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 FIRM’S 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 FIRM’S COST OF EQUITY CAPITAL.

THIS APPROACH EXPLICITLY ACCOUNTS FOR EACH INVESTMENT’S METHOD OF FINANCING.

BASED ON THE ASSUMPTION THAT THE INVESTMENT’S FINANCING COSTS MAY STRONGLY INFLUENCE THE FIRM’S 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-TO-

EQUITY 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 ROEROA ROE

Initial Investment Total amount of the investment

Only the equity invested

Terminal Value Total residual value of the assets

Equity portion after repayment of any outstanding debt

Discount Rate Weighted average cost of capital

Cost of equity capital

Net Cash Flows After tax net cash flows to the investment

After tax net cash flows including the servicing of debt

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 RelationshipReturn

Risk

Risk Free Rate

RiskPremium

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 YEAR’S 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 Before Tax CF

Depr Taxable Inc

Inc Tax

After Tax CF

1 20,000 13,000 7,000 1,400 18,600

2 25,000 13,000 12,000 2,400 22,600

3 35,000 13,000 22,000 4,400 30,600

4 50,000 13,000 37,000 7,400 42,600

5 50,000 13,000 37,000 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 Tax CF

Depr Interest Expense

Taxable Inc

Inc Tax

Loan Payment

After Tax CF

1 20,000 13,000 10,200 -3,200 -640 30,452 -9,812

2 25,000 13,000 8,479 3,521 704 30,452 -6,156

3 35,000 13,000 6,611 15,389 3,078 30,452 1,470

4 50,000 13,000 4,584 32,416 6,483 30,452 13,065

5 50,000 13,000 2,386 34,614 6,923 30,452 12,625