The Different Capital Budgeting Techniques You Need to Know

Equity Financing 

Cost of equity =Dividend per share/Current market value of stock +growth

Dividend per share for the next year = 2.50*1.06 = 2.65

Cost of equity =2.65/50*(1-10%) + 6%

=5.89%+6%

=11.89%

Companies can finance their activities through the sale of its shares. It is an alternative to borrowing cash for investment purposes. The company can obtain equity financing from the owners, friends, and family, business angels, venture capitalist and public floats.

Some of the major advantages of equity financing include freedom from debt as there are no repayments on investment which can be advantageous for start-ups. The business can bring in investors with valuable experience contacts, networks, managerial and technical skills and credibility. Investors can also provide additional funding with the growth and expansion of the business. The funds obtained from the potential investors are committed to the business and the investments are realized if the business is performing well where its stocks can be sold to new investors or even through market floatation. The business will not have to continue servicing bank loans or other debt financing giving it an opportunity to utilize the capital for business activities. The investors expect the business to deliver value for them and therefore, the management will have to identify and explore growth ideas. Investors have a vested interest in the business and determined to see that the business grows to profitability and also increase in its value.

Some of the disadvantages of equity financing include shared ownership where the owners have to give up some control to the investors who share in the profits and maintain an oversight on how the business is run. Equity financing can affect the personal relationship if funds from family or friends are used and the business fails. It is time-consuming to approach potential investors and even to make them investment ready. It is a demanding and costly process that takes away the management attention from the key business activities. Similarly, the investors will conduct a comprehensive study of the business and its management a process that the perceived to be useful but might end up denying the business the much-needed capital (Welch, 2008). The management must dedicate some of its time to communicate to the investors for monitoring purposes. The owners will have a reduced share of the business in monetary terms and as a percentage but can also be more in absolute monetary terms when the business succeeds. Legal and regulatory issues can arise while raising funds.

Debt Financing 

After tax cost of debt = 10% *(100-35)

= 5%*65%

=3.25%

Debt financing involves the use of borrowed funds which will be repaid latter for investment purposes. The company will pay the initial amount plus the interest. The debt can be secured using the assets of the company or they can be unsecured. The company would take up a debt to finance an acquisition or working capital. The company borrows funds to speed up the rate of investment without losing control of the business (Welch, 2008). Debts can be repaid on a monthly, quarterly or annual basis or even towards the end of the loan period. A firm in need of a bigger loan can use debt financing where the assets of the company are attached and their value is used to finance business activities.

The advantages of using debt to finance the operations of the company include the retention of control as the lender has no control over the management of the company. They are only interested in the repayment of the loan amount plus the interest. The management, therefore, makes all the decisions concerning business operations and the relationship between the lender and the business ends once the full loan amount is repaid. The company can benefit from tax advantage by using debt to finance its operations (Welch, 2008). The interest paid on loans and other debts is tax deductible which reduces the tax obligations for the company. The management also can easily plan its activities since it is aware well in advance about the principal and the interest payments each month making it easier to budget and plan in advance.

Debt financing has its disadvantages in that it is difficult for start-ups to access loans as they lack credit histories and good credit ratings. Similarly, it is difficult for an established business to access loans if it has a low credit score. Debt financing requires financial disciple to be able to repay the installments and interest on time. The management must also use good financial judgment while using debt financing. If the company uses more debt to finance its operations it can be seen as too risky and therefore less attractive to the investors and lending institutions (Berk & DeMarzo, 2013). Such a scenario can limit access to equity and debt financing in the future leading to liquidity problems. The collateral used to secure the debt could be repossessed if the company is unable to repay its debt. The owners might also be asked to personally guarantee the debt which might place their personal assets at risk.

The management of the company must, therefore, consider the advantages and disadvantages of debt financing before they can decide whether to go for it or not. The company should decide the level of control that they need to have in the business. They must also consider the ability to repay the monthly installments and the interest amounts and its impact on the cash flows of the company. The management must also consider the convenience of repaying the loan versus using equity financing. The collateral of the company must also be considered while determining the amount to borrow and the risks of failing to repay the loan.

Weighted Average Cost of Capital

WACC= 70%*11.89 + 30%*3.25%

=8.323% + 0.975%

=9.2988%

The weighted cost of capital for a firm is the combined cost of debt, equity and /other sources of funds. The cost of each source is weighted based on its proportion of the entire capital of the company. WACC is used to determine the cost of capital for each component in the capital structure. The cost of equity, for example, is 11.89% whereas the cost of debt is 3.25%. WACC, in this case, is used to determine the cost of the combined debt and equity for the company. The Company will pay a fixed rate of interest for borrowed funds in addition to having a fixed yield on the preferred stock if any and dividend in the form of cash (Berk & DeMarzo, 2013). The WACC is an important component for estimating the average cost of capital where the different components are separated and the cost for each component is calculated. The cost of debt in the weighted average cost of capital is the yield of the debt held by the company which in this case is 30% of the entire capital. The cost of debt also considers the tax as the interest payments on debt is not taxed.

