The Capital Budgeting Decision - BookSummary

Investment Analysis Assignment
Summary of Book:
“THE CAPITAL BUDGETING DECISION”
Mohamad Odang Rizki (29108310)
Investment Analysis MM – 6056

Lecturer
Uke MMP Siahaan
Kelas MBA Reguler 41 + 42

2010
CHAPTER 1
INVESTMENT DECISIONS AND CORPORATE OBJECTIVE
INVESTMENT DECISIONS
Capital budgeting decision process must take consideration four basic factors:
Time value of money
Risk considerations
Alternative investments
Future opportunities
THE STATE OF BUSINESS PRACTICE
The formula (1+r)-n used to transform future value of money into their present value
equivalents. The interest rate (r) either takes into consideration the pure time value (using a
risk free rate), the risk of the corporation (the firm’s WACC), and the risk of the operating
unit (plant or division), the risk of the specific project being evaluated or the risk of the
specific cash flow component.
TIME, RISK, AND THE RISK-RETURN TRADE OFF
The decision that we take today can affect the cash flow for many future time periods and the
outcomes of the actions are uncertain, so we need to formulate decision rules that take a risk
and time value into consideration systematic fashion. Uncertainty makes the decision-maker
face alternatives that involve trade-offs of less return and less risk or more return and more
risk.
THREE BASIC GENERALIZATIONS
In the financial decision, there are three basic generalizations that are useful:
First: Investor more prefer more return (cash and value) to less, all other things being
equal (risk is held constant)
Second: Investor is risk averse. They prefer less risk (a possibility of loss) to more
risk and have to be paid to undertake risky endeavors.
Third: Cash to be received today is preferred to the same amount of cash to be
received in the future.
CASH FLOWS VERSUS EARNINGS
A decision may be characterized by its effect on accounting earnings, as well as by its

incremental cash flows. Future cash flows were consider to be a relevant measure of the
impact of a decision on the firm and will use anticipated cash flows as the primary input in
the decision to be analyzed.
Summary of “The Capital Budgeting Decision” Book 1
THE CAPITAL MARKET
The cost of capital for one firm will depend on:

Returns investors can obtain from other firms
Characteristics of the assets of the firm that is attempting to raise additional capital
Firm’s capital structure
THE WEIGHTED AVERAGE COST OF CAPITAL
Commonly, people used WACC firm’s WACC as discount rate for computing the project’s
net present value. The WACC of each project can be estimated and used as a discount rate.
TACTICAL AND STRATEGIC DECISIONS
Tactical Investment Decision Strategic Investment Decisions

Involves a relatively small amount of Involve large sums of money and may.
funds. Result in a major departure from what the
Does not constitute a major departure company has been doing in the past.
from what the firm has been doing in the Example: Private corporation
past. manufacturing airplanes undertook the
Example: The decision to buy or not buy a development of a supersonic commercial
new machine tool. transport.
THE ROLE OF STRATEGIC PLANNING
Strategic planning guides the search for project by identifying promising product lines or
geographic areas in which to search for good investment projects. A strategic plan should
reflect both the special skill and abilities of the firm (its comparative advantage) and the
opportunities that are available as a result of dynamic changes in the world economy.
If attractive project are not found where the strategic plan had expected them, or if desirable
project appear in lines of business that the strategic plan had identified as unattractive, a
reassessment of both the project studies and the strategic plan may be in order.

CHAPTER 2
THE TIME VALUE OF MONEY
Assume that both the discount rate and the dollar amounts are know with certainty, so it
would enable us to establish basic mathematical relationship and the compute exact
relationship between future sums and their present value.
TIME DISCOUNTING
The time value effect a wide range of business decision, and how to incorporate time value
consideration systematically into a decision is essential to an understanding of finance.
FUTURE VALUE
The future value is known as the future cash flow available at the end of period from the
amount available at the beginning of the period.
FV1 = (1+ r) Xo
X0 = the amount available at the beginning of the period
FVn = the future cash flow available at the end of period n
r = the interest rate per period
Repeating the process, the formulization can be generalized and the future value factor
function can be written as; FVF(n,t) = (1+ r) n
PRESENT VALUE
To perform a discounted cash flow (DCF) analysis, we must find the present value
equivalents of the future sums of money (can be answered by using the future value). By
using the future value equation where the future value is known (with the formulation
FVN(n,t) = (1+ r) n) and we solve rod the present sum.
FVn
X0
(1 r )n
Treating the quantity FV n as known and the quantity X0 as the unknown, the equation can be
written as X0 = Xn (1 + r) -n. In general, the present value factor function can be written as;
PVN (n,r) = (1 + r) –n
1 1
By combining those equation; PVF (n, r ) And FVF (n, r )
FVF (n, r ) PVF (n, r )
PRESENT VALUE MULTIPLICATION RULE
The present value factor for n years is equal to the product of the present value for factor for t
years and the present value factor for (n - t) years. The present value multiplication rule
applies even if the applicable discount rate is not the same for each group of years.
PRESENT VALUE OF ANNUITY
An annuity is a sequence of n equal cash flows, one per period. Let B(n,r) represent the
present value of an ordinary annuity.
n
1 (1 r )
B(n, r )
r
If we have the first payment taking place immediately (called annuity due / annuity in
advance), than we have a (n-1) period ordinary annuity plus the initial payment.
For an ordinary annuity, for X dollars per period, the present value is;
PV = XB (n,r)
PRESENT VALUE OF PERPETUALITY
Perpetuity is an annuity that goes on forever (a infinitive sequence). If we let n of equation

2.5 go to infinity, so that the annuity becomes a perpetuity, then the (1 + r) -n term goes to
zero, and the present value of the perpetuity using the equation becomes
1
B (∞ , r) =
r
INTUITIVE INTERPRETATION
1 (1 r ) n 1 1
By rearranging B(n, r ) then we obtain B (n , r) = - (1 + r) –n
r r r
Think of the annuity as the difference between two perpetuities;
1
is the present value of perpetuity.
r
1
(1 + r) –n, which is subtracted from the first, is the product of two present values.
r
The first perpetuity consists of inflows beginning at the end of period 1. The second
perpetuity consists of outflows of the same absolute magnitude beginning at the end of period
n + 1. The net result is that beginning in period (n + 1) the inflows and the outflows offset
one another, and we have net cash flows of zero.
A FLEXIBLE TOOL
We now have the tools to solve a wide range of time-value problem that have not been
described. While we could introduce other formulas, we prefer to adapt the three basic
formulas that have been introduced. ; PV = XB(n,r)(1 + r)-t
Note that if the first annuity payment is at time 10 we only have to discount the annuity for
nine years to find the present value, since B(n,r) gives the annuity value as of the end of
period 9.
ANNUAL EQUIVALENT AMOUNTS
In many situations we want to determine the annual equivalent of a given sum. For solve for
annual cash flow, is
PV
X
B ( n, r )
That is to find the annual equivalent X of a present sum PV, that sum is divided by the
annuity factor B(n,r), where r is the time value of money and n is the number of years over
which the annual equivalent is to be determined. Calculation of this type are particularly in
the management of financial institutions such as insurance companies or banks, where
customers make periodic payments over an extended time period in return for a lump-sum
immediate loan.
A GROWING ANNUITY
Assume that;
X1 = D (received at time one). X2 = (1 + g) D (received at time two, in each subsequent
period grows at a rate of g). X3 = (1+g)2 D (received at time three).
The present value (P) on this infinite series is;
D
P
r g
A CONSTANT INTEREST BOND
The present value of the constant interest bond with a par value of P paying interest of kP per
year and P maturity when the market interest r.
Present value of interest = kP X B(n,r)
The value of the bond, V is equal to the present value of the principal repayment and the
present value of interest payments.
Present value of principal = P(1 + r) –n
If the value (V) equal to par value (P) and k is the discount rate.
Market value bond V = P[(1 + r) –n + kB(n,r)]
PRESENT VALUE FACTORS DERIVED FROM MARKET PRICE
In the real world we cannot use the same interest rate for each period, because it’s not
realistic. The prices of the discount securities are a convenient source of realistic present
value factors for default-free cash flows. The present value factor obtained from the market
prices of discount securities can be converted into equivalent discount rates using the present
value function Rt=(PVF(t) –(1/t)) -1.

