1. CAPITAL FINANCING AND ALLOCATION
CHAPTER 14
CAPITAL FINANCING AND ALLOCATION

2. CAPITAL BUDGETING
To produce goods and services, the first thing an entrepreneurial firm must do is obtain capital funds from investors and lenders

3. CAPITAL ALLOCATION
After obtaining funds, the entrepreneurial firm must invest these funds in equipment, tools and other resources

4. ADDITIONAL WEALTH
Revenues from the engineering and other capital projects must earn an adequate return on funds invested in terms of profit for a firm to achieve economic growth and be competitive in the future

5. CAPITAL FINANCING FUNCTION
Determines the amount of new funds needed from investors, lenders, and internal sources (I.e., depreciation and retained earnings) to support new capital projects
Decides on the sources of new externally acquired funds (I.e., issuing additional stock, selling bonds, obtaining loans, etc…)
This function also insures that the total amount of new funds and the ratio of debt to equity capital is commensurate with the financial status of the firm and balanced with the current and future capital investment requirements

6. CAPITAL ALLOCATION FUNCTION
Selects engineering projects for implementation based on constraints of total capital investment during capital financing considerations
Capital allocation activities begin in various company organizations --departments, operating divisions, research and development, etc…
During each capital budgeting cycle, these organizations plan, evaluate and recommend projects for funding and implementation

7. COMBINED SCOPE OF CAPITAL FINANCING AND ALLOCATION FUNCTIONS
Acquisition of financial resources
Establishment of minimum economic acceptability requirements
Identification and evaluation of capital Projects
Selection of projects for implementation
Postaudit reviews

8. SOURCES OF CAPITAL Debt Capital
Involves both short and long-term borrowing of funds
Interest must be paid to capital providers and the debt must be repaid by a specified time
Capital providers do not share in any profits resulting from capital use
Borrower may be required to pledge some type of security to ensure money will be repaid
Terms of loan may limit the use of borrowed funds
Terms may also restrict further borrowing
Loan interest is a tax-deductible expense for the firm

9. SOURCES OF CAPITAL Equity Capital
Supplied and used by owners in expectation of profit
No assurance that profit will be made or that investment capital will be recovered
No limitations placed on the use of funds
No explicit cost for use of such capital; therefore, not tax deductible for firm
Expected rate-of-return must be high enough, at an acceptable risk, to be attractive to potential investors

10. SOURCES OF CAPITAL Retained Earnings
Profits that are reinvested in the business instead of being paid as dividends to owners
Retention of some of company’s profits reduces the immediate amount of dividends per share, increases the book value of the stock, and results in greater future dividends and / or market resale value of the stock
While some investors expect more of the profit a company earns, many prefer to have some of the profits retained and reinvested to help increase the value of their stock

11. SOURCES OF CAPITAL Depreciation Reserves
Set aside out of revenue as an allowance for the replacement of equipment and other depreciable assets
Depreciation funds provide a revolving investment fund that may be used to the best possible advantage
A source of capital for financing new projects within existing firm, so long as required capital is available for replacing essential equipment as required

12. SOURCES OF CAPITAL Leasing
A way of acquiring use of an asset without capital expenditure for purchase
A form of contract that establishes conditions under which asset owner conveys use, and associated costs,of the asset to the lessee
A method of achieving benefits of capital investment witout actually acquiring additional debt ot equity capital
Leasing costs are tax deductible from operating income

13. COST OF DEBT CAPITAL
The debt part of the capital structure leverages the equity part by increasing the total funds available for capital projects and wealth of the firm
Proportion of debt capital, however, must be maintained below a level which would adversely affect the market value of the firm’s common stock
Varies by type of company

14. LOANS (SHORT-TERM DEBT)
Usually for periods less than five years and frequently for less than two years
Sources are banks, insurance companies, retirement systems, other lending institutions
Financial instrument – line of credit or short-term note – defines promise to repay, amount of borrowed funds, interest , some prearranged repayment schedule
Lending institution may require tangible value as security or the certainty that borrowers financial position presents minimal risk

15. LOANS (SHORT-TERM DEBT)
Assuming all interest payments and income taxes paid by firm are paid on annual basis, after-tax cost of capital
CL = iL(1 – t)
CL = after-tax cost of capital for a loan
iL = rate of interest per year paid on the loan
t = effective (marginal) income tax rate

