Corporate Finance PDF

Corporate Finance - Capital Budgeting Basics
What is Capital Budgeting?

Capital budgeting is defined as the process of planning for projects on assets
with cash flows of a period greater than one year.
These projects can be classified as:
· Replacement decisions to maintain the business

· Existing product or market expansion
· New products and services
· Regulatory, safety and environmental
· Other, including pet projects or difficult to evaluate projects
Additionally, projects can also be classified as mutually

exclusive or independent:
- Mutually exclusive projects indicate there is only one project among all
possible projects that can be accepted.
- Independent projects are potential projects that are unrelated, and any
combination of those projects can be accepted.
The Importance of Capital Budgeting

Capital budgeting is important for many reasons:
- Since projects approved via capital budgeting are long term, the firm becomes
tied to the project and loses some of its flexibility during that period.
- When making the decision to purchase an asset, managers need to forecast
the revenue over the life of that asset.
- Lastly, given the length of the projects, capital-budgeting decisions ultimately
define the strategic plan of the company.
Corporate Finance - The Cost of Capital
The following sections discuss the cost of capital in terms of its components,
calculations, and company internal targets. Readers should know the costs that
make up the weighted cost of capital (WACC).
Interpreting the Cost of Capital

Given the importance of capital budgeting, a company should use the weighted
average of the costs of the various types of capital it may use in financing its
operations.
A company uses debt, common equity and preferred equity to fund new
projects, typically in large sums. In the long run, companies typically adhere to
target weights for each of the sources of funding. When a capital budgeting
decision is being made, it is important to keep in mind how the capital structure
may be affected.
Cost Components
A company's weighted average cost of capital (WACC) is comprised of the
following costs:
1.Cost of debt
2.Cost of preferred stock
3.Cost of retained earnings
4.Cost of external equity
1. Cost of Debt
In the WACC calculation, the after-tax cost of debt is used. Using the after-tax
cost takes into account the tax savings from the tax-deductibility of interest.
The after-tax cost of debt can be calculated as follows:
Formula 11.1
After-tax cost of debt = kd (1-t)
Look Out!
It is important to note that kdrepresents
thecost to issue new debt, not the firm\'s
existing debt.
Example: Cost of Debt

Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and
state) tax rate is 40%. What is Newco's cost of debt?
Answer:
kd (1-t) = 7% (1-0.40) = 4.2%

2. Cost of Preferred Stock
Cost of preferred stock (kps) can be calculated as follows:
Formula 11.2
kps = Dps/Pnet
where:
Dps = preferred dividends
Pnet = net issuing price
Example: Cost of preferred stock
Assume Newco's preferred stock pays a dividend of $2 per share and it sells for
$100 per share. If the cost to Newco to issue new shares is 4%, what is
Newco's cost of preferred stock?
Answer:
kps = Dps/Pnet = $2/$100(1-0.04) = 2.1%
Corporate Finance - Cost of Retained Earnings
3. Cost of retained earnings

Cost of retained earnings (ks) is the return stockholders require on the
company's common stock.
There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach
a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first
estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or
the 30-day Treasury-bill rate as well as the expected rate of return on the
market (rm).
The next step is to estimate the company's beta (bi), which is an estimate of
the stock's risk. Inputting these assumptions into the CAPM equation, you can
then calculate the cost of retained earnings.
Formula 11.3
Example: CAPM approach

For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of
retained earnings for Newco using the CAPM approach?
Answer:
ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%
b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings.
Simply take the interest rate of the firm's long-term debt and add a risk
premium (typically three to five percentage points):
Formula 11.4
ks = long-term bond yield + risk premium
Example: bond-yield-plus-premium approach

The interest rate on Newco's long-term debt is 7% and our risk premium is 4%.
What is the cost of retained earnings for Newco using the bond-yield-plus-
premium approach?
Answer:
ks = 7% + 4% = 11%
c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus

growth approach". Using the dividend-growth model, you can rearrange the
terms as follows to determine ks.
Formula 11.5
ks = D1 + g;
P0
where:
D1 = next year's dividend
g = firm's constant growth rate
P0 = price
Typically, you must also estimate g, which can be calculated as follows:
Formula 11.6
g = (retention rate)(ROE) = (1-payout rate)(ROE)
Example: discounted cash flow approach

Assume Newco's stock is selling for $40; its expected return on equity (ROE) is
10%, next year's dividend is $2 and the company expects to pay out 30% of its
earnings. What is the cost of retained earnings for Newco using the discounted
cash flow approach?
Answer:
g must first be calculated:
g = (1-0.3)(0.10) = 7.0%
ks = 2/40 + 0.07 = 0.12 or 12%

Corporate Finance - Cost of Newly Issued Stock
4. Cost of external equity

Cost of newly issued stock (kc) is the cost of external equity, and it is based on
the cost of retained earnings increased for flotation costs (cost of issuing
common stock). For a constant-growth company, this can be calculated as
follows:
Formula 11.7
kc = D1__ + g
P0 (1-F)
where:
F = the percentage flotation cost, or (current stock price - funds going to
company) / current stock price
Example: cost of newly issued stock
As in our previous example for Newco, assume the company's stock is selling
for $40, its expected ROE is 10%, next year's dividend is $2 and the company
expects to pay out 30% of its earnings. Additionally, assume the company has a
flotation cost of 5%. What is Newco's cost of new equity?
Answer:
kc = 2 + 0.07 = 0.123, or 12.3%
40(1-0.05)
It is important to note that the cost of newly issued stock is higher than the
company's cost of retained earnings. This is due to the flotation costs.
Corporate Finance - Target Capital Structure
The target (optimal) capital structure is simply defined as the mix of debt,
preferred stock and common equity that will optimize the company's stock
price. As a company raises new capital it will focus on maintaining this target
(optimal) capital structure.
Look Out!
It is important to note is that while the target structure is
the capital structure that will optimize the company\'s stock
price, it is also the capital structure that minimizes the
company\'s weighted-average cost of capital (WACC).
Calculating Weighted Average Cost of Capital

A company's weighted average cost of capital (WACC) is calculated as follows:
Formula 11.8
WACC = (wd) [kd (1-t)] + (wps)(kps) + (wce)(kce)
Where:
Wd = weight percentage of debt in company's capital structure
Wps = weight percentage of preferred stock in company's capital structure
Wce = weight percentage of common stock in company's capital structure
As discussed previously, the weights of debt, preferred securities and common

equity are based on the company's target (optimal) capital structure.
Look Out!
One thing to note is that the weights should be based on the
market value of the firm\'s securities, unless the firm\'s
book value shown on the balance sheet is similar to the
market value.
Example: WACC
For Newco, assume the following weights: wd = 40%, wps = 5% and wce = 55%.
Compute Newco's weighted average cost of capital using the costs calculated in
the examples above. For the purposes of this example, assume new equity
comes from retained earnings and the discounted cash flow approach is used to
derive kce.
Answer:
WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%
Taking the example further, suppose new equity needs to come from newly
issued common stock; the WACC would then be calculated using a kc of 12.3%.
Thus our WACC would be as follows:

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)
WACC = 0.086 or 8.6%
Corporate Finance - Marginal Cost of Capital
The marginal cost of capital (MCC) is the cost of the last dollar of capital
raised, essentially the cost of another unit of capital raised. As more capital is
raised, the marginal cost of capital rises.
With the weights and costs given in our previous example, we computed
Newco's weighted average cost of capital as follows:

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%
We originally determined the WACC for Newco to be 8.4%. Newco's cost of

capital will remain unchanged as new debt, preferred stock and retained
earnings are issued until the company's retained earnings are depleted.
Example: Marginal Cost of Capital

Once retained earnings are depleted, Newco decides to access the capital
markets to raise new equity. As in our previous example for Newco, assume the
company's stock is selling for $40, its expected ROE is 10%, next year's
dividend is $2.00 and the company expects to pay out 30% of its earnings.
Additionally, assume the company has a flotation cost of 5%. Newco's cost of
new equity (kc) is thus 12.3%, as calculated below:
kc = 2 + 0.07 = 0.123, or 12.3%

40(1-0.05)
Answer:
Using this new cost of equity, we can determine the WACC as follows:

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)
WACC = 0.086, or 8.6%
The WACC has been stepped up from 8.4% to 8.6% given Newco's need to
raise new equity.
Corporate Finance - Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has control
over:
1. Capital Structure Policy

