FIN 6301 Unit IV

FIN 6301, Corporate Finance 1

Course Learning Outcomes for Unit IV At the end of this unit, you should be able to:

4. Determine budgeting feasibility of projects. 4.3 Analyze the key financial metrics, including net present value, internal rate of return, and

profitability index to assess the financial feasibility of proposed projects. 4.4 Apply real-world research comparing and contrasting the financial metrics of projects with

actual project valuations.

Required Unit Resources Chapter 9: The Cost of Capital (ULO 4.3) You are not required to read the Summary, Questions, or Web Extension at the end of the chapter. The purpose of this chapter is to understand the cost of capital. First, we will name the capital components used to estimate the cost of capital and explain why accounts payable and accruals are not capital components. We will determine the cost of debt, preferred stock, and common stock. Next, we will apply the dividend growth model, calculate the market risk premium, and the weighted average cost of capital. Finally, we will propose methods to estimate the cost of capital, calculate the cost of capital for individual projects, and discuss managerial issues with the cost of capital. Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows (ULO 4.4) You are not required to read the Summary, Questions, or Web Extension at the end of the chapter. The purpose of this chapter is to understand the basics of capital budgeting by evaluating cash flows. First, we will review ways in which firms categorize projects and the steps in a project analysis. Next, we will estimate a project’s net present value, determine a project’s rate of return, and assess the profitability index of a project. Finally, we will identify a project’s payback period, discuss capital budgeting methods, and choose mutually exclusive projects with unequal lives.

Unit Lesson Lesson: Capital Dynamics: Understanding the Cost and Strategizing Investments (ULOs 4.3 and 4.4)

The Cost of Capital and Evaluating Cash Flows The cost of capital is essentially the price a company pays to have access to the funds it needs, whether from debt, equity, or other financial instruments. For businesses, understanding this cost is critical; it determines how much return an investment must yield for it to be profitable. The lower the cost of capital, the more projects a firm can undertake and still expect a profit. In this lesson, we will delve deeper into the critical components that shape this cost. Naming the Components When estimating the cost of capital, it is imperative to identify its components. These include debt (e.g., bonds), equity (e.g., common, and preferred stock), and sometimes other specialized instruments. You might wonder about accounts payable or accruals. Why are they not considered? Simply put, while these are obligations, they do not represent capital provided by investors. They are operational by nature and do not bear the same type of cost as the funds supplied by investors or lenders.

UNIT IV STUDY GUIDE

Projects and Their Valuation

FIN 6301, Corporate Finance 2

UNIT x STUDY GUIDE

Title

Debt, preferred stock, and common stock: each of these components has its own cost.

Figure 1: Cost of debt, preferred stock, and common stock These explanations, while concise, offer a foundation. In practice, the computation and considerations can become complex (Dahlquist & Knight, 2022). Applying the Dividend Growth Model and Market Risk Premium A cornerstone in finance, the dividend growth model (DGM), helps in estimating the cost of common stock. It relates the expected dividend payment, its growth rate, and the stock’s current price. Further, the market risk premium plays a role, especially when considering the risks associated with a particular investment compared to the overall market. A high market risk premium indicates that investors expect a higher return due to perceived risks (Dahlquist &Knight, 2022). The Weighted Average Cost of Capital (WACC) The Weighted Average Cost of Capital (WACC) is an essential metric. It provides a clear picture by averaging out the various costs associated with each capital component, considering their proportion in the overall capital structure. This average serves as a benchmark rate of return for a company’s investments. Projects with expected returns over the WACC may be deemed profitable (Borad, 2022). Managerial Implications and the Cost of Capital The cost of capital is not just a number; it has profound managerial implications. For instance, if a firm’s WACC is high, it might be perceived as risky by investors. This perception can influence decisions about which projects to undertake, how to finance them, and even how dividends are distributed. Remember that the cost of capital serves as a bridge between the realms of finance and strategy, influencing both in equal measure. In essence, the cost of capital plays a pivotal role in how businesses operate, invest, and grow. Through this lesson, we aim to offer you the tools and understanding to navigate this crucial terrain in the world of finance.