16. BONDS (LONG-TERM DEBT)
A long-term note given to the lender by the borrower, stipulating the terms of repayment and other conditions
In return for the money loaned, the company promises to repay the loan (bond) and interest upon it at a specified rate
As long as interest is paid, bondholder has no voice in affairs of business and is not entitled to a share of profits
Face value or par value of a bond is the amount (I.e., $1,000, $10,000, etc… ) for which bond is issued
When face value is repaid, bond is retired or redeemed
Interest rate quoted on the bond is the bond rate
The periodic interest payment due is computed as the face value times the bond interest rate per period

17. BONDS (LONG-TERM DEBT)
Annual After-Tax Cost of Capital
[ Zr + (Z –P +Se) / N + Ae ] (1- t)
CB = (Z + P – Se) / 2
Z = face (par) value of bond
r = bond rate (nominal interest) per year
N = Number of years until bond is retired (redeemed)
Se = initial selling expense associated with the bond
P = Actual selling price of the bond) [if P<Z, the bond is sold at a discount (to par value), and if P>Z, the bond is sold at a premium]
Ae = annual administrative expenses associated with bond
t = effective (marginal) income tax rate

18. BONDS (LONG-TERM DEBT)
Annual After-Tax Cost of Capital
[ Zr + (Z –P +Se) / N + Ae ] (1- t)
CB = (Z + P – Se) / 2
Numerator is the after-tax cost of the bond based on the annual interest expenses plus annualized amount (over the life of the bond) of any discount or premium and initial selling expenses plus the annual administrative expenses
Denominator is the average investment in the bond over its life

19. BOND RETIREMENT
A systematic program for repayment of a bond issue when it becomes due gives assurance to bondholders and makes bonds more attractive to the public
To do this a company periodically sets aside definite sums, that with interest, will accumulate to the amount needed to retire the bonds when they are due
A sinking fund is most typically used for this procedure

20. CORPORATION
A corporation is a fictitious being, recognized by law, that can pursue almost any type business transaction that a real person can .
It operates under a state-granted charter which allow certain rights and privileges, and is subject to certain restrictions.
Special taxes may be assessed against it.

21. COST OF EQUITY CAPITAL
Equity capital for a corporation is acquired through the sale of stock.
Purchasers of the stock are part owners, usually called stockholders, of the corporation.
Although stockholders are entitled to a share of the profits, they are typically not liable for the debts of the corporation.
Stockholders are never compelled to suffer any loss beyond the value of their stock.
The continuous or indefinite corporation life is conducive to long-term investments and a degree of certainty
This makes debt capital easier to obtain, and at a lower interest cost

22. COMMON STOCK
Primary source of equity capital used to finance a corporation’s capital projects
The value of common stock must be a measure of the earnings received and on factors related to dividends and market price

23. DIVIDEND VALUATION MODEL
A simple approach for the valuation of common stock and the estimation of per share rate of return expected by the investor
The current value of a share of common stock can be approximated by the PW of future cash receipts during an N-year ownership period
Div1 Div DivN PN
P0 ~ (1 + ea) + (1 + ea)2 + … + (1 + ea)N + (1 +ea)N
ea = rate of return per year required by common stockholders
P0 = current value of a share of common stock
PN = selling price of a share of common stock at the end of N years
Divk = After-tax value of cash dividends received during year k

24. DIVIDEND VALUATION MODEL
Incorporates two conservative assumptions:
dividends are constant over the long term
P0 = PN
In this case, current price of a share of common stock equals PW of an assumed indefinite series of dividend receipts that remain constant
P0 = Div (P / A, ea,  ) = Div / ea

25. AFTER-TAX COST OF EQUITY
Given: P0 = selling price of a share of common stock
Div = annual dividend for past year
ea = Div / P0
If future price of security is expected to grow at a rate of ‘g’ each year
ea = Div / P0 + g

26. PREFERRED STOCK
Represents ownership with additional privileges and restrictions not assigned to a holder of common stock
Preferred stockholders guaranteed a dividend on their stock, usually a percentage of par value, before common stockholders receive any return
If corporation is dissolved, assets must be used to satisfy claims of preferred stockholders before holders of common stock
Preferred stockholders usually have voting rights
Because the dividend rate is fixed, preferred stock is a more conservative investment than common stock, and has many features of long-term bonds

27. PREFERRED STOCK
Because dividend rate is fixed, market value is les likely to fluctuate
After-tax cost of capital for preferred stock (ep) can be approximated by dividing guaranteed dividend (Divp -- paid out after tax earnings) by the original par value of the stock (Pp)
ep = Divp / Pp

28. RETAINED EARNINGS Normally assumed to be the same as for common stock
These earnings are equity funds that are retained and reinvested for future growth and increasing stockholder wealth

29. WEIGHTED-AVERAGE COST OF CAPITAL
A Weighted-Average Cost of Capital (WACC) for a firm can be determined once the amount and explicit cost is established for each debt and equity component in the capital structure
This includes short-term debt, bond, common stock, and preferred stock components
Retained earnings are also included; the cost of these funds should be the same as cost of common stock

30. WEIGHTED-AVERAGE COST OF CAPITAL
Depreciation funds (reserves), another source of internal funds for investment, are not included in the weighted average cost of capital calculation.
These funds are are assumed to replace the need for additional debt and equity capital in the same proportions as the present capital structure, and have an opportunity cost equal to the weighted average cost of capital.

