e421-14 - CHAPTER 14 CHAPTER CAPITAL FINANCING CAPITAL AND...

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Unformatted text preview: CHAPTER 14 CHAPTER CAPITAL FINANCING CAPITAL AND ALLOCATION AND CAPITAL BUDGETING CAPITAL To produce goods and services, To the first thing an entrepreneurial firm must do is obtain capital funds from investors and lenders funds CAPITAL ALLOCATION CAPITAL After obtaining funds, the After entrepreneurial firm must invest these funds in equipment, tools and other resources and ADDITIONAL WEALTH ADDITIONAL Revenues from the engineering Revenues and other capital projects must earn an adequate return on funds invested in terms of profit for a firm to achieve economic growth and be competitive in the future and CAPITAL FINANCING FUNCTION CAPITAL • Determines the amount of new funds needed from Determines investors, lenders, and internal sources (I.e., depreciation and retained earnings) to support new capital projects capital • Decides on the sources of new externally acquired Decides funds (I.e., issuing additional stock, selling bonds, obtaining loans, etc…) obtaining • This function also insures that the total amount of This new funds and the ratio of debt to equity capital is commensurate with the financial status of the firm and balanced with the current and future capital investment requirements investment CAPITAL ALLOCATION FUNCTION CAPITAL • Selects engineering projects for Selects implementation based on constraints of total capital investment during capital financing considerations considerations • Capital allocation activities begin in various Capital company organizations --departments, operating divisions, research and operating development, etc… development, • During each capital budgeting cycle, these During organizations plan, evaluate and recommend projects for funding and implementation projects COMBINED SCOPE OF CAPITAL FINANCING AND ALLOCATION FUNCTIONS FUNCTIONS 1. Acquisition of financial resources 2. Establishment of minimum economic Establishment acceptability requirements acceptability 3. Identification and evaluation of capital Identification Projects Projects 4. Selection of projects for implementation 5. Postaudit reviews Postaudit SOURCES OF CAPITAL SOURCES Debt Capital • Involves both short and long-term borrowing of funds • Interest must be paid to capital providers and the debt Interest must be repaid by a specified time must • Capital providers do not share in any profits resulting from Capital capital use capital • Borrower may be required to pledge some type of security Borrower to ensure money will be repaid to • Terms of loan may limit the use of borrowed funds Terms • Terms may also restrict further borrowing • Loan interest is a tax-deductible expense for the firm SOURCES OF CAPITAL SOURCES Equity Capital • Supplied and used by owners in expectation of Supplied profit profit • No assurance that profit will be made or that No investment capital will be recovered investment • No limitations placed on the use of funds • No explicit cost for use of such capital; therefore, No not tax deductible for firm not • Expected rate-of-return must be high enough, at Expected an acceptable risk, to be attractive to potential investors SOURCES OF CAPITAL SOURCES Retained Earnings • Profits that are reinvested in the business instead Profits of being paid as dividends to owners of • Retention of some of company’s profits reduces Retention the immediate amount of dividends per share, increases the book value of the stock, and results in greater future dividends and / or market resale value of the stock value • While some investors expect more of the profit a While company earns, many prefer to have some of the profits retained and reinvested to help increase the value of their stock SOURCES OF CAPITAL SOURCES • Set aside out of revenue as an allowance Set for the replacement of equipment and other depreciable assets depreciable • Depreciation funds provide a revolving Depreciation investment fund that may be used to the best possible advantage best • A source of capital for financing new source projects within existing firm, so long as required capital is available for replacing essential equipment as required essential Depreciation Reserves SOURCES OF CAPITAL SOURCES Leasing • A way of acquiring use of an asset without capital way expenditure for purchase expenditure • A form of contract that establishes conditions form under which asset owner conveys use, and associated costs,of the asset to the lessee associated • A method of achieving benefits of capital method investment witout actually acquiring additional debt ot equity capital debt • Leasing costs are tax deductible from operating Leasing income income COST OF DEBT CAPITAL COST • The debt part of the capital structure The leverages the equity part by increasing the total funds available for capital projects and wealth of the firm wealth • Proportion of debt capital, however, must be Proportion maintained below a level which would adversely affect the market value of the firm’s common stock firm’s – Varies by type of company Varies LOANS (SHORT-TERM DEBT) LOANS • Usually for periods less than five years and Usually frequently for less than two years frequently • Sources are banks, insurance companies, Sources retirement systems, other lending institutions retirement • Financial instrument – line of credit or short-term Financial note – defines promise to repay, amount of borrowed funds, interest , some prearranged repayment schedule repayment • Lending institution may require tangible value as Lending security or the certainty that borrowers financial position presents minimal risk position LOANS (SHORT-TERM DEBT) LOANS Assuming all interest payments and Assuming income taxes paid by firm are paid on annual basis, after-tax cost of capital annual CL = iL(1 – t) (1 CL = after-tax cost of capital for a loan iL = rate of interest per year paid on the