Question

Explain all in detail and support your argument using the financial concepts that are consistent with the book.

1. (10 points) Make distinctions between the net present value (NPV) and the profitability (PI) method in the capital budgeting analysis.

2. (10 points) Explain in detail what the weighted average cost of capital (WACC) is and the role it plays in capital budgeting.

3. (10 points) Explain what is meant by the incremental cash flow and tell me why the incremental cash flow is only relevant for the capital budgeting analysis.

4. (10 points) What are flotation costs and why must they be included in the initial cost of a project? Explain in detail.

5. (10 points) Make distinctions between the standard deviation and beta in the measurement of risk in the capital market. Which one of these two metrics (standard deviation and beta) is relevant for measuring the risk of well-diversified portfolio? Explain why.

Answer 1

Make distinctions between the net present value (NPV) and the profitability (PI) method in the capital budgeting analysis.

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

A positive net present value indicates that the projected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive NPV values should be considered.

Apart from the formula itself, net present value can be calculated using tables, spreadsheets, calculators, or Investopedia’s own NPV calculator.

Money in the present is worth more than the same amount in the future due to inflation and to earnings from alternative investments that could be made during the intervening time. In other words, a dollar earned in the future won’t be worth as much as one earned in the present. The discount rate element of the NPV formula is a way to account for this.

For example, assume that an investor could choose a $100 payment today or in a year. A rational investor would not be willing to postpone payment. However, what if an investor could choose to receive $100 today or $105 in a year? If the payer was reliable, that extra 5% may be worth the wait, but only if there wasn’t anything else the investors could do with the $100 that would earn more than 5%.

An investor might be willing to wait a year to earn an extra 5%, but that may not be acceptable for all investors. In this case, the 5% is the discount rate which will vary depending on the investor. If an investor knew they could earn 8% from a relatively safe investment over the next year, they would not be willing to postpone payment for 5%. In this case, the investor’s discount rate is 8%.

A company may determine the discount rate using the expected return of other projects with a similar level of risk or the cost of borrowing money needed to finance the project. For example, a company may avoid a project that is expected to return 10% per year if it costs 12% to finance the project or an alternative project is expected to return 14% per year.

Imagine a company can invest in equipment that will cost $1,000,000 and is expected to generate $25,000 a month in revenue for five years. The company has the capital available for the equipment and could alternatively invest it in the stock market for an expected return of 8% per year. The managers feel that buying the equipment or investing in the stock market are similar risks.

The profitability index (PI), alternatively referred to as value investment ratio (VIR) or profit investment ratio (PIR), describes an index that represents the relationship between the costs and benefits of a proposed project. It is calculated as the ratio between the present value of future expected cash flows and the initial amount invested in the project. A higher PI, the more attractive a project will be.

The PI is helpful in ranking various projects because it lets investors quantify the value created per each investment unit. A profitability index of 1.0 is logically the lowest acceptable measure on the index, as any value lower than that number would indicate that the project's present value (PV) is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

The profitability index is an appraisal technique applied to potential capital outlays. The method divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. As indicated by the aforementioned formula, the profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned variables.

When using the profitability index to compare the desirability of projects, it's essential to consider how the technique disregards project size. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margins are not as high.

Explain in detail what the weighted average cost of capital (WACC) is and the role it plays in capital budgeting.

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.

Cost of equity (Re) can be a bit tricky to calculate since share capital does not technically have an explicit value. When companies pay a debt, the amount they pay has a predetermined associated interest rate that debt depends on the size and duration of the debt, though the value is relatively fixed. On the other hand, unlike debt, equity has no concrete price that the company must pay. Yet that doesn't mean there is no cost of equity.

Since shareholders will expect to receive a certain return on their investments in a company, the equity holders' required rate of return is a cost from the company's perspective, because if the company fails to deliver this expected return, shareholders will simply sell off their shares, which leads to a decrease in share price and in the company’s value. The cost of equity, then, is essentially the amount that a company must spend in order to maintain a share price that will satisfy its investors.

Calculating the cost of debt (Rd), on the other hand, is a relatively straightforward process. To determine the cost of debt, you use the market rate that a company is currently paying on its debt. If the company is paying a rate other than the market rate, you can estimate an appropriate market rate and substitute it in your calculations instead.

There are tax deductions available on interest paid, which are often to companies’ benefit. Because of this, the net cost of a company's debt is the amount of interest it is paying, minus the amount it has saved in taxes as a result of its tax-deductible interest payments. This is why the after-tax cost of debt is Rd (1 - corporate tax rate).

Explain what is meant by the incremental cash flow and tell me why the incremental cash flow is only relevant for the capital budgeting analysis.

Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project. A positive incremental cash flow is a good indication that an organization should invest in a project.

There are several components that must be identified when looking at incremental cash flows: the initial outlay, cash flows from taking on the project, terminal cost or value, and the scale and timing of the project. Incremental cash flow is the net cash flow from all cash inflows and outflows over a specific time and between two or more business choices.

For example, a business may project the net effects on the cash flow statement of investing in a new business line or expanding an existing business line. The project with the highest incremental cash flow may be chosen as the better investment option. Incremental cash flow projections are required for calculating a project's net present value (NPV), internal rate of return (IRR), and payback period. Projecting incremental cash flows may also be helpful in the decision of whether to invest in certain assets that will appear on the balance sheet.

