Corporate finance theory

Capital budgeting

• “Capital budgeting is a long-term planning for making and financing

proposed capital outlay” - Charles T. Horngreen.

• Capital budgeting is the process of evaluating and selecting long-term

investments that are consistent with the goal of shareholder’s wealth
maximization

• It is the process of investing a sum of money when the expected

benefits/results flow in after a lapse of the time period of more than one
year

• Investment decisions of a firm are generally known as capital budgeting

Objectives of capital budgeting:

1. Selecting profitable projects: An organization comes across various
profitable projects frequently. But due to capital restrictions, an
organization needs to select the right mix of profitable projects that will
increase its shareholders’ wealth.

2. Capital expenditure control: Selecting the most profitable investment is

the main objective of capital budgeting. However, controlling capital
costs is also an important objective. Forecasting capital expenditure
requirements and budgeting for it, and ensuring no investment
opportunities are lost is the crux of budgeting.

3. Finding the right sources of funds: Determining the quantum of funds

and the sources for procuring them is another important objective of
capital budgeting. Finding the balance between the cost of borrowing
and returns on investment is an important goal of Capital Budgeting.

Capital Budgeting process:

1. Project identification and generation: The first step is to generate a

proposal for investments. There could be various reasons for taking up
 investments in a business.

2. Project screening and evaluation: This step involves selecting the right
criteria to judge the desirability of a proposal. Time value of money
comes handy in this step.

3. Project selection: After the screening and evaluation, the right proposal
is selected. However, there is no right method to select the proposal of
an investment as different business have different methods.

4. Implementation: After the final selection has been made, the firm must
acquire the necessary funds, purchase the asset and begin the
implementation of the project.

5. Performance review: The final stage of the capital budgeting process

involves comparing the actual results with the standard ones. The
organization must review its project to explain its success or failure.

SIGNIFICANCE OF CAPITAL BUDGETING

• Capital budgeting is an essential tool in financial management

• Capital budgeting provides a wide scope for financial managers to
evaluate different projects in terms of their viability to be taken up for
investments
• It helps in exposing the risk and uncertainty of different projects
• It helps in keeping a check on over or under investments
• The management is provided with effective control on cost of capital
expenditure projects
• Ultimately the fate of a business is decided on how optimally the
available resources are used

Methods of capital budgeting

I. Traditional/Non discounted cash flow methods

1. Payback period: It refers to the method by which the proposal will

generate cash to recover the initial investment made. It purely
 emphasizes on the cash inflows, economic life of the project and the
investment made in the project, with no consideration to time value of
money.

Advantages

1. It is easy to understand and simple to operate.

2. It is suitable if there is a fear of the project being obsolete in short period of time.
3. It is suitable for industries where rapid technological changes take place.
4. Easy to liquidate
5. Helps deal with short-term effects

Limitations

1. Ignores the interest factor which is important while making investment decisions
2. It is inconsistent with the shareholder wealth maximisation value
3. Cash flows are ignored
4. Cash flow patterns are ignored

Accounting rate of return: Accounting Rate of Return (ARR) is the average net
income an asset is expected to generate divided by its average investment,
expressed as an annual percentage. This formula is used to make capital
budgeting decisions.

- These typically include situations where companies are deciding on

whether or not to proceed with a specific investment (a project, an
acquisition, etc.) based on the future net earnings expected compared to
the capital cost. Ignores the time value of money and does not consider
the life of the project.

Advantages

1. It is easy to understand and simple to operate.

2. It takes into account the earnings of the project over the entire period of its economic
life
3. It recognizes the concept of net earnings

Limitations

1. The time value of money and interest factor is ignored

2. Cash flows are ignored

II. Discounted cash flow methods

(calculates cash inflow and outflow through the life of an asset) This
 technique takes into account the interest factor and the return after
payback period

1. Net Present Value: This is one of the most common methods for
evaluating capital investment proposals. It is the difference between
present value of cash inflows and the present value of cash outflows.

2. Internal rate of return: This is defined as the rate at which the net
present value of the investment is zero. This method considers the time
value of money. It tries to arrive at a rate of interest at which funds
invested in the project could be repaid out of cash inflows.

3. Profitability index: It is the ratio of the present value of cash inflows at

the required rate of return to the intial cash outlay or outflow of
investment.

 The modified internal rate of return (MIRR) is the compound average

annual rate that is calculated with a reinvestment rate different than the
project’s IRR.