loan rate t = effective (marginal) income tax rate BONDS (LONG-TERM DEBT) BONDS • A long-term note given to the lender by the borrower, long-term stipulating the terms of repayment and other conditions stipulating • In return for the money loaned, the company promises to In repay the loan (bond) and interest upon it at a specified rate rate • As long as interest is paid, bondholder has no voice in As affairs of business and is not entitled to a share of profits affairs • Face value or par value of a bond is the amount (I.e., Face $1,000, $10,000, etc… ) for which bond is issued $1,000, • When face value is repaid, bond is retired or redeemed When retired redeemed • Interest rate quoted on the bond is the bond rate Interest bond • The periodic interest payment due is computed as the face The value times the bond interest rate per period BONDS (LONG-TERM DEBT) BONDS Annual After-Tax Cost of Capital [ Zr + (Z –P +Se) / N + Ae ] (1- t) CB = (Z + P – Se) / 2 Z = face (par) value of bond r = bond rate (nominal interest) per year N = Number of years until bond is retired (redeemed) Se = initial selling expense associated with the bond P = Actual selling price of the bond) [if P<Z, the bond is sold Actual at a discount (to par value), and if P>Z, the bond is sold at a premium] premium] Ae = annual administrative expenses associated with bond t = effective (marginal) income tax rate BONDS (LONG-TERM DEBT) BONDS Annual After-Tax Cost of Capital [ Zr + (Z –P +Se) / N + Ae ] (1- t) CB = (Z + P – Se) / 2 Numerator is the after-tax cost of the bond based on the Numerator after-tax annual interest expenses plus annualized amount (over the life of the bond) of any discount or premium and initial selling expenses plus the annual administrative expenses expenses Denominator is the average investment in the bond over its Denominator average life life BOND RETIREMENT BOND • A systematic program for repayment of a bond systematic issue when it becomes due gives assurance to bondholders and makes bonds more attractive to the public the • To do this a company periodically sets aside To definite sums, that with interest, will accumulate to the amount needed to retire the bonds when they are due are • A sinking fund is most typically used for this sinking procedure procedure CORPORATION CORPORATION • A corporation is a fictitious being, corporation recognized by law, that can pursue almost any type business transaction that a real person can . person • It operates under a state-granted charter It which allow certain rights and privileges, and is subject to certain restrictions. and • Special taxes may be assessed against it. COST OF EQUITY CAPITAL COST • Equity capital for a corporation is acquired through the Equity sale of stock. sale • Purchasers of the stock are part owners, usually called Purchasers stockholders, of the corporation. stockholders, • Although stockholders are entitled to a share of the profits, Although they are typically not liable for the debts of the corporation. they • Stockholders are never compelled to suffer any loss Stockholders beyond the value of their stock. beyond • The continuous or indefinite corporation life is conducive The to long-term investments and a degree of certainty to • This makes debt capital easier to obtain, and at a lower This interest cost COMMON STOCK COMMON • Primary source of equity capital Primary used to finance a corporation’s capital projects capital • The value of common stock must The be a measure of the earnings received and on factors related to dividends and market price dividends • A simple approach for the valuation of common simple stock and the estimation of per share rate of return expected by the investor expected • The current value of a share of common stock can The be approximated by the PW of future cash receipts during an N-year ownership period Div1 Div2 DivN PN Div Div P0 ~ (1 + ea) + (1 + ea)2 + … + (1 + ea)N + (1 +ea)N ea = rate of return per year required by common stockholders P0 = current value of a share of common stock PN = selling price of a share of common stock at the end of N years years Divk = After-tax value of cash dividends received during year DIVIDEND VALUATION MODEL DIVIDEND DIVIDEND VALUATION MODEL DIVIDEND • Incorporates two conservative assumptions: – dividends are constant over the long term – P0 = PN • In this case, current price of a share of common In stock equals PW of an assumed indefinite series of dividend receipts that remain constant of P0 = Div (P / A, ea, ∞ ) = Div / ea Div AFTER-TAX COST OF EQUITY Given: P0 = selling price of a share of Given: common stock common Div = annual dividend for past year year ea = Div / P0 If future price of security is expected If to grow at a rate of ‘g’ each year to ea = Div / P0 + g PREFERRED STOCK PREFERRED • Represents ownership with additional privileges and Represents restrictions not assigned to a holder of common stock restrictions • Preferred stockholders guaranteed a dividend on their Preferred stock, usually a percentage of par value, before common stockholders receive any return stockholders • If corporation is dissolved, assets must be used to satisfy If claims of preferred stockholders before holders of common stock common • Preferred stockholders usually have voting rights • Because the dividend rate is fixed, preferred stock is a Because more conservative investment than common stock, and has many features of long-term bonds has • Because dividend rate is fixed, market value Because is les likely to fluctuate is • After-tax cost of capital for preferred stock After-tax (ep) can be approximated by dividing (e can guaranteed dividend (Divp -- paid out after guaranteed tax earnings) by the original par value of the stock (Pp) stock ep = Divp / Pp PREFERRED STOCK PREFERRED RETAINED EARNINGS RETAINED • Normally assumed to be the same as Normally for common stock for • These earnings are equity funds that These are retained and reinvested for