CAPITAL BUDGETING

INITIAL INVESTMENT PLANNING HORIZON

TERMINAL VALUE
REQUIRED RATE OF RETURN NET CASH FLOWS

RETURNS TO ASSETS OR RETURNS TO EQUITY?

IF THE OBJECTIVE IS TO MEASURE THE PROFITABILITY OF THE ASSETS COMMITTED TO THE INVESTMENT, NET CASH FLOWS ARE THE PROJECTED AFTER-TAX CASH FLOWS WITHOUT DEDUCTION OF CHARGES FOR INTEREST OR LOAN PAYMENTS. THE DISCOUNT RATE USED IS THE WEIGHTED AVERAGE COST OF CAPITAL.

BASED ON THE ASSUMPTION THAT THE FIRMS LEVERAGE OR OVERALL FINANCIAL STRUCTURE DETERMINES THE FINANCING COST OF THE INDIVIDUAL INVESTMENT AND THAT THE FINANCING ARRANGEMENTS FOR THE INDIVIDUAL INVESTMENT DO NOT SUBSTANTIALLY INFLUENCE THE FIRMS OVERALL COST OF CAPITAL

IF THE OBJECTIVE IS TO MEASURE THE PROFITABILITY OF THE EQUITY CAPITAL COMMITTED TO THE INVESTMENT, NET CASH FLOWS ARE THE PROJECTED AFTER-TAX CASH FLOWS WITH THE DEDUCTION OF CHARGES FOR INTEREST AND PRINCIPAL ON LOAN PAYMENTS. THE DISCOUNT RATE USED IS THE FIRMS COST OF EQUITY CAPITAL.

THIS APPROACH EXPLICITLY ACCOUNTS FOR EACH INVESTMENTS METHOD OF FINANCING. BASED ON THE ASSUMPTION THAT THE INVESTMENTS FINANCING COSTS MAY STRONGLY INFLUENCE THE FIRMS LEVERAGE AND COST OF CAPITAL.

INITIAL INVESTMENT

THE INITIAL EQUITY THE INVESTOR COMMITS TO THE INVESTMENT. ALL COSTS NECESSARY TO MAKE THE INVESTMENT ARE INCLUDED. IF FINANCING IS USED, THE INITIAL INVESTMENT WILL BE LOWER.

NET CASH FLOWS

REFERS TO CASH FLOWS

INCLUDES ALL CASH INFLOWS AND CASH OUTFLOWS ON AN AFTER TAX BASIS

OUTFLOWS INCLUDE:

OPERATING EXPENSES CAPITAL EXPENDITURES INCOME TAXES FINANCING (UNDER THE RETURN-TOEQUITY APPROACH)

TERMINAL VALUE

THE RESIDUAL VALUE OF ASSETS INVOLVED IN THE INVESTMENT. ONLY THE EQUITY PORTION OF ANY SALE OF ASSETS SHOULD BE INCLUDED. ANY OUTSTANDING DEBT WOULD BE REPAID WHEN THE ASSETS ARE SOLD.

DISCOUNT RATE

THE DISCOUNT RATE USED IS CONSIDERED TO CONTAIN THREE COMPONENTS:

REAL RISK FREE RATE OF RETURN RISK PREMIUM ANTICIPATED RATE OF INFLATION

Comparison of ROA and ROE

ROA Initial Investment Terminal Value Total amount of the investment Total residual value of the assets Weighted average cost of capital After tax net cash flows to the investment ROE Only the equity invested Equity portion after repayment of any outstanding debt Cost of equity capital After tax net cash flows including the servicing of debt

Discount Rate Net Cash Flows

WHAT GOES INTO THE DISCOUNT RATE?

THE DISCOUNT RATE SHOULD REFLECT THE COST OF CAPITAL OR THE COST OF FUNDS USED TO FINANCE THE BUSINESS. AN INVESTMENT IS NOT ACCEPTABLE UNLESS IT GENERATES A RETURN SUFFICIENT TO COVER THE COST OF FUNDS.

THE DISCOUNT RATE CONTAINS THREE COMPONENTS: REAL RISK-FREE RATE RISK PREMIUM INFLATION EXPECTATIONS

WEIGHTED AVERAGE COST OF CAPITAL

THE COST OF CAPITAL IS WEIGHTED BY THE PROPORTION OF EACH TYPE OF CAPITAL (DEBT AND EQUITY) IN THE CAPITAL STRUCTURE OF THE FIRM.

