Session 2, Monday, April 8th (11:30-12:30) · the project’sexpected cash flows to equal the initial outlay • Time needed to recover initial investment • Decision rule: Compare

v2.0 © 2014 Association for Financial Professionals. All rights reserved. Session 3 - 1

Session 2, Monday, April 8th (11:30-12:30)Capital Budgeting Continued and the Cost of Capital


• Internal Rate of Return: Part I, Domain B Chapter 6

• Payback Period and Discounted Payback Period: Part II, Domain B Chapter 11

• Cost of Capital: Part I, Domain B Chapter 6

Chapters Covered


Financial Valuation Methods

Discounts the future value of all cash inflows and outflows of an

investment back to their present value by factoring in costs of capital—

debt and equity costs.

Discounted Cash Flow (DCF)

The minimum annual percentage earned on invested capital for it to be

deemed acceptable. Equal to the weighted average cost of capital

(WACC).

Required Rate of Return (RRR)


Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero.

Internal Rate of Return (IRR)

A project is acceptable only if the IRR

exceeds the organization’s target rate of

return or weighted average cost of capital

(WACC).


The discount rate that forces the NPV to equal $0

• Since an NPV of $0 means that the PV of CFs equals the upfront cost, the IRR is considered to be the yield or rate of return earned

$0 =𝐶𝐹1

1 + 𝐼𝑅𝑅 1+

𝐶𝐹2

1 + 𝐼𝑅𝑅 2+…..

𝐶𝐹𝑁

1 + 𝐼𝑅𝑅 𝑁− 𝑈𝑝𝑓𝑟𝑜𝑛𝑡 𝐶𝑜𝑠𝑡𝑠

Decision Rule: Accept if IRR > WACC

• Must rely on the spreadsheet to calculate IRR

More on IRR


• An investment with an upfront cost of $55,000 will generate the following CFs at the end of the next 5 years: $16,000, $19,000, $18,000, $17,500, $17,500.

• What is the IRR?

IRR Example


• Possibility of multiple IRRs

• The number of IRRs will equal the number of sign changes in the cash flow stream

• Reinvestment rate assumption

• The process used to calculate the IRR assumes that cash flows are re-invested at the IRR

• The scale problem

• If two projects/investments are mutually exclusive, the project/investment with the higher NPV may have a lower IRR

Problems with the IRR


Payback Period

• The payback period is the number of periods required for the sum ofthe project’s expected cash flows to equal the initial outlay

• Time needed to recover initial investment

• Decision rule: Compare the payback period to a standard value

• E.g., If standard value is 2 years, then a given project with a 3.5year payback period would be rejected.

• Projects with longer payback periods may have more risk andare generally less desirable


• An investment with an upfront cost of $55,000 will generate the following CFs at the end of the next 5 years: $16,000, $19,000, $18,000, $17,500, $17,500.

• What is the payback period?

Payback Period Example


Payback Method

Year Cash InflowCumulative Cash

Inflow

Unrecovered

Investment at Year

End

0 0 $55,000

1 $16,000 $16,000 $39,000

2 $19,000 $35,000 $20,000

3 $18,000 $53,000 $2,000

4 $17,500 $70,500 ─

5 $17,500 $88,000 ─

𝐏𝐚𝐲𝐛𝐚𝐜𝐤 𝐏𝐞𝐫𝐢𝐨𝐝 = 𝟑 𝐘𝐞𝐚𝐫𝐬$𝟐, 𝟎𝟎𝟎

$𝟏𝟕, 𝟓𝟎𝟎× 𝟏 𝐘𝐞𝐚𝐫 = 𝟑. 𝟏𝟏 𝐘𝐞𝐚𝐫𝐬


Weaknesses and Strengths of Payback Period

• Weaknesses• Does not account for the timing or risk of cash flows (i.e., no time value of

money adjustment)

