Financial Management 2 UCP-001B

CAPITAL BUDGETING Part 2

Review of Capital Budgeting Methods

The regular payback period is defined as the number of years required to recover a project’s cost. The regular
payback method has three flaws: It ignores cash flows beyond the payback period, it does not consider the time
value of money, and it doesn’t give a precise acceptance rule. The payback does, however, provide an indication of
a project’s risk and liquidity, because it shows how long the invested capital will be tied up. The discounted
payback is similar to the regular payback except that it discounts cash flows at the project’s cost of capital. It
considers the time value of money, but it still ignores cash flows beyond the payback period.

The net present value (NPV) method discounts all cash flows at the project’s cost of capital and then sums those
cash flows. The project should be accepted if the NPV is positive because such a project increases shareholders’
value.

The internal rate of return (IRR) is defined as the discount rate that forces a project’s NPV to equal zero. The
project should be accepted if the IRR is greater than the cost of capital.

The NPV and IRR methods make the same accept–reject decisions for independent projects, but if projects are
mutually exclusive then ranking conflicts can arise. In such cases, the NPV method should generally be relied upon.

The NPV method assumes that cash flows will be reinvested at the firm’s cost of capital, whereas the IRR method
assumes reinvestment at the project’s IRR. Reinvestment at the cost of capital is generally a better assumption
because it is closer to reality.

Modified Internal Rate of Return (MIRR)

The modified IRR (MIRR) method corrects some of the problems with the regular IRR. MIRR involves finding the
terminal value (TV) of the cash inflows, compounding them at the firm’s cost of capital, and then determining the
discount rate that forces the present value of the TV to equal the present value of the outflows. Thus, the MIRR
assumes reinvestment at the cost of capital, not at the IRR. If management wants to know the rate of return on
projects, the MIRR is a better estimate than the regular IRR.

Cost of Capital

The cost of capital used in capital budgeting is a weighted average of the types of capital the firm uses—typically
debt, preferred stock, and common equity.

The component cost of debt is the after-tax cost of new debt. It is found by multiplying the interest rate paid on
new debt by 1 − T, where T is the firm’s marginal tax rate:

Most debt is raised directly from lenders without the use of investment bankers, hence no flotation costs are
incurred. However, a debt flotation cost adjustment should be made if large flotation costs are incurred. We
reduce the bond’s issue price by the flotation expenses, reduce the bond’s cash flows to reflect taxes, and then
solve for the after-tax yield to maturity.

The component cost of preferred stock is calculated as the preferred dividend divided by the net price the firm
receives after deducting flotation costs: rps = Dps/[Pps(1 − F)]. Flotation costs on preferred stock are usually fairly
high, so we typically include the impact of flotation costs when estimating rps. Also note that if the preferred stock

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is convertible into common stock, then the true cost of the preferred stock will exceed the flotation-adjusted yield
of the preferred dividend.

The cost of common equity, rs, also called the cost of common stock, is the rate of return required by the firm’s
stockholders, and it can be estimated in three ways: (1) the CAPM; (2) the dividend-yield-plus-growth-rate, or
DCF, approach; and 3) the over-own-bond-yield-plus-judgmental-risk-premium approach.

To use the CAPM approach, we (1) estimate the firm’s beta, (2) multiply this beta by the market risk premium to
obtain the firm’s risk premium, and then (3) add the firm’s risk premium to the risk-free rate to obtain its cost of
common stock:

The best proxy for the risk-free rate is the yield on long-term T-bonds, with 10 years the maturity used most
frequently.

To use the dividend-yield-plus-growth-rate approach, which is also called the discounted cash flow (DCF)
approach, add the firm’s expected dividend growth rate to its expected dividend yield:

Here P0 is the price of the stock, F is flotation cost, D1 is the dividend expected to be paid at the end of Year 1, g is
the expected growth rate in dividends, and re is the required rate of return.

Weighted Average Cost of Capital

Here wd, wps, and ws are the target weights for debt, preferred, and common equity, respectively.

Exercises
Ex.1
You are a financial analyst for Dawson Electronics Company. The director of capital budgeting has asked you to
analyze two proposed capital investments, Project X and Y. Each project has a cost of P10,000, and the cost of
capital for each project is 12%. The projects’ expected net cash flows are as follows:
Expected Net Cash Flows
Year Project X Project Y
0 (P10,000) (P10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
Required:
1. Calculate each project’s - (a) payback period (b) net present value (c) internal rate of return (IRR), and
modified internal rate of return (MIRR).
2. Which project or projects should be accepted if they are independent?
3. Which project should be accepted if they are mutually exclusive

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4. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these
two projects? would this conflict exist if cost of capital is 5%
5. Why does the conflict exist?

Ex.2
Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers to be optimal:
Debt 25%
Preferred Stock 15%
Common equity 60%
100%
LEI’s expected net income this year is P34,285.72, its established dividend payout ratio is 30%, its tax rate is 40%
and investors expect earnings and dividends to grow at constant rate of 9% in the future. LEI paid dividend of
P3.60 per share last year, and its stock currently sells at a price of P54 per share.

LEI can obtain new capital in the following ways:

a. Preferred: New preferred stock with a dividend of P11 can be sold to the public at a price of P95 per
share.
b. Debt: debt can be sold at an interest rate of 12%.

Required:
1. Determine the cost of each capital structure component.
2. Calculate the weighted average cost of capital.
3. LEI has the following investment opportunities that are typical average risk projects for the firm:
Project Cost at t = 0 Rate of Return
A P 10,000 17.4%
B 20,000 16.0%
C 10,000 14.2%
D 20,000 13.7%
E 10,000 12.0%
Which projects should LEI accept? Why?

Ex. 3
Longstreet Communications Inc. (LCI) has the following capital structure, which it considers to be optimal: debt =
25%, preferred stock = 15%, and common stock = 60%.

LCI’s tax rate is 40%, and investors expect earnings and dividends to grow at a constant rate of 6% in the future. LCI
paid a dividend of P3.70 per share last year (D0), and its stock currently sells at a price of P60 per share. Ten-year
Treasury bonds yield 6%, the market risk premium is 5%, and LCI’s beta is 1.3. The following terms would apply to
new security offerings.

Preferred: New preferred could be sold to the public at a price of P100 per share, with a dividend of P9. Flotation
costs of P5 per share would be incurred.
Debt: Debt could be sold at an interest rate of 9%.
Common: New common equity will be raised only by retaining earnings.

a. Find the component costs of debt, preferred stock, and common stock.
b. What is the WACC?

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