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Optimal Capital Budget

Optimal Capital Budget

11 – 1 11 – 2 Choosing the Optimal Capital Budget ? Finance theory says to accept all positive NPV projects. ? Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: Increasing Marginal Cost of Capital ?Externally raised capital can have large flotation costs, which increase the cost of capital. ?Investors often perceive large capital budgets as being risky, which drives up the cost of capital. (More… ) ?An increasing marginal cost of capital. ?Capital rationing Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press

All rights reserved. 11 – 3 11 – 4 Capital Rationing ? If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. ?Capital rationing occurs when a company chooses not to fund all positive NPV projects. ?The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. (More… ) Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved. 11 – 5 11 – 6 Reason: Companies want to avoid the direct costs (i. e. flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital. (More… ) Copyright © 1999 by The Dryden Press All rights reserved. Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing. (More… ) Copyright © 1999 by The Dryden Press All rights reserved. 11 – 7 11 – 8 Blum Industries has 5 potential projects: ?We’ve seen how to evaluate projects. ?We need cost of capital for evaluation. ?But corporate cost of capital depends on size of capital budget. ?Must combine WACC and capital budget analysis. Project Cost CF Life (N) IRR A $400,000 $119,326 5 15% B 200,000 56,863 5 13 B* 200,000 35,397 10 12 C 100,000 27,057 5 11 D 300,000 79,139 5 10 Projects B & B* are mutually exclusive, the others are independent. Neither B nor B* will be repeated. Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press

All rights reserved. 11 – 9 11 – 10 Additional Information Interest rate on new debt Tax rate Debt ratio Current stock price, P0 Last dividend, D0 Expected growth rate, g Flotation cost on CS, F Expected addition to RE (NI = $500,000, Payout = 60%. ) 8. 0% 40. 0% 60. 0% $20. 00 $2. 00 6. 0% 19. 0% $200,000 Calculate WACC, then plot IOS and MCC schedules. Step 1: Estimate the cost of equity D0(1 + g) + g = $2(1. 06) + 6% = 16. 6%. P0 $20 D1 $2(1. 06) + 6% ke = +g= P0(1 – F) $20(1 – 0. 19) ks = = $2. 12 + 6% = 19. 1%. $16. 2 All rights reserved. For differential project risk, add or subtract 2% to WACC.

Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press 11 – 11 11 – 12 Step 2: Estimate the WACCs WACC1 = w dkd(1 – T) + w ceks = (0. 6)(8%)(0. 6) + 0. 4(16. 6%) = 9. 5%. Step 3: Estimate the RE break point BPRE = Retained earnings Equity fraction $200,000 = $500,000. 0. 4 = WACC2 = w dkd(1 – T) + w ceke = (0. 6)(8%)(0. 6) + 0. 4(19. 1%) = 10. 5%. Each dollar up to $500,000 has $0. 40 of RE at cost of 16. 6%, then WACC rises. Only 1 compensating cost increase, so only 1 break point. Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press

All rights reserved. 2 11 – 13 % 16 15 14 13 12 11 10 9 WACC1 = 9. 5% D 11 – 14 FIGURE 1 A B B* C WACC2 = 10. 5% MCC IOS ?The IOS schedule plots projects in descending order of IRR. ?Two potential IOS schedules–one with A, B, C, and D and another with A, B*, C, and D. ?The WACC has a break point at $500,000 of new capital. 8 7 500 700 New Capital (000s) All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press 11 – 15 11 – 16 What MCC do we use for capital budgeting, i. e. , for calculating NPV? If all 5 projects are average risk, what’s the optimal capital budget? MCC = 10. 5%. ?MCC: WACC that exists where IOS and MCC schedules intersect. In this case, MCC = 10. 5%. ?IRR and NPV lead to same decisions for independent projects. Thus, all independent projects with IRRs above 10. 5% should be accepted. ?Therefore, accept A and C, reject D, and accept B or B*. Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved. 11 – 17 11 – 18 The risk-adjusted rates are as follows: ? NPV and IRR can conflict for mutually exclusive projects. ?NPV method is better, so choose between B and B* based on NPV at WACC = 10. 5%. NPVB* = $12,905 > NPVB = $12,830, so choose B* over B. WACC = 10. 5% ± 2% Risk-Adjusted Hurdle Rate 8. 5% 10. 5 12. 5 Project Risk Low: C, D Average: B, B* High: A Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved. 3 11 – 19 IRR A B B* C D 15% 13 12 11 10 Hurdle Rate 12. 5% 10. 5 10. 5 8. 5 8. 5 Accept Accept Accept Accept Accept one Now the optimal capital budget consists of A, B (or B*), C, and D, for a total of $1,000,000. Corporate k is still = 10. 5%, so NPVB* still larger than NPVB. Copyright © 1999 by The Dryden Press All rights reserved. 4