CAPITAL BUDGETING

1. Advanced Corporate Finance
Ronald F. Singer
FINA 7330
Review of Financial
Management
Lecture 1
Fall 2010

2. Administration
• Instructor: Ronald F. Singer
• Phone: 713-743-4771
• Office Hours: Tuesday 4:45 to 6:00,
Thursday 4:00 to 4:45 or by appointment
• Room 210F Melcher Hall
• Webpage: www.bauer.uh.edu/singer

3. Class Administration
• Exams
• Late Entrants
• Reading, Eating, etc.
• Attendance
• Texts:
– Brealey, Myers and Allen, Principles of Corporate
Finance, 10th ed.
– Wall Street Journal
• Valuation Problem
– Groups, presentation, study

4. Outline
• Capital Budgeting Decision
– Financial Statement Analysis
– NPV Rule
– Arbitrage and Risk
– Time Value of Money
– Complicated Decisions
• Investments
– Risk versus Return
– Optimal Portfolio Selection (CML)
– Equilibrium Prices (SML and CAPM)

5. Review of Corporate Finance
• Three areas of inquiry
–Capital Budgeting
–Capital Structure
–Payout policy

6. Capital Budgeting
• What is to be discounted?
• How do we discount?
• What is the decision rule and why?

7. Macintosh Enterprises
Pro-Forma Income Statement
(Year ending December 31, 2008)
($ thousand)
Sales $5,000
Less: Operating Expenses (COGS) 2,000
Depreciation & Amortization 500
Allocated G & A Costs 300
Operating Income (EBIT) $2,200
Less: Interest Expense 800
Earnings Before Tax (taxable income) 1,400
Less Tax (@ 35%) 490
Net Income (Earnings after Tax) $910
Earnings per Share (EPS) = Net Income/Shares = $0.91
Assuming 1 million shares outstanding

8. 8
Macintosh Enterprises
Pro-Forma Cash Flow Statement
(Year ending December 31, 2008)
($ thousand)
Earnings Before Interest and Taxes $2,200
Less: Tax on Operations (@ 35%) (Note: not $490) 770
Operating Income after Tax (EBIT(1-t) ) 1,430
Plus: Non-Cash Expenses (Depreciation & Amortization) 500
Less: Change in Working Capital - 300
{Increase a/c receivable 200
increase in Inventory 100
Increase other ST Assets 100
Less: increase in a/c payable 150
Decrease ST Liabil. (50))}
Change in Working Capital +300
Cash Flow from Operations $1,630
Plus Interest Tax Shield (800 times 0.35) 280
CASH FLOW $1,910
Less: Net New Investment (net of capital gains tax) 200
Less: Cash Flow to Bondholders (Interest, principal, Bond Repurchase, Call) 1, 270
Less: Cash Flow to Preferred stockholders 100
Free Cash Flow to Common Stockholders 340
EBITDA $2,700

9. Firm Valuation
• What determines the value of the Firm?
– In a perfect capital market setting
– In an efficient market setting
– In the “Real World”

10. What determines the value of
securities
• Security Pricing Models
– Capital Asset Pricing Model (CAPM)
– Arbitrage Pricing Model (APT)
– Multifactor Model
– Option Pricing or Contingent Claims Pricing

11. Capital Budgeting
• The Net Present Value Rule
– What is it?
– Why does it work?
– Why would all investors regardless of their
personal preferences for current versus future
consumption agree on the NPV Rule?
– Present Value and the No-Arbitrage Price
• Why securities should sell at a price that is equal
to the PV of the Cash Flow to the holders.

12. First Separation Principle
• The firm can make a capital budgeting
decision independently of how the project
will be financed.
• Eventually, the firm will have to worry
about how to finance the project, but the
simple question right now is:
– Are the benefits from investing greater than
the cost?
• i.e. is the NPV of the project positive?

13. Risk
• Securities are priced as if the market in general
is “risk averse”. That is, the typical investor
appears to prefer a less risky alternative to a
more risky alternative.
• So in order to induce investors to hold risky
investments, the investment must be priced so
as to reward the investor for the risk he takes on.
• This reward is called the risk premium
associated with the expected return of risky
securities, and projects.

14. Risk versus Return
• That is:
• E(Return of a risky venture)
= The reward for waiting plus
compensation for taking on risk.
= Risk free return plus a risk premium.

15. Present value of what?
• We talk about the “Value” of something
being equal to the “present value” of
something.
What is this “something”?

16. CASH!!!
So, when we consider the value of a
security or of a project, or of a firm, or any
investment activity, we want to know what
the Cash Flow will be and how to discount
it.

17. Central Role of Cash Flow
• Capital Budgeting: Must consider
Incremental Cash Flow
• Bonds and Stock (Dividends, interest,
repurchases, principle)
• Investments (Free Cash Flow)
• Firm Valuation (Free Cash Flow)

18. Bond valuation
• What is the cash flow expected from a typical
bond?
– You must be careful here to distinguish between the
Coupon Rate and the Required Return.
• The coupon rate describes how the bond gets some of its
cash flow out to the holders. It reflects the risk and interest
rate of the Bond at the time the bond was originally issued,
and may or may not be representative of the risk and level of
interest rates today.

19. Stock
• Again, we need to find the Present Value
of the Dividend stream.
– Predicting the dividend stream is not easy.
– We generally rely on fundamental analysis of
the value of the issuer.
– Then value the firm and subtract the non-
equity securities issued by the firm to get the
value of the Equity.

20. Investments
• Here the real question is how does a rational
investor choose a portfolio of securities?
• There are three things that needs to be
considered:
– The Efficient set of Risky Assets
• Diversification
– The Efficient Risky Portfolio (CML)
– the Relationship Between Risk and Expected Return
for:
• Portfolios
• Individual Securities

21. Efficient Set of Risky Assets
return
P
minimum
variance
portfolio
Individual Assets

22. Efficient Risky Portfolio
return
P
rf
M

23. Relationship between Risk and
Return
• Efficient Portfolios (Capital Market Line)
Rp = Rf + Risk Premium
= Rf + (Rm - Rf) p
M

24. Relationship between Risk and
Return
• Individual Securities (Capital Asset
Pricing Model)
Ri = Rf + Risk Premium
= Rf + (Rm - Rf) bi

25. Capital Structure
• What is the Capital Structure Decision?
• What are the determinants of a firms’
capital structure
• What do we have to consider?

26. Payout Policy
• What is payout policy?
• What are the Issues?
• What factors are important?

27. Generally
• We look to violations of Perfect Capital
markets: In particular:
– Costly Information
– Taxes
– Agency Problems
• Failure to align
managements’ with stockholders’ interest
• Market for corporate control