CORPORATE FINANCE ASSIGNMENT

Submitted to Dr. N. R. Parasuraman

Submitted ByGorai Kunal K Section B PGDM No: 11078

CHAPTER 6
6-1 Define each of the following terms: a. The weighted average cost of capital, WACC, is the weighted average of the after-tax component costs of capital-debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure. b. The component cost of preferred stock is calculated by dividing the preferred dividend by the net issuing price, where the net issuing price is the price the firm receives after deducting the flotation costs. Note that no tax Ps n adjustments are made when calculating the component cost of preferred stock because, unlike interest payments on debt, dividend payments on preferred stock are not tax deductible. The cost of new common equity, r, is the cost to the firm of equity obtained by e selling new common stock. It is, essentially, the cost of retained earnings adjusted for flotation costs.

c. Flotation costs are the costs that the firm incurs when it issues new securities. The fund actually available to the firm for capital investment from the sale of new securities is the sales price of the securities less flotation costs. Note that flotation costs consist of (1) direct expenses such as printing costs and brokerage commissions, (2) any price reduction due to increasing the supply of stock, and (3) any drop in price due to informational asymmetries.

d. The target capital structure is the relative amount of debt, preferred stock, and common equity that the firm desires. The WACC should be based on these target weights. WACC = wdrd (1-T) + wpsrps + wcers e. There are considerable costs when a company issues a new security, including fees to an investment banker and legal fees. These costs are called flotation costs. The cost of new common equity is higher than that of common equity raised internally by reinvesting earnings. Projects financed with external equity must earn a higher rate of return, since they project must cover the flotation costs. 6.2 In what sense is the WACC an average cost? A marginal cost? The WACC is an average cost because it is a weighted average of the firm's component costs of capital. WACC is a Marginal cost from the standpoint that the firm has to withhold the entire amount of WACC in order to repay investor and debtors to keep them happy. Thus, the WACC is the weighted average marginal cost of capital.

6.3

How would each of the following affect a firms cost of debt, rd(1-T); its cost of equity, rs; and its weighted average cost of capital, WACC? Indicate by a plus, a minus or a zero if the factor would raise, lower or have an indeterminate effect on the item in question. Probable Effect on WACC + O + + + + + + + + + + + + O + + +

a. The corporate tax in lowered b. The Federal Reserve tightens credit c. The firm uses more debt; that is, it increases its debt/assets ratio d. The firm doubles the amount of capital it raises during the year e. The firm expands into a risky new area. f. Investors become more risk averse.

6.4

Distinguish between beta risk, within-firm risk and stand-alone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why? Stand-alone risk views a projects risk in isolation, hence without regard to portfolio effects; within-firm risk, also called corporate risk; and market risk (beta) recognizes that the firms stockholders hold diversified portfolios of stocks. With greater risk the company's should have a larger beta. And with greater leverage the company's stock should also have a larger beta. A larger beta corresponds to high return.

6.5

Suppose a firm estimates its cost of capital for the coming year to be 10 percentage. What might be reasonable cost of capital for average-risk, high-risk and low-risk projects? If a companys composite WACC estimate were 10 percent, its managers might use 10 percent to evaluate average-risk projects, 11-12 percent for those with high-risk and 8-9 percent for low-risk projects. Unfortunately, there is no completely satisfactory way to specify exactly how much be considered higher or lower.

