Capital Budgeting and Risk - Case Study Example

Mini Case 1. There are 3 major areas in finance. These are Financial Management, Financial Markets & s and Investments. 2. People working in one of these areas must have a reasonably good knowledge of the other two areas as well since there is a strong interaction between these areas. 3. Corporate finance is important to all managers irrespective of their primary responsibility in the organization. It is so because the ultimate objective of a business is to generate sufficient profits to keep the business running and create value for all stakeholders. Hence, every function in the organization such as marketing, operations, sales, HR etc. needs to be aligned with this objective. 4. The primary objective of a manager is to maximize and to manage organizational resources in order to control costs and generate revenue. 5. A financial market is a broad term used for a market where the buyers and the sellers trade with each other on assets such as bonds, equities, currencies and derivatives. Markets for physical (tangible) assets deal only with trading of tangible assets such as cash, inventories, equipment and property. Money market is only a component of financial market for trading of assets involving short term borrowing and lending with maturities of one year or less. 6. The financial markets run due to the transactions between providers and users. Providers (savers) are the individuals or entities who provide capital to the system. Users (borrowers) are the individuals or entities who use this capital or take loans. A person or an entity is generally both a provider and a user. It is the net savings or borrowings that determine their type. 7. There are two primary groups which contribute to the capital structure of the firm – shareholders and creditors. Shareholders own the stocks of the company and are virtual owners of the company. Creditors provide long and short term loans to a firm. 8. As a company evolves from a start-up to a major corporation, it could involve into 3 forms which are sole proprietorships, partnerships and corporations. Proprietorships and partnerships are easily formed and have fewer regulations but find it difficult to raise funds. Corporations have unlimited life and limited liability but are subject to multiple taxes. 9. The total value of a corporation, in simplest terms, is the difference between its assets and liabilities. The creditors of the firm have the foremost claim on the value followed by promoters and shareholders. 10. There is a potential conflict between interests of shareholders, creditors and managers. Shareholders are concerned about the capital appreciation of the firm in the long term. Creditors look for reducing business risk by efficient risk management. Managers are concerned about short term profits and growth. 11. TCI should utilize a major part of 10 million of excess cash to create various reserves and to reinvest back into the business. The remainder could be distributed as dividend to shareholders. 12. There are 3 aspects of cash flows that impact value of an investment. These are Sales revenues, Operating Margin & Taxes and New investments required. 13. Depreciation is the deterioration in the value of an asset over a period of time. Depreciation is a loss for an organization. The organization has to bear this loss as a cost of manufacturing new products or services. Therefore, it is included in the income statement. Depreciation has no effect on the firm’s cash flows as the cost of assets paid is a one-off event and depreciation is only a way to write off the asset periodically. 14. The three ways proforma statements are used for financial planning are to forecast profits, to budget cash flows and to allocate capital. 15. The first step in financial forecasting is to estimate all sources of revenue. The next step is to estimate all expenses. This is followed by calculating contribution to the bottom line. The financial future can be forecasted by designing the three financial statements i.e. balance sheet, income statement and cash flow statement. A Discounted Cash flow analysis can also be used for multi-year forecasting. 16. AFN = Additional funds needed = Capital Intensity ratio * Increase in sales - Spontaneous liabilities ratio * Increase in sales – Projected sales * Profit Margin * (1 – Dividend Payout ratio) Using this formula, the impact of each change can be calculated: 1) If sales increase, AFN increase 2) If Dividend payout ratio increases, AFN increases 3) If profit margin increases, AFN increases 4) If capital ratio intensity increases, AFN increases 5) If TCI begins paying its suppliers sooner, spontaneous liability ratio increases and hence AFN decreases. 17. In percent of sales method, most of the balance sheet and income statement amounts are expressed as a percentage of sales while the others such as interest expenses are expressed as a relation with sales. Mini Case #2 1. Nominal interest rate is the rate of interest to be paid by the borrower or to be yielded by the lender before adjustment for inflation. Real interest rate is the rate of interest to be paid by the borrower or to be yielded by the lender after adjustment for inflation. Thus, Real Interest Rate = Nominal Interest Rate – Actual or Expected Inflation Rate 2. Market risk is the risk that occurs due to the potential for various securities in an investor’s portfolio to decrease in value because of market fluctuations. Total Risk is the sum of systemic risk as well as unsystemic risk. Systemic risk is common to all classes of assets while unsystemic risk is unique for each investment. 