FIN 6301, Corporate Finance 3

UNIT x STUDY GUIDE

Title

Capital Budgeting and Its Importance Capital budgeting is the process firms use to decide which major projects in which they should invest. At its heart, this involves assessing a project’s potential cash flow over time. Since firms have limited resources, they must allocate capital efficiently, ensuring that chosen projects yield the maximum return for the risk taken (All Things Business,2023). Categorizing and Analyzing Projects Firms do not view all projects through the same lens. Projects can involve several different facets:

Figure 2: Potential project categories Understanding the nature of the project is the first step, followed by an in-depth project analysis, which evaluates the feasibility, risks, and returns with which is associated. Estimating Net Present Value (NPV) The net present value (NPV) is one of the most trusted tools in capital budgeting. By discounting future cash flows to their value in present terms and subtracting the initial investment, NPV tells us the potential profitability of a project. A positive NPV suggests that the project may yield a return higher than the discount rate used, making it an attractive investment (Girardin, 2023). Rate of Return and the Profitability Index While NPV provides an absolute value, the rate of return gives a percentage—the potential return as a percentage of the initial investment. The profitability index, on the other hand, divides the present value of future cash flows by the initial investment. Both tools are invaluable in gauging a project's attractiveness, especially when resources are scarce (Dahlquist & Knight, 2022). Delving into the Payback Period The payback period is a simple yet crucial metric, indicating how long it would take for a project to recoup its initial investment. While it does not account for the time value of money, it provides a quick snapshot of a project’s risk profile, with shorter payback periods typically signaling less risk (Gaille, 2020).

FIN 6301, Corporate Finance 4

UNIT x STUDY GUIDE

Title

Navigating Capital Budgeting Methods Beyond the tools already discussed, various other capital budgeting methods are employed, like the internal rate of return (IRR) or the modified internal rate of return (MIRR). These methods, each with its own strengths and shortcomings, allow firms to view projects from different angles, ensuring robust decision-making (Franklin et al., 2019). Selecting Between Mutually Exclusive Projects with Unequal Lives A real challenge arises when two projects are mutually exclusive, meaning choosing one negates the other, and they have different life spans. In such cases, traditional metrics may not provide a clear answer. Methods like the equivalent annual annuity approach can be employed to make apples-to-apples comparisons and informed decisions. To conclude, capital budgeting stands at the crossroads of finance and strategy, guiding firms in their quest for growth and value creation. Through this lesson, we have illuminated the methods and considerations that underpin this essential process. Dive in, explore, and let’s make every investment count!

References All Things Business. (2023, April 11). The importance of capital budgeting in business decision-making.

Whisperings of an Expert. https://www.whisperingsofanexpert.com/post/the-importance-of-capital- budgeting-in-business-decision-making

Borad, S. B. (2022). Importance and use of weighted average cost of capital (WACC). eFinanceManagement.

https://efinancemanagement.com/investment-decisions/importance-and-use-of-weighted-average- cost-of-capital-wacc

Dahlquist, J., & Knight, R. (2022 Principles of finance. OpenStax.

https://openstax.org/details/books/principles-finance Franklin, M., Grabeal, P., & Cooper, D. (2019). Principles of accounting, volume 2: Managerial accounting.

OpenStax. https://openstax.org/details/books/principles-managerial-accounting Gaille, L. (2020, March 29). 18 major advantages and disadvantages of the payback period. Vittana.

https://vittana.org/18-major-advantages-and-disadvantages-of-the-payback-period Girardin, M. (2023, October 13). How to calculate net present value (NPV). Forage.

https://www.theforage.com/blog/skills/npv Rode, A. L. G., Svejvig, P., & Martinsuo, M. (2022, August). Developing a multidimensional conception of

project evaluation to improve projects. Project Management Journal, 53(4), 416–432. https://libraryresources.columbiasouthern.edu/login?url=https://search.ebscohost.com/login.aspx?dire ct=true&db=bsu&AN=157901915&site=ehost-live&scope=site

Suggested Unit Resources Article: Developing a Multidimensional Conception of Project Evaluation to Improve Projects (Optional) This article analyzes promotion of continuous improvement through defining project evaluation (16 pages).

