite NPV analysis is only based on financial aspects and it ignore non-financial information such as brand loyalty, brand goodwill and other intangible assets, NPV analysis is still the most popular way evaluate a project by companies.
10. What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow. Assume a 35% tax rate. A correct response requires that you define capital structure and Weighted Average Cost of Capital (WACC) with a formula. When defining a term with a formula be sure that all the variables are also defined.
2. The current NPV is negative. One way to save money would be to reduce consulting costs. Please set the average consulting cost per month in cell b33 to $5000. At what discount rate is the NPV for the project 0?_____0.026____
However, two known authors in this field of study believe that companies with low business risk obtains factors of production at a lower cost which may also pave to the ability of the firm to operate more efficiently (Amit & Wernerfet, 1990). Therefore, many stockholders faced a high of uncertainty; this is because some companies do not have the financial strengths to cover its debts that even may result to bankruptcy.
In order to find the WACC, we need to find the cost of the components of the capital structure and their proportion in the total capital.
* Compute the value with leverage, VL, by discounting the free cash flows of the investment using the WACC.
Moreover, let’s calculate the Weighted Average Cost of Capital (WACC). And in order to calculate it we need to know the capital structure of the company. Knowing the capital structure of the
Account for time. Time is money. We prefer to receive cash sooner rather than later. Use net present value as a technique to summarize the quantitative attractiveness of the project. Quite simply, NPV can be interpreted as the amount by which the market
For this reason, new, or marginal, costs are used in its calculation. WACC is calculated by multiplying the cost of each capital component by its proportional weight and then summing then together. The capital components included in this calculation are a firms after-tax costs of debt, preferred stock, and common stock.
WACC = (1-corporate tax rate)(Pretax rate of cost of debt)(Market value of debt/ D+E))+ After tax rate of cost of equity(market value of equity/D+E))
WACC is the Weighted Average Cost of Capital, which provides an average return for all of a
If company doesn’t have any debt, it means that WACC is equal to cost of equity.
WACC is the weighted average cost of capital and provides firms with the idea of the proportion of debt