As we have been discussing above, a firm has control over its capital structure,
targeting an optimal capital structure. As more debt is issued, the cost of debt
increases, and as more equity is issued, the cost of equity increases.
2. Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the MCC
schedule can be changed. For example, as the payout ratio of the company
increases the breakpoint between lower-cost internally generated equity and
newly issued equity is lowered.
3. Investment Policy
It is assumed that, when making investment decisions, the company is making
investments with similar degrees of risk. If a company changes its investment
policy relative to its risk, both the cost of debt and cost of equity change.
Uncontrollable Factors Affecting the Cost of Capital

These are the factors affecting cost of capital that the company has no control
over:
1. Level of Interest Rates

The level of interest rates will affect the cost of debt and, potentially, the cost of
equity. For example, when interest rates increase the cost of debt increases,
which increases the cost of capital.
2. Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of
debt decreases, decreasing the cost of capital.
Corporate Finance - Payback Period
Payback Period
Payback period (PP) is the number of years it takes for a company to recover its
original investment in a project, when net cash flow equals zero. In the
calculation of the payback period, the cash flows of the project must first be
estimated. The payback period is then a simple calculation.
Formula 11.10
PP = years full recovery + unrecovered cost at beginning of last year
cash flow in last year
The shorter the payback period of a project, the more attractive the project will
be to management. In addition, management typically establishes a maximum
payback period that a potential project must meet. When two projects are
compared, the project that meets the maximum payback period and has the
shortest payback period is the project to be accepted. It is a simplistic measure,
not taking into account the time value of money, but it is a good measure of a
project's riskiness.
Look Out!
For payback periods, the decision rules are as follows:
If payback period < the minimum payback, accept the
project
If payback period > the minimum payback, reject the
project
Example: Payback Period

Assume Newco is deciding between two machines (Machine A and Machine B) in
order to add capacity to its existing plant. The company estimates the cash
flows for each machine to be as follows:
Figure 11.2: Expected after-tax cash flows for the new machines
Calculate the payback period of the two machines using the above cash flows
and decide which new machine Newco should accept. Assume the maximum
payback period the company establishes is five years.
Answer:
First it would be helpful to determine cumulative cash flow for the machine
project. This is done in the following table:
Figure 11.3: Cumulative cash flows for Machine A and Machine B

Payback period for Machine A = 4 + 1,000 = 4.67
1,500
Payback period for Machine B = 2 + 0 = 2.00

0
Both machines meet the company's maximum payback period. Machine B,
however, has the shortest payback period and is the project Newco should
accept.
2. Discounted Payback Period

The one issue we mentioned with the payback period is that it does not take
into account the time value of money, but the discounted payback period
does.The discounted payback period discounts each of the estimated cash flows
and then determines the payback period from those discounted flows.
Example: discounted payback period

Using our last example above, determine the discounted payback period for
Machine A and Machine B, and determine which project Newco should accept.
As calculated previously, Newco's cost of capital is 8.4%.
Figure 11.4: Discounted cash flows for Machine A and Machine B
Answer:
Payback period for Machine A = 5 + 147 = 5.24
616
Payback period for Machine B = 2 + 262 = 2.22

1178
Machine A now violates management's maximum payback period of five years

and should thus be rejected. Machine B meets management's maximum
payback period of five years and has the shortest payback period.
Corporate Finance - Net Present Value (NPV) and the Internal
Rate of Return (IRR)
Net Present Value

Using the company's cost of capital, the net present value (NPV) is the sum of
the discounted cash flows minus the original investment.
Formula 11.11
Look Out!
Projects with NPV > 0 increase stockholders return
Projects with NPV < 0 decrease stockholders return
Example: Net Present Value

Using the cash flows in the previous examples, calculate the NPV for each
machine and decide which project Newco should accept. As calculated
previously, Newco's cost of capital is 8.4%.
Answer:
NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469
(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929

(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
Given that both machines have NPV > 0, both projects are acceptable.
However, for mutually exclusive projects, the decision rule is to choose the
project with the greatest NPV. Since the NPVB > NPVA, Newco should choose the
project for Machine B.
Internal Rate of Return

The internal rate of return (IRR) on a project is the rate of return at which the
projects NPV equals zero. At this point, a project's cash flows are equal to the
project's costs. Similar to how management must establish a maximum payback
period, management must also set what is known as a "hurdle rate", the
minimum rate of return a company will accept for a project.
When a project is reviewed with a hurdle rate in mind, the greater the IRR is
above the hurdle rate, the greater the NPV, and conversely, the further the IRR
is below the hurdle rate, the lower the NPV.
Look Out!
For the IRR, the decision rules are as follows:
If IRR > hurdle rate, accept the project
If IRR< hurdle rate, reject the project
For a project to be accepted, the IRR must be greater than or equal to the
hurdle rate. If a company is deciding between two projects, the project with the
highest IRR is the project to be accepted.
Formula 11.12
The IRR formula is quite difficult to calculate without the use of a financial
calculator. Thus, a financial calculator is highly recommended to solve for a
project's IRR. Otherwise trial and error must be used.
Corporate Finance - The NPV Profile
The NPV profile is a graph that illustrates a project's NPV against various
discount rates, with the NPV on the y-axis and the cost of capital on the x-axis.
To begin, simply calculate a project's NPV using different cost-of-capital
assumptions. Once these are calculated, plot the values on the graph.
Figure 11.5
Look Out!
Since the IRR is the discount rate where the NPV of a
project equals zero, the point where the NPV crosses the x-
axis is also the project's IRR.
Corporate Finance - Cash Flow and NPV Applications
Accounting Profits
Accounting profits are cash flows that include non-cash inflows/outflows such as
depreciation.
Cash Flows
Cash flows are a firm's actual cash inflows/outflows and are important in capital
budgeting.
Example: Net Cash Flows

Assume Newco has $10,000 in annual depreciation and $20,000 in accounting
net income. Because the $10,000 in annual depreciation is not an actual cash
outflow, the $20,000 in accounting net income is not the true cash flow to the
firm.
If, while all else is constant, annual depreciation were to decline by $5,000 to
$5,000, accounting net income would increase to $25,000, but actual cash flow
would remain unchanged. However, calculations of net cash flow exclude the
effects of depreciation.
Formula 11.13
For purposes of capital budgeting,
Net Cash Flow = Net Income + Depreciation
Answer: Therefore, net cash flow would be equal to $30,000 ($20,000 net
income +$10,000 depreciation) before the changes in depreciation and $30,000
($25,000 net income + $5,000 depreciation) after the changes in depreciation.
Incremental Cash Flow and Capital Budgeting

Once a company makes a decision to accept a project, an incremental cash flow
is then the cash flow that is added to the firm's existing cash flow as a result of
accepting a new project.
However, in determining incremental cash flows from a new project, problems

arise, such as:
1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be
recovered even if a project is accepted. As such, these costs will not affect the
future cash flows of the project and should not be considered when making
capital-budgeting decisions.
Suppose Newco is considering whether to make an addition to its current plant

to increase production. To determine if the new addition is worthwhile, Newco
hired a consulting firm for $50,000 to analyze the addition and the effect it will
have on production. The $50,000 is considered a sunk cost. If the project is
rejected, the $50,000 will still be paid, and if the project is accepted, the
$50,000 will not affect the future cash flows of the addition.
2. Opportunity Cost
This is the cost of not going forward with a project or the cash outflows that will
not be earned as a result of utilizing an asset for another alternative. For
example, the opportunity cost of Newco's new addition considered above is the
cost of the land on which Newco is considering putting the new plant addition.
As such, it should be included in the analysis of the project.
3. Externality
Additionally, in the consideration of incremental cash flows of a new project,
there may be effects on the existing operations of the company to consider,
known as "externalities". For example, the addition to Newco's plant is for the
purpose of producing a new product. It must be considered if the new product
may actually take away or add to sales of the existing product.
4. Cannibalization
This is the type of externality where the new project takes sales away from the
existing product.
Changes in Net Working Capital

A change in net working capital is essentially the changes in current assets
minus changes in current liabilities. Within the capital-budgeting process, a
project typically adds to current assets given additional inventories or potential
increases in accounts receivables from new sales. The increases to current
assets, however, are offset by current liabilities needed to finance the new
project.
Overall, there may be change to net working capital from the new project.
 If the change in net working capital is positive, the change to current

assets outweighs the change in the current liabilities.
 If, however, the change in net working capital is negative, the change to
current liabilities outweighs the change in current assets.
Corporate Finance - Advantages and Disadvantages of the NPV

and IRR Methods
While useful NPV and IRR methods are useful methods for determining whether
to accept a project, both have their advantages and disadvantages.
Advantages:
 With the NPV method, the advantage is that it is a direct measure of the
dollar contribution to the stockholders.
 With the IRR method, the advantage is that it shows the return on the
original money invested.
Disadvantages:
 With the NPV method, the disadvantage is that the project size is not
measured.
 With the IRR method, the disadvantage is that, at times, it can give you
conflicting answers when compared to NPV for mutually exclusive
projects. The 'multiple IRR problem' can also be an issue, as discussed
below.
The Multiple IRR Problem

A multiple IRR problem occurs when cash flows during the project lifetime is
negative (i.e. the project operates at a loss or the company needs to contribute
more capital).
This is known as a "non-normal cash flow", and such cash flows will give
multiple IRRs.
Why Do NPV and IRR Methods Produce Conflicting Rankings?