What are flotation costs and why must they be included in the initial cost of a project? Explain in detail.

Flotation costs are the costs that are incurred by a company when issuing new securities. The costs can be various expenses including, but not limited to, underwriting, legal, registration, and audit fees. Flotation expenses are expressed as a percentage of the issue price.

After the flotation costs are determined by a company, the expenses are incorporated into the final price of the issued securities. Essentially, the incorporation of the costs reduces the final price of the issued securities and subsequently lowers the amount of capital that a company can raise.

The size of flotation expenses depends on many factors, such as the type of issued securities, their size, and risks associated with the transaction. Note that the costs for issuing debt securities or preferred shares are generally lower than those for issuing common shares. The flotation costs for the issuance of common shares typically ranges from 2% to 8%.

Flotation cost is defined as the cost incurred by the company when they issue new stocks in the market as the process involves various stages and participants. It includes audit fees, legal fees, accounting fees, investment bank’s share out of the issuance and the fees to list the stocks on the stock exchange that needs to be paid to the exchange.

• It is expressed as a percentage of the issue price since the capital that is raised after the sale of the new stocks will be after the deduction of the flotation cost.
• It is evident that due to this cost that is involved in the issuance of the new stocks, the final price of the new stocks is reduced and ultimately results in a lowered amount of capital that can be raised.
• The cost involved in the issuance of debt securities or preferred stocks is often less than issuing common stocks.
• The average range of flotation costs for issuing common stocks falls anywhere between a minimum of 2% to a maximum of 8%.

Make distinctions between the standard deviation and beta in the measurement of risk in the capital market. Which one of these two metrics (standard deviation and beta) is relevant for measuring the risk of well-diversified portfolio? Explain why.

Beta and standard deviation are measures of volatility used in the analysis of risk in investment portfolios. Beta shows the sensitivity of a fund’s, security’s, or portfolio’s performance in relation to the market as a whole. Standard deviation measures the volatility or risk inherent to stocks and financial instruments. While both beta and standard deviation show levels of risk and volatility there are a number of major differences between the two. The following article explains each concept in detail and highlights the differences between the two.

What is Beta Measure?

Beta measures a security’s or portfolio’s performance (asset’s risk and return) in relation to the movements in the market. Beta is a relative measure used for comparison and does not show a security’s individual behavior. For example, in the case of stocks, beta can be measured by comparing the stock’s returns to the returns of a stock index such as S&P 500, FTSE 100. Such a comparison allows the investor to determine a stock’s performance in comparison to the entire market’s performance. A beta value of 1 show that the security is performing in line with the market’s performance and a beta of less than 1 show that security’s performance is less volatile than the market. A beta of more than 1 show that a security’s performance more volatile than the benchmark.

What is Standard Deviation?

Standard deviation as a statistical measure shows the distance from the mean of a sample of data, or the dispersion of returns from the sample’s mean. In terms of a portfolio of stock, standard deviation shows the volatility of stocks, bonds, and other financial instruments that are based on the returns spread over a period of time. As the standard deviation of an investment measures the volatility of returns, the higher the standard deviation, the higher volatility and risk involved in the investment. A volatile financial security or fund displays a higher standard deviation in comparison to stable financial securities or investment funds. A higher standard deviation is seen to be more risky as the investment’s performance may change drastically in any direction at any given moment.

Beta vs Standard Deviation

Unsystematic risk is the risk that comes with the type of industry or company in which funds are invested. Unsystematic risk can be eliminated by diversifying investments into a number of industries or companies. Systematic risk is the market risk or the uncertainty in the entire market that cannot be diversified away. Standard deviation measures the total risk, which is both systematic and unsystematic risk. Beta on the other hand measures only systematic risk (market risk). Standard deviation shows an asset’s individual risk or volatility. On the other hand, Beta is a relative measure used for comparison and does not show a security’s individual behavior. Beta measures an asset’s volatility in relation to the market’s performance.

What is the difference between Beta and Standard Deviation?

• Beta and standard deviation are measures of volatility used in the analysis of risk in investment portfolios.

• Beta measures a security’s or portfolio’s performance (asset’s risk and return) in relation to the movements in the market.

• A beta value of 1 show that the security is performing in line with the market’s performance; a beta of less than 1 show that security’s performance is less volatile than the market, and a beta of more than 1 show that a security’s performance is more volatile than the benchmark.

• The standard deviation of an investment measures the volatility of returns, and so the higher the standard deviation, the higher volatility and risk involved in the investment.

Beta Coefficient – a Measure of Systematic Risk

Beta coefficient is a measure of sensitivity of an investment (when considered in a well-diversified portfolio) to the systematic risk factors.

The economy-wide factors affect all stocks in one way or the other. There is no way to escape this component of risk. Hence, it is called undiversifiable risk. It is also called systematic risk because it results from and affects the whole macroeconomic system. Some investments are affected more by the systematic risk and some less.

The following equation expresses the relationship between standard deviation and beta:

Risk Captured by Risk Captured by   Unique Risk

Where σ stands for investment standard deviation while β refers to the investment’s beta coefficient.

In evaluating an investment in a portfolio context, the beta coefficient is relevant because the unique risk can be diversified away, and only undiversifiable risk should be priced. It is why Treynor’s ratio is considered a better measure of a portfolio’s return per unit of risk than the Sharpe ratio which is based on standard deviation.