CHAPTER 7
7.1 Define each of the following terms: a. Capital budgeting: It is the whole process of analyzing projects and deciding whether they should be included in the capital budget. This process is of fundamental importance to the success or failure of the company for many years into the future. The payback period, is the number of years it takes a firm to recover its project investment. Payback may be calculated with either raw cash flows (regular payback) or discounted cash flows (discounted payback). b. Mutually exclusive projects: They cannot be performed at the same time. We can choose either Project 1 or Project 2, or we can reject both, but we cannot accept both projects. Independent projects: They can be accepted or rejected individually. c. The net present value (NPV) and internal rate of return (IRR) techniques are discounted cash flow (DCF) evaluation techniques. Net Present Value: NPV is the present value of the project's expected future cash flows (both inflows and outflows). Internal Rate of Return: (IRR) is the discount rate that equates the present value of the expected future cash inflows and outflows. IRR measures the rate of return on a project, but it assumes that all cash flows can be reinvested at the IRR rate. d. Modified Internal Rate of Return: It (MIRR) assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project's own IRR. This makes the modified internal rate of return a better indicator of a project's true profitability. The profitability index is found by dividing the projects PV of future cash flows by its initial cost. A profitability index greater than 1 is equivalent to a positive NPV project. e. NPV Profile: An NPV profile is the plot of a project's NPV versus its cost of capital. The crossover rate is the cost of capital at which the NPV profiles for two projects intersect. f. Non Normal Cash Flows: Capital projects with non-normal cash flows have a large cash outflow either sometime during or at the end of their lives. A common problem encountered when evaluating projects with non-normal cash flows is multiple IRRs. Normal Cash Flows: A project has normal cash flows if one or more cash outflows (costs) are followed by a series of cash inflows.

g. Hurdle Rate: It is the project cost of capital, or discount rate. It is the rate used in discounting future cash flows in the NPV method, and it is the rate that is compared to the IRR. Post-Audit: The post-audit is the final aspect of the capital budgeting process. The postaudit is a feedback process in which the actual results are compared with those predicted in the original capital budgeting analysis. The post-audit has several purposes, the most important being to improve forecasts and improve operations. h. Replacement chain: It is a method of comparing mutually exclusive projects that have unequal lives. Each project is replicated such that they will both terminate in a common year. Not all projects maximize their NPV if operated over their engineering lives and therefore it may be best to terminate a project prior to its potential life. Economic Life: The economic life is the number of years a project should be operated to maximize its NPV, and is often less than the maximum potential life. Capital rationing: It occurs when management places a constraint on the size of the firms capital budget during a particular period. 7.2 How is a project classification scheme used in the capital budgeting process? Project classification schemes can be used to indicate how much analysis is required to evaluate a given project and the cost of capital that should be used to calculate the project's NPV. Thus, classification schemes can increase the efficiency of the capital budgeting process.

7.3

Explain why the NPV of a relatively long-term project, defined as one for which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of capital than is the NPV of a short term project. The rationale of NPV method is that NPV method discounts all the cash flows at the projects cost of capital and then sums those cash flows. Then these discounted cash flows are compounded over time. Thus, NPV is related to the cost of capital. So if the cost of capital changes, the cash flows in the distant future are affected more than the cash flows in the near future. This is the reason why we could say that the NPV of a long term project which has a high percentage of its cash flows in the distant future is more sensitive to changes in the cost of capital than is the NPV of a short term project.

7.4

Explain why, if two mutually exclusive projects are being compared, the short-term project might have the higher ranking under the NPV criterion if the cost of capital is high, but the long term project might be deemed better if the cost of capital is low. Would changes in the cost of capital ever cause a change in the IRR ranking of two such projects? As mentioned above the long term projects cash flows in the distant future will be lower and it will have a lower NPV. But if the cost of capital is low, the long term projects cash flows in the distant future will be higher and it will have a higher NPV. With regard to the second part of the question, the answer is no; the IRR rankings are constant and independent of the firm's cost of capital.

7.5

In what sense is a reinvestment rate assumption embodied in the NPV, IRR, and MIRR methods? What is the assumed reinvestment rate of each method? The NPV and IRR methods both involve compound interest, and the discounting requires an assumption about reinvestment rates. The NPV method assumes reinvestment at the cost of capital, while the IRR method assumes reinvestment at the IRR. MIRR is a modified version of IRR which assumes reinvestment at the cost of capital.

7.6

Suppose a firm is considering two mutually exclusive projects. One has a life of 6 years and other has a life of 10 years. Would the failure to employ some type of replacement chain analysis bias an NPV analysis against one of the projects? Explain. One project is having 6 years and the other has 10 years life. When we implement the NPV analysis, it may reveal that second project (10 years life) will have a higher NPV. But, if the first project is replaced after 6 years and when it is done, the first project will have a higher NPV. Thus we should employ Replacement chain technique