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Compounding You Lend me Rs.2,00,000 @ 10% p.a. for 2 years, how much do I return? Discounting You need Rs.2,00,000 at the end of 2 years from now. 2 year Term deposit rates are 8% p.a. How much do you deposit? Amortizing Loans You need Rs.2,00,000 to purchase a motorbike. SBI offers you auto loan @ 10% rate, 5 Equated Annual Installments. What is the EAI? Non-Amortizing Loans (Bullet Payments) Bonds
t=1
X
t=2
X
t=3
X
t=4
X
t=5
X
Year 1
Principal 200000
EAI 52759
2
3 4 5
167241
131205 91566 47963
52759
52759 52759 52759
16724
13121 9157 4796
36035
39639 43603 47963
131205
91566 47963 0
Types of Projects Expansion Projects Replacement Projects New Product Development Mandatory Projects Other Projects
5 key Principles of Capital Budgeting 1. Cash flows only, not accounting income 2. Cash flows are based on opportunity costs 3. Cash flows should be timed properly 4. Cash flows are always after-tax 5. Financing costs are reflected in required rate of return
Independent Projects Project decisions are unrelated to each other Mutually Exclusive Projects Only one of the projects can be done Capital Rationing Firm should maximize shareholder value with the limited capital available
1 2
3 4
1000 800
600 200
-1000 -200
400 600
200 600
800 1200
-1800 -1200
-400 800
Payback Period of A = 2 + (200/600) = 2.33 years Payback Period of B = 3 + (400/1200) = 3.33 years
NPV assumes cash flows are re-invested at the cost of capital NPV does not take project size into consideration Multiple IRR / No IRR arise when sign of cash flows change more than once Each method has its advantages and disadvantages
When faced with a conflict between NPV and IRR, always go with NPV
European firms prefer PBP and DPBP methods Larger firms prefer NPV and IRR methods Public firms prefer NPV & IRR. Private firms prefer PBP Firms run by MBAs and CFAs prefer NPV and IRR
A firms capital has 3 main components Common Equity Preferred Equity Debt Weighted Average Cost of Capital (WACC) is:
WACC
Cost of Preferred Equity Kpe is given by preferred dividend CMP of preferred equity Cost of Equity 3 methods CAPM Method DDM Method Bond yield plus risk premium approach
What is Beta measures the systematic risk of a stock Beta formula = covariance (stock, market)
variance (market)
CRP = sovereign yield spread * (annualized sd of equity index / annualized sd of sovereign bond market in terms of developed market currency
Marginal Cost of Capital shows the WACC for different amounts of financing Break Point = amt. of capital at which components cost of capital changes
weight of the component in the capital structure
Include floatation costs in the numerator, never along with the discount rate
Degree of Operating Leverage - % change in operating income for a given % change in sales DOL = (change in EBIT / EBIT) / (change in sales / sales) DOL = Q*(P-V) / Q*(P-V) F Degree of Financial Leverage - % change in EPS for a given % change in EBIT DFL = EBIT / EBIT Interest Degree of Total Leverage = DOL * DFL