CHAPTER 3
CAPITAL BUDGETING: THE TRADITIONAL SOLUTIONS
A capital budgeting decision is characterized by cash flows (costs and benefits) that are
spread out over several time periods. The time value of money must be considered in order to
evaluate the alternatives correctly. The term time value of money is used to describe the
discount rate that can be used to compute present values (PV).
CLASSIFICATION OF CASH FLOWS
There are 3 types of investment cash flows:

1. Conventional investment defined as having one or more periods of outlays followed
by one or more periods of positive cash proceeds.
2. Loan type of flows defined as borrowing money or “negative investment” in which
one or more periods of cash followed by one or more periods in which there are cash
outlays.
3. Non-conventional investment defined as investments that have one or more periods of
outlays interspersed with periods of proceeds.
An estimate of relative cash flows always involves a comparison of two alternatives. It is

necessary to consider all feasible alternatives (including doing nothing or abandoning what is
currently being done). The choice of a standard of comparison may lead to mistaken
conclusions only if some advantageous alternatives (such as ceasing production entirely) are
excluded from the analysis. There are four common methods for making capital budgeting
decisions.
Method-1: Net Present Value (NPV)
The sum of the present value of the proceeds minus the present value of the outlays is the net
present value of the investment. To be acceptable, an investment must meet two criteria, both
of which can be described in terms of its net present value (NPV):
1. The NPV > 0 (greater than zero), but it’s not mandatory, because it could also based
on other criteria e.g. strategic positioning or other factors not explicitly included in the
calculation.
2. The NPV of the investment must be greater than any mutually exclusive alternative
available to the firm.
n = period of investment
I0 = Initial investment (used as PV outflow or outlays)
In = cash in period n (used as PV inflow or cash income)
R = discount rate

Method-2: Internal Rate of Return (IRR)
Many different terms are used to define the internal rate of return concept. Among these
terms are yield, yield to maturity, interest rate of return, rate of return, return on invest ment,
present value return on investment, discounted cash flow, time-adjusted rate of return, and
marginal efficiency of capital. The internal rate of return method utilizes present value
concepts. The procedure is to find a rate of discount or discount rate(r) that will make the
sum of the net present values of the cash flows expected from an investment equal to zero
(find IRR at NPV = 0). The procedure for this method is “trial-and-error”.
Method-3: Payback Period
It is defined as the length of time required for the stream of cash proceeds produced by an
investment to equal the original cash outlay required by the investment.
Method-4: Return on Investment (ROI)
It defined as ratio of money gained or lost on an investment relative to the amount of money
invested.
Avg. present value of net income after tax
ROI =
Initial investment
OPPORTUNITY COST
It is the cost related to the next-best choice available to someone who has picked between
several choices (also can be referred to implicit cost if there is no corresponding money
payment).
TAX SHIELD
It is the reduction in income taxes that results from taking an allowable deduction from
taxable income (from interest loan and/or depreciation tax shield).
MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)
It is a method introduced by the US Congress in August 1981 to calculate tax depreciation

expense. It includes two types of depreciation system, the General Depreciation System
(GDS) and the Alternative Depreciation System (ADS).

CHAPTER 4
MUTUALLY EXCLUSIVE INVESTMENTS
Two common discounted cash flow methods to make correct investment decisions are NPV
and IRR. It is somewhat more difficult to use the IRR method correctly. It is recommended to
use NPV method, and in this chapter, we shall explain why we believe the IRR method is
sometimes difficult to interpret.
Two methods to accept or reject decisions

Net Present Value Internal Rate of Return
- Accept if NPV > 0. - Accept if IRR > discount rate.
- Reject otherwise. - Reject otherwise.
CASH FLOW
A. Conventional and Nonconventional Cash Flow

Conventional Cash Flow
Define as those in which there were one or more periods of net cash outlays (or net
proceeds) followed by one or more periods of net cash proceeds (or net outlays). A
conventional investment will have at most one positive internal rate of return.
Investment type loan type
Significance of Nonconventional Cash Flows

With non-conventional investment, any one of the following situations is possible:
- The investment has no IRR
- The investment has one IRR
- The investment has more than one IRR
B. Loan-Type Flows
Loan-type cash flows define as positive flows followed by negative flows or outlays. The
characteristic of loan-type flows is that their net present value increases with higher rates
of discount.
MUTUALLY EXCLUSIVE INVESTMENT
Mutually exclusive investments: undertaking one of the investments will completely

eliminates the expected proceeds of the other investments.
The two discounted cash flow methods (NPV and IRR) may give different rankings to
the same set of mutually exclusive investments.

INCREMENTAL BENEFITS: THE SCALE PROBLEM
The IRR method’s recommendations for mutually exclusive investments are less reliable than
NPV because IRR fail to consider the size of investment.
Consider the following example:
A quick answer would be that A

is more desirable, based on the
hypothesis that the higher the
IRR, the better the investment.
The figure above shows both investments. It can be seen that investment B is more
desirable than A, as long as the discount rate is less than 14%.
TIMING
One disadvantage associated with the use of the internal rate of return method is the necessity
of computing the IRR on the incremental cash proceeds in order to determine which of pair of
mutually exclusive investments is preferable.
MULTIPLE IRR
When the IRR method is used, the ability to choose the best of two investments depends on
whether a given series of incremental cash flows is like a conventional investment-in which
case the higher the rate, the better-or whether it’s like a loan – in which case the lower the
rate or interest cost, the better.
Consider the following example

Interpretation
The first figure shows that investment B has higher present value at rates of discount in
excess of 10%. The two curves cross again at 100%, but normally the values at very high
interest rates are not relevant.
The second figure shows the incremental cash flow of A relative to B. The left-hand part
of I is typical of that of a loan; the right-hand part has the downward slope typical of the
ordinary investment. This series of cash flows would be worthwhile at rates of discount
between 10 and 100 percent.
CONVERTING MULTIPLE IRRs TO A SINGLE IRR
Adjust the cash flows in such a way as to eliminate the possibility of multiple IRRs. Then a
new internal rate of return is calculated from the adjusted cash flows. In evaluating a
nonconventional cash flow stream, one should plot its net present value profile.
DURATION
Duration is a measure of the sensitivity of the asset’s price to interest rate movement.
Duration of an investment is its weighted average life, where the weights are the present
value of the cash flows received in the period.
WHY IRR IS POPULAR
IRR method is popular because they give a differential measure between the proposed
investment rate of return and the required return. If an investment has an IRR of 30% and the
required return is 12%, this is a large margin, which allows for error.

CHAPTER 5
ANNUAL EQUIVALENT COST AND REPLACEMENT DECISIONS
This chapter will focus on the characteristics of the investments that will replace the
investment. And also the calculations enable us to analyze the decision in terms of unit costs
rather than the net present value of the project.
Annual equivalent cost used as method to compute the cost of making a product and also
used as a decision making tool in capital budgeting when comparing investment projects of
unequal lifespan. Investment tend to involve large expenditures that benefit many time
periods and to have lives that are longer or shorter than the time period for which the decision
is being made. In these situations it would be useful to compute the annual equivalent cost of
utilizing a long-lived asset. Considered an investment with expected lifetime of 20 years and
initial investment $2 million, and the required rate of return 10 percent, then the annual
equivalent cost calculation is:
Annual equivalent cost = $ 2million / A20, 0.10
= $ 2million / 8.5136 = $ 234,918
MAKE OR BUY DECISION
Present value calculations may not be meaningful to executives who are not familiar with it.
Additionally, the present value calculation doesn’t provide a convenient means of evaluating
the savings from whether buy or make. An alternative approach is to present the analysis in
terms of annual equivalent costs. The annual equivalent cost per unit can be obtained by
dividing the total annual equivalent cost by the number of units expected to be produced per
year.
MUTUALLY EXCLUSIVE ALTERNATIVE WITH DIFFERENT LIVES
Mutually exclusive alternatives aren’t necessary to have same lives in order to be

comparable. When mutually exclusive investments have unequal lives and there is a necessity
to make the alternatives comparable, a choice of assumption has to be made:
1. Assume that the firm will reinvest in assets of exactly the same characteristics as
those currently being used.
2. The reinvestment opportunities that will become available in the future.
THE REPLACEMENT DECISION
A special classification of investment decisions involves the replacement of currently owned

assets. Two methods to make replacement decision:
1. Computing the absolute cash flow of each alternative
2. Computing the savings resulting from using the new asset instead of the old asset.

ITEM OLD ASSET NEW ASSET
Cost New $ 100,000 $ 70,000
Book Value $ 60,000 -
Estimated remaining useful
life (with zero salvage now 10 years 10 years
and at the end of 10 years)
Costs per year (including
labor, power, maintenance, $ 200,000 $ 190,000
and so on from replacement)
Absolute cash flow of each alternatives

PV of the cost for 10 years of not replacing:
PV of cost = $200,000 x A10,0.10 = $200,000 x 6.1446 = $1,229,000
PV of the cost of replacing:
PV of cost = $190,000 x A10,0.10 + $70,000
= $190,000 x 6.1446 + $70,000 = $1,237,000
Present value of the net savings
Advantage of replacing = $10,000 x A10,0.10 - $70,000
= $10,000 x 6.1446 - $70,000
= $61,446 - $70,000 = -$8,554
One of the problems in this type of analysis is the treatment of depreciation. The book
depreciation of the new asset and the old should be excluded. The expense of utilizing the old
asset would be recognized in the accounts whether is replaced or not. Any decrease in salvage
value of the old asset is relevant. Also any tax basis of the old asset is relevant, as are tax
shields from depreciation expense of the new asset.
REPLACEMENT CHAINS
Suppose that a real estate company considering whether to remodel a motel and continue
operating it for additional 10 years or to raze it and build a new motel that should have an
economic life of 20 years. If the alternatives were comparable, we would compare the present
value of expected cash outlays and proceeds from the two unequal-lived streams. If we
considered ourselves sufficiently clairvoyant, we might attempt to estimate the cost of
building a new motel 10 years from now and also the cash precedes that would be generated
by operating this new motel. Even this wouldn’t solve the problem if this new model is
expected to last longer than an additional 10 years, because the two alternatives wouldn’t
then be comparable. Sometimes a practical solution is found by putting an upper or lower
limit on the value of potential future opportunities.

