1. --Managing Capital for Investment, Financing and Operation
Corporate Financial Management --Capital Budgeting, Cost of Capital & Firm Valuation
--Managing Capital for Investment, Financing and Operation
By Dr. Xueping Wu City University of Hong Kong April

2. 1. Capital Budgeting A firm has existing and future projects
Good managers maintain and launch good projects
What are good projects?
A project provides a stream of future cash flows
We need the knowledge of finance to shift cash flows across time
 Discounted cash flows=Present value for today’s decision making
 “Good” projects = high present values

3. Project Selection Rules
Net Present Value
Payback Period
Discounted Payback Period
The Internal Rate of Return
The Profitability Index

4. The Net Present Value (NPV) Rule
=Total PV of future cash flows - Initial Investment
Estimating NPV (three components):
(1) Estimate future cash flows
(2) Estimate discount rate
(3) Estimate initial costs (investment)
NPV>0
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV

5. Example  Accept the project because NPV>0. 1 2 3 $50 $100 $1501 2 3
$50
$100
$150
-$200 (Investment)
 Accept the project because NPV>0.

6. The Payback Period Rule
How long does it take the project to “pay back” its initial investment?
Payback Period = number of years to recover initial investment
Minimum Acceptance Criteria is set by management
Ranking Criteria is also set by management
Example: Initial Investment=$200
Project A: Project B:
CF(Year 1)=$50 CF(Year 1)=$50;
CF(Year2)=$150 CF(Year2)=$100;
CF(Year3)=$100 CF(Year 3)=$250
Payback Period (A) Payback Period (B)
= 2 Years =2 + ( )/250 = 2.2 Years

7. The Discounted Payback Period Rule
How long does it take the project to “pay back” its initial investment taking the time value of money into account?
Example: Initial Investment=$200, cost of capital=15%
Project A: Project B:
PV(50)=50/1.15= PV(50)=50/1.15=43.48
PV(150)=150/1.152= PV(100)=100/1.152=75.61
PV(100)=100/1.153= PV(250)=250/1.153=164.38
Total PV(A)=$ Total PV(A)=$283.47
Discounted Payback Period (A) Discounted Payback Period (B)
=2+( )/65.75 =2+ ( )/131.50
=2.66 years =2.49 years
 Time value of money matters!

8. The Internal Rate of Return (IRR) Rule
IRR: the special discount rate that sets NPV to zero
Minimum Acceptance Criteria: Accept if the IRR exceeds the required return.
Ranking Criteria: Select alternative with the highest IRR
Example: 1 2 3
$50
$100
$150
-$200
The IRR for this project is 19.44%

9. The Profitability Index (PI) Rule
PI=PV(all future cash flows) divided by initial investment
Minimum Acceptance Criteria: Accept if PI > 1
Ranking Criteria: Select alternative with highest PI
Example: Initial Investment=$200
Project A: PV=$222.65, so PI=222.65/200=1.11
Project B: PV=$283.47, so PI=283.47/200=1.42

10. Work Sheet for Cash Flows (CF)
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales (Revenues)
$100.0
$163.00
$249.72
$212.20
$129.90
(2) Operating costs
-50.00
-88.00
133.10
-87.84
(3) Taxes
-10.20
-14.69
-29.01
-22.98
-10.38
(4) Operating CF
(1) – (2) – (3)
39.80
60.51
75.51
56.12
31.68
(5) Investments
–260.
–6.32
–8.65
3.75
192.98
(6) CF
[(4) + (5)]
–260.
39.80
54.19
66.86
59.87
224.66 05 .
588 , 51 $ ) 10 1 ( 66
224 87 59 86 19 54 80 39
260 5 4 3 2 = + -
NPV

11. 2. Cost of Capital
Capital = Debt + Equity (or actually all financing means including convertible bonds and warrants)
Cost of Debt=Interest Rate(s)
Debt-rating (S&P: AAA, AA, …, BBB,… Junk..)
Cost of Equity=Required rate of return
Capital Structure (mix of financing means)
WACC=Weighted Average of Cost of Capital

12. Average Return and Risk
Average Returns and Standard Deviation for Equities, Bonds, and Bills in the US., 1900 – 2006 (over 106 yrs)
 Asset classes with greater volatility (std. Dev.) pay higher average returns.
 Average return on stocks is more than double the average return on bonds, but stocks are 2.5 times more volatile.

