Capital

Financing &
Allocation
CAPITAL BUDGETING
To produce goods and services, the first thing an
entrepreneurial firm must do is obtain capital
funds from investors and lenders. Armstrong
CAPITAL ALLOCATION
After obtaining funds, the entrepreneurial firm
must invest these funds in equipment, tools and
other resources.
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
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…).
CAPITAL FINANCING FUNCTION
•This function also ensures 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.
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.
CAPITAL ALLOCATION FUNCTION

•During each capital budgeting cycle, these

organizations plan, evaluate and recommend
projects for funding and implementation.
COMBINED SCOPE OF CAPITAL FINANCING AND
ALLOCATION FUNCTIONS

1. Acquisition of financial resources

2. Establishment of minimum economic acceptability
requirements
3. Identification and evaluation of capital Projects
4. Selection of projects for implementation
5. Post-audit reviews
SOURCES OF CAPITAL
1. 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
SOURCES OF CAPITAL
1. Debt Capital

•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
SOURCES OF CAPITAL
2. 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
SOURCES OF CAPITAL
2. Equity Capital

•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
SOURCES OF CAPITAL
3. 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
SOURCES OF CAPITAL
3. Retained Earnings

•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
SOURCES OF CAPITAL
4. 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
SOURCES OF CAPITAL
5. 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 lease
SOURCES OF CAPITAL
5. Leasing

•A method of achieving benefits of capital investment

without actually acquiring additional debt to equity capital
•Leasing costs are tax deductible from operating income
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
Loans- Short Term Debts
•Usually for periods less than five years and
frequently for less than two years
•Sources are banks, insurance companies, retirement
systems, other lending institutions
Loans- Short Term Debts
•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
Loans- Short Term Debts
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
Bond- 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
Bond- Long Term Debt
•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
Bond- Long Term Debt
Annual After-Tax Cost of Capital
CB = [ Zr + (Z –P +Se) / N + Ae ] (1- t)
(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)
Bond- Long Term Debt
•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
Bond- Long Term Debt

Annual After-Tax Cost of Capital

CB = [ Zr + (Z –P +Se) / N + Ae ] (1- t)
(Z + P – Se) / 2
Bond- Long Term Debt
•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
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
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
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
Cost of Equity Capital
•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
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
Dividend Evaluation 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
Dividend Evaluation Model
•ea = rate of return per year required by common stockholders
•Po = 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
Dividend Evaluation Model
Incorporates two conservative assumptions:
• dividends are constant over the long term
• Po = P N
•In this case, current price of a share of common stock equals PW
of an assumed indefinite series of dividend receipts that remain
constant
Po = Div (P / A, ea, ꝏ ) = Div / ea
After Tax Cost of Equity
Given: Po = selling price of a share of common stock
Div = annual dividend for past year
ea = Div / Po
If future price of security is expected to grow at a rate of ‘g’ each
year
ea = Div / Po + g
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 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
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
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
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
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 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
WCC 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
WCC 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
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
Leasing as a Source of Capital
•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
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
Cost of the Lease Alternative
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

Annual lease costs are borne by equipment supplier

Cost of the Purchase Alternative

•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
Cost of the Purchase Alternative
•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
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.
Linear Programming Formulations of
Capital Allocation Problems

•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
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
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
Linear Programming Formulations of
Capital Allocation Problems
2. Interrelationships among projects:
◦ a. If projects p,q and r are mutually exclusive

◦ b. If project r can be undertaken only if project s has already been selected

Linear Programming Formulations of
Capital Allocation Problems
◦ c. If projects u and v are mutually exclusive and project r is dependent
(contingent) on acceptance of u and v

And
 Linear Programming - Example

A lumber mill saws both finish-grade and construction-grade boards from the logs
that it receives. Suppose that it takes 2 hr to rough-saw each 1000 board feet of the
finish-grade boards and 5 hr to plane each 1000 board feet of these boards. Suppose
also that it takes 2 hr to rough-saw each 1000 board feet of the construction-grade
boards, but it takes only 3 hr to plane each 1000 board feet of these boards. The saw is
available 8 hr per day, and the plane is available 15 hr per day. If the profit on each
1000 board feet of finish-grade boards is $120 and the profit on each 1000 board feet
of construction-grade boards is $100, how many board feet of each type of lumber
should be sawed to maximize the profit?
 Linear Programming – Example Solution
MATHEMATICAL MODEL.
◦ Let x and y denote the amount of finish grade and construction-grade lumber, respectively, to be sawed per day.
◦ Let the units of x and y be thousands of board feet. The number of hours required daily for the saw is 2x + 2y.
◦ Since only 8 hours are available daily, x and y must satisfy the inequality 2x + 2y < 8.
◦ Similarly, the number of hours required for the plane is 5x + 3y,
◦ so x and y must satisfy 5x + 3y < 15.
◦ Of course, we must also have x>0 and y>0.
◦ The profit (in dollars) to be maximized is given by z = 120x + 100y.
◦ Thus, our mathematical model is:

