Financial Management VIII Math Worksheet

FIN 3301, Financial Management 1

Course Learning Outcomes for Unit VIII Upon completion of this unit, students should be able to:

7. Perform a capital budgeting analysis. 7.1 Compute the net present value, profitability index, and internal rate of return for a given

company. 7.2 Predict the best choice for a company based on analysis of financial data.

8. Calculate weighted average cost of capital used in capital budgeting analysis.

8.1 Compute a company’s weighted average cost of capital (WACC) using given percentages. 8.2 Calculate the cost of capital of a stock. 8.3 Compute the after-tax cost of capital for bonds.

Course/Unit Learning Outcomes

Learning Activity

7.1 Unit Lesson Chapter 17 Unit VIII Assignment

7.2 Unit Lesson Chapter 17 Unit VIII Assignment

8.1

Unit Lesson Chapter 17 Chapter 18 Unit VIII Assignment

8.2

Unit Lesson Chapter 17 Chapter 18 Unit VIII Assignment

8.3

Unit Lesson Chapter 17 Chapter 18 Unit VIII Assignment

Required Unit Resources Chapter 17: Capital Budgeting Analysis Chapter 18: Capital Structure and The Cost of Capital

Unit Lesson

Introduction In Unit VIII, we will evaluate the capital budgeting process and learn how to compute the internal rate of return, net present value, and profitability index. Further, we will learn how to evaluate a project’s risk and examine cash flow estimates. We will assess how capital structure impacts a firm’s capital budgeting discount rate, and we will review the relationship between cost of capital and required return. Finally, we will explore the factors that impact a firm’s capital structure.

UNIT VIII STUDY GUIDE

Capital Budgeting and the Cost of Capital

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Capital Budgeting and Cost of Capital Capital budgeting is the name of the process that firms use to acquire long-term investments that, ideally, will produce value for the organization. A company will use capital budgeting when the benefits in terms of cash flow from the investment are expected to occur for a period longer than one year. In practice, capital budgeting involves an investment with cash today in an asset that will produce future revenues. The following sections discuss the capital budgeting process, capital budgeting techniques, estimated cash flows, required rate of return, the cost of capital, and the weighted average cost of capital.

Capital Budgeting Process

All companies engage in some type of capital budget process, which can be defined as evaluating large long-term projects to determine if the project will bring value to the company (Gallagher & Andrew, 2007). The evaluation of the project is critical for the company's success because long-term projects can tie up the company's cash and other resources for an extended period of time. In addition, an element of uncertainty is involved with capital projects because the estimated future cash flow may not materialize or the conditions in the company's external or internal environment may change over time. The resources of a company may be limited, which limits the ability of the company to undertake all capital budget projects. As a result, companies use a system of prioritization in the capital budget process. The need to prioritize is associated with mutually exclusive projects for which accepting one project means the exclusion of another project. The capital budgeting process involves a series of interrelated steps for developing capital project proposals and for analyzing the proposals to identify the best options for a company (Baker & Powell, 2005). There are four major steps in the capital budgeting process. The first step involves identifying projects that will add value to a company, which can include replacement projects that replace obsolete or depreciated equipment and new projects that add some type of capacity to the company. The second step involves estimating the incremental cash flows that the project will generate for the company, which can include new cash flows or savings in expenses that reduce outgoing cash flows. The third step involves evaluating

projects to identify the projects that will produce the greatest value for the company. The fourth step involves implementing and monitoring the project. In general, the capital budgeting techniques used to evaluate the project may be the most important aspect of the capital budgeting process because of the importance of selecting the optimal projects.

Capital Budgeting Techniques The capital budgeting techniques that are used to evaluate projects consist of approaches that use a present value method and approaches that do not use a present value method. The present value methods are net present value (NPV) and internal rate of return (IRR), and the profitability ratio while the approach that does not use present value is the payback period method (Warren et al., 2009). The present value is the current value of future cash flows in terms of current dollars when discounted by an assumed rate of return. Net Present Value The NPV approach to evaluating a project computes the free future cash flows of the project discounted to the present at the company's cost of capital (Brigham & Houston, 2015). If the discounted cash flows are higher than the costs associated with initially implementing the project, then the project is likely to produce value for the company. The greater the positive amount of NPV, the greater the value that the project will add to the company. On the other hand, if the project has a negative NPV, it will reduce the value of the company. The NPV can be useful for prioritizing projects that have similar lifespans.