FIN 6301, Corporate Finance 1

Course Learning Outcomes for Unit IV At the end of this unit, you should be able to:

4. Determine budgeting feasibility of projects. 4.3 Analyze the key financial metrics, including net present value, internal rate of return, and

profitability index to assess the financial feasibility of proposed projects. 4.4 Apply real-world research comparing and contrasting the financial metrics of projects with

actual project valuations.

Required Unit Resources Chapter 9: The Cost of Capital (ULO 4.3) You are not required to read the Summary, Questions, or Web Extension at the end of the chapter. The purpose of this chapter is to understand the cost of capital. First, we will name the capital components used to estimate the cost of capital and explain why accounts payable and accruals are not capital components. We will determine the cost of debt, preferred stock, and common stock. Next, we will apply the dividend growth model, calculate the market risk premium, and the weighted average cost of capital. Finally, we will propose methods to estimate the cost of capital, calculate the cost of capital for individual projects, and discuss managerial issues with the cost of capital. Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows (ULO 4.4) You are not required to read the Summary, Questions, or Web Extension at the end of the chapter. The purpose of this chapter is to understand the basics of capital budgeting by evaluating cash flows. First, we will review ways in which firms categorize projects and the steps in a project analysis. Next, we will estimate a project’s net present value, determine a project’s rate of return, and assess the profitability index of a project. Finally, we will identify a project’s payback period, discuss capital budgeting methods, and choose mutually exclusive projects with unequal lives.

Unit Lesson Lesson: Capital Dynamics: Understanding the Cost and Strategizing Investments (ULOs 4.3 and 4.4)

The Cost of Capital and Evaluating Cash Flows The cost of capital is essentially the price a company pays to have access to the funds it needs, whether from debt, equity, or other financial instruments. For businesses, understanding this cost is critical; it determines how much return an investment must yield for it to be profitable. The lower the cost of capital, the more projects a firm can undertake and still expect a profit. In this lesson, we will delve deeper into the critical components that shape this cost. Naming the Components When estimating the cost of capital, it is imperative to identify its components. These include debt (e.g., bonds), equity (e.g., common, and preferred stock), and sometimes other specialized instruments. You might wonder about accounts payable or accruals. Why are they not considered? Simply put, while these are obligations, they do not represent capital provided by investors. They are operational by nature and do not bear the same type of cost as the funds supplied by investors or lenders.

UNIT IV STUDY GUIDE

Projects and Their Valuation

FIN 6301, Corporate Finance 2

UNIT x STUDY GUIDE

Title

Debt, preferred stock, and common stock: each of these components has its own cost.

Figure 1: Cost of debt, preferred stock, and common stock These explanations, while concise, offer a foundation. In practice, the computation and considerations can become complex (Dahlquist & Knight, 2022). Applying the Dividend Growth Model and Market Risk Premium A cornerstone in finance, the dividend growth model (DGM), helps in estimating the cost of common stock. It relates the expected dividend payment, its growth rate, and the stock’s current price. Further, the market risk premium plays a role, especially when considering the risks associated with a particular investment compared to the overall market. A high market risk premium indicates that investors expect a higher return due to perceived risks (Dahlquist &Knight, 2022). The Weighted Average Cost of Capital (WACC) The Weighted Average Cost of Capital (WACC) is an essential metric. It provides a clear picture by averaging out the various costs associated with each capital component, considering their proportion in the overall capital structure. This average serves as a benchmark rate of return for a company’s investments. Projects with expected returns over the WACC may be deemed profitable (Borad, 2022). Managerial Implications and the Cost of Capital The cost of capital is not just a number; it has profound managerial implications. For instance, if a firm’s WACC is high, it might be perceived as risky by investors. This perception can influence decisions about which projects to undertake, how to finance them, and even how dividends are distributed. Remember that the cost of capital serves as a bridge between the realms of finance and strategy, influencing both in equal measure. In essence, the cost of capital plays a pivotal role in how businesses operate, invest, and grow. Through this lesson, we aim to offer you the tools and understanding to navigate this crucial terrain in the world of finance.