CHAPTER 6
CAPITAL BUDGETING UNDER CAPITAL RATIONING
In this chapter we consider situations in which the assumption that the firm can borrow or
lend any quantity of funds that desires at a given market rate of interest is not valid. There are
two distinctly different capital rationing, external capital rationing and internal capital
rationing.
EXTERNAL CAPITAL RATIONING
Capital rationing situation that must be considered is when there is a difference between the
market rate of interest at which the firm can borrow money and the market rate at which it
can lend. External capital rationing is actually as the result of market imperfections or
transaction cost or perceptions of imperfections.
The term borrow is used when a firm obtains capital from the market by issuing any type of
security. The term lend is used to mean the use of funds to purchase any type of security.
Ideally, rate of interest would be same for both the borrowing and the lending transactions,
but this theoretical situation is an ideal never encountered in practice. There will usually be
some divergence.
If the borrowing rate and lending rate are almost equal, little is lost by neglecting the
difference and speaking of a market rate of interest. If the difference is large, it cannot be
ignored in determining the investment and financial policies of the firm. This gives rise to the
situations we describe as external capital rationing.
INTERNAL CAPITAL RATIONING
These capital rationing situations arises because of a decision by management either to limit
arbitrarily the total amount invested or the kind of investments the firm undertakes or to set
acceptance criteria that lead it to reject some investment that are advantageous when judged
by market criteria. For example, instead of using the market interest rate, the firm might use
some higher rate as a cutoff or hurdle rate.
There are two types of internal capital rationing.

In the first, the firm sets a cutoff rate for investments that is higher than the firm’s cost
of money.
In the second type, the firm decides to limit the total amount of funds committed to
internal investments in a given year to some fixed sum, even though investments
having positive present value at the firm’s cost of money may be rejected as a result
of this decision.

RANKING OF INVESTMENT
The issue for independent investment is no longer a matter of accept or reject decisions, but
management wants to know the ranking of investment so that it can choose the best set of
investment. There are several procedures that seem to give a reliable ranking of investment,
but that appearance is an illusion. There is no sure procedure for the ranking of independent
investment.
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index
A third popular discounted cash flow method of ranking investment is Profitability
Index (present value of benefit divided by present value of outlays). If our objective
limited to accept or reject decision, the index of Profitability Index (accept all
investments with an index greater than 1) will give results identical to those of the
NPV method.
But this method has several difficulties in using this technique to rank investment:
o Mutually exclusive investment
Profitability Index is a ratio of benefits to outlay. But it fails to consider the scale
of the investment in the same manner, as do other ratio measures, such as ROI and
IRR. This point can be seen more clearly if we look at the incremental investment.
The problem of scale can be solved by comparing pairs of investment, but this is
unnecessary because the problem can be solved more easily by using NPV. Also,
the problem of the classification of cash flows still exists.
o Classification of cash flows
The second difficulty with the Profitability Index is that it requires a distinction be
made between deductions from cash proceeds and investment type outlays
A misconception about Profitability Index is that it will rank independent investments

in a useful manner. This ranking is not reliable. If the company does not intend to
accept all independent investment, with a positive present value (or an index greater
than 1), the cost of money used will not be the appropriate rate of discount, and the
index ranking will not be reliable. It is not claimed here that the NPV method may be
used to rank independent investment. It is claimed only that the NPV method will lead
to more easily obtained decisions involving choices between mutually exclusive
investment and will give equally correct accept or reject decision when applied to
independent investment.

CHAPTER 7
THE USE OF THE WEIGHTED AVERAGE COST OF CAPITAL AND
ANOTHER RATES OF DISCOUNT
The use of the borrowing rate has a good deal of merit for a default rate to compute a present
value of a cash flow, yet the risk characteristics of the individual investment will greatly
influence the investment decision and the net present-value calculation is viewed as only one
information input.
THE SOURCES OF CASH
Funds to finance an investment proposal may be obtained by a firm in a variety of ways such
as; borrowing from banks, allowing short-term liabilities, selling marketable securities,
selling other assets or parts of its business, issuing additional securities, or by committing
funds generated by operations. For all these types of sources of cash, there will be a cost of
funds generated as a represent of one’s estimated opportunity cost.
COST OF CAPITAL
Retained earnings have a cost, and this cost should be

Retained Earnings
measured by alternative returns the shareholders can earn.
The value of a share of stocks is determined by the present

value of the dividends (dividend as the cost of the capital
Common Stock gained)
The cost of the capital could change because of the
uncertainties of the stock prices and stock value
The amount of depreciation expensed for tax purpose

affected the tax amount to paid to the government (affecting
Accumulated Depreciation
the cash flow that could change the value of the cost of
capital)
The cost of long-term debt capital is the present effective

interest rate for long-term securities of the specific firm
Long-Term Debt The cost figured out from combination of three factor: (1)
time value of money; (2) the contractual interest payments
may be larger than the expected interest; (3) the investors
Short -Term Debt Analogous to that of long-term debt

THE OPTIMUM CAPITAL STRUCTURE
The Optimum Capital Structure is reached when the cost of capital is minimum.
At least two kinds of risk to which common stockholders are subject when debt is
included in the capital structure; (1)The risk of bankruptcy or cost of financial
distress, (2) The risk of increased variability for the common stock
WEIGHTED AVERAGE COST OF CAPITAL
Firms want to reduce the cost of obtaining new capital or even reduce the cost of the firm’s
present capital. The weighted average cost of capital (WACC) represent the firm’s average
cost of capital, it’s a combine from more than one specific asset that have (might be) a
different amount of risk.
The weighted average cost of capital represents an averaging of all risks of the firm (WACC
is the correct discount rate only for one level of risk). It would be incorrect to assume that the
same rate of discount should be used for a marginal investment. Also, it should be recognized
that if a firm accepts a substantial investment whose risk characteristics are very different
from the risk of the firm’s average investment, the firm’s cost of capital is likely to change as
a result of accepting the investment.
DISCOUNT RATE
Interest rates are determined by comparing the market price of debt security with the
promised payments of the security. The two mains possibilities that provide the best estimate
of the time value of money for use in making capital budgeting are; (1) interest rate of US
government securities, and (2) interest rate of long term bonds of the firm.
The interest rate on short-term government debt constitute a reasonable choice of discount
rates representing default free-lending opportunities (do not represent risk-free market
opportunities). Given the risk of default and the lower level of liquidity, the rates at which a
corporation could borrow would be higher than the rates at which the government can borrow
for loans of the same cash payment schedule. If a default-free rate of discount is used to
compute present values, then before a decision can be made, a subtraction from the present
values to take into consideration for risk-adjustment due the riskiness of the cash flows.
ADJUSTING THE DEFAULT FREE RATE
Neither private corporations nor individuals can actually borrow money at the same rate
as the federal government. Given the risk of default and the lower level of liquidity, the
rates would be higher than the US Government securities rate.
If a default free rate of discount is used to compute present value, then before a decision
can be made, a dollar amount must be subtracted from the present value to take into
consideration the riskiness of the cash flow.

CHAPTER 8
THE CAPITAL ASSET PRICING MODEL
The capital asset pricing model assumes that investor make decisions regarding portfolio
securities (a portfolio is a collection of securities that has a correlation of coefficient
between the rates of return of the securities plus/minus), for the interaction of return and
risk in a single period model.
The capital asset pricing model assume utility-maximizing investor who; (1) are risk
averse, (2) measure the risk of an investment portfolio by the standard deviation of the rate
of return on that investment portfolio, and (3) have indifference curves (different
combination of expected return and standard deviation for which the investor are
indifferent)
The capital asset pricing model offers a tool for accomplishing a systematic calculation of
risk-adjusted present value.
There are two risk components, systematic risk (market risk that represents the change in
value resulting from market value changes) and unsystematic risks (independent to what
happens to other securities). Unsystematic risk might be formed when the portfolio is not
well-diversified.
THE CAPITAL MARKET LINE
The capital market line is correlation between the return from a risk free securities (such a
government security as a default-free asset) with the standard deviation of rate-of-return from
the securities in the market.
The capital market line constructed from the point where the return of government securities
(have standard deviation of rate-of-return = 0), with the return of securities (r m) that have σ m
(have standard deviation of rate-of-return = m)
CAPM Formula
Which,
E(ri) = Return required on financial asset i
Rf = risk-free rate of return
βi = beta value for financial asset i
E(rm) = average return on capital market
BETA (β)
There are many way would describes about beta (β), that are:
The beta (β) of a stock or portfolio is a number describing the relation of its returns with
that of the financial market as a whole. (Wiki)

Beta measures the volatility of the security (appeal for the risk)
A company's beta is that company's risk compared to the risk of the overall market
Example: company beta 2.0 it means that 2 times riskier than market
THE SECURITY MARKET LINE
The security market line is the relationship between expected return and beta (for β is a level
of systematic risk in the market).
If the risk is β=1, then the expected return is r m (from the expected rate of return of a security
is ri = rf + (rm-rf)β ) and the investment has the same expected return as the market portfolio.
The security market lines leads to a conclusion that if a security has more systematic risk, the
market will require a higher return.
REQUIRED RATE OF RETURN VERSUS WACC
The WACC represents the required rate of return for the firm as a whole (an average), thus
only accepting the investment if its expected internal rate of return if exceed or equal to the
firm’s cost of capital. It’s tend to accept a project that has IRR which above the WACC even
when the investment have a high level of risk (the rates of returns doesn’t compensate enough
for their risk). The approach also tends to reject some of low-risk project that should be
accepted (had enough rates of return to compensate for their risk) because the IRR below the
WACC

