Raamkanna Saranathan
Finance Management
September 21, 2003 Capital Budgeting Assignment
1)
What is the basic principle underlying the approach used by a profitmaximizing manager in making capital budgeting decisions?
The principle underlying capital budgeting decisions is that expenditures
are made until the marginal return on the last dollar invested equals the
marginal cost of capital. The cost of capital is the rate that must be paid
on money raised externally by the firm (e.g., by borrowing or selling
stock) or the opportunity cost (i.e., the foregone return).
2)
Why is the marginal cost of capital schedule or function upward sloping
for most firms?
The marginal cost of capital schedule or function is upward sloping for
most firms because most firms are required to pay a higher cost to obtain
increasing amounts of capital. For example, if the firm is borrowing those
funds, the more that is borrowed, the greater is the risk that the firm will
be unable to repay the lender.
3)
Contrast the net present value and internal rate of return approaches in
the evaluation of capital projects. In general, if the NPV is greater than
zero, what does this imply about the internal rate of return?
The net present value (NPV) method of evaluation consists of comparing
the present value of all net cash flows (appropriately discounted using the
firm’s cost of capital as the discount rate) to the initial investment cost. At
the same time, if the net present value is greater than zero, the implicit
rate of return on the capital expenditure exceeds the firm’s cost of capital,
and thus future profits will be higher if the investment is made.
4)
Why is it that the net present value and internal rate of return methods
can yield contradictory results when evaluating two mutually exclusive
investments? Develop an example of two investments in which this would
happen.
NPV and IRR methods are closely related because:
i)
ii)
Both are time-adjusted measures of profitability.
Their mathematical formulas are almost identical.
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NPV and IRR may give conflicting decisions where projects differ in their
scale of investment.
Example:
Years
0
1
2
3
Project A -2,500 1,500 1,500 1,500
Project B -14,000 7,000 7,000 7,000
Assume k= 10%.
NPVA = $1,500 x PVFA at 10% for 3 years
= $1,500 x 2.487
= $3,730.50 - $2,500.00
= $1,230.50.
NPVB == $7,000 x PVFA at 10% for 3 years
= $7,000 x 2.487
= $17,409 - $14,000
= $3,409.00.
IRRA =
= 1.67.
Therefore IRRA = 36% (from the tables)
IRRB =
= 2.0
Therefore IRRB = 21%
Decision:
Conflicting, as:
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NPV
IRR
Project A $ 3,730.50 36%
Project B $17,400.00 21%
Figure 6.3 Scale of investments
To show why:
i) the NPV prefers B, the larger project, for a discount rate below 20%
ii) the NPV is superior to the IRR
a) Use the incremental cash flow approach, "B minus A" approach
b) Choosing project B is tantamount to choosing a hypothetical project "B
minus A".
0
1
2
3
Project B
- 14,000 7,000 7,000 7,000
Project A
- 2,500 1,500 1,500 1,500
"B minus A" - 11,500 5,500 5,500 5,500
IRR"B Minus A"
= 2.09
= 20%
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c) Choosing B is equivalent to: A + (B - A) = B
d) Choosing the bigger project B means choosing the smaller project A
plus an additional outlay of $11,500 of which $5,500 will be realised each
year for the next 3 years.
e) The IRR"B minus A" on the incremental cash flow is 20%.
f) Given k of 10%, this is a profitable opportunity, therefore must be
accepted.
g) But, if k were greater than the IRR (20%) on the incremental CF, then
reject project.
h) At the point of intersection, NPVA = NPVB or NPVA - NPVB = 0, i.e.
indifferent to projects A and B.
i) If k = 20% (IRR of "B - A") the company should accept project A. This
justifies the use of NPV criterion.
Advantage of NPV:
- It ensures that the firm reaches an optimal scale of investment.
Disadvantage of IRR:
- It expresses the return in a percentage form rather than in terms
of absolute dollar returns, e.g. the IRR will prefer 500% of $1 to 20%
return on $100. However, most companies set their goals in absolute
terms and not in % terms, e.g. target sales figure of $2.5 million.
5)
What is the relationship between a firm’s marginal income tax rate and
the net cost of debt capital to the firm?
