Capital budgeting is the process of evaluating capital projects, projects with cash flows over more than one year.

The four steps of the capital budgeting process are: (1) Generate investment ideas; (2) Analyze project ideas; (3) Create firm-wide capital budget; and (4) Monitor decisions and conduct a post-audit.

Categories of capital projects include: (1) Replacement projects for maintaining the business or for cost reduction; (2) Expansion projects; (3) New product or market development; (4) Mandatory projects to meet environmental or regulatory requirements; (5) Other projects, such as research and development or pet projects of senior management.

Acceptable independent projects can all be undertaken, while a firm must choose between or among mutually exclusive projects.

Project sequencing concerns the opportunities for future capital projects that may be created by undertaking a current project.

If a firm cannot undertake all profitable projects because of limited ability to raise capital, the firm should choose that group of fundable positive NPV projects with the highest total NPV.

NPV is the sum of the present values of a project’s expected cash flows and represents the increase in firm value from undertaking a project. Positive NPV projects should be undertaken, but negative NPV projects are expected to decrease the value of the firm.

The IRR is the discount rate that equates the present values of the project’s expected cash inflows and outflows and, thus, is the discount rate for which the NPV of a project is zero. A project for which the IRR is greater (less) than the discount rate will have an NPV that is positive (negative) and should be accepted (not be accepted).

The payback (discounted payback) period is the number of years required to recover the original cost of the project (original cost of the project in present value terms).

The profitability index is the ratio of the present value of a project’s future cash flows to its initial cash outlay and is greater than one when a project’s NPV is positive.

An NPV profile plots a project’s NPV as a function of the discount rate, and it intersects the horizontal axis (NPV = 0) at its IRR. If two NPV profiles intersect at some discount rate, that is the crossover rate, and different projects are preferred at discount rates higher and lower than the crossover rate.

For projects with conventional cash flow patterns, the NPV and IRR methods produce the same accept/reject decision, but projects with unconventional cash flow patterns can produce multiple IRRs or no IRR.

Mutually exclusive projects can be ranked based on their NPVs, but rankings based on other methods will not necessarily maximize the value of the firm.

WACC = (w_d)(k_d)(1 − t) + (w_ps)(k_ps) + (w_ce)(k_ce)

The weighted average cost of capital, or WACC, is calculated using weights based on the market values of each component of a firm’s capital structure and is the correct discount rate to use to discount the cash flows of projects with risk equal to the average risk of a firm’s projects.

Interest expense on a firm’s debt is tax deductible, so the pre-tax cost of debt must be reduced by the firm’s marginal tax rate to get an after-tax cost of debt capital:

after-tax cost of debt = k_d(1 − firm's marginal tax rate)

The pre-tax and after-tax capital costs are equal for both preferred stock and common equity because dividends paid by the firm are not tax deductible.

WACC should be calculated based on a firm’s target capital structure weights.

If information on a firm’s target capital structure is not available, an analyst can use the firm’s current capital structure, based on market values, or the average capital structure in the firm’s industry as estimates of the target capital structure.

A firm’s marginal cost of capital (WACC at each level of capital investment) increases as it needs to raise larger amounts of capital. This is shown by an upward-sloping marginal cost of capital curve.

An investment opportunity schedule shows the IRRs of (in decreasing order), and the initial investment amounts for, a firm’s potential projects.

The intersection of a firm’s investment opportunity schedule with its marginal cost of capital curve indicates the optimal amount of capital expenditure, the amount of investment required to undertake all positive NPV projects.

The marginal cost of capital (the WACC for additional units of capital) should be used as the discount rate when calculating project NPVs for capital budgeting decisions.

Adjustments to the cost of capital are necessary when a project differs in risk from the average risk of a firm’s existing projects. The discount rate should be adjusted upward for higher-risk projects and downward for lower-risk projects.

The before-tax cost of fixed-rate debt capital, k_d, is the rate at which the firm can issue new debt.

• The yield-to-maturity approach assumes the before-tax cost of debt capital is the YTM on the firm’s existing publicly traded debt.
• If a market YTM is not available, the analyst can use the debt rating approach, estimating the before-tax cost of debt capital based on market yields for debt with the same rating and average maturity as the firm’s existing debt.

The cost of equity capital, k_ce, is the required rate of return on the firm's common stock.

There are three approaches to estimating k_ce:

• CAPM approach: k_ce = RFR + β[E(R_mkt) − RFR].
• Dividend discount model approach: k_ce = (D₁/P₀) + g.
• Bond yield plus risk premium approach: add a risk premium of 3% to 5% to the market yield on the firm’s long-term debt.

