11_CorpFinance

11_CorpFinance - Capital Budgeting Capital Budgeting...

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Capital Budgeting: - Capital Budgeting Process: o Step One: Generating Ideas o Step Two: Analyzing Individual Proposals o Step Three: Planning the Capital Budget o Step Four: Monitoring and Post-auditing - Independent versus mutually exclusive projects: Independent projects are those whose cash flows are independent of each other. Mutually exclusive projects compete directly with each other. Only one can be chosen. - Unlimited Fund versus Capital Rationing: An unlimited funds environment assumes that the company can raise the funds it wants for all profitable projects simply by paying the required rate of return. Capital rationing exists when the company has fixed amount of funds to invest. - Investment Decision Criteria: o NPV o IRR o Payback Period o Discounted Payback Period o Average accounting rate of return (AAR) = Average NI/Average Book Value. AAR is based on accounting numbers and not on cash flows o Profitability Index: PV of future cash flows/Initial Investment = 1 + (NPV/Initial Investment) - US companies, large companies, public companies and higher management skills tend to prefer discounted cash flow techniques. Cost of Capital: - WACC = w d r d (1-t) + w p r p + w e r e - In the context of a company’s investment decision, the optimal capital budget is that amount of capital raised and invested at which the marginal cost of capital is equal to the marginal return from investing. A company’s marginal cost of capital may increase as additional capital is raised, whereas returns to a company’s investment opportunity are generally believed to decrease as the company makes additional investments, as represented by the investment opportunity schedule. - Cost of Debt: o YTM Approach: YTM is the annual return that an investor earns on a bond if the investor purchases the bond today and hold it until maturity. In other words, it is the yield that equates the present value of the bond’s promise payments to its market price. o Debt Rating Approach: When a reliable market price of debt is not available, this method can be used. Based on the company’s debt rating, we estimate the before-tax cost of debt by using the yield on comparably rated bonds for maturities that closely match that of the company’s existing debt. o Other Issues:
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Fixed Rate vs. Floating Rate: Use the current term structure of interest rates and term structure to assign an average cost. Debt with Optionlike features: Must make market value adjustments to the current YTM to reflect the value of such options. Nonrated Debt: Use synthetic debt rating based on financial ratios. Leases: If the company uses leases as a source of capital, the cost of these leases should be included in the cost of capital. -
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This note was uploaded on 02/25/2012 for the course FIN 4319 taught by Professor Toles during the Fall '08 term at Texas State.

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11_CorpFinance - Capital Budgeting Capital Budgeting...

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