31. WACC TO MARR RELATIONSHIP
If MARR were assumed less than WACC implementing the project would result in a decrease in the value of the firm:
There would be no surplus earned above the cost of capital invested in the project
project would impact negatively on wealth of firm
WACC should be minimum value used for MARR

32. WACC TO MARR RELATIONSHIP
If MARR were assumed greater than WACC
Then best economic measure of equivalent current value that would be added to the firm by the project remains the PW value calculated at i = WACC.
Regardless of MARR, WACC is important and should be available for decision making.

33. LEASING AS A SOURCE OF CAPITAL
Leasing is a business arrangement that makes assets available without initial capital investment costs of purchase
Leasing is a source of capital generally regarded as a long-term liability, similar to a mortgage
For corporations, rent paid on leased assets used in business is generally deductible as a business expense
Studies have shown no real income tax advantage in leasing
There may or may not be savings in maintenance expenses through leasing, but simplifies maintenance problems
True advantage in leasing is in allowing a firm to obtain modern equipment that is subject to rapid technological change -- a hedge against inflation and obsolescence

34. COST OF THE LEASE ALTERNATIVE
Ik = Lk ( 1 - t )
Ik = after-tax lease expense during year k
Lk = before-tax lease expense during year k
t = effective income-tax rate
If i, the after-tax MARR is known and fixed, PW of the after-tax cost of the lease during a life of N years is
PWLease (i%) =Sk=1N[Lk (1 - t ) / ( 1 + i )k
Annual lease costs are borne by equipment supplier

35. COST OF PURCHASE ALTERNATIVE
After-tax cost of equipment when purchased is a function of
expected annual expenses during life of equipment
purchase price
book value
and expected market value

36. COST OF PURCHASE ALTERNATIVE
MVN( 1 - t ) + tBV O&Mk( 1 - t ) - dk(t)
PWBuy(i%) = 1- ( 1 - I )N Sk=1N ( 1 + i )k
I = capital investment
MV = expected market value at the end of year N
BVN = book value at the end of year N
i = interest rate per year
N = life of equipment in years
O&Mk = operating and maintenance expense during year k
t = effective income tax rate
dk = depreciation during year k
Note that market value, book value and depreciation amounts are negative because they reduce costs

37. LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS
Linear programming is a mathematical procedure for maximizing ( or minimizing) a linear objective function, subject to one or more linear constraint equations
A useful technique for solving certain multi-period capital allocation problems when a firm is not able to implement all projects that may increase PW.
Maximize net PW = Sj = 1mBj*Xj
Bj* = net PW of investment opportunity (project) j during the planning period being considered
Xj = fraction of project j that is implemented during the planning period (Note Xj will normally be ‘0’ or ‘1’)
m = number of mutually exclusive combinations of projects under consideration

38. LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS
In computing the net PW of each mutually exclusive combination of projects, a MARR must be specified
Notation used in writing constraints for linear programming
ckj = cash outlay (e.g., initial capital investment or annual operating budget) required for project j in time period k
Ck = maximum cash outlay that is permissible in time period k

39. LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS
Two types of constraints in capital budgeting problems
1. Limitations on cash outlays for period k of planning horizon
Sj=1m ckXj < Ck

40. LINEAR PROGRAMMING FORMULATIONS OF CAPITAL ALLOCATION PROBLEMS
Two types of constraints in capital budgeting problems
2. Interrelationships among projects:
a. If projects p,q and r are mutually exclusive
Xp + Xq + Xr < 1
b. If project r can be undertaken only if project s has already been selected
Xr < Xs or Xr - Xs < 0
c. If projects u and v are mutually exclusive and project r is dependent (contingent) on acceptance of u and v
xu + xv < 1
and
xr < xu + xv

41. CAPITAL BUDGETING PROCESS OVERVIEW
Preliminary planning and cost of capital
Annual capital budget and proposed project portfolio
Capital expenditure policies and evaluation procedure
Project implementation and postaudit review
Communication