When a project’s risk differs from that of the firm’s average project, we can use the beta of a company or group of companies that are exclusively in the same business as the project to calculate the project’s required return. This pure-play method involves the following steps:

1. Estimate the beta for a comparable company or companies.

2. Unlever the beta to get the asset beta using the marginal tax rate and debt-to-equity ratio for the comparable company:

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3. Re-lever the beta using the marginal tax rate and debt-to-equity ratio for the firm considering the project:

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4. Use the CAPM to estimate the required return on equity to use when evaluating the project.

5. Calculate the WACC for the firm using the project’s required return on equity.

A country risk premium should be added to the market risk premium in the CAPM to reflect the added risk associated with investing in a developing market.

The country risk premium for a developing country can be estimated as the spread between the developing country’s sovereign debt (denominated in a developed country’s currency) and the developed country’s sovereign debt (e.g., U.S. T-bills), multiplied by the ratio of the volatility of the developing country’s equity market to the volatility of the market for its developed-country-denominated sovereign debt.

The marginal cost of capital schedule shows the WACC for successively greater amounts of new capital investment for a period, such as the coming year.

The MCC schedule is typically upward-sloping because raising greater amounts of capital increases the cost of equity and debt financing. Break points (increases) in the marginal cost of capital schedule occur at amounts of total capital raised equal to the amount of each source of capital at which the component cost of capital increases, divided by the target weight for that source of capital.

Leverage increases the risk and potential return of a firm’s earnings and cash flows.

Operating leverage increases with fixed operating costs.

Financial leverage increases with fixed financing costs.

Sales risk is uncertainty about the firm’s sales.

Business risk refers to the uncertainty about operating earnings (EBIT) and results from variability in sales and expenses. Business risk is magnified by operating leverage.

Financial risk refers to the additional variability of EPS compared to EBIT.

Financial risk increases with greater use of fixed cost financing (debt) in a company’s capital structure.

The degree of operating leverage (DOL) is calculated as [image] and is interpreted as [image].

The degree of financial leverage (DFL) is calculated as [image] and is interpreted as [image].

The degree of total leverage (DTL) is the combination of operating and financial leverage and is calculated as DOL × DFL and interpreted as [image].

The breakeven quantity of sales is the amount of sales necessary to produce a net income of zero (total revenue just covers total costs) and can be calculated as:

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Net income at various sales levels can be calculated as total revenue (i.e., price × quantity sold) minus total costs (i.e., total fixed costs plus total variable costs).

The operating breakeven quantity of sales is the amount of sales necessary to produce an operating income of zero (total revenue just covers total operating costs) and can be calculated as:

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Cash dividends are a payment from a company to a shareholder that reduces both the value of the company’s assets and the market value of equity. They can come in the forms of regular, special, or liquidating dividends.

Stock dividends are distributions of new shares rather than cash. Stock splits divide each existing share into multiple shares. Both create more shares, but there is a proportionate drop in the price per share, so there is no effect on the total value of each shareholder’s shares.

Other things equal, paying a cash dividend decreases liquidity ratios and increases leverage ratios. Stock dividends and stock splits do not affect liquidity or leverage ratios.

The chronology of a dividend payout is:

• Declaration date.
• Ex-dividend date.
• Holder-of-record date.
• Payment date.

Stocks purchased on or after the ex-dividend date will not receive the dividend. The ex-dividend date is two business days prior to the holder-of-record date.

The effect of share repurchases using borrowed funds on EPS is:

• If the company’s E/P is equal to the after-tax cost of borrowing, there will be no effect on EPS.
• If the company’s E/P is greater than the after-tax cost of borrowing, EPS will increase.
• If the company’s E/P is less than the after-tax cost of borrowing, EPS will decrease.

The effect of a share repurchase on book value per share is:

• An increase if the share price is less than the original BVPS.
• A decrease if the share price is greater than the original BVPS.

Primary sources of liquidity are the sources of cash a company uses in its normal operations. If its primary sources are inadequate, a company can use secondary sources of liquidity such as asset sales, debt negotiation, and bankruptcy reorganization.

A company’s liquidity position depends on the effectiveness of its cash flow management and is influenced by drags on its cash inflows (e.g., uncollected receivables, obsolete inventory) and pulls on its cash outflows (e.g., early payments to vendors, reductions in credit limits).

Measures of a company’s short-term liquidity include:

• Current ratio = current assets / current liabilities.
• Quick ratio = (cash + marketable securities + receivables) / current liabilities.

Measures of how well a company is managing its working capital include:

• Receivables turnover = credit sales / average receivables.
• Number of days of receivables = 365 / receivables turnover.
• Inventory turnover = cost of goods sold / average inventory.
• Number of days of inventory = 365 / inventory turnover.
• Payables turnover = purchases / average trade payables.
• Number of days of payables = 365 / payables turnover.