• Does not account for cash flows that occur after payback

• Inherent bias against long-term investments

• Strengths• Simple and easy to apply, providing an efficient “screening” tool

• Provides a measure of project liquidity


Discounted Payback Method

YearCash Inflow

Discounted at 8%

Cumulative

Discounted

Cash Inflow

Unrecovered

Investment at Year

End

0 ─ 1.0 ─ ─ $55,000

1 $16,000 .926 $14,816 $14,816 $40,184

2 $19,000 .857 $16,283 $31,099 $23,901

3 $18,000 .794 $14,292 $45,391 $9,609

4 $17,500 .735 $12,863 $58,254 ─

5 $17,500 .681 $11,918 $70,172 ─

𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐏𝐚𝐲𝐛𝐚𝐜𝐤 𝐏𝐞𝐫𝐢𝐨𝐝 = 𝟑 𝐘𝐞𝐚𝐫𝐬$𝟗, 𝟔𝟎𝟗

$𝟏𝟐, 𝟖𝟔𝟑× 𝟏 𝐘𝐞𝐚𝐫 = 𝟑. 𝟕𝟓 𝐘𝐞𝐚𝐫𝐬


More on Discounted Payback Period

• Accounts for timing and risk of cash flows via adjustmentfor time value of money

• Still, it is a limited capital budgeting measure


Comparison of Analysis Methods

Net present value (NPV)

• Identifies cash flow for each year of the project.

• Computes PV of cash flow for each period.

• Add present values of cash flows.

• An acceptable NPV is greater than Zero.

Internal rate of return (IRR)

• Uses discounted cash flow.

• Discount rate at which the present value off all cash inflows equals the

present value of all cash outflows.

• Acceptable only if the IRR exceeds target rate of return or WACC.


Comparison of Analysis Methods

Payback and Discounted Payback

• Determines the time required for an organization to recover its original

investment through future cash flows.

• The longer the period required to recoup the original investment the less

certain the projected cash flows are.

• The payback method is a good screening tool .

• Does not consider what happens to cash flows after the break-even point.

Profitability Index

• Ratio of a project’s returns to the project’s required investment.

• If the ratio is greater than 1, the project is viable.


WACC

The capital budgeting metrics account for the opportunity cost of future cash inflows using the weighted average cost of capital (WACC)

• WACC = [WD*kD*(1-T)] + [WE*kE]

• kD = the annual cost of debt; best proxy is the yield to maturity (YTM) on the firm’s most recent bond issue

• kE = the cost of equity

• T = Marginal tax rate


• How to define the capital structure weights?

• Book values

• Market values

• My best guess: Book values

More on WACC


WACC Example from L.S.

CapitalCapital

Structure

Rate of

Return

Weighted

Cost of

Capital

Debt 40% 7% 2.8%

Equity 60% 5% 3.0%

5.8%


A firm is trying to determine the best capital structure, and the following options are available. Which capital structure will maximize the value of the firm’s cash flows?

a. 30% Debt; 70% Equity: Cost of Debt = 5%; Cost of Equity = 9%

b. 40% Debt; 60% Equity: Cost of Debt = 6%; Cost of Equity = 10%

c. 60% Debt; 40% Equity: Cost of Debt = 6.5%; Cost of Equity = 11%

d. 70% Debt; 30% Equity: Cost of Debt = 8.5%; Cost of Equity = 13%

More on WACC


From the Balance Sheet: Assets = $2,000,000 and Equity is $700,000

YTM on bonds = 7%

Cost of equity = 12%

Tax rate = 35%

What is the firm’s WACC?

More on WACC


• WACC = 7.16%

Answer


• Know the calculation and interpretation

• Be able to think through the qualitative implications

• What happens if the tax rate increases?

• If kD < kE, then why not 100% debt?

More on WACC

Documents

Session 2, Monday, April 8th (11:30-12:30) · the project’sexpected cash flows to equal the initial outlay • Time needed to recover initial investment • Decision rule: Compare