When a project is an independent project, meaning the decision to invest in a
project is independent of any other projects, both the NPV and IRR will always
give the same result, either rejecting or accepting a project.
While NPV and IRR are useful metrics for analyzing mutually exclusive projects -
that is, when the decision must be one project or another - these metrics do not
always point you in the same direction. This is a result of the timing of cash
flows for each project. In addition, conflicting results may simply occur because
of the project sizes.
Look Out!
The timing of cash flows as well as project sizes
can produce conflicting results in the NPV and IRR
methods.
Example: NPV and IRR Analysis

Assume once again that Newco needs to purchase a new machine for its
manufacturing plant. Newco has narrowed it down to two machines that meet
its criteria (Machine A and Machine B), and now it has to choose one of the
machines to purchase. Further, Newco has assumed the following analysis on
which to base its decision:
Figure 11.6: Potential Machines for Newco
Answer:
We first determine the NPV for each machine as follows:
NPVA = ($5,000) + $2,768 + $2.553 = $321
NPVB = ($10,000) + $5,350 + $5,106 = $456
According to the NPV analysis alone, Machine B is the most appropriate choice
for Newco to purchase.
The next step is to determine the IRR for each machine using our financial
calculator. The IRR for Machine A is equal to 13%, whereas the IRR for Machine
B is equal to 11%.
According to the IRR analysis alone, Machine A is the most appropriate choice
for Newco to purchase.
The NPV and IRR analysis for these two projects give us conflicting results. This
is most likely due to the timing of the cash flows for each project as well as the
size differential between the two projects.
The Post-Audit's Role

The post-audit process in the capital-budgeting process is quite important. In
the post-audit process, an analyst examines a company's capital-budgeting
decisions to see how the actual results from the projects compare to the results
the company estimated. The post-audit process gives the company a sense of
not only how the projects are performing, but also how good its inputs were.
If a project's actual results differed significantly in a negative direction, the

post-audit process will help the company learn where it went wrong with
respect to inputs so that the same mistake will not be made when analyzing
future projects.
Corporate Finance - Applying NPV Analysis to Project Decisions
As a primer, readers should remember that:
Expansion projects are projects companies invest in to expand the earnings of

its business.
Replacement projects, are projects that companies invest in to replace old

assets in order to maintain efficiencies.
Example: NPV Analysis

Assume Newco is planning to add new machinery to its current plant. There are
two machines Newco is considering, with cash flows as follows:
Calculate the NPV for each machine and decide which machine Newco should
invest in. As calculated previously, Newco's cost of capital is 8.4%.
Formula 11.14
Answer:
NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469

(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929

(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
When considering mutually exclusive projects and NPV alone, remember that
the decision rule is to invest in the project with the greatest NPV. As Machine B
has the greatest NPV, Newco should invest in Machine B.
Determining a Project's Cash Flows

When beginning capital-budgeting analysis, it is important to determine the
cash flows of a project. These cash flows can be segmented as follows:
1. Initial Investment Outlay

These are the costs that are needed to start the project, such as new
equipment, installation, etc.
2. Operating Cash Flow over a Project's Life

This is the additional cash flow a new project generates.
3. Terminal-Year Cash Flow

This is the final cash flow, both the inflows and outflows at the end of the
project's life, such as potential salvage value at the end of a machine's life.
Look Out!
It is important to note that while interest expense is included
in a company\'s earnings per share, it is not included in
operating cash flows as it is already in the discounting process.
Example: Expansion Project
Let us begin with our previous example. Newco is looking to add to its
production capacity and is looking closely at investing in Machine B. Machine B
has a cost of $2,000, with shipping and installation expenses of $500 and $300
in net working capital. Newco expects the machine to last for five years, at
which point Machine B will have a book value (BV) of $1,000 ($2,000 minus five
years of $200 annual depreciation) and a potential market value of $800.
With respect to cash flows, Newco expects the new machine to generate an
additional $1,500 in revenues and costs of $200. We will assume Newco has a
tax rate of 40%. The maximum payback period that the company established is
five years.
As required in the LOS, calculate the project's initial investment outlay,

operating cash flow over the project's life and the terminal-year cash flow for
the expansion project.
Answer:
Initial Investment Outlay:
Machine cost + shipping and installation expenses + change in net working
capital = $2,000 + $500 + $300 = $2,800
Operating Cash Flow:

CFt = (revenues - costs)*(1 - tax rate)
CF1 = ($1,500 - $200)*(1 - 40%) = $780
CF2 = ($1,500 - $200)*(1 - 40%) = $780
CF3 = ($1,500 - $200)*(1 - 40%) = $780
CF4 = ($1,500 - $200)*(1 - 40%) = $780
CF5 = ($1,500 - $200)*(1 - 40%) = $780
Terminal Cash Flow:

Tips and Tricks
For determining the terminal cash flow, the key metrics are
salvage value of the asset, net working capital and tax benefit/loss
from the asset.
The terminal cash flow can be calculated as illustrated:
Return of net working capital +$300

Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF5 +$780
Total year-five cash flow $1,960
For determining the tax benefit or loss, a benefit is received if the book value of
the asset is more than the salvage value, and a tax loss is recorded if the book
value of the asset is less than the salvage value.
Example: Replacement Project

Now, let us assume that rather than investing in an additional machine, Newco
is exploring replacing its current machine with a newer, more efficient machine.
Based on the current market, Newco can sell the old machine for $200, but this
machine has a book value of $500.
The new machine Newco is looking to invest capital in has a cost of $2,000, with
shipping and installation expenses of $500 and $300 in net working capital.
Newco expects the machine to last for five years, at which point Machine B
would have a book value of $1,000 ($2,000 minus five years of $200 annual
depreciation) and a potential market value of $800.
With respect to cash flows, Newco expects the new machine to generate an
additional $1,500 in revenues and costs of $200. We will assume Newco has a
tax rate of 40%. The maximum payback period that the company established is
five years.
As required in the LOS, calculate the project's initial investment outlay,

operating cash flow over the project's life and the terminal-year cash flow for
the replacement project.
Answer:
Initial Investment Outlay
Computing the initial investment outlay of a replacement project is slightly
different than the computation for an existing project. This is primarily because
of the expected cash flow a company may receive on the sale of the equipment
to be replaced.
Value of the old machine = sale value + tax benefit/loss

= $200 + $120
= $320
Sale of old equipment + machine cost + shipping and installation expenses +

change in net working capital = $320 + $2,000 + $500 + $300 = $3,120
Look Out!
In the analysis of either an expansion or a replacement project,
the operating cash flows and terminal cash flows are calculated
the same.
Operating cash flow:
CFt = (revenues - costs)*(1 - tax rate)

CF1 = ($1,500 - $200)*(1 - 40%) = $780
CF2 = ($1,500 - $200)*(1 - 40%) = $780
CF3 = ($1,500 - $200)*(1 - 40%) = $780
CF4 = ($1,500 - $200)*(1 - 40%) = $780
CF5 = ($1,500 - $200)*(1 - 40%) = $780
Terminal Cash Flow:

The terminal cash flow can be calculated as illustrated:
Return of net working capital +$300

Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF5 +$780
Total year 5 cash flow $1,960
orporate Finance - Comparing Projects With Unequal Lives
As mentioned previously, NPV and IRR can sometimes lead to conflicting results
in the analysis of mutually exclusive projects. One reason for this potential
problem is the timing of the cash flows of the mutually exclusive projects. As a
result, we need to adjust for the timing issue in order to correct this problem.
There are two methods used to make the adjustments:
1. Replacement-chain method
2. Equivalent annual annuity
Example:
Once again, assume Newco is planning to add new machinery to its current
plant. There are two machines Newco is considering, with cash flows as follows:
Compare the two projects with unequal lives using both the replacement-chain
method and the equivalent annual annuity (EAA) approach.
1. Replacement-Chain Method
In this example, Machine A has an operating lifespan of six years. Machine B
has an operating lifespan of three years. The cash flows for each project are
discounted by Newco's calculated WACC of 8.4%.
 NPV of Machine A is equal to $2,926.
 NPV of Machine B is equal to $1,735.
The initial analysis indicates that Machine A, with the greater NPV, should be
the project chosen.
 The IRR of Machine A is equal to 8.3%.