CHAPTER 9
THE COST OF CAPITAL AND CAPITAL STRUCTURE
DEFINITION
The Weighted Average Cost of Capital (k0 or WACC) is defined as the sum of the weighted
cost of debt and equity capital where the weights are the relative importance each in the
firm’s capital structure and the ki and ke cost are the expected returns required by investors as
an inducement to commit fund.
The market value of the firm is the sum of the market values of the outstanding debt and
equity:
V=B+S
In practice, the book value of B and S are frequently used instead of market value
k0 =
k0 = the weighted average after-tax cost of capital

ki = the before-tax average cost of debt, ki (1- tc) the after tax cost of debt
ke = the after tax average cost of equity capital
B = the market value of the debt in the capital structure
S = the market value of the stock equity in the capital structure
V = the total market value of the firm (Vu unlevered firm, VL levered firm)
tc = the corporate tax rate
If we were considering the rising of new capital to finance additional investment, it

would be more accurate to speak in terms of the return that would required if the a
mixture of additional debt and common stock were issued
Where the issuance of the debt and common stock will not change the firm’s capital
structure, the marginal cost may equal the average cost
if the capital structure were to change, but the WACC doesn’t change, the marginal
cost of capital is again equal to the average cost.
Debt capital:
financial leverage for remaining equity capital

increase the debt equity ratio will increase the variability of earnings per share
compared to the use of common stock capital
the issuance of debt may increase the expected earnings per share
interest expense is deductible buy taxable income, whereas dividends on common
stock are not deductible

The Weighted
in academic prefer the used of Market value rather than book value
the weighted should reflect the economic importance of the capital and not the
historical amount of debt and common stock as recorded by accountant
Practitioners favor the book values since they are objective and tend to be used by
other managers (e.g., bankers and bond analysts)
CAPITAL BUDGETING DECISION
The use of WACC has great intuitive as long as the WACC effectively reflects the riskiness
of the project. The normal investment has a life of more than one year and has unique risk
characteristics, so the use of one WACC measures as a discount rate for the entire firm’s
investments is not likely to be an effective method of evaluating investments.
Investment and Taxes
Shows if we include tax considerations and if the return required by debt and stock
can be defined for a given investment and a given capital structure
The use of WACC as the required return will lead to the investors receiving their
required returns
Assume:
Debt to equity 1/3 : 2/3 Total Investment $300

Cost of stock 0,12
Cost of debt before tax 0,06 To earn 0,093 an investment $300 should
Tax rate 0,35 earn $327,90 (0,093 x 300 = $27,9)
Cost of debt after tax 0,039
Cost of equity = 0,12 x $200 = $24
WACC = 1/3 x (0,12) + 2/3(1-0,35)(0,06) Cost of debt = 0,039 x $100 = $3,9
= 0,013 + 0,08
= 0,093
Existence of a Unique Optimal Financial Structure
The definitional relationship for weighted average cost of capital (k0) is:
The value of k0 is a function of the degree of financial leverage (B/V or S/V).
Consider how the two cost components of the cost of capital, k i and ke, react to an increase in
financial leverage, that is, a substitution of debt for equity financing. Assuming that investor
demand more return if their investment is subject to greater risk, we conclude that k i will
increase as more debt is substitute for equity because the payment stream to the debt holders
become more risky.

The same logic leads to the conclusion that ke will also increase as debt is substitutes for
equity since the benefit stream accruing to equity becomes more risky as debt obligations
increase in size relative to the amount of equity.
The shape of the k0 curve will depend on the shapes of the ki and ke curves. The traditional or
classical position assumes that ki and ke are shaped such that the resultant k0 curve is U or
sauced shaped, implying that there exists a unique minimum cost of capital structure.
No Taxes
The perfect market assumption implies that, with zero taxes, two non-growth firms,
which pay all net income as dividends and are identical in every respect except for capital
structure, should have the same market value. The market, as a whole, is purchasing the
same future stream of net operating income (EBIT) from both. How that EBIT stream is
divided into interest and dividend payment is immaterial in a perfect market, and the total
value of the firm will not affected by the firm capital structure. The value of the firm (V)
is independent of the amount of debt, and we can write:
The zero tax assumption makes new k0 equation:

The constant WACC (k0) showed by the graph below.
A Constant Value
Unlevered firm value with zero growth and zero taxes:
Now assume B of debt paying I interest is substituted for B of stock. The investor buys
the B debt and S stock and earns:
S stock earns : EBIT-I
B debt :I
An investment of S plus B Earns : EBIT
Therefore,
The firm value is not affected by the amount of debt.
Levering Firm
Firm can be de-levered by the investor buying stocks and bonds of the same firm
Levered by the use of personal borrowing
Investor substitute their own borrowing capacity for that of the firm to attain the
amount of total leverage that can desired
Purchase a combination of firms (one firm with too low and one firm with too high
leverage). In practice, mixture the extreme firms will not exactly duplicate the
medium firm.

THE VALUE OF LEVERED FIRM WITH TAXES
Assume an unlevered firm has a value of V U and is earning EBIT of X per year (no growth).
Assume B of debt paying I interest is substituted for B of stock and that the investor buy (1-
tc) of the debt and all the stock.
Investment of S earns: (X-1)(1-tc)

Investment of (1-tc) B earns (1-tc)I
Investment S + (1-tc) B earns: (1-tc)X
Since Vu also earns X (1-tc) we have:

Vu = S + (1-tc)B = S + B - tcB
Since Vt = S + B, we obtain
Vt = Vu + tcB
PERSONAL TAXES
The conclusion that the optimal capital structure decision is for the corporation to issue as
much debt as permissible may be modified when we allow the firm to retain earnings and to
include personal tax consideration in examining the wealth position of stockholder. The high
tax shareholders prefer retain earnings rather than dividends, which make the firm less
leveraged. The zero tax stockholder prefer dividend, which make the firm more leveraged.
If the debt holder and equity holder are identical groups, tax avoidance by labeling dividends
as interest can be in the owners’ best interest.

CHAPTER 10
DISTRIBUTION POLICY AND CAPITAL BUDGETING
The Corporate has to choose between:
Directly investing in real assets

Indirectly investing in real assets by buying the stock of another corporation
Giving the funds to its equity investors in the form of a cash dividend
Giving the funds to its equity investors in the form of a share repurchase process
The distribution policy defines:
The level of cash distributions to shareholders

The form of the distribution (dividend vs. stock repurchase)
The stability of the distribution
CASH DIVIDEND: FROM RETAINED EARNING
Cash dividends must be paid to preferred shareholders before any common shareholders are
paid.
Regular cash dividend – cash payments made directly to stockholders, usually each
quarter
Extra cash dividend – indication that the “extra” amount may not be repeated in the
future
Special cash dividend – similar to extra dividend, but definitely won’t be repeated
Liquidating dividend – some or all of the business has been sold
INVESTMENT: NEW CAPITAL
To be worthwhile investment (1 - td)r > rp ,(the return the investor can earn in the market after
income tax)
SHARE REPURCHASE VERSUS REAL INVESTMENT
Should a corporation repurchase shares or make real investments that earn r?
If r > rp the corporation should invest rather than repurchase share, r should (logically) be
larger than rp since r is the corporate return earned after the investor invests in the market and
the investment return is then taxed.
(1+ r)n > (1+ rp)n
tp = capital gains tax rate

rp = after income tax earning rate for investment in the market
r = after corporate tax return on new investment by corporation

A DIFFERENT REQUIRED RETURN
As an alternative method of determining the opportunity cost of capital, compares the return
earned by using free cash flow to repurchase shares of the firm’s stock with the return earned
by real investments. The model being described does assume that proposed investment’s one
period return can be computed or that the cash flows are a constant perpetuity.
Model
Define;M to be the stock price to free cash flow multiplier

Po to be the stock price
C to free cash flow
, the return from repurchasing share (setting the opportunity cost for equity capital)
is then: Repurchase return =
It is being assumed that the firm’s basic value at the end of the year is equal to its value at the
beginning of the year plus the year’s free cash flow.
The simple word, maintenance Cap-Ex is capital expenditures which were needed to
maintain the basic cash flow streams. Maintenance cap-ex must be substracted from
the total cash flow from operations to obtain the value of M.
The FCF that is used in determining the value of M includes as a subtraction the after-
tax interest cost. For simply calculation, firm is started from an optimum capital
structure which is assumed that any debt principal will be balanced with new
proceeds, thus no net change in the debt.
When repurchase return is computed = ; the decision maker in a new investment
can justify that the firm reinvest rather than repurchase shares, to earn the return on
equity capital. The important thing is that capital structure of the proposed investment
is consistent and firm’s risk or growth prospect are not changed.
The assumtion is that the multiplier of the stock of the firm undertaking the risky
investment will adjust once the investment is udertaken to reflect the new
investment’s risk.
Derivation of 1/(M-1)
Since the stockholders can earn a return of from a share repurchase strategy, an
investment in a real asset must do as well to be acceptable.
Let (NP0-NC) be the basic value of firm (that will earn NC the next year) after repurchase at
time zero, assume at time zero there is an investment of NC in a real asset that earns r.
The firm value at time one is; V1 = N (P0+ C (1+ r)).
Thus the stock price at time one is : P1 = = P0 + C(1+r),
where; P0 to be initial stock price; C is FCF per share at time zero; r as return expected.