After-Tax Cash Flows 

After-tax cash flows = Revenues – additional cost – Capital cost – tax

Year	0	1	2	3
Revenues		1,200,000	1,200,000	1,200,000
Operating cost		600,000	600,000	600,000
Capital Cost	(1,500,000)
BTCF	(1,500,000)	600,000	600,000	600,000
Non cash capital deductions		(500,000)	(500,000)	(500,000)
Taxable income		100,000	100,000	100,000
Income tax		35,000	35,000	35,000
Net income		65,000	65,000	65,000
+Non cash capital cost		500.000	500,000	500,000
Capital cost	1,500,000
ATCF	(1,500,000)	565,000	565,000	565,000

The calculations of the after-tax cash flows involve the deduction of the additional annual costs of $600,000 from the annual revenues of $1,200,000 to obtain the before-tax cash flows. The noncash capital deduction is then computed by allocating the entire capital to the three years. the company is allowed to recover the out of pocket cash capital cost which is deducted from the taxable income. The taxable income is obtained by distributing the capital cost of 1,500,000 over the three which is the maximum useful time of the investment with no salvage value. The after-tax cash flows are then determined by computing the taxable income (Berk & DeMarzo, 2013). The corporate rate of 35% is then applied to the taxable income for the three years to obtain the income tax for the company. The net income is obtained by deducting the income tax from the taxable income. The after-tax cash flows are then obtained by adding back the noncash capital cost deducted earlier in the calculations.

Net present value 

Year	Before Tax Cashflow	After-Tax Cash flows	PV factor 6%	Before tax PV	After tax PV
0	(1,500,000)	(1,500,000)	1	(1,500,000)	(1,500,000)
1	600,000	565,000	0.9434	566,040	533,021
2	600,000	565,000	0.8899	533,997.86	502,793.5
3	600,000	565,000	0.8396	503,771.57	474,374
NPV				103809.43	10,188.5

Based on NPV calculations, the project is a viable one because it has a positive net present value. The calculations show that the project can be relied upon to generate revenues that can cover the initial investment while leaving a positive value. The NPV, in this case, shows the present value of the cash flows from the project at the required rate of return of 6% compared to the initial investment of $1,500,000. It shows that the investment has a high rate of return compared to the investment made. The use of NPV in this project is helpful in determining whether to go ahead with the investment or not. Its ability to consider the time value of money helps to translate cash inflows into today's cash. Similarly, it offers a concrete number that can be used by the management to compare the capital invested in a project against the present values of the expected return (Gallo, 2014).

Internal Rate of Return 

IRR = ra +NPVa/(NPVa – NPVb) (rb - ra)

Where ra is the lower discount selected

=rb is the higher discount selected

NPVa is the NPV at the lower rate

NPVb is the NPV at the higher rate

IRR For before tax cash flows

NPV at 6% =103,807.17

NPV at 12% =(58,901.24)

IRR = 6% + 103,807.17/(103,807.17- 58,901.24) * (12-6)

IRR = 6% + 3.701%

= 9.701%

IRR for after tax cash flows

NPV at 6% =10,188.5

NPV at 9% =(69,818.51)

IRR = 6% + 10,188.5/(10,188.5- 69818.51) * (9-6)

=6%+0.63

=6.063%

The project is acceptable because its expected internal rate of return is higher than the discount rate of 6%. Any internal rate that is higher than the .discount rate is acceptable for investment purposes. The before tax and after tax IRR are higher than the discount rate and therefore it is worth investing in the project. The company, therefore, can go ahead and invest in the sense it has a higher return than what is expected. There are no conflicts in the outcome between NPV and IRR since the two give the management the go-ahead to invest in the project. The decision rule for NPV is that the investment is a good bet which is supported by the IRR that also gives the management the go-ahead to invest.

Other possible Investments 

Investment B			Investment C
Probability	After-Tax Cash flows			Probability	After Tax cash flow
0.25	$20000			0.30	$22,000
0.50	$32,000			0.50	$40,000
0.25	$40,000			0.20	$50,000

The two investments will cost $120,000 and have 6 years and similar after-tax cash flows. The expected value of the project’s annual after-tax cash flows = the sum of the probabilities multiplied by the after-tax flow as shown in the table below

Investment B			Investment C
Probability	After-tax cash flows	Expected value		Probability		After-tax cash flows	Expected value
0.25	20000	5000		0.30		22000	6600
0.50	32000	16000		0.50		40000	20000
0.25	40000	10000		0.20		50000	10000
Expected Value		31,000					36,600

There are no conflicts between IRR and NPV as the project considers the probability and there are cash flows throughout the period. If annual cash flows of $31,000 are used, the internal rate of return will be 14.167%. Any IRR value that is higher than the WACC value of 9.29% should be accepted as the investment has a higher return than the cost of capital. If the investment has a higher value than the weighted average cost of capital, its NPV will also be positive and therefore prove to be a good investment option for the company (Welch, 2009). The NPV for the project using 9.29 as the discount rate will be $17,869.27. The IRR and NPV agree and support investment in the project.

If the appropriate discount rate for the project of a similar risk value is 8%, the risk-adjusted NPV for project B and C will be as follows; The projects use the Expected value as the cash flows for each year.

NPV for Investment B = - 120,000.00 + 31,000/1.08 + 31,000,1.08^ 2 + 31,000,1.08^ 3 + 31,000,1.08^ 4 + 31,000,1.08^ 5 +31,000,1.08^ 6 

NPV =23,309.27

NPV for Investment C = -120,000.00 + 36,600/1.08 + 36,600/1.08^ 2 + 36,600/1.08^ 3 + 36,600/1.08^ 4 +36,600/1.08^ 5 + 36,600/1.08^ 6 

NPV = 49,197.40

Investment B and C have positive NPV and therefore could be selected in a scenario where the company is not constrained by available resources. However, for mutually exclusive projects the company will select one that has a higher return than the other. The management, in this case, should select investment C and put investment B on hold since the two are mutually exclusive and the selection of one means that the other will not be chosen. The company should, therefore, invest in project A and project C.

References

Berk, J., & DeMarzo, P. (2013).  Corporate Finance, Global Edition . Pearson Education UK.

Gallo, A. (2014). A Refresher on Net Present Value. Retrieved from https://hbr.org/2014/11/a-refresher-on-net-present-value

Welch, I. (2008).  Corporate finance: An introduction . New York, N.Y: Prentice Hall.