THERE ARE TWO TYPES OF CAPITAL INVESTED IN A BUSINESS: DEBT CAPITAL EQUITY CAPITAL

COST OF DEBT COST OF EQUITY

COST OF DEBT

The cost of debt is the interest expense associated with the debt capital used in the business. Since interest is a tax deductible expense, the cost of debt should be calculated on an after-tax basis.

After-Tax Cost of Debt

ATCD = Cost of Debt * (1-marginal tax rate) Example:

Cost of debt is 7.5% Marginal tax rate of 20%

ATCD = 0.075 * (1 0.2) ATCD = 0.075 * 0.8 = 0.06 or 6.0%

COST OF EQUITY

The cost of equity is not as easy to determine as the cost of debt. It involves the concept of opportunity cost and a consideration of the relative risk versus debt capital. The cost of equity to a business should be higher than its cost of debt because equity holders take on more risk than debt holders and therefore expect a higher return.

Risk Return Relationship

Return

Risk Free Rate

Risk Premium

Risk

Cost of Equity - Calculation

Capital Asset Pricing Model (CAPM) is used where a firm is traded on the equity markets (stock market). Formula: Cost of equity capital = Risk free rate + Beta (Market risk premium)

But what about firms not traded on a stock exchange?

The calculation of equity costs for a business not traded on an exchange (ie. an agribusiness or farming operation) is problematic, since the beta and market risk premium is not apparent. Therefore, a substitute method would be: Cost of Equity = Risk free rate + equity risk premium Where the equity risk premium is based on the owners required rate of return to accept the risk of ownership.

WEIGHTED AVERAGE COST OF CAPITAL

Kc = wd Kd + we Ke Where:

Kc is the weighted average cost of capital wd is the proportion of assets financed with debt Kd is the cost of debt capital we is the proportion of assets financed with equity Ke is the cost of equity capital

DEPRECIATION

AN ACCOUNTING PROCEDURE BY WHICH THE PURCHASE COST OF A DEPRECIABLE ASSET IS PRORATED OVER ITS PROJECTED ECONOMIC LIFE REFLECTS THE ANTICIPATED DECLINE IN THE ASSETS VALUE OVER TIME

DEPRECIATION METHODS

STRAIGHT LINE DECLINING BALANCE SUM OF THE YEARS DIGITS

DEPRECIATION IS USED IN THE CALCULATION OF CASH FLOWS TO CALCULATE THE TAXABLE INCOME AND INCOME TAX LIABILITY. DEPRECIATION IS A NON-CASH EXPENSE, THEREFORE, NOT DEDUCTED FROM THE NET CASH FLOW

Income Taxes and Capital Budgeting

The payment of income taxes constitutes a cash flow, therefore, income taxes should be accounted for in capital budgeting.
An after-tax cash flow should be estimated using projected before-tax cash flows and deducting tax liabilities.

Calculation of After-Tax Cash Flows

Net before-tax cash flows are calculated as the net of revenues less related production expenses. Additional deductible expenses in the calculation of income taxes include:

Depreciation (non-cash expenses) Interest paid on any business loans

Calculation of After-Tax Cash Flows Under the Return on Asset Method

(Before Tax Net CF Depreciation) = Taxable Income Taxable Income *Marginal Tax Rate = Tax Due After Tax CF = Before Tax Net CF Tax Due

Year
1 2

Before Depr Taxable Inc After Tax CF Inc Tax Tax CF 20,000 13,000 7,000 1,400 18,600
25,000 13,000 12,000 2,400 22,600

3
4 5

35,000 13,000 22,000

50,000 13,000 37,000 50,000 13,000 37,000

4,400 30,600
7,400 42,600 7,400 42,600

Calculation of After-Tax Cash Flows Under the Return on Equity Method

(Before Tax Net CF Depreciation - Interest) = Taxable Income Taxable Income *Marginal Tax Rate = Tax Due After Tax CF = Before Tax Net CF Tax Due Principal and Interest on Loan

Year

Before Depr Tax CF

Interest Taxable Expense Inc

Inc Tax

Loan Payment

After Tax CF
-9,812

20,000

13,000 10,200

-3,200

-640

30,452

25,000

13,000 8,479

3,521

704

30,452

-6,156

35,000

13,000 6,611

15,389

3,078 30,452

1,470

50,000

13,000 4,584

32,416

6,483 30,452

13,065

50,000

13,000 2,386

34,614

6,923 30,452

12,625