Steps of the capital budgeting process

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The NPV method has several drawbacks that should be considered when evaluating projects. The future cash flows are often very difficult to estimate accurately, particularly long-range cash flows. In addition, the company's cost of capital can change over time. Internal Rate of Return The IRR of a project is the NPV of the project at which the interest rate or discount rate equals zero (Mowen et al., 2012). The point at which this occurs is when the future cash flows equal the costs of the project. If the IRR is higher than the cost of the funds used to finance the project, it will produce value for the company. A significant disadvantage of the IRR is the assumption that the future cash flows can be reinvested at the same rate as the initial project. The cost of capital and the amount realized from investments can fluctuate significantly over time. The IRR also does not consider the size of the project and treats all projects equally. Profitability Index The profitability index is a ratio of the payoff in terms of the present value of future cash flow to the amount of investment in the project. The project with the highest ratio has the highest priority. The profitability index has the disadvantages of difficulty comparing projects with different life expectancies and ignoring any sunk costs in the calculation. Payback Period The payback period is the number of years it takes to recover the cost of a project based on the estimated project cash flows (Brigham & Houston, 2015). The payback period approach has several drawbacks. All dollar amounts received in future years are treated equally although long-range cash flow may be worth less than early cash flows. If cash flows beyond the payback time are very large, they are still not given any consideration.

Estimating Project Cash Flows Estimating project cash flows is difficult because of the large number of variables associated with cash flow that are difficult to forecast over the medium to long term (Gallagher & Andrew, 2007). The operating cash flows represent the cash generated by a project after all costs of operations are considered. The operating cash flows can include expenses that are liable to change because of factors such as inflation. Cash flows also consider taxes, with the tax rate subject to change over time. At the end of the life of the project, any portion of the project that can be sold represents recovery of costs that have to be considered in the operating cash flows. Factors such as changes in the economy that are not easy to predict over the long run could have an effect on the revenues generated by the project. To adjust for different possibilities, cash flow estimation often uses scenario analysis. The estimate is based on high, low, and medium scenarios concerning the effect of various economic situations on the cash flows of the project.

Required Rate of Return The required rate of return is the minimum rate of return that the company expects to realize from a project and is sometimes called the hurdle rate (Weygandt et al., 2010). Companies often set the required rate of return higher than the cost of capital because the project entails some degree of risk for which the company must be compensated. As the perceived risk of the project increases, the required rate of return also increases to justify taking the risk. The required rate of return can be substituted for cost of capital in the discount rate when evaluating a project to determine if the project is likely to provide value for the company. For example, if the company uses a high required rate of return in an NPV calculation, the project will have to generate more cash flow than with a discount rate set at the cost of capital for the company to deem the project profitable given the risks.

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Cost of Capital and Weighted Average Cost of Capital The cost of capital is the cost that companies bear to obtain capital from investors and creditors. Companies have different types of capital in the form of equity and debt and have different amounts of each type of capital in their capital structure. The cost of capital is significant for discounting future cash flows to their present value when using capital budgeting techniques such as NPV. The actual cost of capital for a company is based on the weighted average cost of capital (WACC), which is based on the cost of equity and the cost of debt as well as the proportion of each type of capital in the company. For a company with no preferred equity, the WACC is usually determined by the following formula:

In that formula, Wd is the percentage of debt in the capital structure, Rd is the average interest rate of debt, t is the tax rate, We is the percentage of equity in the capital structure, and Re is the interest rate of equity (Brigham & Houston, 2015, p. 343). The interest rate of the debt is reduced by the tax rate because the company can deduct any interest paid on debt from its taxes. The Capital Asset Pricing Model (CAPM) is the commonly used method of determining the cost of equity. The cost of equity is found by using the following formula:

In that formula, Rf is the risk-free return usually measured by the rate on Treasury bills, Rm is the average return of the market, and β is the beta of the stock that is based on the volatility of the stock compared to the market as a whole and is a measure of risk. In general, debt has a lower cost than equity. An excessive amount of debt in the capital structure, however, increases the risk that the company will not be able to meet its debt obligations in the event of a market downturn. As a result, companies have an optimal capital structure that balances debt and equity capital. In summary, we dug into the topic of capital budgeting methods and their use in decision-making. We learned how each method is unique in the type of information it provides. Further, we gained insight into the risk factors and how they are built into the discount rate. We also examined how relevant cash flows are determined in capital budgeting analysis. Finally, we evaluated the conflicts that occur between project rankings.

References Baker, H. K., & Powell, G. (2005). Understanding financial management. Wiley-Blackwell. Brigham, E. F, & Houston, J. F. (2015). Fundamentals of financial management. Cengage. Gallagher, T. J., & Andrew, J. D. (2007). Financial management: Principles and practice. Freeload Press. Mowen, M. M., Hansen, D. R., & Heitger, D. L. (2012). Cornerstones of managerial accounting. South-

Western. Warren, C., Reeve, J., & Duchac, J. (2009). Managerial accounting. South Western.

WdRd(1-t)+WeRe

Rf +(Rm-Rf)β

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Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Managerial accounting. Wiley.

Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. The Unit VIII Knowledge Check Quiz will give you practice using the math skills that you have learned in this unit. It will be very helpful practice for the assignment in this unit, and you are encouraged to complete this prior to completing the assignment. (PDF of Unit VIII Knowledge Check Quiz)