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Chapter 8
Capital budgeting techniques
Net present value; Accept the project if NPV is positive
Reject the project if NPV is negative
Payback period; Accept the project if the payback period is shorter than the company
policy.
Reject the project if the payback period is longer than the company
policy
IRR; Accept the project if the IRR is higher than cost of capital.
Reject the project if the IRR is higher than cost of capital.
Chapter 9 Review
Salvage value=$65,000
0 1 2 3
.____________.____________.__________.
-$126,000 $35,530 $35,530 $35,530
salvage value 65,000
Net working capital 5,500
Ks = Cost of equity
Ks = D1/P0 + g
Chapter 11
Capital structure change; its impact on the cost of equity,
weighted average cost of capital (WACC), and the firm value.
Rational investors should require a higher rate of return for a riskier investment.
No free lunch!!
Equity investors require a higher rate of return for firms with high debt to equity ratio, as shown below
Ks = K0 + (K0 - Kb) D/E
Ks = cost of equity,
K0 = weighted average cost of capital = cost of equity of ulevered firm
Kb = cost of debt
D/E = debt to equity ratio
WACC= (portion of equity)(cost of equity) + (portion of debt)(cost of debt)
K0 = WsKs + WdKd
Example
1. Worldwide Sprint is all-equity financed firm
2. currently no debt in the balance sheet
3. Call the firm as an unlevered firm
Value of Worldwide Sprint is:
V = equity value of $1,000
Ks = 16%
No change in operating earnings, Worldwide Sprint changes its capital structure
Case 1:
Issue $200 of debt at Kd = 10%, and use $200 to buyback equity.
So the firm value is now
V = equity value + debt value
= $800 + $200
Now, the new cost of equity is:
Ks = K0 + (K0 - Kb) D/E
200
= 16% + (16% - 10%)
800
= 17.5%
The new WACC is:
WACC= (portion of equity)(cost of equity) + (portion of debt)( cost of debt)
K0 = WsKs + WdKd
K0 = (800/1000) * 0.175 + (200/1000) * 0.10
= (0.8) * 0.175 + (0.2) * 0.10
= 0.16
4
Case 2:
No change in operating earnings, worldwide Sprint changes its capital structure
Issue $400 of debt and use $400 to buyback equity.
So the firm value is now
We have seen that the weighted average cost of capital, Ko, remains at 16%, even if the financial leverage
increases. This is because the cost of equity, Ks, increases as the financial risk of the firm increases.
Remember that the value of a firm (V) with a constant cash inflow (EBIT) through infinity is annual cash
flows divided by the discount rate (K0)
V= EBIT/ K0
We have seen that K0 remains unchanged as the financial leverage ratio changes,
So the firm value remains unchanged as the financial ratio changes for a given EBIT.
Based on this logic, Modogliani and Miller (1959), known as the MM irrelevance theorem, argue that
the firm value is irrelevant to the capital structure.
5
♠Given expected future cash flows, can financial managers increase firm
Value by changing capital structure?
♠ Given net income (internal cash inflows), can dividend policy influence share value?