Fin 331 Test 4

The New Common Equity is raised in two ways:

(1) by retaining some of the current year's earnings and (2) by issuing new common stock.

Sunk cost

- A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. - A sunk cost is an outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted. - Because sunk costs were incurred in the past and cannot be recovered regardless of whether the project is accepted or rejected, they are not relevant in the capital budgeting analysis.

Strategic business plan

- A long-run plan that outlines in broad terms the firm's basic strategy for the next 5 to 10 years. - These targets, which are spelled out in the corporation's strategic business plan, provide a general guide to the operating executives who must meet them.

Weighted average cost of capital, WACC

- A weighted average of the component costs of debt, preferred stock, and common equity. - The target proportions of debt (wd) , preferred stock (wp) , and common equity(wc) , along with the costs of those components, are used to calculate the firm's WACC - We assume at this point that all new common equity is raised as retained earnings, as is true for most companies; hence, the cost of common equity is :rs

Mutually Exclusive Projects

- Accept the project with the highest IRR, provided that IRR is greater than WACC. Reject all projects if the best IRR does not exceed WACC.

Incremental cash flows

- Cash flows that will occur if and only if the firm takes on a project. - Incremental cash flows are flows that will occur if and only if some specific event occurs.

Market, or beta, risk,

- Considers both firm and stockholder diversification. It is measured by the project's beta coefficient. - Market, or beta, risk, which is the riskiness of the project as seen by a well-diversified stockholder who recognizes (a) that the project is only one of the firm's assets and (b) that the firm's stock is but one part of his or her stock portfolio. - The project's market risk is measured by its effect on the firm's beta coefficient.

Externalities

- Effects on the firm or the environment that are not reflected in the project's cash flows. - externalities, which are defined as the effects of a project on other parts of the firm or the environment.

Capital components

- One of the types of capital used by firms to raise funds. - The investor-supplied items—debt, preferred stock, and common equity—are called capital components. Increases in assets must be financed by increases in these capital components.

Corporate, within-frim, Risk

- Risk considering the firm's diversification, but not stockholder diversification. It is measured by a project's effect on uncertainty about the firm's expected future returns. - Corporate, or within-firm, risk, which is a project's risk to the corporation as opposed to its investors. Within-firm risk takes account of the fact that the project is only one asset in the firm's portfolio of assets; hence, some of its risk will be eliminated by diversification within the firm. - This type of risk is measured by the project's impact on uncertainty about the firm's future returns.

Opportunity costs

- The best return that could be earned on assets the firm already owns if those assets are not used for the new project. - opportunity costs associated with assets the firm already owns.

Modified IRR (MIRR)

- The discount rate at which the present value of a project's cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital.

Internal Rate of Return (IRR)

- The discount rate that forces a project's NPV to equal zero. - A project's IRR is the discount rate that forces the PV of its inflows to equal its cost. This is equivalent to forcing the NPV to equal zero. The IRR is an estimate of the project's rate of return, and it is comparable to the YTM on a bond.

Before-tax cost of debt, (rd)

- The interest rate the firm must pay on new debt. - The interest rate a firm must pay on its new debt is defined as its before-tax cost of debt

Payback period (PB)

- The length of time required for an investment's cash flows to cover its cost. - payback period, defined as the number of years required to recover the funds invested in a project from its cash flows. - Payback and discounted payback provide indications of a project's liquidity and risk.

Target capital structure

- The mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects. - which refers to how Allied plans to raise capital to fund its future projects

Flotation Cost

- The percentage cost of issuing new common stock. -The bankers' fees are called flotation costs, and the total cost of the capital raised is the investors' required return plus the flotation cost.

Capital budgeting

- The process of planning expenditures on assets with cash flows that are expected to extend beyond one year. - the capital budget is a summary of planned investments in long-term assets, and capital budgeting is the whole process of analyzing projects and deciding which ones to include in the capital budget. Boeing,

after-tax cost of debt, rd (1-T)

- The relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate the WACC. - after-tax cost of debt, should be used to calculate the weighted average cost of capital. This is the interest rate on new debt, rd, less the tax savings that result because interest is tax deductible:

Cannibalization

- The situation when a new project reduces cash flows that the firm would otherwise have had. - This type of externality is called cannibalization because the new business eats into the company's existing business.

Calculating WACC

- When calculating the WACC, our concern is with capital that must be provided by investors—interest-bearing debt, preferred stock, and common equity. Accounts payable and accruals, which arise spontaneously when capital budgeting projects are undertaken, are not included as part of investor-supplied capital because they do not come directly from investors. - We use those target weights when we calculate Allied's weighted average cost of capital. It follows that Allied's overall cost of capital is a weighted average of the costs of the various types of capital it uses, where the weights correspond to the company's target capital structure.

