Capital Budgeting Continued-Managerial Economics-Lecture Notes, Study notes of Managerial Economics

Download Capital Budgeting Continued-Managerial Economics-Lecture Notes and more Study notes Managerial Economics in PDF only on Docsity! Lesson 44 CAPITAL BUDGETING (CONTINUED) PROJECT SELECTION Decision Rule Conflict Problem  NPV analysis has large project bias.  With scarce capital, PI method can lead to a better project mix.  IRR can overstate attractiveness if you can’t reinvest excess cash flows at the IRR. Ranking Reversal Problem  Ranking reversal occurs when a switch in project standing follows an increase in the relevant discount rate. Crossover discount rate is the interest factor that equates NPV for two or more projects When Independent projects are being analyzed, both IRR and NPV criteria give consistent results. “Independent” implies that if a firm is considering several projects at the same time, they can all be implemented simultaneously as long as they pass the IRR and NPV tests and as long as funds are not limited. The adoption of one independent project will have no effect on the cash of another. However, proposals may be mutually exclusive projects. This occurs when two solutions of a particular proposals are offered, only one of which can be accepted. Conflicting results can be caused by a difference in project size. Table 1 shows such a case. Project A involves an original outlay of Rs 1,500 and Project B is less expensive i.e. only Rs.1, 000. Each project has a 4-year life and no salvage value. The cost of capital is 15%. The IRR of Project A > Project B. To resolve the dilemma, we calculate the NPV and IRR for an “incremental” (or delta) project. That is, we take the differences between two project cash flows and create a delta project. Both criteria indicate that the additional investment of Rs.500 is worthwhile. It follows that the NPV rule, which suggested Project A, was the correct indicator, and that Project A should be chosen over Project B. Conflicting rankings occurs when: 1. The initial costs of the two projects differ. 2. The shapes of the cash inflow streams differ significantly. The reason for the differences between NPV and IRR results is the implicit re-investment assumption. In the NPV calculation, inflows are automatically assumed to be re-invested at the cost of capital (the project’s k). The IRR solution assumes re-investment at the internal rate of return (the project’s k*). Table 1 Delta Project Project t = 0 t = 1 t = 2 t = 3 t =4 t =5 A 1500 580 580 580 580 0 B 1000 400 400 400 400 0 Cost of CAP 15% Project A IRR 20.1% NPV 156 Project B IRR 21.9 NPV 142 Delta Project (A – B) 500 180 180 180 180 0 IRR 16.4% NPV 14 docsity.com Even though alternative capital budgeting decision rules consistently lead to the same project accept/reject decision, they involve important differences in terms of project ranking. Projects ranked most favorably using the NPV method may appear less so when analyzed using the PI or IRR methods. Projects ranked most favorably using the PI or IRR methods may appear less so when analyzed using the NPV technique. Both NPV and PI methods differ from the IRR technique in terms of their underlying assumptions regarding the reinvestment of cash flows during the life of the project. In the NPV and PI methods, excess cash flows generated over the life of the project are “reinvested” at the firm’s cost of capital. In the IRR method, excess cash flows are reinvested at the IRR. For especially attractive investment projects that generate an exceptionally high rate of return, the IRR can actually overstate project attractiveness because reinvestment of excess cash flows at a similarly high IRR is not possible. When reinvestment at the project-specific IRR is not possible, the IRR method must be adapted to take into account the lower rate of return that can actually be earned on excess cash flows generated over the life of individual projects. Otherwise, use of the NPV or PI methods is preferable. RANKING REVERSAL PROBLEM A more serious conflict can arise between NPV and IRR methods when projects differ significantly in terms of the magnitude and timing of cash flows. When the size or pattern of alternative project cash flows differ greatly, each project’s NPV can react quite differently to changes in the discount rate. As a result, changes in the appropriate discount rate can sometimes lead to reversals in project rankings. Table 1 NPV Profile: Crossover Discount Rate CAP-Bud Tech Build New (A) Remodel Old (B) 0% D Rate NPV 38.4 m 42.1 m 15% D Rate NPV 7.7 m 8.3 m 25% D Rate NPV 0.99 m 0.03 m Crossover 18.08% 4.7 m 4.7 m Figure 1 displays the potential conflict between NPV, PI, and IRR project rankings at various interest rates by showing the effect of discount rate changes on the NPV of