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Chapter 14

Chapter 14. CAPITAL FINANCING AND ALLOCATION. Learning Objectives. Capital financing and allocation functions Differences between sources of capital Cost of debt capital Cost of equity capital Weighted average cost of capital Leasing as a source of capital Capital allocation.

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Chapter 14

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  1. Chapter 14 CAPITAL FINANCING AND ALLOCATION

  2. Learning Objectives • Capital financing and allocation functions • Differences between sources of capital • Cost of debt capital • Cost of equity capital • Weighted average cost of capital • Leasing as a source of capital • Capital allocation

  3. Capital Budgeting • First thing must do is to obtain capital funds from investors and lenders • Revenues from the engineering and other capital projects must earn an adequate return to achieve economic growth • Involves the expenditure of the current capital funds to obtain future economic benefits

  4. Capital Financing Function • Determines the amount of new funds needed from investors, lenders, and internal sources to support new capital projects • Decides on the sources of new externally acquired funds • These amounts as well as the ratio of debt to equity capital must be commensurate with the financial status of the firm

  5. Capital Allocation Function • Selects engineering projects for implementation based on constraints of total capital investment • Capital allocation activities begin in various company organizations • Organizations plan, evaluate and recommend projects for funding and implementation • Engineering economy studies are performed to develop much of the information required

  6. Various Sources of Capital • Methods by which the capital is obtained will impact the MARR • Obtained from either internal sources, external sources, or both • Various sources of capital are • Debt capital • Equity capital • Retained earnings • Depreciation reserves • Leasing

  7. Debt Capital • Involves both short and long-term • Interest must be paid to capital providers and by a specified time • Lenders do not share in profits • Borrower may be required to pledge some type of security • Terms may limit the use of borrowed funds • Terms may also restrict further borrowing • Loan interest is a tax-deductible expense for the firm

  8. Equity Capital • Supplied and used by owners in expectation of profit • No assurance that profit will be made or that investment capital will be recovered • No limitations placed on the use of funds • No explicit cost for use of such capital; therefore, not tax deductible for firm • Expected rate-of-return must be high enough, at an acceptable risk, to be attractive to potential investors

  9. Retained Earnings • Profits that are reinvested in the business instead of being paid as dividends to owners • Keeping some portion of the company’s profit • Reduces the immediate amount of dividends per share • Increases the book value of the stock • Results in greater future dividends and / or market resale value of the stock

  10. Depreciation Reserves • Set aside out of revenue as an allowance for the replacement of equipment and other assets • Provide a revolving investment fund that may be used to the best possible advantage • An important source of capital for financing new projects within existing firm • Required capital is available for replacing essential equipment when the time for replacement arrives

  11. Leasing • A way of acquiring use of an asset without capital expenditure for purchase • A form of contract that establishes conditions under which asset owner conveys the use and associated costs to the lessee • A method of achieving benefits of capital investment without actually acquiring additional debt • Leasing cost are tax deductible

  12. Cost of Debt Capital • Proportion of debt capital must be maintained below a level which would adversely affect the market value of the firm’s common stock • Vary by type of company • Components of debt capital are short-term loans and long-term bonds • Discussed in the following slide

  13. Loans (Short-term Debt) • Usually for periods less than five years and frequently for less than two years • Sources are banks, insurance companies, retirement systems, other lending institutions • Used a note to define promise to repay, amount of borrowed funds, interest, etc. • Lending institution may require tangible value as security

  14. Loans (Short-term Debt) • Assuming all interest payments and income taxes paid by firm are paid on annual basis, after-tax cost of capital CL = iL(1 – t) • CL = after-tax cost of capital for a loan • iL =rate of interest per year paid on the loan • t = effective (marginal) income tax

  15. Bonds (Long-term Debt) • A long-term note given to the lender by the borrower • Bondholder has no voice in affairs of business and is not entitled to a share of profits • Face value or par value of a bond is the amount (I.e., $1,000, $10,000, etc… ) for which bond is issued • When face value is repaid, bond is retired or redeemed • Interest rate quoted on the bond is the bond rate • The periodic interest payment due is computed as the face value times the bond interest rate per period

  16. Bonds (Long-term Debt) • Annual after-tax cost of capital for a bond [ Zr + (Z –P +Se) / N + Ae ] (1- t) CB =---------------------------------------------------- (Z + P – Se) / 2 • Z = face (par) value of bond; • r = bond rate (nominal interest) per year; • N = Number of years until bond is retired (redeemed); • Se = initial selling expense associated with the bond; • P = Actual selling price of the bond) [if P<Z, the bond is sold at a discount (to par value), and if P>Z, the bond is sold at a premium]; • Ae = annual administrative expenses associated with bond; • t = effective (marginal) income tax rate

  17. Example • Assume the initial selling expenses of the bond issue is 1.17% of the par (face) value; the annual administrative expense of servicing the bond issue is 3.1% of the annual interests costs; and the corporation’s marginal (effective) income-tax rate is 39.6%. Based on this additional information, what is the after-tax cost of capital to the corporation of the bond issue?