 The IRR of Machine B is equal to 15.5%.
This analysis indicates that Machine B, with the greater IRR, should be the
project chosen.
The NPV analysis and the IRR analysis have given us differing results. This is
most likely due to the unequal lives of the two projects. As such, we need to
analyze the two projects over a common life.
For Machine A (project 1), the lifespan is six years. For Machine B (project 2),
the lifespan is three years. Given that the lifespan of the longest project is six
years, in order to measure both over a common life, we must adjust the
lifespan of Machine B to six years.
Because the lifespan of Machine B is three years, the lifespan of this project
needs to be doubled to equal the six-year lifespan of Machine A. This indicates
that another Machine B would have to be purchased (to get two machines with
a lifespan of three years each) to get to the six-year lifespan of Machine A -
hence, the replacement-chain method.
The new cash flows would be as follows:
Figure 11.9: Cash flows over a common life

 NPV of Machine A remains $2,926.
 NPV of Machine B is now $3,098 given the adjustment.
The initial analysis indicates that Machine B, with the greater NPV, should be
the project chosen. Recall, this is different from our first analysis where Machine
A was chosen given its greater NPV.
 The IRR of Machine A remains 8.3%.

 The IRR of Machine B remains 15.5%.
Look Out!
Note, while the NPV has changed given the additional cash
flows, the IRR for the projects remain the same.
This analysis indicates that Machine B, with the greater IRR, should be the
project chosen. Recall, this is the same as our first analysis, where Machine B
was chosen given its greater IRR.
With the cash flows adjusted with the replacement-chain method, both the NPV
and the IRR arrive at the same conclusion. With this adjusted analysis, Machine
B (project 2), should be the project accepted.
2. Equivalent-Annual-Annuity Approach
While easy to understand, the replacement-chain method can be time
consuming. A simpler approach is the equivalent-annual-annuity approach.
This is the procedure for determining EAA:
1) Determine the projects' NPVs.

2) Find each project's EAA, the expected payment over the project's life, where
the future value of the project would equal zero.
3) Compare the EAA of each project and select the project with the highestEAA.
From our example, the NPV of each project is as follows:

-NPV of Machine A is equal to $2,926.
-NPV of Machine B is equal to $1,735.
To determine each project's EAA, it is best to use your financial calculator.
- For, Machine A (project 1), our assumptions are as follows:
i = 8.4% (the company's WACC)

n=6
PV = NPV = -2,926
FV = 0
Find PMT
For Machine A, the EAA (the calculated PMT) is $640.64.
- For Machine B (project 2), our assumptions are as follows:
i = 8.4% (the company's WACC)

n=3
PV = NPV = -1,735
FV = 0
Find for PMT
For Machine B, the EAA (the calculated PMT) is $678.10.
Answer
Machine B should be the project chosen as it has the highest EAA, which is
$678.10, relative to Machine A whose EAA is $640.64.
Inflation Effects on Capital Budgeting Analysis

Inflation exists and should not be forgotten when making capital-budgeting
decisions. It is important to build inflation expectations into the analysis. If
inflation expectations are left out of the capital-budgeting analysis, the NPV
calculated from the biased cash flows will be incorrect.
As an example, suppose Newco unintentionally leaves out its inflation

expectations when determining the plant addition. Since inflation expectations
are included in the WACC, and PV of each cash flow is discounted by the WACC,
the NPV will be incorrect and have a downward bias.
Corporate Finance - Types of Risk
Like anything, projects do have risks. There are three types of project risks
associated with capital budgeting:
1. Stand-Alone Risk
This risk assumes the project a company intends to pursue is a single asset that
is separate from the company's other assets. It is measured by the variability of
the single project alone. Stand-alone risk does not take into account how the
risk of a single asset will affect the overall corporate risk.
2. Corporate Risk
This risk assumes the project a company intends to pursue is not a single asset
but incorporated with a company's other assets. As such, the risk of a project
could be diversified away by the company's other assets. It is measured by the
potential impact a project may have on the company's earnings.
3. Market Risk
This looks at the risk of a project through the eyes of the stockholder. It looks
at the project not only from a company's perspective, but from the
stockholder's overall portfolio. It is measured by the effect the project may have
on the company's beta.
Corporate Finance - Risk-Analysis Techniques

It is important to keep in mind that when a company analyzes a potential
project, it is forecasting potential not actual cash flows for a project. As we all
know, forecasts are based on assumptions that may be incorrect. It is therefore
important for a company to perform a sensitivity analysis on its assumptions to
get a better sense of the overall risk of the project the company is about to
take.
There are three risk-analysis techniques that should be known for the exam:
1. Sensitivity Analysis
Sensitivity analysis is simply the method for determining how sensitive our NPV
analysis is to changes in our variable assumptions. To begin a sensitivity
analysis, we must first come up with a base-case scenario. This is typically the
NPV using assumptions we believe are most accurate. From there, we can
change various assumptions we had initially made based on other potential
assumptions. NPV is then recalculated, and the sensitivity of the NPV based on
the change in assumptions is determined. Depending on our confidence in our
assumptions, we can determine how potentially risky a project can be.
2. Scenario Analysis
Scenario analysis takes sensitivity analysis a step further. Rather than just
looking at the sensitivity of our NPV analysis to changes in our variable
assumptions, scenario analysis also looks at the probability distribution of the
variables. Like sensitivity analysis, scenario analysis starts with the construction
of a base case scenario. From there, other scenarios are considered, known as
the "best-case scenario" and the "worst-case scenario". Probabilities are
assigned to the scenarios and computed to arrive at an expected value. Given
its simplicity, scenario analysis is one the most frequently used risk-analysis
techniques.
3. Monte Carlo Simulation

Monte Carlo simulation is considered to be the "best" method of sensitivity
analysis. It comes up with infinite calculations (expected values) given a
number of constraints. Constraints are added and the system generates random
variables of inputs. From there, NPV is calculated. Rather than generating just a
few iterations, the simulation repeats the process numerous times. From the
numerous results, the expected value is then calculated.
Corporate Finance - Security Market Line and Beta Basics
The security market line (SML) is simply a plot of expected returns of

investments with respect to its beta, market risk. Expected values are
calculated with the following equation:
Formula 11.15
Es = rf + Bs(Emkt - rf)
Where:
rf = the risk-free rate
Bs = the beta of the investment
Emkt = the expected return of the market
Es = the expected return of the investment
The beta is thus the sensitivity of the investment to the market or current
portfolio. It is the measure of the riskiness of a project. When taken in isolation,
a project may be considered more or less risky than the current risk profile of a
company. Through the use of the SML as a means to calculate a company's
WACC, this risk profile would be accounted for.
Example:
When a new product line for Newco is considered, the project's beta is 1.5.
Assuming the risk-free rate is 4% and the expected return on the market is
12%, compute the cost of equity for the new product line.
Answer:
Cost of equity = rf + Bs(Emkt - rf) = 4% + 1.5(12% - 4%) = 16%
The project's required return on retained earnings is thus 16% and should be
used in our calculation of WACC.
Estimating Beta
In risk analysis, estimating the beta of a project is quite important. But like
many estimations, it can be difficult to determine.
The two most widely used methods of estimating beta are:
1. Pure-Play Method
When using the pure-play method, a company seeks out companies with a
product line that is similar to the line for which the company is trying to
estimate the beta. Once these companies are found, the company would then
take an average of those betas to determine its project beta.
Suppose Newco would like to add beer to its existing product line of soda.
Newco is quite familiar with the beta of making soda given its history. However,
determining the beta for beer is not as intuitive for Newco as it has never
produced it.
Thus, to determine the beta of the new beer project, Newco can take the
average beta of other beer makers, such as Anheuser Busch and Coors.
2. Accounting-Beta Method
When using the accounting-beta method, a company would run a regression
using the company's return on assets (ROA) against the ROA for market
benchmark, such as the S&P 500. The accounting beta is the slope coefficient of
the regression.
The typical procedure for developing a risk-adjusted discount rate is as

follows:
1. A company first begins with its cost of capital for the firm.
2. The cost of capital then must be adjusted for the riskiness of the project, by
adjusting the company's cost of capital either up or down depending on the risk
of the project relative to the firm.
For projects that are riskier, the company's WACC would be adjusted higher and
if the project is less risky, the company's WACC is adjusted lower. The main
issue in this procedure is that it is subjective.
Capital Rationing
Essentially, capital rationing is the process of allocating the company's capital
among projects to maximize shareholder return.
When making decisions to invest in positive net-present-value (NPV) projects,

companies continue to invest until their marginal returns equal their marginal
cost of capital. There are times, however, when a company may not have
capital to do this. As such, a company must ration its capital among the best
combination of projects with the highest total NPV.
Corporate Finance - Factors that Influence a Company's Capital-