each alternative investment project. This net present-value profile relates the NPV for each project to the discount rate used in the NPV calculation. Using a k = 0 percent discount rate, the NPV for the “build new plant” investment project is $38.4 million, and it is $42.1 million for the “remodel old plant” alternative. These NPV values correspond to the difference between nominal dollar cash inflows and outflows for each project and also coincide with NPV line Y-axis intercepts of $38.4 million for the “build new plant” project and $42.1 million for the “remodel old plant” alternative. The X-axis intercept for each curve occurs at the discount rate where NPV = 0 for each project. Because NPV = 0 when the discount rate is set equal to the IRR, or when IRR = k, the X-axis intercept for the “build new plant” alternative is at the IRR = 25.06 percent level, and it is at the IRR = 23.57 percent level for the “remodel old plant” alternative. docsity.com For example, if the firm pays a dividend of $20/share and the growth rate of dividend payments is expected to be 5 %/year, the cost of equity capital for this firm is: ke = $20 / $200 + 0.05 = 0.10 + 0.05 = 0.15 or 15% THE COST OF EQUITY CAPITAL: THE CAPITAL ASSET PRICING MODEL (CAPM) This method takes into consideration not only the risk differential between common stocks and government securities but also the risk differential between the common stock of the firm and the average common stock of all firms or broad-based market portfolio. The risk differential between common stocks and government securities is measured by (km - rf), where' km is the average return on all common stocks and rf is the return on government securities. A beta coefficient of 1 means that the variability in the returns on the common slack of the firm is the same as the variability in the returns on all stocks. Thus, investors holding the stock of the firm face the same risk as holding a broad-based market portfolio of all stocks. A beta coefficient of 2 means that the variability in the returns on (i.e., risk of holding) the stock of the firm is twice that of the average stock. On the other hand, holding a stock with a beta coefficient of 0.5 is half as risky as holding the average stock. The cost of equity capital to the firm estimated by the capital asset pricing model is measured by ke = rf +  (km - rf) Where ke is the cost of equity capital to the firm, rj is the risk-free rate,  is the beta coefficient and km is the average return on the stock of all firms. Thus, the CAPM postulates that the cost of equity capital to the firm is equal to the sum of the risk free rate plus the beta coefficient () times the risk premium on the average stock (km = rf). Note that multiplying  by (km - rf) gives the risk premium on holding the common stock of the particular firm. For example, suppose that the risk-free rate (rf) is 8 percent, the average return on common stocks (km) is 15 percent, and the beta coefficient (P) for the firm is 1. The cost of equity capital to the firm (ke) is then ke = 8% + 1(15% - 8%) = 15% That is, since a beta coefficient of 1 indicates that the stock of this firm is as risky a the average stock of all firms, the equity cost of capital to the firm is 15 percent (the same as the average return on all stocks). If  = 1.5 for the firm (so that the risk involved in holding the stock of the firm is 1.5 times larger than the risk on the average stock), the equity cost of capital to the firm would be ke = 8% + 1.5(15% - 8%) = 18.5% On the other hand, if  = 0.5, ke = 8% + 0.5(15% - 8%) = 11.5% Firms usually use all three methods and then attempt to reconcile the differences and arrive at a consensus equity cost of capital for the firm. THE WEIGHTED COST OF CAPITAL In general, a firm is likely to raise capital from undistributed profits, by borrowing, and by the sale of stocks, and so the marginal cost of capital to the firm is a weighted average of the cost of raising the various types of capital. Since the interest paid on borrowed funds is tax deductible while the dividend paid on stocks are not, the cost of debt is generally less than the cost of equity capital. The risk involved in raising funds by borrowing, however, is greater than the risk on equity capital because the firm must regularly make payments of the interest and principal on borrowed funds before paying docsity.com dividends on stocks. Thus, firms do not generally raise funds only by borrowing but also by selling stock (as well as from undistributed profits). Firms often try to maintain or achieve a particular long-term capital structure of debt to equity. For example, public utility companies may prefer a capital structure involving 60 percent debt and 40 percent equity, while auto manufacturers may prefer 30 percent debt and 70 percent equity. The