  18. Cost of Equity Capital • Acquired through the sale of stock. • Purchasers of the stock are part owners usually called stockholders • Stockholders are entitled to a share of the profits • Are not liable for the debts of the corporation • Because the life of a corporation is continuous, long-term investments can be made • Makes debt capital easier to obtain, and at a lower interest cost

  19. Types of Stocks • Many types of stocks • Common stock • represents ordinary ownership without special guarantees of return on investment • Preferred stock • has certain privileges over common stock • Dividends on common stock are not paid until the fixed percentage return on preferred stock has been paid

  20. Dividend Valuation Model • Value of a share of common stock can be approximated by the PW of future cash receipts • P0 = selling price of a share of stock • Div = annual dividend for past year • Current price of a share of common stock equals PW of an assumed indefinite series of dividend receipts P0 = Div (P / A, ea,  ) = Div / ea • After-tax cost of equity (common stock) ea = Div / P0 • If future price of security is expected to grow at a rate of ‘g’ each year ea = Div / P0 + g

  21. Example • The Yog Manufacturing Company’s common stock is presently selling for $32 per share, and annual dividends have been constant at $2.40 per share. If an investor believes that the price of a share of common stock will grow at 5% per year into the foreseeable future, what is the approximate cost of common stock equity to Yog? What assumptions did you make?

  22. Retained Earnings • Normally assumed to be the same as for common stock • Retained and reinvested for future growth and increasing stockholder wealth

  23. Weighted-Average Cost of Capital • Determined once the amount and explicit cost is established • Includes short-term debt, bond, retained earnings common stock, and preferred stock components

  24. Leasing as a Source of Capital • Leasing is a business arrangement that makes assets available • Leasing is a source of capital generally regarded as a long-term liability • For corporations, rent paid is generally deductible as a business expense • Studies have shown no real income tax advantage in leasing

  25. Leasing as a Source of Capital-Cont. • May or may not be savings in maintenance expenses, but simplifies maintenance problems • True advantage is in allowing a firm to obtain modern equipment • Provides a hedge against inflation and obsolescence

  26. Cost of the Lease Alternative • After-tax cost of a lease Ik = Lk ( 1 - t ) • Ik = after-tax lease expense during year k • Lk = before-tax lease expense during year k • t = effective income-tax rate • If i is known and fixed, PW of the after-tax cost PWLease (i%) =Sk=1N[Lk (1 - t ) / ( 1 + i )k • Noted that the annual maintenance expenses are not included

  27. Cost of Purchase Alternative • After-tax cost of equipment is a function of expected annual expenses, purchase price, book value, and expected market value • PW of after-tax cost of purchased equipme • I = capital investment • MV = expected market value at the end of year N • BVN = book value at the end of year N • i = interest rate per year • N = life of equipment in years • O&Mk = operating and maintenance expense during year k • t = effective income tax rate • dk = depreciation during year k • Note that market value, book value and depreciation amounts are negative because they reduce costs

  28. Example • An existing piece of equipment has been performing poorly and needs replacing. More modern equipment can be purchased or it can be leased. If purchased, the equipment will cost $20,000 and have a depreciable life of 5 years with no market value. For simplicity, assume straight-line depreciation is used by the firm. Because of improved operating characteristics of the equipment, raw materials savings of $5,000 per year are expected to result relative to continued use of the present equipment. However, annual labor expenses for the new equipment will most likely increase by $2,000 and annual maintenance will go up by $1,000.

  29. Capital Allocation • Allocate the obtained capital through activities that transform various types of resources into goods and services • Process of the capital-expenditure decision-masking is referred to capital allocation • Involves planning, evaluation, and management of capital projects

  30. Linear Programming Formulations of Capital Allocation Problems • Linear programming is a mathematical procedure for maximizing ( or minimizing) a linear objective function, subject to one or more linear constraint equations • A useful technique for solving certain multi-period capital allocation problems • Objective function of the capital allocation problem • Bj* = net PW of investment opportunity • Xj = fraction of project j that is implemented during the planning period • Note Xj will normally be ‘0’ or ‘1’ • m = number of mutually exclusive combinations of projects

  31. Linear Programming Formulations of Capital Allocation Problems • Notation used linear programming model • ckj = cash outlay (e.g., initial capital investment or annual operating budget) required for project j in time period k • Ck = maximum cash outlay that is permissible in time period k

  32. LP Formulations • Two types of constraints • Limitations on cash outlays for period k of planning horizon Sj=1m ckXj< Ck 2. Interrelationships among projects: • If projects p, q, and r are mutually exclusive Xp + Xq + Xr< 1 2. If project r can be undertaken only if project s has already been selected Xr< Xs or Xr - Xs< 0 3. If projects u and v are mutually exclusive and project r is dependent (contingent) on acceptance of u and v xu + xv< 1 and xr< xu + xv

  33. Example • Three alternatives are being considered for an engineering project. Their cash flow estimates are shown in the accompanying table. A and B are mutually exclusive, and C is an optional add-on feature to alternative A. Investment funds are limited to $5,000,000. Another constraint on this project is the engineering personnel needed to design and implement the solution. No more than 10,000 person-hours of engineering time can be committed to the project. Setup a linear integer programming formulation of this resource allocation problem

  34. Example-Cont.

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