1) We know that capital budgeting is a forward looking process based on sales/re
ID: 2753463 • Letter: 1
Question
1) We know that capital budgeting is a forward looking process based on sales/revenue and expense projections which convert to operating cash flows which are then discounted to the present and compared to the project cost. Briefly EXPLAIN this process and make sure you coverissues with respect to estimation errors and how this may impact net present value (NPV) and IRR results.
Now, what does positive net present value mean? How is it that the firm will succeed in earning a return above the one you would expect given the risk of the project under consideration? Discuss the possible sources of positive net present value and why is it critical to understand its source?
2) The president of a company states, “Since we are going to finance our new manufacturing facility entirely with equity, we must evaluate the project using a higher rate of return than we would if we financed the facility with debt.” As CFO you note that the president is violating a basic capital budgeting premise- that is the required return is based on where ‘the money is going to, not where it’s coming from’. How would you determine the required rate of return?
3) We know that the use of debt magnifies potential gains and losses to shareholders. Given that
there are taxes and financial distress costs, is there an easily identifiable debt/equity ratio (leverage) that will maximize the value of the firm? Why or why not? What are the trade-offs involved?
4) What is Absolute Purchasing Power Parity (APPP) and what is Relative Purchasing Power Parity (RPPP)?
Now, consider the following: The inflation rate in the US is projected at 5% per year for the next 4 years. The Australian inflation rate is projected to be 3% during that time. Currently, the spotrate is Australian Dollars, (AD$ 1.35/1US$) - European Quote. Based on relative Purchasing Power Parity (RPPP), what is the expected exchange rate in 4 years for the Australian Dollar (AD) vs. the US Dollar?
Explanation / Answer
1) The capital budgeting process is a forward looking process. It tries to estimate the revenues and costs and also the discount rate.
The revenue estimates are based on forecasts of demand for the product and also the prices at which the deman will materialise. The costs are based on the availability and the prices in future of the factors of production, which are again economic forecasts subject to variations of actuals.
The cost of capital, which is the weighted average cost of the debt and equity is further prone to errors.
Though the cost of debt can be ascertained with more preceision, the cost of equity is fraught with a lot of assumptions about the future. The dividend model is based on a lot of assumptions like the expected divdends and growth rates. The CAPM relies on past market date or expected values of variables relating to the average returns for the stock and market portfolio. Than again the CAPM is useful only for public quoted shares and Dividend model is applicatble only for companies which distribute dividends.
The Size of the cash flows and the interest rates can potentially affect the NPV and IRR values. Since copounding is used for discounting, the variation in interest rartes can also affect project evalution as discounting gives lesser weight to later cash flows. This is more pronounces when the discount rates are high.
Positive net woth means that the project cash inflows are more than sufficient to cover the return expected by teh debt and equity holders and also to repay their principal amounts. The balance left over is the NPV which represents the absolute addition to the net worth of the shareholders if the project is undertaken.
2) As stated the President is going against the basic dictum of Capital Budgeting that the rate of return required should match the riskiness of the project and is not guided by the means of finance.
What the firm should be doing is to find out the project Beta, ie: the Asset Beta of the project and then assess the required rate of return using the CAPM formula of
Rp = Rf + Bp (Rm - Rf), where Rp is the projects required return, Rf the risk free return, Rm the market return and Bp the beta of the project.
3) The value of the firm is maximised when the WACC is minimised.
The cost of debt is less than the cost of equity due to two reasons;
1. debt suppliers seek less return as their risk is less than that of the equity.
2. in addition to the above, from the firms poing of view, debt is tax deductible.
Given the above two advantages of debt, it appears that the more debt proportion is increased the more the return to equity, subject of course to the basic earning power of the assets being more than the cost of debt.
But this cannot hold good beyond the debt level (leverage) considered as normal for the investment. Beyond this level the debt suppliers and the equity suppliers will start asking for more return. The bankruptcy costs would also figure in for higher debt levels.
When the level of debt is increased beyond an acceptable level, the advantage gained by increased debt will be reduced by the increase in the required return of debt holders and also the increase in the required of the equity holders. The debt suppliers will also factor the bankruptcy costs, which will have to be borne by the equity suppliers as they have to make good the shortfall in funds by increased prices.
4) What is Absolute Purchasing Power Parity (APPP) and what is Relative Purchasing Power Parity (RPPP)?
The APPP (propounded by Prof. Gustav Cassel) states that the equilibrium exchange rate between two currencies, stated as no of units of home currency for one unit of the foreign currency, is determined by the ratio of the price level of the domestic country to the price level of the foreign country. This theory is derived from the basic idea that a commodity should have the same price in all countries if one accounts for the exchange rates. In other words price levels determine exchange rates between two countries.
Thus, if the price of a basket of goods is 1 GBP in Britain and 2 $ in USA, it means that the exchange rate between Pound sterling and the Dollar will be the ratio of the prices in the respective countries.
Here it would be 1GBP = 2 $, meaning that one GBP can be exchanged for 2 dollars.
The RPPP states that the exchange rate between two currencies will move in consonance with the change in price levels in the two countries; ie: the exchange rate movements will compensate for inflation differentials.
This can be expressed in the form of the following equation:
S1/S0 = [(1 + Id)/(1+ If)]n
From the above the future rate S1 = S0 * (1 + Id)/(1 + If)
Where, S1 is the future rate, S0 is the current spot, Ih is the inflation rate in the home country, If is the inflation rate in the foreign country and n the no of time periods.
The exchange rate for the AD for USD for four years hencewill be
1.35*[(1.03)/1.06)]4 = 1.35*0.97174 = 1.35*0.8915 = 1.20
So the exchange rate after four years would be 1.2AD = 1 USD.
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