FIN 6301, Corporate Finance 3

UNIT x STUDY GUIDE

Title

Capital Budgeting and Its Importance Capital budgeting is the process firms use to decide which major projects in which they should invest. At its heart, this involves assessing a project’s potential cash flow over time. Since firms have limited resources, they must allocate capital efficiently, ensuring that chosen projects yield the maximum return for the risk taken (All Things Business,2023). Categorizing and Analyzing Projects Firms do not view all projects through the same lens. Projects can involve several different facets:

Figure 2: Potential project categories Understanding the nature of the project is the first step, followed by an in-depth project analysis, which evaluates the feasibility, risks, and returns with which is associated. Estimating Net Present Value (NPV) The net present value (NPV) is one of the most trusted tools in capital budgeting. By discounting future cash flows to their value in present terms and subtracting the initial investment, NPV tells us the potential profitability of a project. A positive NPV suggests that the project may yield a return higher than the discount rate used, making it an attractive investment (Girardin, 2023). Rate of Return and the Profitability Index While NPV provides an absolute value, the rate of return gives a percentage—the potential return as a percentage of the initial investment. The profitability index, on the other hand, divides the present value of future cash flows by the initial investment. Both tools are invaluable in gauging a project's attractiveness, especially when resources are scarce (Dahlquist & Knight, 2022). Delving into the Payback Period The payback period is a simple yet crucial metric, indicating how long it would take for a project to recoup its initial investment. While it does not account for the time value of money, it provides a quick snapshot of a project’s risk profile, with shorter payback periods typically signaling less risk (Gaille, 2020).

FIN 6301, Corporate Finance 4

UNIT x STUDY GUIDE

Title

Navigating Capital Budgeting Methods Beyond the tools already discussed, various other capital budgeting methods are employed, like the internal rate of return (IRR) or the modified internal rate of return (MIRR). These methods, each with its own strengths and shortcomings, allow firms to view projects from different angles, ensuring robust decision-making (Franklin et al., 2019). Selecting Between Mutually Exclusive Projects with Unequal Lives A real challenge arises when two projects are mutually exclusive, meaning choosing one negates the other, and they have different life spans. In such cases, traditional metrics may not provide a clear answer. Methods like the equivalent annual annuity approach can be employed to make apples-to-apples comparisons and informed decisions. To conclude, capital budgeting stands at the crossroads of finance and strategy, guiding firms in their quest for growth and value creation. Through this lesson, we have illuminated the methods and considerations that underpin this essential process. Dive in, explore, and let’s make every investment count!

References All Things Business. (2023, April 11). The importance of capital budgeting in business decision-making.

Whisperings of an Expert. https://www.whisperingsofanexpert.com/post/the-importance-of-capital- budgeting-in-business-decision-making

Borad, S. B. (2022). Importance and use of weighted average cost of capital (WACC). eFinanceManagement.

https://efinancemanagement.com/investment-decisions/importance-and-use-of-weighted-average- cost-of-capital-wacc

Dahlquist, J., & Knight, R. (2022 Principles of finance. OpenStax.

https://openstax.org/details/books/principles-finance Franklin, M., Grabeal, P., & Cooper, D. (2019). Principles of accounting, volume 2: Managerial accounting.

OpenStax. https://openstax.org/details/books/principles-managerial-accounting Gaille, L. (2020, March 29). 18 major advantages and disadvantages of the payback period. Vittana.

https://vittana.org/18-major-advantages-and-disadvantages-of-the-payback-period Girardin, M. (2023, October 13). How to calculate net present value (NPV). Forage.

https://www.theforage.com/blog/skills/npv Rode, A. L. G., Svejvig, P., & Martinsuo, M. (2022, August). Developing a multidimensional conception of

project evaluation to improve projects. Project Management Journal, 53(4), 416–432. https://libraryresources.columbiasouthern.edu/login?url=https://search.ebscohost.com/login.aspx?dire ct=true&db=bsu&AN=157901915&site=ehost-live&scope=site

Suggested Unit Resources Article: Developing a Multidimensional Conception of Project Evaluation to Improve Projects (Optional) This article analyzes promotion of continuous improvement through defining project evaluation (16 pages).