Structure Decision
The primary factors that influence a company's capital-structure decision are:

1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The
greater the business risk, the lower the optimal debt ratio.
As an example, let's compare a utility company with a retail apparel company. A

utility company generally has more stability in earnings. The company has les
risk in its business given its stable revenue stream. However, a retail apparel
company has the potential for a bit more variability in its earnings. Since the
sales of a retail apparel company are driven primarily by trends in the fashion
industry, the business risk of a retail apparel company is much higher. Thus, a
retail apparel company would have a lower optimal debt ratio so that investors
feel comfortable with the company's ability to meet its responsibilities with the
capital structure in both good times and bad.
2. Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high,
using debt as a means of financing a project is attractive because the tax
deductibility of the debt payments protects some income from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come
as no surprise that companies typically have no problem raising capital when
sales are growing and earnings are strong. However, given a company's strong
cash flow in the good times, raising capital is not as hard. Companies should
make an effort to be prudent when raising capital in the good times, not
stretching its capabilities too far. The lower a company's debt level, the more
financial flexibility a company has.
The airline industry is a good example. In good times, the industry generates
significant amounts of sales and thus cash flow. However, in bad times, that
situation is reversed and the industry is in a position where it needs to borrow
funds. If an airline becomes too debt ridden, it may have a decreased ability to
raise debt capital during these bad times because investors may doubt the
airline's ability to service its existing debt when it has new debt loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more
conservative a management's approach is, the less inclined it is to use debt to
increase profits. An aggressive management may try to grow the firm quickly,
using significant amounts of debt to ramp up the growth of the company's
earnings per share (EPS).
5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth
through debt, borrowing money to grow faster. The conflict that arises with this
method is that the revenues of growth firms are typically unstable and
unproven. As such, a high debt load is usually not appropriate.
More stable and mature firms typically need less debt to finance growth as its
revenues are stable and proven. These firms also generate cash flow, which can
be used to finance projects when they arise.
6. Market Conditions
Market conditions can have a significant impact on a company's capital-
structure condition. Suppose a firm needs to borrow funds for a new plant. If
the market is struggling, meaning investors are limiting companies' access to
capital because of market concerns, the interest rate to borrow may be higher
than a company would want to pay. In that situation, it may be prudent for a
company to wait until market conditions return to a more normal state before
the company tries to access funds for the plant.
Corporate Finance - Business and Financial Risk
To further examine risk in the capital structure, two additional measures of risk
found in capital budgeting:
1. Business Risk
A company's business risk is the risk of the firm's assets when no debt is used.
Business risk is the risk inherent in the company's operations. As a result, there
are many factors that can affect business risk: the more volatile these factors,
the riskier the company. Some of those factors are as follows:
 Sales risk - Sales risk is affected by demand for the company's product
as well as the price per unit of the product.
 Input-cost risk - Input-cost risk is the volatility of the inputs into a
company's product as well as the company's ability to change pricing if
input costs change.
As an example, let's compare a utility company with a retail apparel company. A

utility company generally has more stability in earnings. The company has les
risk in its business given its stable revenue stream. However, a retail apparel
company has the potential for a bit more variability in its earnings. Since the
sales of a retail apparel company are driven primarily by trends in the fashion
industry, the business risk of a retail apparel company is much higher. Thus, a
retail apparel company would have a lower optimal debt ratio so that investors
feel comfortable with the company's ability to meet its responsibilities with the
capital structure in both good times and bad.
2. Financial Risk
A company's financial risk, however, takes into account a company's leverage.
If a company has a high amount of leverage, the financial risk to stockholders is
high - meaning if a company cannot cover its debt and enters bankruptcy, the
risk to stockholders not getting satisfied monetarily is high.
Let's use the troubled airline industry as an example. The average leverage for
the industry is quite high (for some airlines, over 100%) given the issues the
industry has faced over the past few years. Given the high leverage of the
industry, there is extreme financial risk that one or more of the airlines will face
an imminent bankruptcy.
Effect of Changes in Sales or Earnings on EBIT

Differing amounts of debt financing cause changes in EPS and thus a company's
stock price. The calculations for EBIT and EPS are as follows:
Formula 11.16
EBIT = sales - variable costs - fixed costs
EPS = [(EBIT - interest)*(1-tax rate)] / shares outstanding
This LOS is best explained by the use of an example.

Example:
The following is Newco's cost of debt at various capital structures. Newco has $1
million in total assets and a tax rate of 40%. Assume that, at a debt level of
zero, Newco has 20,000 shares outstanding.
Figure 11.10: Newco's cost of debt at various capital structures
In addition, Newco has annual sales of $5 million, variable costs are 40% of
sales and fixed costs are equal to $2.4 million. At each level of debt, determine
Newco's EPS.
Answer:
At debt level 0%:
Shares outstanding are 20,000 and interest costs are 0.
EPS = [($5,000,000 - 2,000,000 - 2,400,000-0)*(1-0.4)]/20,000
EPS = $18 per share
At debt level 20%:

Shares outstanding are 16,000 [20,000*(1-20%)] and interest costs are 8,000
(200,000*0.04).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-8,000)*(1-0.4)]/16,000
EPS = $22.20 per share
At debt level 40%:

(400,000*0.06).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-24,000)*(1-0.4)]/12,000
At debt level 60%:

(600,000*0.08).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-48,000)* (1-0.4)]/8,000
EPS= $41.40 per share
At debt level 80%:

(800,000*0.10).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-80,000)* (1-0.4)]/4,000
With each increase in debt level (accompanied with the decrease in shares
outstanding), Newco's earnings per share increases.
Corporate Finance - Operating Leverage and its Effects on a
Project's Expected Rate of Return
Operating leverage can be defined as the degree to which a company uses

fixed costs in its operations. The higher the fixed costs as a percentage of total
costs, the higher the company's operating leverage. For companies with high
operating leverage, a small change in company revenues will result in a larger
change in operating income since most costs are fixed rather than variable.
Degree of Leverage
The degree of leverage within a company can be calculated based on various
metrics.
Some common metrics include:

1. Degree of operating leverage
2. Degree of financial leverage
3. Degree of total leverage
We will discuss operating leverage within this section.
Degree of Operating Leverage

Degree of operating leverage (DOL) is the percentage change in operating
income, also known as EBIT, divided by the percentage change in sales. It is the
measure of the sensitivity of EBIT to changes in sales as a result of changes in
operating expenses. Degree of operating leverage is also commonly estimated
using production output.
Formula 11.18
DOL = change in EBIT/EBIT or Q (P - V)

change in sales/sales Q(P - V)- F
A key shortcut to remember is that, if fixed costs of the project are equal to 0,
the DOL is actually 1.
Example: Degree of Operating Leverage

Newco produces 140,000 units annually. With Project 1, the company's variable
costs are $20 per unit, and its fixed costs total $2.4 million. With Project 2, the
company's variable costs are $30 per unit, and its fixed costs total $2 million.
Newco has the ability to see each unit at $50. Compute the DOL for Project 1
and Project 2.
Answer: Project 1 DOL = 140,000(50-20)/140,000(50-20) - 2,400,000 = 2.33
With Project 1, for every percentage increase in sales, the company's EBIT will
increase 2.33 times; a 10% increase in sales will lead to a 23.3% increase in
EBIT.
Project 2 DOL = 140,000(50-30)/140,000(50-30)-2,000,000 = 3.50
With Project 2, for every percentage increase in sales, the company's EBIT will
increase 3.50 times; a 10% incr
Corporate Finance - Financial Leverage
Financial leverage can be defined as the degree to which a company uses fixed-
income securities, such as debt and preferred equity. With a high degree of
financial leverage come high interest payments. As a result, the bottom-line
earnings per share is negatively affected by interest payments. As interest
payments increase as a result of increased financial leverage, EPS is driven
lower.
As mentioned previously, financial risk is the risk to the stockholders that is
caused by an increase in debt and preferred equities in a company's capital
structure. As a company increases debt and preferred equities, interest
payments increase, reducing EPS. As a result, risk to stockholder return is
increased. A company should keep its optimal capital structure in mind when
making financing decisions to ensure any increases in debt and preferred equity
increase the value of the company.
Degree of Financial Leverage