Time value of money

 Time preference for money is an individual’s preference for possession
of a given amount of money now, rather than the same amount at some
future time.
 Three reasons may be attributed to the individual’s time preference for
money:
 risk / uncertainty
 inflation
 preference for consumption
 investment opportunities

Interest rate.
 This rate will be positive even in the absence of any risk. It may be
therefore called the risk-free rate.
 An investor requires compensation for assuming risk, which is called risk
premium.
  The investor’s required rate of return is:
 Risk-free rate + Risk premium

 Two most common methods of adjusting cash flows for time value of
money:
◼ Compounding—the process of calculating future values of cash
flows and
◼ Discounting—the process of calculating present values of cash
flows.

Compound interest is the interest received on the principal amount as well as

on any interest earned but not withdrawn during earlier periods.

Simple interest is the interest only applied to the principal amount and thus no
compounding of interest takes place.

 Corporate finance refers to efficient acquisition of finance, efficient

utilization of finance and efficient distribution and disposal of surplus for
smooth working of the company.

Financial goals of a firm:

 Profit maximization (profit after tax)
 Maximizing Earnings per Share
 Shareholder’s Wealth Maximization

Modern vs traditional financial manager

 The traditional financial manager was generally involved in – banking
operations, record keeping, management of the cash flow on a regular
basis and informing the funds requirement to the top management,
etc.
 Modern financial manager – raising of funds, allocation of funds, profit
planning and understanding capital markets.
  Reason for placing the finance functions in the hands of top
management
◼ Financial decisions are crucial for the survival of the firm.
◼ The financial actions determine solvency of the firm
◼ Centralisation of the finance functions can result in a number of
economies to the firm.

Concept of agency and agency problem

 Within corporate finance, the agency problem is considered as the
conflict of interest between the company’s managers and its
stockholders.

 This conflict occurs when personal interests are given priority over the
professional duties each party needs to fulfill.

 The core of the conflict is that managers want higher compensation,

and shareholders want higher profits.

 A secondary conflict is that managers want to re-invest profits in the

business, while shareholders may prefer more dividends paid out.

 The agency problem is often used as a basis of judgment regarding the

working relationship between individuals who play an essential role in
a company’s operations.

 It is considered highly unethical by many as it involves exploiting the

interests of others for personal benefits.

 As a company officer or representative, you may be tempted to increase

your share prices to raise the company value. It is unethical, but many
companies do it through miscalculations in reports.

 Your shareholders invest more capital into the company, expecting a

greater return to make more money.

 This conflict of interest takes away the transparency that is required in

maintaining the principal-agent relationship.
 Capital structure

It refers to the proportion of debt and equity used for financing the
operations of the business.

The capital structure of a firm should be such that it maximises the

wealth of equity shareholders.

how much capital is issued from debt and how much is issued from equity.

Debt and equity differ in cost and risk

In terms of cost, debt is suitable and it requires less charges.

In terms of risk, debt has more risk (from company’s perpective) creates a fixed
obligation.

No fixed obligation in equity.

Optimal capital structure – a perfect mix of debt and equity financing while
minimising costs and maximizing the value of the firm.

Cost of capital decreases, then value of the firm increases.

Capital structure theories:

1. Net income approach:

 According to the NI approach, both the cost of debt and the cost of
equity are independent of the capital structure.

 They remain constant regardless of how much debt the firm uses.

 As a result, the overall cost of capital declines, and the firm value
increases with debt.

 This approach has no basis in reality; the optimum capital structure

would be 100 percent debt financing under NI approach.
2. Traditional approach:
 The traditional approach argues that a moderate degree of debt
can lower the firm’s overall cost of capital and thereby, increase
the firm value.

 The initial increase in the cost of equity is more than offset by the
lower cost of debt.

 But as debt increases, shareholders perceive higher risk and the

cost of equity rises until a point is reached at which the
advantage of lower cost of debt is more than offset by more
expensive equity.

Cost

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Debt

Criticisms:
 The contention of the traditional theory, that moderate amount of debt
in ‘sound’ firms does not really add very much to the ‘riskiness’ of the
shares, is not defensible.
 There does not exist sufficient justification for the assumption that
investors’ perception about risk of leverage is different at different levels
of leverage.
 3. Net operating income approach,
 According to NOI approach the value of the firm and the weighted
average cost of capital are independent of the firm’s capital structure.

 In the absence of taxes, an individual holding all the debt and equity
securities will receive the same cash flows regardless of the capital
structure and therefore, value of the company is the same.

SOURCES OF LONG-TERM FINANCE