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Don Mariano Marcos Memorial State University College of Graduate Studies
Don Mariano Marcos Memorial State University College of Graduate Studies
Objective:
To analyze short-term alternatives when the time value of money is not a factor.
Introduction:
of current capital funds to obtain future economic benefits or to meet safety, regulatory,
well-managed company, as part of a capital budgeting process. The capital financing and
Contents:
Debt Capital
Equity Capital
Project Selection
Postmortem Review
Budgeting of Capital Investments and Management Perspective
Leasing Decisions
Capital Allocation
Capital financing and allocation functions are primary components of capital budgeting.
• Capital financing determines funds needed from investors and vendors—in the
form of additional stock, bonds, loans—and funds available from internal sources.
• Capital allocation is where the competing engineering projects are selected. The
• In summary, these decisions are how much and where financial resources are
Debt Capital
Debt capital represents borrowed money.
• Companies can borrow money from lenders (e.g. banks) or can issue bonds or
debentures.
• Creditors get interest, bondholders get dividends and face value at maturity.
• The cost of bond financing depends on the bond rating, which is dependent on the
• Investors have a risk-free alternative of U.S. government treasure bills. This risk-
Interest paid on corporate debt is tax deductible. This savings can be handled in two
different ways.
• Interest can be deducted each year before taxes are computed. This approach
specific project.
• The most commonly used is to modify the MARR to account for the tax
• The percentage cost of equity funds, ea, can be estimated in many ways, perhaps
the best of which is using the capital asset pricing model (CAPM).
The CAPM asserts that the best combinations of risk and return lie along the security
The CAPM reveals that the return, RS, on any stock depends on its risk relative to the
A company has a beta value of 2.4, with no long term debt. If the market premium is
8.4%, and the risk-free rate is 2%, what is the company’s cost of equity?
The Weighted Average Cost of Capital (WACC) represents the average cost of all funds
In the first fiscal quarter of 2009 Dell Computer showed total debt of $1.98mil and total
equity of $3.55mil. Assume Dell’s beta is 2.2, the cost of debt is 7%, and Dell’s effective
• If risks are roughly normal, the WACC is an appropriate hurdle rate (i.e., MARR).
• WACC is a floor on the MARR, which should be increased to reflect more risk.
• Management may choose to set the MARR based on many factors, such as
• Prospective projects (of similar risk) are ranked in order of profitability. The cut-
off point falls such that the capital is used on the better (more profitable) projects.
• Firms may set two or more MARR levels, analyzing within particular risk
categories.
Selecting projects that are not mutually exclusive has multiple considerations.
• Those projects that are most profitable should be selected, allowing for
– risk considerations
– availability of capital
Investment proposals can be classified in any number of different ways, some of which
• Tactical or strategic
proposal.
outcomes.
these results.
Leasing Decisions
• Leases allow the firm to use available capital for other uses.
• Leases are legal obligations very similar to debt, reducing the ability to attract
• One should not compare only lease and buy, but also the status quo (do nothing),
One way to allocate capital among independent projects is to create MEAs from the set of
• Enumerate all feasible combinations (those that meet any budget constraints).
• The acceptance of the best MEA will specify those projects in which to invest.
• The corporate strategic plan may favor one part of the company over another for
investment.
Capital Allocation
a linear function subject to one or more linear constraints. We will present the
formulation of problems, but not the solution, which is beyond our scope.
Consider these four independent projects and determine the best allocation of capital
Solution:
After eliminating those combinations that violate the $300,000 funds constraint (labeled
as not feasible), the proper selection of projects would be ABD, and the maximum PW is
$95,000.