The operating cycle and the cash conversion cycle are summary measures of the effectiveness of a company’s working capital management.

• Operating cycle = days of inventory + days of receivables.
• Cash conversion cycle = days of inventory + days of receivables − days of payables.

Operating and cash conversion cycles that are high relative to a company’s peers suggest the company has too much cash tied up in working capital.

Commonly used annualized yields for short-term pure discount securities are based on the days to maturity (days) of the securities and include:

• Discount-basis yields = % discount from face value × (360/days).
• Money market yields = HPY × (360/days).
• Bond-equivalent yields = HPY × (365/days).

The overall objective of short-term cash management is to earn a reasonable return while taking on only very limited credit and liquidity risk. Returns on the firm’s short-term securities investments should be stated as bond equivalent yields. The return on the portfolio should be expressed as a weighted average of these yields.

An investment policy statement should include the objectives of the cash management program, details of who is authorized to purchase securities, authorization for the purchase of specific types of securities, limitations on portfolio proportions of each type, and procedures in the event that guidelines are violated.

A firm’s inventory, receivables, and payables management can be evaluated by comparing days of inventory, days of receivables, and days of payables for the firm over time and by comparing them to industry averages or averages for a group of peer companies.

A receivables aging schedule and a schedule of weighted average days of receivables can each provide additional detail for evaluating receivables management.

There are many choices for short-term borrowing. The firm should keep costs down while also allowing for future flexibility and alternative sources.

The choice of short-term funding sources depends on a firm’s size and creditworthiness. Sources available, in order of decreasing firm creditworthiness and increasing cost, include:

• Commercial paper.
• Bank lines of credit.
• Collateralized borrowing.
• Nonbank financing.
• Factoring.

A majority of board and committee members should be independent (not management), and the board should meet regularly without management present.

Board members should have the experience and knowledge necessary to advise management and review its activities.

The board should have the resources it needs to act independently, including the ability to hire outside consultants without approval from management.

A board can be considered independent if its decisions are not controlled or biased by the management of the firm.

An independent board member must work to protect the long-term interests of shareholders.

Board members should have the skills and experience required to make informed decisions about the firm’s future.

A qualified board member should have experience with:

• The products or services the firm produces.
• Financial operations, accounting, and auditing.
• Legal issues.
• Strategies and planning.
• The firm's business and financial risks.

Members who serve on the board for a long time (more than ten years) may become too closely aligned with management to be considered independent.

The audit committee is responsible for providing financial information to shareholders. The audit committee should:

• Follow proper accounting and auditing procedures.
• Appoint an external auditor that is free from management influence.
• Resolve conflicts between the auditor and management in a way that favors shareholders.
• Approve or reject any non-audit engagements with the external auditors.
• Have no restrictions on its communications with the firm’s internal auditors.
• Control the audit budget.

The compensation (remuneration) committee sets the compensation for the firm’s executives. The compensation committee should:

• Determine whether executives’ compensation is appropriate and linked to the firm’s long-term profitability.
• Provide shareholders with details about executive compensation in public documents.
• Require the firm and the board to seek shareholder approval for any share-based compensation plans.

The nominations committee is responsible for recruiting new, qualified, independent board members. The nominations committee should:

• Review the performance, independence, and skills of existing board members.
• Create nomination procedures and policies.
• Prepare a succession plan for senior management.

A firm’s code of ethics sets the standard for basic principles of integrity, trust, and honesty. Having a code of ethics can be a mitigating factor with regulators if a breach occurs.

A strong code of ethics should:

• Comply with corporate governance standards of the company’s home country and stock exchange.
• Prohibit the company from giving advantages to company insiders that are not available to shareholders.
• Discourage payments to board members of consultancy fees or finder’s fees for acquisition targets.
• Designate a person responsible for corporate governance.

A company with a weak code of ethics may allow practices such as transactions with parties related to management or personal use of company assets by management or board members. Such practices benefit company insiders rather than shareholders.

Consider whether company policies make it difficult to vote proxies and whether a significant minority shareholder group can serve their own interests through cumulative voting. Confidential voting and remote proxy voting promote the interests of shareholders.

Investors should determine whether a firm permits shareholders to nominate board members and propose initiatives to be discussed at the annual meeting and whether the firm regards shareholder proposals as binding or advisory.

Corporate structure changes can alter the relationship between shareholders and the firm. Different classes of equity may separate the voting rights of shares from their economic value.

Takeover defenses are provisions that make a company less attractive to a hostile bidder or more difficult to acquire. They are generally not in shareholders’ interests.