CHAPTER 11
A FIRM INVESTING IN A SECOND FIRM
The acquisition of a firm by another firm is not about purchasing plant and equipment. It
differs because acquisition needs more information.
The more important reasons for an acquisition is that it will lead quickly to the obtaining of
resources such as; (1) Management talent, (2) Markets, (3) Products, (4) Cash or debt
capacity, (5) Plant and equipment (replacement cost is more than the price of the firm), (6)
Raw material, (7) Patents, (8) Knowhow (processes or people teams)
Another reason for acquisitions is diversification for risk reduction. The investors can
diversify relatively cheaply and risk reduction by the firm might enable the firm to do things
that would otherwise be too risky.
Acquisitions give popular reason is that two firms joined together will be more valuable than
the sum of the values of the two independent firms which is called synergy.
Several reasons why a merger of two firms may result in total profits larger than the sum of
two individual profits:
1. One firm be badly managed, and the second firm may be able to improve the level of
management skills of the total operation.
2. Vertical integration may allow better planning, the saving of some selling effort, and
improved distribution of product in process.
3. Horizontal integration may allow efficiencies in market coverage.
TAX IMPLICATION
A tax-loss company might acquire a profitable company in order to use its tax loss. The tax
motivation is sometimes not apparent to the public since both firms involved are reporting
incomes. It should be remembered that a firm with accounting income might still have a tax
loss.
There are advantages to an estate in having marketable stock whose value is relatively easily
liquidated, rather than having partial ownership in a privately owned corporation.
ANTI-RAIDING MANEUVER
Some acquisitions take place in order to fight off an unwanted raider. Managers are people,
and it is reasonable to expect that they will have preferences when they fear they will not be
able to continue as they did in the past. Managers would prefer merger with friendly firm
even though they would continue with unchanged operations.

ANTITRUST CONSIDERATIONS
Mergers can be prevented by certain laws which tend to lessen competition or tend to create
monopoly. The prevention of any merger or acquisition will obviously be a judgment call if
two firms involved in are in the same industry.
It is reasonable to expect that a conglomerate acquisition will be more likely to be approved

than will a horizontal acquisition. A vertical integration will lend to be less acceptable than
will a conglomerate acquisition but more acceptable than a horizontal acquisition.
AN ACQUISITION FOR CASH
A firm finding itself with extra cash above that required for normal operations essentially has
four choices:
1. Expand present activities
2. Add new activities
a. Do it yourself with basic building blocks
b. Acquire ongoing activity by the merger and acquisition process
3. Give the excess cash to stockholders via the following methods
a. Dividends
b. Other cash distributions (ex: repurchase of shares by the firm)
4. Retire debt or preferred stock
DETERMINING THE PREMIUM
We will assume that investor’s objective is to acquire the shares of common stock in the
target being acquired.
Let Po be the current market price of the firm to be acquired and x equal the stock price
multiplier. Thus, bid price = xPo
The shares to be purchased by the investor with the after-tax proceeds of a cash dividend of D
are ΔN =
With retention and a bid price of xPo, the share purchased by the firm with the D dollars are
ΔN =
D = dollars id price of available either for reinvestment or for a cash dividend

P0 = the current common stock price (the price paid per share)
td = tax on the investor’s dividend
Equating the two equations for ΔN yields
Solving for x, we obtain (1 - td) = or x =

ANALYSIS WITH CAPITAL GAINS
With a cash dividend of D, the after tax change in value for the investor is;
ΔV = (1- td)D
With retention, the firm can buy D/xPo shares. If each share has a value of Po, the total value
of share acquisition is;
Value = Po( )=
If we assume retention and then an immediate sale with a capital gain of D/x and a capital
gains tax of tg (D/x). The after-tax value is;
After-tax value = (1 – tg)
Equating the two values (dividends and retention with purchase and sale of stock),
(1 – td)D = (1 – tg)
Solving for x we find that x =
A HOLDING COMPANY
Example of Holding company

A owns B which owns C which owns D which owns E. The common stock of A is $10.000.
Mr Jones owns 50% of A’s common stock financed with borrowed funds.
A B C D E
Assets $50.000 $500.000 $5.000.000 $50.000.000 $500.000.000
Debt $40.000 $400.000 $4.000.000 $40.000.000 $400.000.000
Common stock $10.000 $100.000 $1.000.000 $10.000.000 $100.000.000
Condition:
1. A owns 50% of B’s common stock
2. B owns 50% of C’s common stock
3. C owns 50% of D’s common stock
4. D owns 50% of E’s common stock
Firm E has $500.000.000 of assets, and Jones controls it all with an investment of $5.000
financed with the bank’s money. The consolidation balance sheet shows the immense amount
of debt.
Consolidated balance sheet

Debt $444.440.000
Common stock $55.550.000
Minority interest
Common stock $10.000
$500.000.000

VALUATION FOR ACQUISITION
The four basic methods of valuating firm are:
1. Cash flow (DCF method or multiplier of cash flow)

Present value
2. Earnings
book value
3. Asset-liabilities market values (liquidation model)
replacement cost
4. Stock price: present and past

CHAPTER 12
INVESTING IN CURRENT ASSETS
INTRODUCTION
Management of working capital conflict:

Desired to have a safety stock of liquid assets.
Objective to apply a series of optimizing model (minimize cost of carrying working
capital and maximize the firm’s profits)
Advantages of having working capital that can be easily converted into cash:
Avoid bankruptcy.
Gain the liquid necessary to survive the period of unprofitable operations.
Decision Affecting Cash

Determining when cash should be obtained and how much new cash should be
obtained from sources outside the firm.
Determining whether marketable securities should purchase or sold.
A corporation may hold cash for; (1) Conform with the bank request that balances be carried,
(2) Financing transactions involving normal operations or capital asset acquisitions, (3)
Preparing for contingencies.
The amount of cash hold to provide for transactions should be no more than the amount
necessary to pay today’s bills
Models for optimizing the amount invested in working capital:

• Timing Strategy
• Acquiring the cash from long-term sources
• Near cash securities
• Managing accounts receivable
• Inventory and finance
TIMING STRATEGY
Issue long-term debt to replace short term debt

$ Cash Needs
Short-term debt
Amount of Long-term
capital outstanding
Time

Issue long-term debt to acquire short-term assets
Mixed Strategy
Acquiring the cash from Long-Term Sources
Total cost of acquiring cash over the planning period is the sum of acquisition costs
plus interest charges minus the interest earned on idle balance.
The acquisition cost is the sum of fixed cost incurred per year plus total variable
flotation cost.
formulation:
C = the amount of cash to be raised over the planning period by issuing debt
ki = the difference between the interest cost of long-term debt capital
i = return earned in idle funds
K = the fixed cost of raising debt (cost per issue)
b = the variable cost per dollar of issuing debt other than interest changes
Q = the size of each separate debt issue
T = total cost of acquiring cash

Optimum Size
Reformulation
and,
s = total controllable relevant cost for a year

r =k-i
Timing considerations:
Anticipate changes in the level of interest rates.

If the interest rate tends to increase, then the company should borrowing more now.
If the interest rate tends to decrease, then the company should borrowing less now.

NEAR-CASH SECURITIES
Virtually zero risk of default near-cash securities: Saving deposits, Certificates of

deposits, Government bills and notes, Prime commercial paper.
Other popular near-cash securities: Variable rate preferred stock & Short term tax-exempt
security
The Risk:
The timing of the firm’s cash needs doesn’t coincide with the maturity of the security.
If market interest rates change over the holding period, the price of the security will
change so as to earn the current market rate.
Risk Mitigation:
It is possible to hedge by buying securities that mature when a known cash need is
Forecasted to occur so that the company would earn the securities’ face value.
Decisions:
The amount of cash to be invested in securities
The type of securities to be purchased
The timing of the security purchases
Managing Account Receivables

Credit granting is an important decision in most firm.
The change of credit policy would affect the economic well-being of the firm.
The firm should makes its decision on credit granting based on the NPV analysis.
The more diversified the customers,
the smaller the credit risk.
Changes in overall business and market conditions, tend to affect nearly all customers in
the same way, therefore diversification may be of limited help in reducing total risk.
Cost Calculation
Firm should offer credit if the expected revenues are greater than the relevant costs of making
sale: pR> C

One Period Case With Time Discounting
or,
R = revenue from the transaction to be collected one period after the sale
C = the incremental cost of the goods or services sold
r = the time value of money
p = the probability of collection
Example:
Consider a bank officer deciding whether or not to lend $1,000 to a customer at 8%.
The expected probability of payment equal to 0.9.
The bank could invest $1,000 in the government bond market to earn 6 % for certain.
Since the 0.9 probability of collection is less than C(1+r)/R equal to 0.98, the loan should be
undertaken.
This example when considering a loan application:

Gross PV using PV net of $1,000 outlay Probability Expectation
outcomes 0.06
$1,080 $1,019 $19 0.9 $17
0 0 0 0.1 -100
Expected net present value = -$83
The use of sales price and incremental costs implies that each product being sold having a
different incremental profit per dollar of sales theoretically will require a different credit
policy.
Inventory & Finance
The accounting measures of inventory stocks and flows affect both the income
statement and the balance sheet.
The level of inventory held affects the amounts of capital needed as well as the
income of the period.
The firm has to balance the costs of having to much inventory with the cost of having
too little.
Inadequate inventory levels lead to disruptions in production and lost sales
opportunities.
Excessive and leftover can lose value through obsolescence and cause excessive
storage cost

Just-In-Time Inventory Model
The next shipment arrive just as the last unit is used.