This measures the percentage change in earnings per share over the
percentage change in EBIT. This is known as "degree of financial leverage"
(DFL). It is the measure of the sensitivity of EPS to changes in EBIT as a result
of changes in debt.
Formula 11.19
DFL = percentage change in EPS or EBIT
percentage change in EBIT EBIT-interest
A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be
equal to 1.
Example: Degree of Financial Leverage

With Newco's current production, its sales are $7 million annually. The
company's variable costs of sales are 40% of sales, and its fixed costs are $2.4
million. The company's annual interest expense amounts to $100,000 annually.
If we increase Newco's EBIT by 20%, how much will the company's EPS
increase?
Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-
$2,400,000-$100,000)
DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase
21.2%.
Corporate Finance - Sales and Leverage
A company's costs include both fixed and variable costs. The breakeven
quantity of sales is the sales amount where both fixed and variable costs are
covered. Breakeven quantity of sales:
Formula 11.17
BEQ = Fixed Costs
Price - Variable Costs
Example:
Assume Newco's product costs for two different products are the figures below.
Calculate Newco's breakeven quantity of sales and determine the company's
gain or loss at various sales levels for each product.
Figure 11.11: Newco's cost breakdown for Product 1
Figure 11.12: Newco's cost breakdown for Product 2
Answer:
Product 1:
For Newco, the breakeven quantity of its product is:
BEQ = $2,400,000/($50 - $20) = 80,000 units
At various sales levels, the company's gains or losses are as follows:
Figure 11.13: Sales analysis
Units Sold Sales/(Loss)
20,000 ($1,800,000)
40,000 ($1,200,000)
60,000 ($600,000)
80,000 $0
100,000 $600,000
120,000 $1,200,000
140,000 $1,800,000
Product 2:
For Newco, the breakeven quantity of its product is:
BEQ = $1,800,000/($50 - $20) = 60,000 units
At various sales levels, the company's gains or losses are as follows
Figure 11.14: Sales analysis
Units Sold Sales/(Loss)
20,000 ($1,200,000)
40,000 ($600,000)
60,000 $0
80,000 $600,000
100,000 $1,200,000
120,000 $1,800,000
140,000 $2,400,000
Look Out
Note from the examples above, the higher a company's fixed
costs, if all else is constant, the higher a company's breakeven
quantity.
Corporate Finance - Effects of Debt on the Capital Structure
Using Greater Amounts of Debt

Recall that the main benefit of increased debt is the increased benefit from the
interest expense as it reduces taxable income. Wouldn't it thus make sense to
maximize your debt load? The answer is no.
With an increased debt load the following occurs:

Interest expense rises and cash flow needs to cover the interest expense also
rise.
Debt issuers become nervous that the company will not be able to cover its
financial responsibilities with respect to the debt they are issuing.
Stockholders become also nervous. First, if interest increases, EPS decreases,

and a lower stock price is valued. Additionally, if a company, in the worst case,
goes bankrupt, the stockholders are the last to be paid retribution, if at all.
In our previous examples, EPS increased with every increase in our debt-to-
equity ratio. However, in our prior discussions, an optimal capital structure is
some combination of both equity and debt that maximizes not only earnings but
also stock price. Recall that this is best implied by the capital structure that
minimizes the company's WACC.
Example:
The following is Newco's cost of debt at various capital structures. Newco has a
tax rate of 40%. For this example, assume a risk-free rate of 4% and a market
rate of 14%. For simplicity in determining stock prices, assume Newco pays out
all of its earnings as dividends.
Figure 11.15: Newco's cost of debt at various capital structures
At each level of debt, calculate Newco's WACC, assuming the CAPM model is
used to calculate the cost of equity.
Answer:
At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50
At debt level 20%:

Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19
At debt level 40%:

Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29
Recall that the minimum WACC is the level where stock price is maximized. As
such, our optimal capital structure is 40% debt and 60% equity. While there is
a tax benefit from debt, the risk to the equity can far outweigh the benefits - as
indicated in the example.
Company vs. Stock Valuation
The value of a company's stock is but one part of the company's total value.
The value of a company comprises the total value of the company's capital
structure, including debtholders, preferred-equity holders and common-equity
holders. Since both debtholders and preferred-equity holders have first rights to
a company's value, common-equity holders have last rights to a company
value, also known as a "residual value".
Corporate Finance - Tax and Bankruptcy Costs
Tax Effect on the Cost of Capital

With respect to taxes, it is important to keep in mind that interest payments on
debt can be deducted as expenses and thus reduce overall taxes. However, a
company cannot report dividends as an expense, so dividends have no effect on
the taxes of a company. This is important for a company to keep in mind when
determining and making changes to its capital structure.
Bankruptcy Effect on the Cost of Capital

Bankruptcy costs can also significantly affect a company's cost of capital. When
a company invests in debt, the company is required to service the debt by
making required interest payments. Interest payments alter a company's
earnings as well as cash flow. For each company there is an optimal capital
structure, including a percentage of debt and equity, a balance between the tax
benefits of the debt and the equity. As a company continues to increase its debt
over the amount stated by the optimal capital structure, the cost to finance the
debt becomes higher as the debt is now riskier to the lender. The risk of
bankruptcy increases with the increased debt load. Since the cost of debt
becomes higher, the WACC is thus affected. With the addition of debt, the
WACC will at first fall as the benefits are realized, but once the optimal capital
structure is reached and then surpassed, the increased debt load will then cause
the WACC to increase significantly.
Corporate Finance - The MM Capital Structure vs. The Tradeoff

Theory of Leverage
Modigliani and Miller's Capital-Structure Irrelevance Proposition

Modigliani and Miller, two professors in the 1950s, studied capital-structure
theory intensely. From their analysis, they developed the capital-structure
irrelevance proposition. Essentially, they hypothesized that in perfect markets,
it does not matter what capital structure a company uses to finance its
operations.
The MM study is based on the following key assumptions:
 No taxes
 No transaction costs
 No bankruptcy costs
 Equivalence in borrowing costs for both companies and investors
 Symmetry of market information, meaning companies and investors have
the same information
 No effect of debt on a company's earnings before interest and taxes
Look Out
The MM capital-structure irrelevance proposition assumes:
(1) no taxes and, (2) no bankruptcy costs.
In this simplified view, it can be seen that without taxes and bankruptcy costs,
the WACC should remain constant with changes in the company's capital
structure. For example, no matter how the firm borrows, there will be no tax
benefit from interest payments and thus no changes/benefits to the WACC.
Additionally, since there are no changes/benefits from increases in debt, the
capital structure does not influence a company's stock price, and the capital
structure is therefore irrelevant to a company's stock price.
However, as we have stated, taxes and bankruptcy costs do significantly affect

a company's stock price. In additional papers, Modigliani and Miller included
both the effect of taxes and bankruptcy costs.
The MM Capital-Structure Irrelevance Proposition

The MM capital-structure irrelevance proposition assumes no taxes and no
bankruptcy costs. As a result, MM states that the capital structure is irrelevant
and has no impact on a company's stock price.
The Tradeoff Theory of Leverage

The tradeoff theory assumes that there are benefits to leverage within a capital
structure up until the optimal capital structure is reached. The theory recognizes
the tax benefit from interest payments. Studies suggest, however, that most
companies have less leverage than this theory would suggest is optimal.
In comparing the two theories, the main difference between them is the
potential benefit from debt in a capital structure. This benefit comes from tax
benefit of the interest payments. Since the MM capital-structure irrelevance
theory assumes no taxes, this benefit is not recognized, unlike the trade-off
theory of leverage, where taxes and thus the tax benefit of interest payments
are recognized.
Corporate Finance - Signaling Prospects Through Financing
Decisions
One of the key assumptions Modigliani and Miller make in their work is that
market information is symmetric, meaning companies and investors have the
same information with respect to the company's future projects/investments.
This assumption, however, is not realistic. When making capital decisions, a
company's management should have more information than an investor, which
implies asymmetric information.
A financing decision is a way in which a company can inadvertently signal its

prospects to investors. For example, suppose Newco decides to finance a new
project with equity. Newco's additional equity would in fact dilute stockholder
value. Since companies typically try to maximize stockholder value, would an
equity offering be a bad signal? The answer is yes.
There would be some benefit from the project to the stockholders; however, the
dilution from the offering would offset some of that benefit. If a company's
prospects are good, management will finance new projects with other means,
such as debt, to avoid giving any negative signals to the market.
Look Out!
Financing a capital project with equity may be a signal to investors
that a company's prospects are not good.
Corporate Finance - Degree of Total Leverage

