Question

Please explain these concepts. My final is coming up and I'm lost.

1. Explain the concepts of capital components and their costs, as well as how the tax and flotation costs affect the component costs.

2. Explain the concepts of NPV and IRR rules and the relationship between NPV and IRR rule

3. How does depreciation affects Cash flows and how does depreciation methods affect the NPV of a project.

Thank you.

Answer 1

(1): The capital components are mainly debt, equity and preferred shares. The cost of capital is reduced when taxation element is present. This is because of the fact that interest payments on debt are tax deductible. So we can say that cost of capital = before tax cost of capital*(1-tax rate). On the other hand flotation costs increases the cost of capital. This is because flotation costs include costs like underwriting, legal, registration, and audit fees. Because of flotation costs current price of a share (equity or preferred) will have to adjusted downwards. If talking about equity then cost of equity = [expected dividends/(Current price*(1-flotation costs)] + g

(2): NPV is the sum of the present values of all the cash flows – positive as well as negative – that are expected to occur over the life of the project. It represents the net benefit over and above the compensation for time and risk. IRR is that discount rate which makes NPV equal to zero. IRR, in other words, is that discount rate which equates the present value of future cash flows with the initial investment.

The relationship between NPV and IRR rule – Both NPV and IRR will lead to identical decisions if the cash flows of the project are conventional and if projects are independent. As per the NPV rule all projects not having negative NPV are accepted and as per IRR rule a project will be accepted if IRR > cost of capital. Both these rules will lead to identical decisions if the two conditions mentioned above are satisfied.

(3): Depreciation directly affects the operating cash flow/total cash flow. The link between depreciation and operating cash flow/total cash flow can be seen form the formulas below:

Operating cash flow = EBIT + Depreciation – Taxes

Total cash flow = Operating cash flow – Changes in net working capital – capital spending.

The depreciation method that is to be used will affect the NPV of a project. For instance in case of a double declining method of depreciation higher amount of depreciation is booked in initial years when compared to the straight line method. As such accelerated depreciation method will provide higher tax shield upfront and this will positively impact the NPV.