The reduction inventory levels results in increased profit.
Needs to determine the position of the optimum level of inventory.
Economic Order Quantity Model
The Assumptions:
A known, constant demand over the period and known delivery time.
No change in holding costs per unit or order costs.
No change in prices through time and no quantity discounts.

CHAPTER 13
FOREIGN INVESTMENT
Assume that we start with two identical risk and return situations relative to the real
investments in plant and equipment. One opportunity is domestic and the second is a foreign
subsidiary. If the domestic investment is treated as a conventional investment and the basic
investment cash flows are used for the analysis instead of the investment cash flows.
There should be an upward switch in the required return if the stock equity cash flow are used
for the analysis instead of the investment cash flow. Foreign currency must be translated back
into domestic currency in computing NPV or IRR. Their primary distinction is exchange
problem, tax, and other institutional problem.
CURRENCY TRANSLATION
or
= the required rate of return of the parent company (say, in dollars)
= the rate of devaluation of the currency
= the rate of return that should be required in terms of the currency of the foreign
investment
So, the foreign company make profit at parent company’s IRR complemented by the
devaluation of foreign currency with an extra of term of interaction which is Parent company
IRR times Foreign currency Devaluation.
A DIFFERENT APPROACH
The foreign currency will be converted to dollars to determine the net present value or
internal rate of return of the investment.
Time Yen Conversion Dollars
0 -1,000,000 100 -10,000
1 100,000 80 1,250
2 1,100,000 50 22,000
Discount Rate NPV IRR Yen IRR Dollars

10% 9,318.18 10.00% 54.71%
The internal rate of return increase from 10% in yen to 54.7% computed using dollars, and
give significant result to the NPV
Time Yen PV factors (0,547) Dollars
0 -1,000,000 1 -10,000
1 +1,250 0.6464 808
2 22,000 0.4178 9,192
NPV 0

IRRELEVANCE OF FUTURE PLANS
The IRR referred before is only applicable if you return the money invested to the parent
company
If the profit were used to re-invest in the foreign country, the IRR applied from the
respected country
LEVERAGE CONSIDERATION
Frequently investments in foreign countries are made by forming subsidiary corporations.

These subsidiaries often will have one or more partners and are financed heavily in debt.
Assume a situation where a firm considering a $ 10,000 investment in a piece of equipment

to be located in US. The firm us 10% as the discount rate and the possibility of two equally
likely outcomes;
0,5 +16,000
-10,000
0,5 +5,800
The expected outcome is $10,900, and the expected net present value is -$91 (NPV< 0)
Let us assume that the firm is financed with 0.4 debt and 0.6 common stock and that the
following capital costs apply:
Capital Structure Cost Weighted cost

Debt 40.00% 6.00% 2.40%
Stock 60.00% 12.70% 7.60%
WACC 10.00%
Most of foreign investments are made by forming subsidiary which is financed heavily with
debt.
0,5 +16,000 -5,350 =
10,650
-5,000
0,5 +5,800 -5,350 =

450
The expected outcome is $5,550 (IRR 11%), and the expected net present value is $45
(NPV< 0)
Capital Structure Cost Weighted cost

Debt 50.00% 6.00% 3.00%
Parent Capital 30.00% 12.70% 3.81%
Parent Debt 20.00% 12.70% 2.54%
WACC 9.35%

In the preceding analysis the in conclusion of the additional debt of the subsidiary was made
obvious. Frequently, in evaluating investments in foreign subsidiaries, the in conclusion of
the parents’ debt is less obvious. It may not be made clear that a higher return is required on
funds invested in the stock equity of a subsidiary because of the additional debt that is
incorporated in the analysis
TAXES
The tax laws applicable to international trade are apt to change through time. But the general
principles are still the same.
Tax could be treated as an expense or a tax credit.
Tax deferral could give incentive for parent company to re-invest their profit in respected
foreign country.
Taxation is entirely depend on the parent country policy, tax credit.
The foreign income is taxed by the foreign country at a rate of t as it is earned
On repatriation, the dividend from the foreign investment will be taxed by US at rate of tc-tf,
a return of capital is not taxed.
One Period Example
In the one-period case with both foreign and domestic investments earning the same before-
tax return, there is indifference to investing domestically or foreign.
Multiple Period Example
The internationalization of business activity requires that the tax laws of the location of the
investment and of the parent be considered. Ideally the laws should not introduce a bias into
the preference for location, but frequently a bias will be introduced.

Remission Of Funds
Some country limiting the flow of funds

Company should develop strategies to facilitate the transfer of funds
Supply capital in the form of debt
Inflate the intracompany transfer prices (affect tax)
declare a cash dividend (simpler way)
FOREIGN INVESTMENT AND RISK
Foreign investment is a form of risk diversification. A foreign investment may be riskier than
a domestic investment, but at the same time is overall effect on the risk of the corporation
might be to reduce it.
For the purposes of illustration, assume that the variance of a domestic investment is 100
while the variance of a foreign investment is 250.
Variance with domestic Investment

1,600 + 100 + 2(40x10) = 2,500
Variance with foreign Investment
1,600 + 250 = 1,850
Even though the variance of the foreign investment is 2.5 times as large as the variance of the
domestic investment, it has a significantly more desirable effect on the firm’s risk. Some of
the company’s stockholders may also benefit from the foreign diversification.

CHAPTER 14
BUY VS LEASE DECISION
Leasing is both a method of financing and a method of acquiring asset. Many reasons are
offered as to why a firm should lease. This chapter suggests that not all the reasons offered
are valid.
The lessor may have made incorrect calculation
The lessor may have economic of scale in purchasing (price discrimination in favor of
large buyers)
The lessor may have lower borrowing costs than the lessee
The lessor may have different estimates of life, cost of capital, or salvage than the lessee
Different tax and borrowing rate situations may exist
A different of opinion of the lessor and the lessee may exist as to the appropriate method
of evaluating the lease alternative
There are three basic problems in analyzing buy v.s. lease

Definition of the cash flows to be used
The choice of the rate of discount
Match the appropriate rate of discount with the choice of cash flow
It is necessary to compare the cash flows and the present value of one alternative (buy) with
the present value of the other alternative (lease).
There are three basic choices for the rate of discount to be used:
The after tax borrowing tax
The before tax borrowing rate
Some type of risk adjusted rate such as the weighted average cost of capital.
Two primary complexities of buy versus lease analysis:

Must be placed on comparable basis.
Review the buy versus lease decision assuming the existence of corporate income taxes.
ONE INCORRECT METHOD

Present value:
PVIFs can be presented in the form of a table with PVIF values separated by respective
period (t) and interest rate combinations (r). The present-value calculation led to an incorrect
decision if the choice of the rate discount was wrong.
THE TWO INCORRECT METHOD
Determine the cash outlay per period for using debt as compared with leasing.
Computed the present value of the lease payment and compared the debt equivalent or
the present value of leasing with the cost of asset.
RESIDUAL VALUE
The amount a company expects to be able to sell a fixed asset for at the end of its useful life,
Residual value (RVs) is one of the constituents of a leasing calculus or operation. It describes
the future value of a good in terms of percentage of depreciation of its initial value.
Residual values are calculated using a number of factors, generally a vehicle market value for
the term and mileage required is the start point for the calculation, followed by seasonality,
monthly adjustment, lifecycle and disposal performance.
THE LEASE DECISION WITH TAXES
The total tax deductions from buying and leasing are equal.
One can only compute the after tax cost of leasing by computing a PV of after tax lease
payments using an annuity if the after tax borrowing rate is used.
RISK-ADJUSTED DISCOUNT RATES
If the after-tax borrowing rate is used computing present values, the calculations of the
net cost of buying and leasing are straightforward. With more than one time period, the
error introduces by discounting the after-tax lease payments by the firm’s risk-adjusted
required return and comparing the present value obtained with the present value of
buying is well hidden.
Lease can be cancelled, it is not necessary to compute a debt equivalent of a lease if the
firm can cancel the lease with the equivalent of a phone call. The present value of leasing
obtained using the unadjusted lease cash flows and a risk-adjusted discount rate is not
comparable to the present value of the buy alternative’s cash flows.
THE CALCULATION THAT IS NOT MADE
We do not take the lease payment, multiply by one minus the tax rate to convert it to an after-
tax cash flow measure, and then compute its present value using a risk-adjusted discount rate.
This type of calculation is correct if the after-tax borrowing rate is used, but it is not
acceptable if any other discount rate is used unless the buy analysis is also adjusted to include
debt flows. Including debt flows in the buy analysis is not a recommended or conventional
procedure.
CASH FLOWS AND DISCOUNT RATE: DEBT
The presence of taxes combined with the desire to use risk-adjusted discount rates could
mislead in to biases in the analysis. A simple solution is to use the after-tax borrowing rate as
the discount rate in buy-versus-lease analysis.
The acceleration of lease payments can be shown to enhance the leasing alternatives.
However, we conclude that if buy-borrow is being compared with leasing it is necessary to

