expenditure. Thus, the available capital will be allocated to the projects that will benefit the company and its shareholdersthe mostHARD CAPITAL RATIONING: capital market unwilling to provide funds, not commonSOFT CAPITAL RATIONING: management limits amount because: poor performance, not prepared to accept lender’sconditions, managers want to limit equity issues & adverse market conditionsIX.PROFITABILITY INDEXShows relative profitability of project or present value benefits per dollar of costPI=(NPV+initial cost)initialcostDECISION RULE: ACCEPT PI ≥ 1, REJECT PI < 17.LECTURE 7 – Capital Budgeting 2I.CASH FLOW TIMING1. Cash flows at the startOccurs at beginning of project’s lifeInclude purchase of plant and equipment, establishment expenses, proceeds from sale of old machine, investment in working capital (inventory), market value of assets owned that are to be used in project (opportunity cost)ALWAYS include TAX ON SALES = (WDV – salvage value) x company tax rate2. Cash flows over the life8 | P a g e
Occurs over the life span of projectFind total cash flow before tax, find tax (CF x company tax rate), then depreciation tax saving (depreciation x company tax rate) 3. Cash flows at the endOne-off group of cash flows occur at end of project’s lifeInclude recovered working capital (inventory), salvage value of assets + tax saving, sale of new machines8.LECTURE 8 – Risk & ReturnI.HISTORICAL RETURN AN investment is the purchase of an asset with the expectation of making positive future returnsInvestment should compensate investor for time, inflation and riskRisk is uncertainty of future returnsPERCENTAGE RETURNS:Measures return taking into account the amount investedCAPITAL GAINS YIELD: Rt=Ending Price−Starting PriceStarting Price=Pt−Pt−1Pt−1Measures value of investment ONLY!The average return on an investment is: ´R=∑rinWhere ri= return for period I & n =number of observationsII.HISTORICAL RISKRisk is variability of returns i.e. standard deviationThe larger the standard deviation, the greater the spread of returns = HIGHER RISKThe smaller the standard deviation, the narrower the spread of returns = LOWER RISKIf asset has PERFECT CERTAINTY, standard deviation = 0s=√(R1−´R)2+(R2−´R)2+…+(Rn−´R)2n−1III.CAPITAL MARKET EFFICIENCYPrices of securities change due to new information arriving and change quickly as there are manyinvestors & competitionCompetition among investors is an important driver of informational efficiencyIf markets are efficient, investors and financial managers can believe securities are priced at or neartrue valueOverall efficiency of a capital market depends on its operational and informational efficiencyIn an efficient market, market prices adjust quickly to new information about a securityas it becomes availableMarket efficiency can be explained at 3 form levels: 1. Strong, 2. Semi-strong and 3. WeakROLE OF SECURITIES MARKETS – Efficient Market Hypothesis (EMH)9 | P a g e
IV.EXPECTED RETURNAssigning probabilities to different outcomes allows a measure of the return that can be expected in the long-runE(R)=∑Pi×RiWhere Pi= Probability of outcome I& Ri= Return of outcome iV.