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4.

a) Capital structure describes how a corporation has organized its capitalhow it obtains the financial resources with which it operates its business. Businesses adopt various capital structures to meet both internal needs for capital and external requirements for returns on shareholders investments. A company's capitalization is constructed from three basic blocks: 1. Long-term debt. By standard accounting definition, long-term debt includes obligations that are not due to be repaid within the next 12 months. Such debt consists mostly of bonds or similar obligations, including a great variety of notes, capital lease obligations, and mortgage issues. 2. Preferred stock. This represents an equity (ownership) interest in the corporation, but one with claims ahead of the common stock, and normally with no rights to share in the increased worth of a company if it grows. 3. Common stockholders' equity. This represents the underlying ownership.It is made up of: (I) the nominal par or stated value assigned to the shares of outstanding stock; (2) the capital surplus or the amount above par value paid the company whenever it issues stock; and (3) the earned surplus (also called retained earnings), which consists of the portion of earnings a company retains after paying out dividends and similar distributions. Put another way, common stock equity is the net worth after all the liabilities (including long-term debt), as well as any preferred stock, are deducted from the total assets shown on the balance sheet. For investment analysis purposes, security analysts may use the company's market capitalizationthe current market price times the number of common shares outstandingas a measure of common stock equity. They consider this market-based figure a more realistic valuation.

CHOOSING DEBT VERSUS EQUITY


It should be noted that companies may operate without funded debt or, more frequently, without any preferred stock. By the very nature of corporate structure, however, they must have common stock and the related stockholders' equity accountthough, when the company fares badly, the equity can be a negative amount. In arranging a company's financial structure, management normally aims for the lowest feasible cost of capital; whereas an investor seeks the greatest possible return. While these desires can conflict, they are not necessarily incompatible, especially with equity investors. The cost of capital can be kept low and the opportunity for return on common stockholders' equity can be enhanced through leveragea high percentage of debt relative to common equity. But increased leverage carries with it increased risk. This is the inescapable trade off both management and investors must factor into their respective decisions. The leverage provided by debt financing is further enhanced because the interest that corporations pay is a tax-deductible expense, whereas dividends to both preferred and common stockholders must be paid with after-tax dollars. Thus, it is argued, the lower net cost of bond interest helps accrue more value for the common.

But, of course, increased debt brings with it higher fixed costs that must be paid in good times and bad, and can severely limit a company's flexibility. Four problems that tend to increase as leverage escalates: (1) a growing risk of bankruptcy; (2) lack of access to the capital markets during times of tight credit; (3) the need for management to concentrate on finances and raising additional capital at the expense of focusing on operations; (4) higher costs for whatever additional debt and preferred stock capital the company is able to raise. Aside from the unpleasantness involved, it is noted that each of these factors also entails tangible monetary costs. Although periodically companies use debt to buy back common shares, a practice that can improve stock performance, most large companies rely heavily on equity financing. The elusive "optimal" capital structure is that which minimizes the total cost of a corporation's capital. In any case, an appropriate capitalization must depend greatly on the nature of the business, prevailing economic and financial conditions, and sundry other shifting factors. Firms with a high degree of management ownership, for instance, are less likely to carry high levels of debt, as are corporations with significant institutional ownership.

FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE


Capital structure is usually planned keeping in view the interests of the ordinary shareholders. The ordinary shareholders are the ultimate owners of the company and have the right to elect the directors. While developing an appropriate capital structure for his company, the financial manager should aim at maximising the long-term market price of equity shares. In practice, for most companies within an industry, there would be a range of appropriate capital structures within which there are not many differences in the market values of shares. A capital structure in this context can be determined empirically. For example, a company may be in an industry that has an average debt to total capital ratio of 60 per cent. It may be empirically found that the shareholders in general do not mind the company operating within a 15 per cent range of the industry's average capital structure. Thus, the appropriate capital structure for the company ranges between 45 per cent to 75 per cent debt to total capital ratio. The management of the company should try to seek the capital structure near the top of this range in order to make maximum use of favourable leverage, subject to other requirements such as flexibility, solvency, etc. A sound appropriate capital structure should have the following features: Profitability: The capital structure of the company should be most advantageous, within the constraints. Maximum use of leverage at a minimum cost should be made. Solvency: The use of excessive debt threatens the solvency of the company. Debt should be used judiciously.

Flexibility: The capital structure should be flexible to meet the changing conditions. It should be possible for a company to adapt its capital structure with minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. In other words, from the solvency point of view we need to approach capital structuring with due conservation. The debt capacity of the company which depends on its ability to generate future cash flows should not be exceeded. It should have enough cash to pay periodic fixed charges to creditors and the principal sum on maturity.

4.b) Capital budgeting (or investment appraisal) is the planning process used to

determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1] Components :

Accounting rate of return Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Net present value


The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment. It should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

Internal rate of return


The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV[citation needed], although they should be used in concert. In a budgetconstrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Equivalent annuity method


The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.

The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.Y

Real options
Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to the NPV.

Profitability index (PI), also known as profit investment ratio (PIR) and value
investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. The ratio is calculated as follows:

Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's PV is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project. Rules for selection or rejection of a project:

If PI > 1 then accept the project If PI < 1 then reject the project

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