The net cost of debt capital is the net interest amount to be paid for
financing the debt and should be an expense which would reduce net
income for the accounting period. Therefore if net income reduces then
so does the income tax paid if the tax rate is calculated as a percentage of
net income.
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6)
Some analysts claim that the cost of debt capital is lower than the cost of
equity capital in most firms. If this is true, why don’t firms rely exclusively
on debt financing and not sell any additional common stock? Explain
The reason why firms don't rely exclusively on debt financing alone and
not sell any additional common stock is because debt financing requires
the firm to pay an interest rate while equity financing does not. It is also
particularly important for the analysis of the financial statements as a high
debt to equity ratio may deter investors and cause concern for
shareholders even though the funds attained may have been used in
capital expenditure for increased income generation. The interest paid on
the debt financing may in addition have tax consequences on the final
accounts.
7)
One firm in an industry may have 50 percent debt while another may
have no debt. Why do some firms in the same industry have substantially
different capital structures? Why do most firms in some industries (e.g.,
public utilities) have a large debt component in their capital structures
while most firms in some other industries have a relatively little debt?
Public utilities tend to have a higher percentage of debt than most other
firms because they have a monopoly position, and usually the product
they sell is a necessity means that the firm will have a reasonably stable
and dependable flow of revenue and profit, and this offsets part of the
high risk associated with a large proportion of debt in their capital
structure.
8)
What is synergy as it applies to mergers? How does it affect the amount
that one firm would be willing to pay for another?
Synergy is the positive incremental net gain associated with the
combination of two firms through a merger or an acquisition.
Synergy exists if a transaction results in increased revenues, decreased
costs, lower taxes, or a reduction in capital requirements.
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9)
Give at least one example (Other than those used in the chapter) of each
of the following types of mergers:
a)
Horizontal
b)
Conglomerate
c)
Vertical
a)
b)
c)
10)
Workers Bank, Jamaica Citizens Bank and Eagle Commercial Bank
combined to form Union/RBTT bank.
Air Jamaica and Sandals.
A sugar company and a confectionery company. The latter would
use the sugar from the first company to produce their sweets and
candies. Another example is a bauxite company and a car
manufacturer
How would a conglomerate merger be used to reduce risk?
Conglomerate merger can be used to reduce risk by implementing two
different accounting procedures for each company and by appointing
different consultants for each company.
11)
Explain how a vertical merger between an electric utility and a coal
company could reduce transaction costs for the combined firm.
Since both companies are now one, they can reduce the paperwork costs
of billing. Previously the electric company may need to order coal to fuel
its energy and the latter needs to send an invoice, delivery or freight bill,
statements of accounts etc. Now the final product is the electricity.
Service costs can also be reduced, as fewer employees are needed.
Transportation and other costs can be reduced as the combined firm now
shares the same capital and equipments. Unlike before, both firms had to
attain their own equipment, motor vehicles, tractors etc.
12)
What are three strategies a firm might use to avoid being acquired by
another company?
The management of the target company will often employ defenses to
resist the takeover such as:
1.
Poison Pill - This occurs when a company issues rights to its
existing shareholders, exercisable only in the event of a potential
takeover, to purchase additional shares at prices below market.
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13)
2.
Pac-man Defense - This involves the target company making an
unfriendly countervailing takeover offer to the shareholders of the
company that is attempting to take it over.
3.
White Knight - In this case, the target company searches out
another company that will come to its rescue with a more
appealing offer for its shares.
4.
Selling The Crown Jewels - This involves selling certain
desirable assets to other companies so the would be acquirer loses
interest.
Suppose that the capital market has correctly valued the price of a firm’s
stock, why would an acquiring firm be willing to pay more than the market
price? What would determine the premium over the market price that the
firm would be willing to pay?
An acquiring firm is willing to pay more than the market price because it
will be holding the entire stock by paying more in order to face the
growing competition. If firms in a market are making large profits, more
entrepreneurs will be attracted to the industry.
The price offered to the target’s shareholders must always be higher than
the stock’s market price to induce a majority to sell.
The excess over market price is the premium. There are several ways of
determining the premium of a market price.
- Forecasts of profit and sales.
- Current and projected interest rates.
- The number of players in the market.
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