Net Present Value (NPV)

-A method of ranking investment proposals using the NPV, which is equal to the present value of the project's free cash flows discounted at the cost of capital. - net present value (NPV), which is simply the present value of the project's free cash flows discounted at the cost of capital. The NPV tells us how much a project contributes to shareholder wealth—the larger the NPV, the more value the project adds; and added value means a higher stock price.Footnote Thus, NPV is the best selection criterion

Retained earnings breakpoint

-The amount of capital raised beyond which new common stock must be issued. - The total amount of capital that can be raised before new stock must be issued is defined as the retained earnings breakpoint

Salvage Value

-The price that the company receives for a fixed asset at the end of the project is often referred to as its salvage value. - The company will also have to pay taxes if the asset's salvage value exceeds its book value

Stand-alone risk

-The risk an asset would have if it were a firm's only asset and if investors owned only one stock. It is measured by the variability of the asset's expected returns. - Stand-alone risk, which is a project's risk assuming (a) that it is the only asset the firm has and (b) that the firm is the only stock in each investor's portfolio. Stand-alone risk is measured by the variability of the project's expected returns - Diversification is totally ignored

Net present value profile

A graph showing the relationship between a project's NPV and the firm's cost of capital.

Opportunity Cost

Although it is true that no direct costs are associated with retained earnings, this capital still has a cost, an opportunity cost.

Equity is raised by...

Equity raised by issuing stock has a higher cost than equity from retained earnings due to the flotation costs required to sell new common stock

IRR

IRR is based on the assumption that projects' cash flows can be reinvested at the IRR. This assumption is generally incorrect, and this causes the IRR to overstate the project's true return.

Independent Projects

If IRR exceeds the project's WACC, accept the project. If IRR is less than the project's WACC, reject it.

Companies use, and we discuss, the following criteria for deciding to accept or reject projects:

Net present value (NPV) Internal rate of return (IRR) Modified internal rate of return (MIRR) Regular payback Discounted Payback

Overall conclusion on which is better

Our overall conclusions are that (1) The MIRR is superior to the regular IRR as an indicator of a project's "true" rate of return. (2) NPV is better than IRR and MIRR when choosing among competing projects.

Preferred Stock

Preferred stock may include an option to convert to common stock, which adds another layer of complexity

Three separate and distinct types of risk are involved:

Stand Alone Risk Corporate Risk Market Risk

NPV is the best because...

The NPV is the best method, primarily because it addresses directly the central goal of financial management—maximizing shareholder wealth.

Flotation cost adjustment

The amount that must be added to rs to account for flotation costs to find re .

Risk-adjusted cost of capital

The cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital.

Component Cost

The cost of each component is called its component cost.

Cost of new common stock (re)

The cost of external equity; based on the cost of retained earnings, but increased for flotation costs necessary to issue new common stock.

discounted payback (DPB)

The length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost.

Cost of preferred stock (rp)

The rate of return investors require on the firm's preferred stock; rp is calculated as the preferred dividend, Dp, divided by the current price,Pp . - The component cost of preferred stock, rp , used to calculate the weighted average cost of capital is the preferred dividend ,Dp , divided by the current price of the preferred stock,Pp :

Cost of retained earnings (rs)

The rate of return required by stockholders on a firm's common stock.

Multiple IRRs

The situation where a project has two or more IRRs.

Which is the key element in capital budgeting?

WACC

WACC

WACC = or overall, cost of capital.

We use after-tax cost ...

We use the after-tax cost of debt in calculating the WACC because we are interested in maximizing the value of the firm's stock, and the stock price depends on after-tax cash flows. Because we are concerned with after-tax cash flows and because cash flows and rates of return should be calculated on a comparable basis, we adjust the interest rate downward due to debt's preferential tax treatment

Free Cash Flow

we noted that investors are particularly concerned with free cash flow. Recall that free cash flow represents the net amount of cash that is available for all investors after taking into account the necessary investments in fixed assets (capital expenditures) and net operating working capital.

Incremental Cash Flow

we subtract the old flows from the new to arrive at the incremental cash flows

...

would a new machine earn a return greater than the cost of the capital needed to acquire the machine? The rate at which the firm has borrowed in the past is irrelevant when answering this question because we need to know the cost of new capital. For these reasons, the yield to maturity on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate.

Three types of Externalities

—negative within-firm externalities, positive within-firm externalities, and environmental externalities—are explained next.