By combining the degree of operating leverage with the degree of financial
leverage we obtain the degree of total leverage (DTL). If a firm has a high
amount of operating leverage and financial leverage, a small change in sales
will lead to a large variability in EPS.
Formula 11.20
DTL = Q(P - V)
Q(P - V) - F - I
Example: degree of total leverage

Using our previous example, say Newco produces 140,000 units annually. The
company's variable costs are $20 per unit, and its fixed costs total $2.4 million.
The company's annual interest expense amounts to $100,000 annually. If
Newco's sales increase by 20%, what is the impact to the company's EPS?
Answer:
DTL = 140,000(50-20)/140,000(50-20)-2,400,000 - $100,000 = 2.47
If Newco's sales increase by 20%, the company's EPS will increase by 49.4%
(20%)(2.47).
Corporate Finance - Dividend Theories
Dividend Irrelevance Theory

Much like their work on the capital-structure irrelevance proposition, Modigliani
and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy
is also irrelevant. This is known as the "dividend-irrelevance theory", indicating
that there is no effect from dividends on a company's capital structure or stock
price.
MM's dividend-irrelevance theory says that investors can affect their return on a
stock regardless of the stock's dividend. For example, suppose, from an
investor's perspective, that a company's dividend is too big. That investor could
then buy more stock with the dividend that is over the investor's expectations.
Likewise, if, from an investor's perspective, a company's dividend is too small,
an investor could sell some of the company's stock to replicate the cash flow he
or she expected. As such, the dividend is irrelevant to investors, meaning
investors care little about a company's dividend policy since they can simulate
their own.
Bird-in-the-Hand Theory
The bird-in-the-hand theory, however, states that dividends are relevant.
Remember that total return (k) is equal to dividend yield plus capital gains.
Myron Gordon and John Lintner (Gordon/Litner) took this equation and assumed
that k would decrease as a company's payout increased. As such, as a company
increases its payout ratio, investors become concerned that the company's
future capital gains will dissipate since the retained earnings that the company
reinvests into the business will be less.
Gordon and Lintner argued that investors value dividends more than capital
gains when making decisions related to stocks. The bird-in-the-hand may sound
familiar as it is taken from an old saying: "a bird in the hand is worth two in the
bush." In this theory "the bird in the hand' is referring to dividends and "the
bush" is referring to capital gains.
Tax-Preference Theory
Taxes are important considerations for investors. Remember capital gains are
taxed at a lower rate than dividends. As such, investors may prefer capital gains
to dividends. This is known as the "tax Preference theory".
Additionally, capital gains are not paid until an investment is actually sold.
Investors can control when capital gains are realized, but, they can't control
dividend payments, over which the related company has control.
Capital gains are also not realized in an estate situation. For example, suppose
an investor purchased a stock in a company 50 years ago. The investor held the
stock until his or her death, when it is passed on to an heir. That heir does not
have to pay taxes on that stock's appreciation.
The Dividend-Irrelevance Theory and Company Valuation

In the determination of the value of a company, dividends are often used.
However, MM's dividend-irrelevance theory indicates that there is no effect from
dividends on a company's capital structure or stock price.
MM's dividend-irrelevance theory says that investors can affect their return on a
stock regardless of the stock's dividend.
For example, suppose, from an investor's perspective, that a company's

dividend is too big. That investor could then buy more stock with the dividend
that is over his or her expectations. Likewise, if, from an investor's perspective,
a company's dividend is too small, an investor could sell some of the company's
stock to replicate the cash flow he or she expected. As such, the dividend is
irrelevant to investors, meaning investors care little about a company's dividend
policy since they can simulate their own.
The Principal Conclusion for Dividend Policy
The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs,

assumes that a company's dividend policy is irrelevant. The dividend-irrelevance
theory indicates that there is no effect from dividends on a company's capital
structure or stock price.
MM's dividend-irrelevance theory assumes that investors can affect their return
on a stock regardless of the stock's dividend. As such, the dividend is irrelevant
to an investor, meaning investors care little about a company's dividend policy
when making their purchasing decision since they can simulate their own
dividend policy.
How Any Shareholder Can Construct His or Her Own Dividend Policy.
Recall that the MM's dividend-irrelevance theory says that investors can affect
their return on a stock regardless of the stock's dividend. As a result, a
stockholder can construct his or her own dividend policy.
 Suppose, from an investor's perspective, that a company's dividend is too

big. That investor could then buy more stock with the dividend that is
over the investor's expectations.
 Likewise, if, from an investor's perspective, a company's dividend is too
small, an investor can sell some of the company's stock to replicate the
cash flow the investor expected.
As such, the dividend is irrelevant to an investor, meaning investors care little
about a company's dividend policy since they can simulate their own.
Corporate Finance - Dividend Growth Rate and the Effect of
Changing Dividend Policy
Calculating a Company's Implied Dividend Growth Rate

Recall that a company's ROE is equal to a company's earnings growth rate (g)
divided by one minus a company's payout rate (p).
Formula 11.21
ROE = g
(1-p)
g = ROE * (1-p)
Example:
Let's assume Newco's ROE is 10% and the company pays out roughly 20% of
its earnings in the form of a dividend. What is Newco's expected growth rate in
earnings?
Answer:
g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%
Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth
rate in earnings is 8%.
Signaling An Earning's Forecast Through Changes in Dividend Policy

Much like a company can signal the state of its operations through its use of
capital-financing projects, management can also signal its company's earnings
forecast through changes in its dividend policy.
Dividends are paid out when a company satisfies its internal needs for cash. If a
company cuts its dividends, stockholders may become worried that the
company is not generating enough earnings to satisfy its internal needs for cash
as well as pay out its current dividend. A stock may decline in this instance.
Suppose for example Newco decides to cuts its dividend to $0.25 per share
from its initial value of $0.50 per share. How would this be perceived by
investors?
Most likely the cut in dividend by Newco would be perceived negatively by

investors. Investors would assume that the company is beginning to go through
some tough times and the company is trying to preserve cash. This would
indicate that the business may be slowing or earnings are not growing at the
rate it once had.
To learn more about dividends, read: The Importance of Dividends
The Clientele Effect.

A company's change in dividend policy may impact in the company's stock price
given changes in the "clientele" interested in owning the company's stock.
Depending on their personal tax situation, some stockholders may prefer capital
gains over dividends and vice versa as capital gains are taxed at a lower rate
than dividends. The clientele effect is simply different stockholders' preference
on receiving dividends compared to capital gains.
For example, a stockholder in a high tax bracket may favor stocks with low
dividend payouts compared to a stockholder in a low tax-bracket who may favor
stocks with higher dividend payouts.
Corporate Finance - Setting Dividends

The residual-dividend model is a model that a company can utilize to set a
target dividend payout ratio.
The residual-dividend model is based on three key pieces:

1. An investment opportunity schedule (IOS),
2. Target capital structure
3. Cost of external capital
Look Out!
Stockholders' preferences for dividends do not affect the
residual-dividend model.
Procedure for the Residual-Dividend Model
1. The first step in the residual dividend model to set a target dividend payout
ratio to determine the optimal capital budget.
2. Then, management must determine the equity amount needed to finance the
optimal capital budget. This should be done primarily through retained
earnings.
3. The dividends then are paid out with the leftover, or residual, earnings.
Given the use of residual earnings, the model is known as the "residual-dividend
model".
As an example, Newco generates sales of $7 million with earnings of $2 million.

