Capital Budgeting
the process of measuring, evaluating, and selecting long-term investment opportunities for a firm
Risk (in reference to project risk)
the possibility of loss or other unfavorable results that derives from uncertainty implicit in future outcomes
Reward
the benefit expected or required from investment of resources in capital projects and other undertakings
Payback Period Approach
Determines the number of years needed to recover the initial cash investment in a project and compares that time with a pre-established maximum payback period
*ignores time value of money
Discounted Payback Period Approach
Determines the # of years needed to recover the initial cash investment in a project using discounted cash flows and compares that time with a pre-established maximum payback period
Accounting Rate of Return Approach (ARR)
- determines the expected annual incremental accounting net income from a project as a percent of the initial (or average) investment
ARR Formula
average annual incremental revenue - average annual incremental expenses / initial (or average) investment
*accrual accounting
Net Present Value Approach (NPV)
Determines the present value of expected cash inflows and compares that value with the present value of expected outflows in the project
*present value is determined using discount rate, also called “hurdle rate”, based on cost of capital to firm (WACC)
Internal Rate of Return Approach (IRR)
Determines the discount rate that equates the present value of expected cash inflows with the present value of expected cash outflows
*IRR computes the discount rate that makes the NPV of cash flows equal to zero
Profitability Index Approach (PI) - Cost Benefit Ratio
Determines project rankings by taking into account both the net present value and the cost of each project
Profitability Index calculation
PI = NPV of project inflows/PV of project cost
Financial Structure
The mixture of liabilities and owners’ equity accounts of a firm
Capital Structure
The long-term sources of funding - long-term debt and owners’ equity
Short-term or Working Capital Financing
The funding provided by obligations which become due within one year (i.e. current liabilities)
Payables
Occur through the acquiring of goods or services financed by incurring an obligation to pay in the future
Accrued Accounts Payable
Result from acquiring cash and other benefits financed by an obligation to be financed in the future
“Stand-by” credit
An arrangement to have financing available for a specific purpose or period of time
Line of credit
Informal agreement whereby a financial institution agrees to a maximum amount of credit that will be extended at any one time
Revolving credit
formal agreement whereby a financial institution or other lender agrees to a maximum amount of credit that will be extended
Letter of credit
A conditional commitment by a financial institution to pay a third party in accordance with specified terms and conditions
Commercial Paper
short-term, unsecured promissory notes sold by large, highly-creditworthy firms
Pledging Accounts Receivable
using accounts receivable as security for short-term borrowings
Factoring Accounts Receivable
Factoring is the sale of Accounts Receivable
- buyer is called the “Factor”
Without recourse
The factor (buyer) bears the risk associated with collectability, expect in the case of fraud
With recourse
The factor (buyer) has recourse against the seller for some or all of the risk associated with uncollectability of the receivables
Inventory Secured Loans
Occur when a firm pledges all or part of its inventory as collateral for a short-term loan
Floating Lien Agreement
Borrower gives a lien on all of its inventory, but retains control of its inventory, which it continuously sells and replaces
Chattel Mortgage Agreement
Lender has a lien against specifically identified inventory, borrower retains control of that inventory, but can’t sell it without lender approval
Field warehouse agreement
Inventory remains at borrower’s warehouse, but under the control of an independent third party
Terminal warehouse agreement
Inventory is moved to a public warehouse and placed under the control of an independent third party
Net lease
- lessee assumes cost associated with ownership:
maintenance, taxes and insurance - called “executory costs” in accounting
Net-net lease
Lessee assumes cost associated with ownership (above) and responsibility for residual value at end of the lease
Bonds
- long-term promissory notes
- in return for proceeds (cash), the issuer of the bonds (the borrower) promises to pay bondholder (the investor) a fixed amount of interest each period and repay the face or principal of the bond at maturity
Bond indenture
bond contract
Par/face value
bond principal
Coupon rate of interest
Annual rate of interest stated on face of bond (“stated rate”)
Debenture bonds
- unsecured
- no specific assets are designated as collateral
- they carry more risk and have higher cost than secured bonds
Secured bonds
- have specific assets designated as collateral
Current yield (CY) - bonds
Ratio of annual interest payments to current price of the bonds in the market
“market interest rate” risk
The risk that the market value will go down due to interest rates going up in the market
Preferred Stock
Ownership interest with preference claims (over common stock)
- usually does not having voting rights
- dividends are usually limited in amount and expected (like bond interest) - not required
Callable preferred stock
gives the firm the right to buy back preferred shares, usually at pre-established price
Preferred stock theoretical value (PSV) calculation
Annual Dividend/Required Rate of Return
Preferred stock expected rate of return (PSER) calculation
annual dividend/market price
Common stock
the basic ownership interest in a corporation *regulatory requirements limit most companies to one class of common stock
Common Stock (CS) valuation
- the present value of expected cash flows
- 2 cash flows - commons dividends and common stock appreciation
Common Stock Expected Rate of Return (CSER)
(1st year dividend/market price) + growth rate
Hedging principle of financing
calls for matching cash flows from assets with cash requirements needed to finance those assets