make the present value calculations to determine which alternative is the more desirable, safe
exact generalizations are very rare in the area of buy-lease analysis.
PROS AND CONS OF LEASING
PROS CONS
Leasing is a method of 100% debt The signing of a lease reduces
financing. A lease is frequently easy somewhat the lessee’s ability to issue
Financing
to obtain and the asset is quickly more debt in the future.
available.
A short-term lease or a cancelable
Flexibility
lease offers flexibility.
With conventional debt, it is clear that
Bankruptcy failure to pay opens up the possibility
of bankruptcy.
With leasing the maintenance may be
Maintenance is contracted. The certainty of
cheap and maintenance and the fact that its cost
certain is certain is said to make leasing
attractive.
Before FAS 13, leases were largely Now capital leases are recorded as
Off-balance
off-balance-sheet debt, and this was liabilities.
sheet financing
thought to be an advantage of
leasing.
Higher return on With an operating lease there is no
investment asset recorded; thus it is easier for
management to justify an investment.
An operating lease will tend to inflate
Higher Incomes the income of early years of life
compared with the expenses resulting
from buying the assets.
Lower property Leasing leads to lower property There is no reason to see an
taxes taxes. advantage relative to property taxes
unless the lessor is tax exempt.
It is difficult for the normal leasing
Income tax
contract to overcome the tax
savings
advantage associated with buying.
A well-defined For certain purpose, it is useful to

cost have the well-defined costs offered
by a lease contract.
THREE DECISION
Firms have three decisions if an asset can be leased;

The firm has to decide whether or not the project is worthwhile.
A decision has to be made whether the financing should be done with straight debtor
leasing.
The firm must consider using equity rather than leasing-or debt.

CHAPTER 15
AN INTRODUCTION TO REAL OPTIONS
A Financial Option arises because of an explicit contractual relationship between the

owner of the option and another party who is called the writer of the asset.
A real option has been defined as “the right, but not the obligation to take an action
(e.g., deferring, expanding, contracting, or abandoning) at a predetermined cost,
called the exercise price, for a predetermined period of time-the life of option.
The owner of a call option can acquire an asset in the future at a known cost. The
owner of a pt option can dispose of an asset in the future at a known price.
The value of flexibility (real option) can be estimated using the theory of pricing
options and the related contingent claims analysis.
BLACK-SCHOLES
F.Black and M.Scholes laid the foundation for the valuation of options.
There are many assumptions in their derivation:
1. The volatility (standard deviation) of the stock’s return is known.
2. There is a risk-free rate that is constant through time.
3. There are no transaction costs, and the seller receives the proceeds from short sales.
4. Taxes are not relevant.
5. There are no dividends.
6. The stock price follows a random walk, and the price, time t, is log normally
distributed.
Black and Scholes assume an economic environment in which arbitrage can replicate the
payoffs from the call option during the next instant with a portfolio of stocks and bonds.
Black and Scholes find the value of an option to be,
where,
and,
N(h1) = the value of the cumulative normal probability distribution function (left tail) for h 1
standard deviations
K = the exercise price
S = the stock price now
= the natural logarithm
r = 1 + rf = the risk-free interest rate plus 1
T = the time until maturity
σ = the standard deviation of the rate of return of the common stock (this is the only input
that cannot be observed)

OPTION VALUATION WHEN THERE IS NO HEDGE PORTFOLIO
Sometimes, it is not easy to devise a hedge portfolio. Without a hedge portfolio, the value of
the option cannot be determined using arbitrage. Nevertheless, the concept of an option may
still be valuable
Option theory contains two important lessons for capital budgeting:
The flexibility may be valuable.
Sometimes, with enough ingenuity, it may be possible to devise an appropriate hedge
portfolio that can be used to value the option using arbitrage.
THE VALUE OF WAITING
An investment can be started now or delayed for one year. These alternatives are mutually
exclusive.
Example:
“Started Now”
Required rate of return for risky expected cash

Outlay = $70,000
flow is 0.15
Cash flow next year
can be either $150,000 Expected cash flow in year one:
or -$30,000
$ 150,000 x 0.6 = $ 90,000
-$ 30,000 x 0.4 = -$ 12,000
Expected cash flow $ 78,000
Probabilities = 0.6
PV expected year one cash flow:
and 0.4
$ 78,000 / 1.15 = $ 67,826
NPV at time zero:
$ 67,826 - $ 70,000 = -$ 2,174
Because the NPV is negative, this alternative should be rejected

“Waiting”
Outlay = $10,000 Required rate of return for risky expected cash

Next = $60,000 flow is 0.15
(if positive) Default free rate is 0.04
Cash flow next year
can be either $150,000 Expected cash flow in year one:
or -$30,000
($ 150,000/1.04) -
= $ 50,539
$60,000 x 0.6
$ 0 x 0.4 = -$ 0
Expected cash flow $ 50,539
Probabilities = 0.6
PV expected year one cash flow:
and 0.4
$ 50,539 / 1.15 = $ 43,947
NPV at time zero:
$ 43,947 - $ 10,000 = $ 33,947
Because the NPV is positive, this alternative should be accepted
AN OPTION TO EXPAND
In case of deciding to build new factory, the site which provides the option of expanding
without relocating has some value. It is the characteristics of a call option.
The more uncertainty about space requirements, the more valuable the option.
The striking price of the option is the cost of the expansion.
If the value of the option is greater than the striking price, the firm should accept it.
To exercise the option, timing are relevant here. The firm must consider if the same
investment opportunity is available to competitors.
PUT OPTION ON REAL ASSETS : AN OPPORTUNITY TO SELL

Put options provide the owner of an asset with the right to dispose of it at a defined price.
There are two necessary circumstances:
A secondary market exists for the asset.
The price at which the asset can be sold in the secondary market may be larger than
the use value of the asset to the present owner
The existence of a put option guarantees that the value of an asset will never be less
than its resale value.
“Specialized” asset is an asset with the only specific use and “general” asset is an asset for
which there are many possible uses. The existence of put option can guarantees the value of
asset, especially the specialized one.

EMBEDDED OPTIONS: THE VALUE OF FUTURE USES
The value of an investment can be underestimated if values of future opportunities resulting

from the investment are not explicitly considered. So, the value the the investment today is
considered to be the sum of:
The value of the cash flows that will occur from assets that will be acquired if the project
is accepted.
The value of the options associated with future decisions related to these assets.
VALUATION: EXPECTED VALUE LESS THAN LIABILITIES
Assume that the expected value of the assets is $1,000,000 and the liabilities are $1,500,000.
Outcome Probability Expected Value
$ 4,000,000 0.25 $ 1,000,000
$ - 0.75 $ -
Expected Value $ 1,000,000
A naive analyst might conclude that this firm’s common stock has little or no value given the
liabilities of $1,500,000. From option perspective, the stock has considerable value. The
expected value of the stock is: (4,000,000 – 1,500,000)(0,25) = $625,000. The expected value
of the debt is: 1,500,000 (0,25) = $ 375,000.
THE OPTION APPROACH
ADVANTAGES DISADVANTAGES
Less chance of overlooking future decision Less of standard to guide future operations
strategies Care should be taken to provide operating
The option-valuation approach helps management some guidelines about what
overcome the possibility of overlooking decisions are optimal (each), so these
important relevant values that can lead to guidelines are not standardized.
wrong investment decision Hidden assumptions
Better valuation procedures Sometimes, implicit economic (cash-flow)
Valuation by market arbitrage is more assumptions may be hidden, preventing
accurate than valuation by projecting future management from effectively evaluating the
cash flows. assumptions.
Fewer cash flow strategies to be considered
The value of an option takes all investment
strategies into account without the necessity
of explicitly considering each one.
The first and most important lesson of option theory for capital budgeting is that
flexibility may be valuable. This lesson is applicable whether or not the option that
provides flexibility can be valued using arbitrage arguments.
The second lesson is that sometimes, with enough ingenuity, it may be possible to devise
an appropriate hedge portfolio that can be used to value the option using arbitrage.

CHAPTER 16
CAPITAL BUDGETING AND INFLATION
The basic principles of capital budgeting are equally applicable when there is a risk of
inflation. However, it is not always easy to apply these principles correctly when the risk of
inflation is primary importance.
With inflation, cash flows will be differred not only in their timing but also in their
purchasing power, investment can analyze using either money cash flows or purchasing
power flows, as long as the present value analysis is done in a consistent manner. In a
dynamically growing economy, price changes take place constantly.
The price changes that are the result of shift in the supply or demand for particular goods and
services, do not imply any change in the general price level.
WHAT IS INFLATION?
Inflation is a rise in the general level of prices of goods and services in an economy over
a period of time.
Deflation is a decline in the general level of prices of goods and services in an economy
over a period of time.
Consumer Price Index (CPI) measures changes through time in the price level of
consumer goods and services purchased by households. CPI is defined as “a measure of
the average change over time in the prices paid by urban consumers for a market basket
of consumer goods and services.
It has long been recognized that one of the disadvantages of an unstable price level is; it
makes the task of appropriately analyzing the economic advantages and disadvantages of
different alternatives more difficult and complex.
REAL CASH FLOWS AND NOMINAL FLOWS
Real Cash Flows Nominal Flows

Better estimation accuracy, if revenues or Better estimation accuracy, if future costs
costs are mainly determined by market forces and revenues are determined by long term
in the period in which the outlays are made fixed price contractual relationships
or the revenues received
REAL AND NOMINAL DISCOUNT RATE
The value of an asset should not depend on whether it is analyzed in nominal terms or in real
terms as long as the appropriate discount rate is used in each case. With nominal cash flows,
the discount rate used should be the nominal discount rate. With real cash flows, the discount
rate used should be the real discount rate.