◦ Find values of x and y that will maximize (optimization) z = 120x + 100y (The Objective Function)
◦ subject to the restrictions (constraints)
◦ 2x + 2y < 8
◦ 5x + 3y < 15
◦ x>0
◦ y>0
 Linear Programming – Example Solution

In terms of the model this means that the

lumber mill should saw 1500 board feet of
finish-grade lumber and 2500 board feet of
construction-grade lumber per day. These
amounts will yield the maximum profit of
$430 per day.
 LINEAR PROGRAMMING TO MAXIMIZE
INCOME FROM JOINT PRODUCTS

A firm manufactures two articles, A and B. The unit cost of production, exclusive of fixed
costs, is $10 for A and $7 for B. The unit selling price is $16 for A and $13.50 for B. The
estimated maximum monthly sales potential of A is 9000 units; of B, 7000 units. It is the
policy of the firm to produce only as many units as can readily be sold. If production is
restricted to one article, the factory can turn out 13,000 units of A or 8500 units of B per
month. The capital allotted to monthly production after payment of fixed costs is
$100,000. What monthly production of each article will yield the maximum profit?
 LINEAR PROGRAMMING TO MAXIMIZE
INCOME FROM JOINT PRODUCTS

Calculation Procedure:
1. Express the production constraints imposed by sales and capital
Let NA and NB denote the number of articles A and B, respectively, produced monthly.
Then potential sales: NA <= 9000, (Eq. a); NB <= 7000, (Eq. b).
Available capital: 10NA + 7NB <=$100,000, (Eq. c).
2. Determine the production constraint imposed by the plant capacity
The number of months required to produce NA units of A is NA/13,000. Likewise, to produce NB units of B would be
NB/8500. Then, NA/13,000 + NB/8500 <= 1, or 8.5NA + 13NB <= 110,500, Eq. d.
3. Express the monthly profit in equation form (Objective Function)
Before fixed costs are deducted, the profit P = (16 - 10)NA + (13.5 - 7)NB, or P = 6NA + 6.5NB, Eq. e.
4. Construct a monthly production chart
Considering the expressions a to d above to be equalities, plot the straight lines representing them
Since these expressions actually establish upper limits to the values of NA and NB, the point representing the joint production
of articles A and B must lie either within the shaded area, which is termed the feasible region, or on one of its boundary lines.
 LINEAR PROGRAMMING TO MAXIMIZE
INCOME FROM JOINT PRODUCTS

Calculation Procedure:
5. Plot an equal-profit line
Assign the arbitrary value of $30,000 to P, and plot the straight line
corresponding to Eq. e above. Every point on this line (Fig. 8) represents a set of
values for NA and NB for which the profit is $30,000. This line is therefore
termed an equal-profit line. Next, consider that P assumes successively greater
values. As P does so, the equalprofit line moves away from the origin while
remaining parallel to its initial position.
6. Maximize the profit potential
To maximize the profit, locate the point in Fig. 8 at which the equal-profit line, in
its outward displacement, is on the verge of leaving the feasible region. This is
point Q, which lies at the intersection of the lines representing the equalities c and
d.
7. Determine the number of units for maximum profit
Establish the coordinates of the maximum-profit point Q either by reading them
from the chart or by solving the equalities c and d simultaneously. The results are
NA = 7468 units; NB = 3617 units.
 Linear Programming – Class Assignment

Carpenter Problem:
◦ Tables take 10 units of lumber, 5 hours of labor, and make $180
◦ Bookcases take 20 units of lumber, 4 hours of labor, and make $200
◦ 200 units of lumber are available
◦ 80 hours of labor available
Capital Budgeting Process Review
•Preliminary planning and cost of capital
•Annual capital budget and proposed project portfolio
•Capital expenditure policies and evaluation procedure
•Project implementation and post audit review
•Communication