particular debt/equity ratio that a firm prefers reflects the risk preference of its managers and stockholders and the nature of the firm's business. Public utilities accept the higher risk involved in a higher debt/equity ratio because of their more stable flow of earnings than automobile manufacturers. When, a firm needs to raise investment capital, it borrows and it sells stocks so as to maintain or achieve a desired debt/equity ratio. The composite cost of capital to the firm (kc) is then a weighted average of the cost of debt capital (kd) and equity capital (ke) as given by: c d d e ek w k w k  where Wd and We are, respectively, the proportion of debt and equity capital in the firm's capital structure. For example, if the (after-tax) cost of debt is 7.5 percent, the cost of equity capital is 15 percent, and the firm wants to have a debt/equity ratio of 40:60, the composite or weighted marginal cost of capital to the firm will be kc = (0.40)(7.5%) + (0.60)(15%) = 3% + 9% = 12% . This is the composite marginal cost of capital that we have used to evaluate all the proposed investment projects. Figure 2 shows how the cost of capital changes as the debt ratio increases for a hypothetical industry with about average risk. The average cost of capital figures in the graph are calculated in Table 15.6. In the figure, each dot represents one of the firms in the industry. For example, the dot labeled “one” represents firm 1, a company with no debt. Because its projects are financed entirely with 10 percent equity money, firm 1’s average cost of capital is 10 percent. Figure 2 Firm 2 raises 10 percent of its capital as debt, and it has a 4.5 percent after-tax cost of debt and a 10 percent cost of equity. Firm 3 also has a 4.5 percent after-tax cost of debt and 10 percent cost of equity, even though it uses 20 percent debt. Firm 4 has an 11 percent cost of equity and a 4.8 percent after-tax cost of debt. Because it uses 30 percent debt, a before-tax debt risk premium of 0.5 percent and an equity risk premium of 1 percent have been added to account for the additional risk of financial leverage. Notice that the required return on both debt and equity rises with increasing leverage for firms 5, 6, and 7. Providers of debt and equity capital typically believe that because of the added risk of financial leverage, they should obtain higher yields on docsity.com the firm’s securities. In this particular industry, the threshold debt ratio that begins to worry creditors is about 20 percent. Below the 20 percent debt level, creditors are unconcerned about any risk induced by debt; above 20 percent, they are aware of higher risks and require compensation in the form of higher expected rates of return. OPTIMAL CAPITAL BUDGET A profit-maximizing firm operates at the point where marginal revenue equals marginal cost. In terms of the capital budgeting process, this implies that the marginal rate of return earned on the last acceptable investment project is just equal to the firm’s relevant marginal cost of capital. The optimal capital budget is the funding level required to guarantee a value-maximizing level of new investment. Investment Opportunity Schedule (IOS)  IOS shows the pattern of returns (IRR) for all potential investment projects.  Marginal cost of capital is the extra financing cost necessary to fund an additional investment project.  Optimality requires setting IRR = MCC. Capital budgeting is essentially an application of the general principle that a firm should produce the output or undertake an activity until the marginal revenue from the output or activity is equal to its marginal cost. In a capital budgeting framework, this principle implies that the firm should undertake additional investment projects until the marginal return from the investment is equal to its marginal cost. The schedule of the various investment projects open to the firm, arranged from the one with the highest to the lowest return, represents the firm's demand for capital. The marginal cost of capital schedule, on the other hand, gives the cost that the firm faces in obtaining additional amounts of capital for investment purposes. The intersection of the demand and marginal cost curves for capital that the firm faces determines how much the firm will invest. This is shown in Figure 3. Figure 3 In Figure 3, the various lettered bars indicate the amount of capital required for each investment project that the firm can undertake and the rate of return expected on each investment project. Faced with the demand for capital and marginal' cost of capital curves shown in Figure 3, the firm will undertake projects A, B, and C because the expected rates of return on these projects exceed the cost of capital to make these investments. Specifically, the firm will undertake docsity.com