To illustrate the relationships between the two discount rates, we firs ignore tax affect. With
annual compounding, if “j” is the annual rate of inflation and “i” is the real rate of interest;
the corresponding nominal rate of interest (r) is
r = (1 + j) (1 + i) - 1 or, r = j + i + ij
the real rate of interest (i) is

I = (r - j) / (1+ j)
In valuing an asset, we can use nominal cash flows and the nominal rate of interest or the
corresponding real cash flows and real interest rate.
i.e. Suppose, we observe a bond that promises interest payments of $133 per year for three
years, with the principal of $1,000 to be repaid at the end of the third year. At the nominal
discount rate of 13.3%, the present value of the bond is $1,000.
Nominal present value

Period Nominal cash flow Present value
factor (0.133)
1 $133 0.8826 $117.39
2 133 0.7790 103.61
3 1,133 0.6876 779.00
$1,000.00
The same present value would result if we first convert the nominal cash flows to real cash
flows and discount these at the corresponding real interest rate of 0.03.
Period Nominal cash Price level Real cash Real present Present value
flow relative flow value factor
n (1) (2) = (1+j)^n (3) = (1)/(2) (4) = (1+i)^-j (5) = (3)(4)
1 $133 1.10 $120.91 0.9709 $117.39
2 133 1.21 109.92 0.9426 103.61
3 1,133 1.331 851.24 0.9151 779.00
$1,000.00
TAX EFFECTS
In general, investors who are taxed will realize lower after-tax returns than investors who are
not. However, there are interactions between the tax effects and the inflation. Suppose an
investor expects that the rate of inflation will be j per year, and the nominal rate of interest on
taxable default-free debt is r. A taxable investor buying taxable nominal default-free debt will
realize an after-tax nominal return of (1-t)r, where t is the investor's marginal tax rate. We
denote the after-tax real return by i(t), to emphasize that the value of the after-tax real return

depends on the marginal tax rate, t. The after-tax real return to the taxable investor can be
expressed as:
rearranging the terms, it can be expressed as
If there is no inflation, then j = 0 and i(t) = r(1-t), as we would expect.
i.e. Suppose that the marginal income tax rate in 30%, the inflation rate is 6% per year, and
nominal default-free taxable debt returns 11%. Then = 0.016
THE REAL RETURN AND THE RATE OF INFLATION
Incomes tax were not a major issue for investor and the formulated the relationships on a
before-tax basis. This is still the relevant relationships for tax-exempt investors. Investors
would like a nominal return that is large enough so that expected after-tax real return does not
decline because of inflation. If an investor in a give tax bracket receives an unchanged real
return, investors in lower tax brackets receive a larger real return, and investors in higher tax
brackets receive a lower real return. The latter will either have to settle for a lower real return
or try to shift into assets that provide better inflation hedges. The tax bracket at which after-
tax real returns do not change will be referred to as the “marginal” tax bracket.
The Darby effect predict that, in the presence of expected inflation, nominal interest rates will
rise by enough so that expected after-tax real return of taxpaying investors in the marginal tax
bracket will remain constant, so that security returns can compete with returns on real asset .
Assume we know that the tax bracket of these marginal investors is t (m) and that the
effective interest rate for these marginal investors is “i” (m). By assuming, “i” (m) will not
change with respect to changes in the rate of inflation, we have solving for r as

CHAPTER 17
REFLECTIONS ON THE CAPITAL BUDGETING DECISIONS
The business community broadened our recommendation by adopting other

discounted cash flow (ODF) methods, and this was acceptable to us as long as the
other DCF methods were used correctly. These other DCF methods included adjusted
present value, internal rate of return (IRR), profitability index, index of present value,
and adjusted internal rate of return.
THE CRITICISMS OF NPV
Some critics have claimed that NPV result in “a bias against long-lived assets”. This
is only true if an excessively high discount rate is used.
Some assumption that needed

Requires determination of the discount rate
All DCF methods require an assumption of the discount rate before a decision is
made.
The NPV is absolute dollar amount; this is difficult to evaluate
The solution is to compute the investments NPV profile with the investments IRR
highlight
The NPV does not consider the real option value
Correctly computed, the value of the options must be included in the investment
analysis. Of the above the real option item deserves expansion.
CASH ON CASH
“Cash is King” This widely accepted saying has led to a calculation called “cash on
cash”. It is used to supplement or replaced IRR and easily calculated and can be used
after the NPV and IRR calculations are made to make an argument, but it should not
be used without first computing the NPV’s.
REAL OPTIONS
There are several points to keep in mind.

Including real option value can only increase the investments NPV if one of real
options has value.
Real option was always difficult to value.
Real options in the end of project’s life offer the opportunity for the analyst to
“game” the result by adding to the analyst a very large amount of value at some
very distant time period; thus the assumptions are difficult to verify.

CASH FLOW COMPONENTS
It has long been known that there are situations where the cash flows of an investment
should be decomposed. Each cash flow component may require its own discount rate
because it has unique risk. The different discounts rates for cash flow components of
different risk should be implemented.
THE COMPOUNDING OF RISK
To find the present value of the future cash flow occurring in n period we use (1+r)-n.
The discount r rate includes consideration of both time value and risk. The time value
formula (1+r)n implicitly assumes risk compounds through time. Define rf to be the
risk free rate. It is useful to compute the present value using (1+rf)n as well (1+r)n
where r includes risk adjustment.
The preference depends on the amount of risk. The choice of the discount rate is very
important to achieve good quality decisions.
INVESTING IN OTHER COUNTRIES
When investing in other countries we must consider:

The relevant tax laws of the country where the firm is investing
The impact of non US tax laws and taxes income on the US taxes
The potential of political and economic instability
The currency translation likelihoods
Currency hedging strategies
The implications of non US investing on a US firm’s debt policy (especially the
best sources of borrowing). The tax laws affect the country source of borrowing
for a US firm.

The Capital Budgeting Decision - BookSummary

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Capital Budgeting Decision - BookSummary

Uploaded by

Copyright:

Available Formats

Investment Analysis Assignment

Mohamad Odang Rizki (29108310)

Investment Analysis MM – 6056

Kelas MBA Reguler 41 + 42

THE STATE OF BUSINESS PRACTICE

TIME, RISK, AND THE RISK-RETURN TRADE OFF

THREE BASIC GENERALIZATIONS

CASH FLOWS VERSUS EARNINGS

A decision may be characterized by its effect on accounting earnings, as well as by its

The cost of capital for one firm will depend on:

THE WEIGHTED AVERAGE COST OF CAPITAL

TACTICAL AND STRATEGIC DECISIONS

Tactical Investment Decision Strategic Investment Decisions

THE ROLE OF STRATEGIC PLANNING

Summary of “The Capital Budgeting Decision” Book 2

PRESENT VALUE MULTIPLICATION RULE

PRESENT VALUE OF PERPETUALITY

Perpetuity is an annuity that goes on forever (a infinitive sequence). If we let n of equation

Think of the annuity as the difference between two perpetuities;

A CONSTANT INTEREST BOND

PRESENT VALUE FACTORS DERIVED FROM MARKET PRICE

Summary of “The Capital Budgeting Decision” Book 5

CLASSIFICATION OF CASH FLOWS

There are 3 types of investment cash flows:

An estimate of relative cash flows always involves a comparison of two alternatives. It is

Method-1: Net Present Value (NPV)

Summary of “The Capital Budgeting Decision” Book 6

Method-3: Payback Period

Method-4: Return on Investment (ROI)

MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)

It is a method introduced by the US Congress in August 1981 to calculate tax depreciation

Summary of “The Capital Budgeting Decision” Book 7

Two methods to accept or reject decisions

A. Conventional and Nonconventional Cash Flow

Investment type loan type

Significance of Nonconventional Cash Flows

MUTUALLY EXCLUSIVE INVESTMENT

Mutually exclusive investments: undertaking one of the investments will completely

Summary of “The Capital Budgeting Decision” Book 8

Consider the following example:

A quick answer would be that A

Consider the following example

Summary of “The Capital Budgeting Decision” Book 9

CONVERTING MULTIPLE IRRs TO A SINGLE IRR

WHY IRR IS POPULAR

Summary of “The Capital Budgeting Decision” Book 10

MAKE OR BUY DECISION

MUTUALLY EXCLUSIVE ALTERNATIVE WITH DIFFERENT LIVES

Mutually exclusive alternatives aren’t necessary to have same lives in order to be

THE REPLACEMENT DECISION

A special classification of investment decisions involves the replacement of currently owned

Summary of “The Capital Budgeting Decision” Book 11

Absolute cash flow of each alternatives

Summary of “The Capital Budgeting Decision” Book 12

EXTERNAL CAPITAL RATIONING

INTERNAL CAPITAL RATIONING

There are two types of internal capital rationing.

Summary of “The Capital Budgeting Decision” Book 13

A misconception about Profitability Index is that it will rank independent investments

Summary of “The Capital Budgeting Decision” Book 14

THE SOURCES OF CASH

Retained earnings have a cost, and this cost should be