FM 4: CAPITAL MARKET

REPORTERS:
MARIANO, HONEY DAYLE A.
BAGARENO, ALTHEA P.
MACA-ALIN, ABULKAIR S.
GALIA, JHARRED S.

CONTENTS:
CHAPTER 11: THE CORPORATE FINANCING DECISION
CHAPTER 13: CAPITAL BUDGETING: PROCESS AND CASH FLOW ESTIMATION
CHAPTER 14: CAPITAL BUDGETING TECHNJQUES

MS. JOHANA CHRISTINE ALBERTO

INSTRUCTOR
Three Sources of Capital;

1. Debt – an obligation or liability that one party owes to another, usually the involving the
repayment of money.

2. Internally Generated Equity – refers to the equity that a company creates through its own
operations.

3. New Equity – refers to new capital or funding raised by a company through the issuance
of the additional shares of its stock.

1.Debt – an obligation or liability that one party owes to another, usually the involving the
repayment of money.

2.Internally Generated Equity – refers to the equity that a company creates through its own
operations.

The Concept of Leverage

•Business Risk – the uncertainty associated with the earnings from operations.

•Sales Risk – the risk associated with sales as a result of economic and market forces that affect
the volume and prices of goods and services sold.

•Operating Risk – the risk associated with the cost structure of the company’s asset.
Degree of Operating Leverage (DOL) – fixed costs operate as a fulcrum in this leverage are
specifically the fixed operating costs.

Capital Structure and Financial Leverage

Debt Financing – obligates the company to pay creditors interest and principal, usually a fixed
amount.

Equity Financing – the process of raising capital by selling shares of a company to investors.

Capital Structure and Taxes

Interest Tax Shield – refers to the benefit from interest deductibility, because the interest expense
shields income from taxation.

Unused Tax Shield – refers to the portion of tax deduction or tax credit that a taxpayer is eligible
for but has been able to use, typically because the entity doesn’t have enough taxable income to
offset the deduction or credit.
THE COST OF CAPITAL

The cost of capital is the return that must be provided for the use of an investor’s funds. If the
funds are borrowed, the cost is related to the interest that must be paid on the loan. If the funds
are equity, the cost is the return that investors expect, both from the stock’s price appreciation
and dividends. The cost of capital is a marginal concept.

THE AGENCY RELATIONSHIP AND CAPITAL STRUCTURE

The cost of capital is the return that must be provided for the use of an investor’s funds. If the
funds are borrowed, the cost is related to the interest that must be paid on the loan. If the funds
are equity, the cost is the return that investors expect, both from the stock’s price appreciation
and dividends. The cost of capital is a marginal concept.

OPTIMAL CAPITAL STRUCTURE: THEORY AND PRACTICE

Management can try to evaluate whether there is a capital structure that maximizes the value
of the company. This capital structure, if it exists, is referred to as the optimal capital structure.

- Benefits of debt financing –

Interest tax shield
Governance value
- Costs of debt financing –
Financial flexibility
Financial distress and bankruptcy

CAPITAL STRUCTURE AMONG DIFFERENT INDUSTRY

The analysis of the capital structure trade-off suggests several financial characteristics of
companies that affect the choice of capital structure such as The greater the marginal tax rate, the
greater the benefit from the interest deductibility and, therefore, the more likely a company is to
use debt in its capital structure. The greater the business risk of a company, the greater the
present value of financial distress and, therefore, the less likely the company is to use debt in its
capital structure.
The greater extent that the value of the company depends on Intangible assets, the less likely it is
to use debt in its capital structure.

CAPITAL STRUCTURE WITHIN INDUSTRIES

The capital structures among companies within industries differ for several possible reasons.
First, within an industry there may not be a homogeneous group of companies.

TRADE-OFF THEORY AND OBSERVED CAPITAL STRUCTURE

The trade-off theories can explain some of the capital structure variations that we observe.
Companies whose value depends to a greater extent on intangibles, such as in the semiconductor
and drug industries, tend to have lower debt ratios.

A CAPITAL STRUCTURE PRESCRIPTION

The analysis of the trade-off and pecking order explanations of capital structure suggests that
there is no satisfactory explanation.

Several factors to consider in making the capital structure decision:

TAXES – The tax deductibility of interest makes debt financing attractive. However, the benehit
from debt financing is reduced it the company cannot use the tax shields.
RISK – Because financial distress is costly, even without legal bankruptcy, the likelihood of
financial distress depends on the business risk of the company, in addition to any risk from
financial leverage.
TYPE OF ASSET – The cost of financial distress is likely to be more for companies whose value
depends on intangible assets and growth opportunities.
FINANCIAL SLACK – The availability of funds to take advantage of profitable investment
opportunities is valuable. Therefore, having a store of cash, marketable securities, and unused
debt capacity is valuable.
INVESTMENT DECISIONS
AND OWNERS’ WEALTH MAXIMIZATION
Managers must evaluate a number of factors in making investment decisions. Not only does the
financial manager need to estimate how much the company’s future cash flows will change if it
invests in a project, but the manager must also evaluate the uncertainty associated with these
future cash flows.