future growth and increasing stockholder wealth wealth WEIGHTED-AVERAGE COST OF CAPITAL CAPITAL • A Weighted-Average Cost of Capital (WACC) Weighted-Average for a firm can be determined once the amount and explicit cost is established for each debt and equity component in the capital structure and • This includes short-term debt, bond, common This stock, and preferred stock components stock, • Retained earnings are also included; the cost Retained of these funds should be the same as cost of common stock common WEIGHTED-AVERAGE COST OF CAPITAL CAPITAL • Depreciation funds (reserves), another source Depreciation of internal funds for investment, are not included in the weighted average cost of capital calculation. capital • These funds are are assumed to replace the These need for additional debt and equity capital in the same proportions as the present capital structure, and have an opportunity cost equal to the weighted average cost of capital. to WACC TO MARR RELATIONSHIP WACC • If MARR were assumed less than WACC If implementing the project would result in a decrease in the value of the firm: decrease • There would be no surplus earned above There the cost of capital invested in the project the – project would impact negatively on wealth of project firm firm • WACC should be minimum value used WACC for MARR for WACC TO MARR RELATIONSHIP WACC • If MARR were assumed greater than WACC If • Then best economic measure of equivalent Then current value that would be added to the firm by the project remains the PW value calculated at i = WACC. calculated • Regardless of MARR, WACC is important Regardless and should be available for decision making. making. • Leasing is a business arrangement that makes assets Leasing available without initial capital investment costs of purchase purchase • Leasing is a source of capital generally regarded as a longterm liability, similar to a mortgage • For corporations, rent paid on leased assets used in For business is generally deductible as a business expense business • Studies have shown no real income tax advantage in Studies leasing leasing • There may or may not be savings in maintenance expenses There through leasing, but simplifies maintenance problems through • True advantage in leasing is in allowing a firm to obtain True modern equipment that is subject to rapid technological change -- a hedge against inflation and obsolescence change LEASING AS A SOURCE OF CAPITAL CAPITAL COST OF THE LEASE ALTERNATIVE COST Ik = L k ( 1 - t ) Ik = after-tax lease expense during year k after-tax Lk = before-tax lease expense during year k before-tax t = effective income-tax rate effective If i, the after-tax MARR is known and fixed, If PW of the after-tax cost of the lease cost during a life of N years is during PWLease (i%) =Σ k=1N[Lk (1 - t ) / ( 1 + i )k Annual lease costs are borne by equipment supplier Annual COST OF PURCHASE ALTERNATIVE COST • After-tax cost of equipment when After-tax purchased is a function of • expected annual expenses during life expected of equipment of • purchase price purchase • book value book • and expected market value COST OF PURCHASE ALTERNATIVE COST MVN( 1 - t ) + tBV MV PWBuy(i%) = 1(i%) 1( 1 - I )N O&Mk( 1 - t ) - dk(t) O&M + Σ k=1N ( 1 + i )k I = capital investment MV = expected market value at the end of year N BVN = book value at the end of year N i = interest rate per year N = life of equipment in years O&Mk = operating and maintenance expense during year k t = effective income tax rate dk = depreciation during year k Note that market value, book value and depreciation Note amounts are negative because they reduce costs amounts LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS CAPITAL • Linear programming is a mathematical procedure for Linear maximizing ( or minimizing) a linear objective function, subject to one or more linear constraint equations subject • A useful technique for solving certain multi-period capital useful allocation problems when a firm is not able to implement all projects that may increase PW. all Maximize net PW = Σ j = 1mBj*Xj Maximize Bj* = net PW of investment opportunity (project) j during the net planning period being considered planning Xj = fraction of project j that is implemented during the planning period (Note Xj will normally be ‘0’ or ‘1’) planning will m = number of mutually exclusive combinations of projects number under consideration under LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS CAPITAL In computing the net PW of each mutually exclusive In combination of projects, a MARR must be specified combination Notation used in writing constraints for linear Notation programming programming ckj = cash outlay (e.g., initial capital investment or annual operating budget) required for project j in time period k time Ck = maximum cash outlay that is permissible in time period k period LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS CAPITAL Two types of constraints in capital budgeting problems 1. Limitations on cash outlays for 1. period k of planning horizon period Σ j=1m ckXj < Ck LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS CAPITAL Two types of constraints in capital budgeting problems 2. Interrelationships among projects: a. If projects p,q and r are mutually exclusive Xp + Xq + Xr < 1 b. If project r can be undertaken only if project s has b. already been selected already Xr < Xs or Xr - Xs < 0 c. If projects u and v are mutually exclusive and project r is c. dependent (contingent) on acceptance of u and v dependent xu + xv < 1 and xr < xu + xv CAPITAL BUDGETING PROCESS OVERVIEW OVERVIEW 1. Preliminary planning and cost of Preliminary capital capital 2. Annual capital budget and proposed Annual project portfolio project 3. Capital expenditure policies and Capital evaluation procedure evaluation 4. Project implementation and postaudit Project review review 5. Communication ...
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