13. Historical Returns,
Average Standard Series Annual Return Deviation Distribution
Large Company Stocks 12.3% 20.0%
Small Company Stocks
Long-Term Corporate Bonds
Long-Term Government Bonds
U.S. Treasury Bills
Inflation 0%
– 90%
+ 90%
Source: © Stocks, Bonds, Bills, and Inflation 2008 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

14. Cost of Equity Tradeoff between risk and return for stocks
Diversification through holding a portfolio
Intuition: Don’t put all eggs in one basket!
Total Risk vs. Priced Risk
Expected return = required rate of return
Capital Asset Pricing Model (CAPM)
 High risk, high (required) return

15. Diversification and Beta Risk
Total risk = Systematic Risk + Unique Risk
Unique risk can be diversified away in a portfolio
Systematic risk arises from the whole economy.
You should not pay any risk premium for unique risk because it will offset itself automatically in a group of different firms (portfolio)
Systematic risk is priced but unique risk isn’t.
Beta risk (b) measures systematic risk or a firm’s return sensitivity to the market return over time.
bi=Cov (rm,ri)/Var(rm)

16. Capital Asset Pricing Model
CAPM: E(ri)=rf+[E(rm)-rf] bi for firm i (any firm)
Example: Firm A: 20%=2%+[15%-2%]x1.385
Firm B: 10%=2%+[15%-2%]x0.615

17. Capital Budgeting & Project Risk
Project IRR
Beta risk rf
bFIRM
Incorrectly rejected positive NPV projects
Incorrectly accepted negative NPV projects
Hurdle rate
Various projects can have different levels of beta risk
A firm that relies on one hurdle rate (discount rate) for all projects may risk over- and under-rejection of projects!

18. Capital Structure The Miller-Modigliani (MM) Theorem
 The value of a pizza remains the same no matter how you slice the pizza.
 In a frictionless market, firm value depends on the quality of projects but not on how to finance the projects (e.g., a specific mix of debt & equity).
But in imperfect markets, how to finance matters in mitigating market imperfection
 Firm-specific, optimal capital structure
Example: Hi-tech firms: a lot of equity financing
Utility firms: a lot of debt financing

19. Cost of Capital with Debt and Equity
The firm as a whole is called the firm’s assets.
The value of the firm as a whole is the value of both stock (S) and debt or bonds (B).
The Weighted Average Cost of Capital (WACC) is given by:
Example: equity=$60, debt=$40 (So firm value=$100)
Required stock return=20%, BBB-rating bond yield=10%
WACC=0.6x20%+0.4x10%=16%
Can you lower WACC? Leverage affects risk and return!

20. Risk and the Income Statement
Sales
Operating – Variable costs
Leverage – Fixed costs
EBIT
– Interest expense
Financial Earnings before taxes
Leverage – Taxes
Net Income

21. Business Risk
The basic risk inherent in the operations of a firm is called business risk
Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)

22. Financial Risk
Debt causes financial risk because it imposes a fixed cost in the form of interest payments.
The use of debt financing is referred to as financial leverage.
Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.