3. The expected rate of return on a portfolio is basically the weighted average of the rates of return on each investment in the portfolio. The riskiness of the portfolio is also dependent upon the amount of portfolio invested in shares of varying degrees of risk. 4. CAPM model is used to describe the relationship between risk and expected rate of return and is used for pricing of securities. According to this model, the rate of return of a security is equal to risk free rate of return plus a risk premium. The two underlying assumptions of the model are: a. Investors agree on the forecasts of expected rates of return, risks and correlations for all assets. b. Investors generally behave rationally 5. Financial managers are generally more concerned about real assets such as Property, Plant and Equipment (PP&E) because these assets are very vital to the operations of the business. They cannot be easily liquidated and depreciate over a long term. On the other hand, financial assets such as securities are highly volatile and liquid. There is a high degree of market risk involved in these investments. 6. Discounted Cash flows are used for corporate financial analysis in order to know the Present value of all future cash flows. This approach is used because the value of money declines over time and future cash flows cannot be treated at par with the current cash flows. Therefore, a discount factor depending upon discount rates is used to account for the time value of money. 7. In the first step of DCF analysis, expected cash flows are forecasted. After this the discount rate is estimated using WACC approach. In the next step, the value of the corporation is calculated. Lastly, intrinsic stock value of the company is evaluated. 8. The value of an asset can be calculated in multiple ways. However absolute value models are most commonly used which make use of discounted cash flows in the future to calculate value. Relative value models and option pricing models are the other type of models used for asset valuation. 9. Opportunity cost is the cost of an activity measured in terms of the cost of the next best alternative that must be foregone to pursue the activity. 10. A perfect capital market is one in which there are no arbitrage opportunities. In such a market there is an equal exchange of information and all investors are rational. The perfect market model is the basis of Fisher separation theorem to establish the objective of profit maximization of a firm. 11. The key features of bonds are nominal or principal amount, issue price, maturity date, Coupon rate, coupon dates, indenture and optionality. 12. Efficient Market Hypothesis is an investment theory according to which it is impossible to beat the market because the stock market is so efficient that it takes into account all relevant information. Therefore, it is not possible to time the market and buy at extremely low rates or sell at highly inflated rates. There are 3 forms of EMH depending upon the degree of information which the stock market digests. These are weak form, semi-strong form and strong form. 13. The key features of common shares or stocks are: a. Limited liability for shareholders b. Decision making and voting rights c. Uncertain returns d. Loss absorption for other investors and creditors Preferred stocks are a class of ownership of a firm which have properties of both equity and debt. They don’t have voting rights. They may carry a dividend. In case of liquidation of a company, preferred stockholders are preferred over common stockholders. 14. A term project’s NPV (Net Present Value) is the sum of all future discounted cash flows. The rationale behind the NPV method lies in the time value of money. Since the value of money depreciates over time, it is important to do financial analysis by using the present value of future cash flows. According to NPV method, for independent or mutually exclusive projects, the projects are accepted if NPV is positive. For interdependent projects, the most feasible combination with highest NPV is selected. 15. Capital budgeting is a process in which a firm evaluates the financial feasibility of new projects such as building a plant through projected cash inflows and outflows. Capital budgeting risk is the potential of a project to have more discounted cash inflows than outflows and hence leading to a net loss. 16. There are 3 types of risks associated with capital budgeting: a. Stand-alone risk: Measured by variability of a single project b. Corporate risk: Measured by impact of project on corporate earnings c. Market Risk: Measured by impact of project on company’s Beta 17. There are many subjective risk factors that need to be considered in a capital budgeting decision. For example, many companies use a single cost of capital for all asset classes in the NPV analysis which is actually dangerous and may give false results. Similarly, the future cash flows assessment may also be a subjective risk since it depends on a number of external factors such as market conditions, competition, consumer demand etc. References Pamela Peterson Drake, “Capital Budgeting & Risk”, Available online January 21, 2012 from Read More