VIEWS: 6 PAGES: 6 POSTED ON: 11/15/2012
1 Chapter 8 Capital budgeting techniques Net present value; Accept the project if NPV is positive Reject the project if NPV is negative Payback period; Accept the project if the payback period is shorter than the company policy. Reject the project if the payback period is longer than the company policy IRR; Accept the project if the IRR is higher than cost of capital. Reject the project if the IRR is higher than cost of capital. Chapter 9 Review Straight line depreciation method is used Salvage value at the end of year 3 is $65,000 Investment classification = replacement No changes in sales Cash inflows are from cost reductions Cost reduction = $44,000 per year Initial investment at t=0 $126,000 Depreciable asset value = $120,500 Economic life of the project = 3 years Annual cost savings = $44,000 Salvage value=$65,000 Annual depreciation expense = ($120,500 - $65,000)/3 = $18,500 Incremental Income statement Income statement relevant to the project Increase in gross profit $44,000 Increase in depreciation -18,500 Increase in EBIT 25,500 Interest expenses XX Earnings before taxes 25,500 Increase in taxes (34%) -8,670 Increase in net income 16,830 Annual cash inflows = $16,830 + $18,500 = $35,530 2 0 1 2 3 .____________.____________.__________. -$126,000 $35,530 $35,530 $35,530 salvage value 65,000 Net working capital 5,500 PV = 35,530 (PVIFA) 3, 12% + $70,500 (PVIF) 3, 12% = 85,343 + 50,196 = 135,539 NPV = $135,539 - $126,000 = $9,539 Accept the project Chapter 10: Cost of Capital Kd = Interest rate on the firm’s debt Kdt = Kd (1-T) = After-tax cost of the firm’s debt Ks = Cost of equity WACC = weighted average cost of capital Ks = Cost of retained earnings (internal equity) Ks = D1/P0 + g Ks = Krf+ (Km – Krf) Chapter 11 Capital structure change; its impact on the cost of equity, weighted average cost of capital (WACC), and the firm value. Modogliani and Miller (1959), known as the MM irrelevance theorem, argue that the firm value is irrelevant to the capital structure. The logic of the theorem is as follows: 1) As a firm increases debt financing, the debt to equity ratio increases. 2) This means that the financial risk of the firm increases 3) which in turn means that the return to equity investors become riskier. 4) ebt holders have a higher priority of claiming the earnings from the firm. 5) Equity holders receive what is left after paying off interest expense and taxes 6) For a given operating earnings; higher the interest expenses, lower the return to equity holders. 3 Rational investors should require a higher rate of return for a riskier investment. No free lunch!! Equity investors require a higher rate of return for firms with high debt to equity ratio, as shown below Ks = K0 + (K0 - Kb) D/E Ks = cost of equity, K0 = weighted average cost of capital = cost of equity of ulevered firm Kb = cost of debt D/E = debt to equity ratio WACC= (portion of equity)(cost of equity) + (portion of debt)(cost of debt) K0 = WsKs + WdKd Example 1. Worldwide Sprint is all-equity financed firm 2. currently no debt in the balance sheet 3. Call the firm as an unlevered firm Value of Worldwide Sprint is: V = equity value of $1,000 Ks = 16% No change in operating earnings, Worldwide Sprint changes its capital structure Case 1: Issue $200 of debt at Kd = 10%, and use $200 to buyback equity. So the firm value is now V = equity value + debt value = $800 + $200 Now, the new cost of equity is: Ks = K0 + (K0 - Kb) D/E 200 = 16% + (16% - 10%) 800 = 17.5% The new WACC is: WACC= (portion of equity)(cost of equity) + (portion of debt)( cost of debt) K0 = WsKs + WdKd K0 = (800/1000) * 0.175 + (200/1000) * 0.10 = (0.8) * 0.175 + (0.2) * 0.10 = 0.16 4 Case 2: No change in operating earnings, worldwide Sprint changes its capital structure Issue $400 of debt and use $400 to buyback equity. So the firm value is now V = equity value + debt value = $600 + $400 Now, the cost of equity with new debt financing is Ks = K0 + (K0 - Kb) D/E 400 = 16% + (16% - 10%) 600 = 20% The new WACC is: WACC= (portion of equity)(cost of equity) + (portion of debt)( cost of debt) K0 = WsKs + WdKd K0 = (600/1000) * 0.20 + (400/1000) * 0.10 = (0.6) * 0.20 + (0.4) * 0.10 = 0.16 We have seen that the weighted average cost of capital, Ko, remains at 16%, even if the financial leverage increases. This is because the cost of equity, Ks, increases as the financial risk of the firm increases. MM Proposition II states that K0 remains unchanged, as Ks increase with financial leverage. Ks = K0 + (K0 - Kb) D/E Remember that the value of a firm (V) with a constant cash inflow (EBIT) through infinity is annual cash flows divided by the discount rate (K0) V= EBIT/ K0 We have seen that K0 remains unchanged as the financial leverage ratio changes, So the firm value remains unchanged as the financial ratio changes for a given EBIT. Based on this logic, Modogliani and Miller (1959), known as the MM irrelevance theorem, argue that the firm value is irrelevant to the capital structure. 5 Review after capital structure theories and dividend policy Stock price = present value of expected future cash flows P0 = D/Ks; for no growth firm P0 = D/( Ks-g); for constant growth firm Given expected future cash flows, can financial managers increase firm Value by changing capital structure? Capital structure Irrelevant Theorem of Modigliani and Miller (MM) Given net income (internal cash inflows), can dividend policy influence share value? Is dividend clientele permanent or temporary? What is MM’s Proposition on dividend policy? Changes in dividend payments carry informational content. Dividend policy changes do not affect share prices to the extent that the policy changes do not carry informational content. Clientele effects of dividend policy changes. Informational content of dividend payment changes. How to increase the share value? Back to capital expenditures decisions that will increase earnings 1. Expansion of the existing physical assets 2. Replacing old plant and equipment 3. Advertising create customer royalty 4. Research and Development (R&D) New products innovation, improvement of the quality, and production technology enhancements. Chapter 16 and 18 1 Corporate restructuring 2. Create new market; in domestic as well as in foreign economies 3. Mergers and Acquisitions; domestic as well as cross-national M&A The life cycle of a firm Birth, Growth, maturity, bankrupt (or acquired) To Grow Company needs capital 6 Borrow or issue equity? Initial public offerings Foreign direct investment and globalization 1. To create new market in foreign economies; exports or foreign direct investment 2. To enter foreign markets, cross-national M&A 3. FDI providing firms as well as recipients economies benefit from globalization. 4. Advanced technology and foreign capital increase the productivity of recipient economies through technology spillovers. 5. As developing economies experience economic growth, these countries will import services and products from advanced economies. 6. The process may force the local power group who run the ‘nation state’ to yield their absolute power to new group. 7. To the extent that anecdotal evidences of ‘exploitation’ by multinational firms from advanced economies exist, the fear of ‘exploitation’ can be used to oppose the globalization process.
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