Cash flow risk comes from two basic sources:

SALES RISK – The degree of uncertainty related to the number of units that will be sold and the
price of the good or service.
OPERATING RISK – The degree of uncertainty concerning operating cash flows that arises
from the particular mix of fixed and variable operating costs.

CAPITAL BUDGETING PROCESS

Because a company must continually evaluate possible investments, capital budgeting is an
ongoing process. However, before a company begins thinking about capital budgeting, it must
first determine its corporate strategy its broad set of objectives for future investment.

STAGES IN THE CAPITAL BUDGETING PROCESS

1. Investment screening and selection – Projects consistent with the corporate strategy are
identified by production, marketing, and research and development management of the company.
2. Capital budgeting proposal – A capital budget is proposed for the projects surviving the
screening and selection process. The budget lists the recommended projects and the dollar
amount of investment needed for each.
3. Budgeting approval and authorization – Projects included in the capital budget are authorized,
allowing further fact gathering and analysis, and approved, allowing expenditures for the
projects.
4. Project tracking – After a project is approved, work on it begins. The manager reports
periodically on its expenditures, as well as on any revenues associated with it. This is referred to
as project tracking, the communication link between the decision makers and the operating
management of the company.
5. Post-completion audit – No matter the number of stages in a company’s capital budgeting
process, most companies include some form of postcompletion audit that involves a comparison
of the actual cash from operations of the project with the estimated cash flow used to justify the
project.

The economic life is an estimate of the length of time that the asset will provide benefits to the
company. After its useful life, the revenues generated by the asset tend to decline rapidly and its
expenses tend to increase.

If benefits are received only within the current period—within one year of making the
investment—we refer to the investment as a short-term investment.
If these benefits are received beyond the current period, we refer to the investment as a long-term
investment
Refer to the expenditure as a capital expendi- ture.

■ Replacement projects. Investments in the replacement of existing equip- ment or facilities.

■ Expansion projects. Investments in projects that broaden existing prod- uct lines and existing
markets.
■ New products and markets. Projects that involve introducing a new product or entering into a
new market.
■ Mandated projects. Projects required by government laws or agency rules.

An independent project is one whose cash flows are not related to the cash flows of any other
project. Therefore, accepting or rejecting an inde- pendent project does not affect the acceptance
or rejection of other projects.

Projects are mutually exclusive if the acceptance of one precludes the accep- tance of other
projects. For example, suppose a manufacturer is considering whether to replace its production
facilities with more modern equipment.
Contingent projects are dependent on the acceptance of another proj- ect. Suppose a greeting
card company develops a new character, Pippy, and is considering starting a line of Pippy cards.

Another form of dependence is found in complementary projects, where the investment in one
enhances the cash flows of one or more other projects. Consider a manufacturer of personal
computer equipment and software.

The difference between the cash flows of the company with the investment project and the cash
flows of the company without the investment project—both over the same period of time—is
referred to as the project’s incremental cash flows.

Investment cash flows take into account asset acquisition costs and disposal costs.

Asset Acquisition
The analysis of an investment must consider all the cash flows associated with acquiring and
disposing of assets.

Asset Disposition

If the company is making a decision that involves replacing an existing asset, the cash flow from
disposing of the old asset must be considered because it is a cash flow relevant to the acquisition
of the new asset.

Operating Cash Flows

In the simplest form of investment, there will be a cash outflow when the asset is acquired and
there may be either a cash inflow or an outflow at the end of its economic life.

Operating Cash Flows

In the simplest form of investment, there will be a cash outflow when the asset is acquired and
there may be either a cash inflow or an outflow at the end of its economic life.
Change in Expenses
When a company takes on a new project, all the costs associated with it will change the
company’s expenses. If the investment involves changing the sales of an existing product, we
need to estimate the change in unit sales.

Change in Taxes
Taxes figure into the operating cash flows in two ways. First, if revenues and expenses change,
taxable income and, therefore, taxes change. That means we need to estimate the change in
taxable income resulting from the changes in revenues and expenses resulting from a new project
to determine the ef- fect of taxes on the company. Second, the deduction for depreciation reduces
taxes. Depreciation itself is not a cash flow. But depreciation reduces the taxes that must be paid,
shielding income from taxation.