The company's optimal capital structure is 50% equity/50% debt. With $2
million in earnings, Newco reinvests the entire amount back into the company.
In this case, Newco would have to borrow $2 million to maintain its optimal
capital structure.
If Newco, however, needed to reinvest only half of the $2 million back into the
company, Newco would then have $1 million in residual earnings to pay
dividends. Given the reduced reinvestment, the company would thus have to
borrow only $1 million to maintain its optimal capital structure.
Advantage of the Residual-Dividend Model
 With capital-projects budgeting, the residual-dividend model is useful in

setting longer-term dividend policy.
Disadvantage of the Residual Dividend Model
 Dividends may be unstable. Earnings from year to year can vary

depending on business situations. As such, it is difficult to maintain with
certainty stable earnings and thus a stable dividend.
While the residual-dividend model is useful for longer-term planning, many
firms do not use the model in calculating dividends each quarter.
Corporate Finance - Dividend Payment Procedures
Dividend payouts follow a set procedure as follows:
Declaration date
Ex-dividend date
Holder-of-record date
Payment date
1. Declaration Date
Declaration date is the announcement that the company's board of directors

approved the payment of the dividend.
2. Ex-Dividend Date
The ex-dividend date is the date on which investors are cut off from receiving a
dividend. If for example, an investor purchases a stock on the ex-dividend date,
that investor will not receive the dividend. This date is two business days before
the holder-of-record date.
The ex-dividend date is important as, from this date and forward, new
stockholders will not receive the dividend. As a result, the stock price of the
company will be reflective of this. For example, on and after the ex-dividend
date, a stock most likely trades at lower price, as the stock price is adjusted for
the dividend that the new holder will not receive.
3. Holder-of-Record Date
The holder-of-record (owner-of-record) date is the date on which the
stockholders who are to receive the dividend are recognized.
Look Out!
Remember that stock transactions typically settle in three
business days.
Understanding the dates of the dividend payout process can be tricky. We clear
up the confusion in the following article:
4. Payment Date
Last is the payment date, the date on which the actual dividend is paid out to
the stockholders of record.
Example of the process of dividend payment

Suppose Newco would like to pay a dividend to its shareholders. The company
would proceed as follows:
1.On Jan 28, the company declares it will pay its regular dividend of $0.30 per
share to holders of record on Feb 27, with payment on Mar 17.
2.The ex-dividend date for the dividend is Feb 23 (usually four days before of
the holder-of-record date). On Feb 23 new buyers do not have a right to the
dividend.
3.At the close of business on Feb 27, all holders of Newco's stock are recorded,
and those holders will receive the dividend.
4.On Mar 17, the payment date, Newco mails the dividend checks to the holders
of record.
Corporate Finance - Stock Dividends and Repurchases
Like cash dividends, stock dividends and stock splits also have effects on a
company's stock price. Stock splits occur when a company perceives that its
stock price may be too high. Companies tend to want to keep their stock price
within an optimal trading range.
While stock prices will most likely rise after a split or dividend (remember price
increases are caused by positive signals a company generates with respect to
future earnings), if positive news does not follow, the company's stock price will
generally fall back to its original level.
There is an argument that stock splits and stock dividends are unnecessary and
do little more than create more stocks.
Stock Split
In a stock split, a company will divide each share of its existing stock into
multiple shares to bring down the company's stock price.
Example:
Suppose Newco's stock reaches $60 per share. The company's management
believes this is too high and that some investors may not invest in the company
as a result of the initial price required to buy the stock. As such, the company
decides to split the stock to make the entry point of the shares more
accessible.
For simplicity, suppose Newco initiates a 2-for-1 stock split. For each share they
own, all holders of Newco stock therefore receive two Newco shares priced at
$30, and the company's shares outstanding double. Keep in mind that the
company's overall equity value remains the same. Say there are 1 million
shares outstanding and the company's initial equity value is $60 million ($60
per share x 1 million shares outstanding). The equity value after the split is still
$60 million ($30 per share x 2 million shares outstanding).
To learn more about stock splits, read: Understanding Stock Splits
Stock Dividends
Stock dividends are similar to cash dividends; however, instead of cash, a
company pays out stock. As a result, a company's shares outstanding will
increase, and the company's stock price will decrease. For example, suppose
Newco decides to issue a 10% stock dividend. Each current stockholder will thus
have 10% more shares after the dividend is issued.
Stock Repurchase
A stock repurchase occurs when a company asks stockholders to tender their
shares for repurchase by the company. This is an alternate way for a company
to increase value for stockholders. First, a repurchase can be used to
restructure the company's capital structure without increasing the company's
debt load. Additionally, rather than a company changing its dividend policy, it
can offer value to its stockholders through stock repurchases, keeping in mind
that capital gains taxes are lower than taxes on dividends.
Advantages of a Stock Repurchase

 Many companies initiate a share repurchase at a price level that
management deems a good entry point. This point tends to be when the
stock is estimated to be undervalued. If a company knows its business
and relative stock price well, would it purchase its stock price at a high
level? The answer is no, leading investors to believe the management
perceives its stock price to be at a low level.
 Unlike a cash dividend, a stock repurchase gives the decision to the
investor. A stockholder can choose to tender his shares for repurchase,
accept the payment and pay the taxes. With a cash dividend, a
stockholder has no choice but to accept the dividend and pay the taxes.
 At times, there may be a block of shares from one or more large
shareholders that could come into the market, but the timing may be
unknown. This problem may actually keep potential stockholders away
since they may be worried about a flood of shares coming onto the
market and lessening the stock's value. A stock repurchase can be quite
useful in this situation.
Disadvantage of a Stock Repurchase
 From the perspective of an investor, a cash dividend is dependable,

usually quarterly. A stock repurchase, however, is not. For some
investors, the dependability of the dividend may be more important. As
such, investors may invest more heavily in a stock with a dependable
dividend than in a stock with less dependable repurchases.
 A company may be in a position where it ends up paying too much for the
stock it repurchases. For example, say a company repurchases its shares
for $30 per share on June 1. On June 10, a major hurricane damages the
company's primary operations. The company's stock therefore drops
down to $20. Thus, the $10-per-share difference is a lost opportunity to
the company.
 Overall, stockholders who offer their shares for repurchase may be at a
disadvantage if they are not fully aware of all the details. As such, an
investor may file a lawsuit with the company, which is seen as a risk.
Price Effect of a Stock Repurchase

A stock repurchase typically has the effect of increasing the price of a stock.
Example: Newco has 20,000 shares outstanding and a net income of $100,000.
The current stock price is $40. What effect does a 5% stock repurchase have on
the price per share of Newco's stock?
Answer: To keep it simple, price-per-earnings ratio (P/E) is the valuation

metric used to value Newco's price per share.
Newco's current EPS = $100,000/20,000 = $5 per share

P/E ratio = $40/$5 = 8x
With a 2% stock repurchase, the following occurs:

Newco's shares outstanding are reduced to 19,000 shares (20,000 x (1-.05))
Newco's EPS = $100,000/19,000 = $5.26
Given that Newco's shares trade on 8 times earnings, Newco's new share price
would be $42, an increase from the $40 per share before the repurchase.

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Corporate Finance - Capital Budgeting Basics

What is Capital Budgeting?

These projects can be classified as:

· Replacement decisions to maintain the business

Additionally, projects can also be classified as mutually

The Importance of Capital Budgeting

Interpreting the Cost of Capital

The after-tax cost of debt can be calculated as follows:

Example: Cost of Debt

kd (1-t) = 7% (1-0.40) = 4.2%

3. Cost of retained earnings

Example: CAPM approach

ks = long-term bond yield + risk premium

Example: bond-yield-plus-premium approach

c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus

Example: discounted cash flow approach

ks = 2/40 + 0.07 = 0.12 or 12%

4. Cost of external equity

Calculating Weighted Average Cost of Capital

As discussed previously, the weights of debt, preferred securities and common

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)

We originally determined the WACC for Newco to be 8.4%. Newco's cost of

Example: Marginal Cost of Capital

kc = 2 + 0.07 = 0.123, or 12.3%

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)

1. Capital Structure Policy

Uncontrollable Factors Affecting the Cost of Capital

1. Level of Interest Rates

Example: Payback Period

Figure 11.3: Cumulative cash flows for Machine A and Machine B

Payback period for Machine B = 2 + 0 = 2.00

2. Discounted Payback Period

Example: discounted payback period

Figure 11.4: Discounted cash flows for Machine A and Machine B

Payback period for Machine B = 2 + 262 = 2.22

Machine A now violates management's maximum payback period of five years

Net Present Value

Example: Net Present Value

NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929

Internal Rate of Return

Example: Net Cash Flows

Incremental Cash Flow and Capital Budgeting

However, in determining incremental cash flows from a new project, problems

Suppose Newco is considering whether to make an addition to its current plant

Changes in Net Working Capital

 If the change in net working capital is positive, the change to current

Corporate Finance - Advantages and Disadvantages of the NPV

The Multiple IRR Problem

Why Do NPV and IRR Methods Produce Conflicting Rankings?

Example: NPV and IRR Analysis

Figure 11.6: Potential Machines for Newco

NPVA = ($5,000) + $2,768 + $2.553 = $321

NPVB = ($10,000) + $5,350 + $5,106 = $456

The Post-Audit's Role

If a project's actual results differed significantly in a negative direction, the

As a primer, readers should remember that:

Expansion projects are projects companies invest in to expand the earnings of

Replacement projects, are projects that companies invest in to replace old

Example: NPV Analysis

Figure 11.7: Discounted cash flows for Machine A and Machine B

NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469

NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929