23. Business Risk and Financial Riskβ
β= 1
βA = β 1
B/S
E(r)
E(rm) rf
E(rS)
E(rA) - rf
E(rA)
E(rS) - E(rA)
Unlevered
A risk profile of a company:
Equity risk  equity β – sensitivity to rm
Financial risk  related to leverage (B/S)
Business risk  economic activity, asset b
 Equity risk reflects the business risk as well as the financial risk  Equity β ≠ Asset β when B/S > 0

24. Market Imperfection (Frictions)
Tax Distortion
Transaction costs
Agency problems
e.g., bond holders versus equity holders
mangers versus equity holders
Controlling versus small investors
Asymmetric information problem
e.g., adverse selection effect

25. Optimal Capital Structure (a Tradeoff Model)
Present value of tax shield
Value if 100% equity financed V
(Market Value)
Debt/Equity Ratio
Optimal debt/equity ratio
Value of company
Present value of financial distress costs
Value of the “Levered” company =
Value of the company when completely equity financed + Present value of the tax advantage for debt
- Present value of financial distress costs

26. Minimal WACC
Cost of Equity
WACC
Cost of debt
Debt Ratio
Cost of Capital ( % )
Optimal debt ratio
Minimal WACC
Cost of equity increases because of financial risk increase
Cost of debt increases because of default risk increase
Cost of capital (WACC) is the lowest at the optimal capital structure

27. WACC Estimates for Some Large U. S. Corporations
Company
WACC
wd=B/(S+B)
Intel (INTC)
16.0
2.0%
Dell Computer (DELL)
12.5
9.1%
BellSouth (BLS)
10.3
39.8%
Wal-Mart (WMT)
8.8
33.3%
Walt Disney (DIS)
8.7
35.5%
Coca-Cola (KO)
6.9
33.8%
H.J. Heinz (HNZ)
6.5
74.9%
Georgia-Pacific (GP)
5.9
69.9%

28. Adjusted Present Value Approach in Capital Budgeting
APV = NPV + NPVF
The value of a project to the firm can be thought of as the value of the project to an unlevered firm (NPV) plus the present value of the financing side effects (NPVF).
There are four side effects of financing:
(1) The Tax Subsidy to Debt
(2) The Costs (or Benefits) of Issuing New Securities
(3) The Costs of Financial Distress
(4) Government Subsidies to Bank Financing

29. APV Example
Consider a project of the Pearson Company. The timing and size of the incremental after-tax cash flows for an all-equity firm are:
–$1,000 $ $ $ $500
The unlevered cost of equity is r0 = 10%:
The project would be rejected by an all-equity firm: NPV < 0.

30. APV = NPV + NPV debt tax shield
APV Example, cont’d
Now, imagine that the firm finances the project with $600 (=B) of debt at rB = 8%.
Pearson’s tax rate is 40% (=tc), so they have an interest tax shield worth tcBrB = .40×$600×.08 = $19.20 each year.
The net present value of the project under leverage is:
APV = NPV + NPV debt tax shield
Note, the example in the text assumes a perpetual project, so the PV of the tax shield is calculated assuming a perpetuity. The approach in this slide is comparable, but for a finite life project.
So, Pearson should accept the project with debt.

31. 3. Growth and Firm Valuation
Investments, growth and firm value
Suppose X = EBIT of current activities (perpetuity)
I(t) = Investment at time t
r* = Return on investment (firm specific)
r = Required Rate of Return (from capital market)

32. Assets-in-Place (AIP) and Investment
(1) Present value of AIP: X/r
NPV(t) of future investment: r*I(t)/r-I(t)
(2) NPV(0) of future investment:
Total Firm Value=(1)+(2)

33. Growth Opportunities
Assume a series of investment I(t) for t=1, 2,…, N, then Total Firm Value becomes:
AIP Value + NPV of GO (very noisy!)
If r*>r, V0>X/r Growth Firm
r*=r, V0=X/r Expanding Firm
r*<0, V0<X/r Shrinking Firm

34. P/E Ratio and Growth If r*>r, P/E>1/r Growth Firm
r*=r, P/E=1/r Expanding Firm
r*<0, P/E<1/r Shrinking Firm
(Negative growth firm)
Get high r*, then the firm can grow!
P/E ratio in the market has the information!

35. Investment Return (r*) and Growth Rate
FX swap contract contains multi-period forward transactions but with one forward price