Change in Working Capital

Working capital consists of short-term assets, also referred to as current as- sets, which support
the day-to-day operating activity of the business. Net working capital is the difference between
current assets and current liabili- ties. Net working capital is what would be left over if the
company had to pay off its current obligations using its current assets.

Net Cash Flows

By now we should know that an investment’s cash flows consist of: (1) cash flows related to
acquiring and disposing the assets represented in the invest- ment; and (2) how it affects cash
flows related to operations. To evaluate any investment project, we must consider both to
determine whether or not the company is better off with or without it.

Net present value

The word “net” in this term indicates that all cash flows—both positive and negative—are
considered. Often the changes in operating cash flows are inflows and the investment cash flows
are outflows. Therefore, we tend to refer to the net present value as the difference between the
present value of the cash inflows and the present value of the cash outflows.

The Investment Profile

A financial manager may want to see how sensitive the decision to accept a project is to changes
in the estimate of the project’s cost of capital. The investment profile (also known as the net
present value profile) is a depiction of the NPVs for different discount rates, which allows an
examination of the sensitivity in how a project’s NPV changes as the discount rate changes.

PROFITABILITY INDEX
The profitability index uses some of the same information we used for the net present value, but
it is stated in terms of an index.

Internal rate of return

An investment’s internal rate of return is the discount rate that makes the present value of all
expected future cash flows equal to zero.

Modified internal rate of return

The modified internal rate of return (MIRR) is a yield on an investment considering a specific
rate on the reinvestment of funds. The NPV method assumes that cash inflows from a project are
reinvested at the project’s cost of capital, whereas the IRR method assumes that cash inflows are
reinvested at the project’s IRR. These assumptions are built into the mathematics of the methods,
but they may not represent the actual opportunities of the company.
Payback Period

The Payback Period for a project is the time it takes for the cash inflows to add up to the initial
cash outflow. In other words, how long it takes to recover the initial cash outflow. The payback
period is also referred to as the payoff period or the capital recovery period.

Discounted Payback Period

The Discounted payback period is the time needed to payback the original investment in terms of
discounted future cash flows. In this technique, each future cash inflow is discounted back to its
present value using a discount rate that reflects both the time value of money and the risk or
uncertainty associated with those future cash flows.

Issues in Capital Budgeting

1. Scale Differences- this refer to the varying sizes and magnitudes of potential projects or
investments being considered. Projects can differ significantly in terms of their
investment amounts, production capacities, or operational scales.
2.Unequal lives- this refer to the differing useful lives or durations of projects or assets being
evaluated. Some projects may have a long lifespan, while others may have a shorter operational
life.

Comparing Techniques

When dealing with mutually exclusive projects, the NPV method leads us to invest in projects
that maximize wealth, that is, capital budgeting decisions consistent with owners’ wealth
maximization. When dealing with a limit on the capital budget, the NPV and PI method lead to
set of projects that maximize wealth.

•Net Present Value(NPV) Method

This aims to maximize shareholder wealth by calculating the difference between the present
value of future cash flows and the initial investment.

•Profitability Index(IP)

It measures a project’s relatively by calculating the ratio of the present value of future cash flows
to the initial investment.

Capital Budgeting techniques in practice

•Techniques that use discounted cash flows are preferred over technique that fail to take into
consideration the time value money.

•There is an increased use of the net present value method.

•Most decision-makers use more than one technique to evaluate the same project’s, with a
discounted cash flow techniques used as a primary method and payback period used as a
secondary method.

•The most commonly used technique is the net present value method, though the internal rate of
return method is still widely used.

Capital Budgeting and the Justification of new Technology

1. The initial cash flows

2. The cash flow from operations
3. The required return(or hurdle rate)

Incorporating risk into capital budgeting analysis

-Incorporating risk into capital budgeting analysis is essential for making sound investment
decisions. By using various assessment techniques and adjusting cash flow projections and
discount rates, organizations can better understand the potential impacts of risks on their projects.
This comprehensive approach enhances strategic decision-making and helps align investments
with the organization’s risk appetite and long-term objectives.

-Capital budgeting involves evaluating a project’s future cash flows, their uncertainty, and their
value to determine which projects will maximize company value and increase shareholder
wealth. Costs include the initial investment outlay and opportunity costs of capital tied up in the
investment, while benefits come from future cash flows generated.

 Higher Discount Rates: Future cash flows are discounted at a high rate to account for
increased risk, reducing their present value and making project’s less attractive unless
they offer high returns.
 Higher Required Returns: A higher hurdle rate is set for project acceptance, ensuring that
only those with sufficient return potential are considered.