Chapter 14

1. Chapter 14 CAPITAL FINANCING AND ALLOCATION

2. Learning Objectives • Capital financing and allocation functions • Differences between sources of capital • Cost of debt capital • Cost of equity capital • Weighted average cost of capital • Leasing as a source of capital • Capital allocation

3. Capital Budgeting • First thing must do is to obtain capital funds from investors and lenders • Revenues from the engineering and other capital projects must earn an adequate return to achieve economic growth • Involves the expenditure of the current capital funds to obtain future economic benefits

4. Capital Financing Function • Determines the amount of new funds needed from investors, lenders, and internal sources to support new capital projects • Decides on the sources of new externally acquired funds • These amounts as well as the ratio of debt to equity capital must be commensurate with the financial status of the firm

5. Capital Allocation Function • Selects engineering projects for implementation based on constraints of total capital investment • Capital allocation activities begin in various company organizations • Organizations plan, evaluate and recommend projects for funding and implementation • Engineering economy studies are performed to develop much of the information required

6. Various Sources of Capital • Methods by which the capital is obtained will impact the MARR • Obtained from either internal sources, external sources, or both • Various sources of capital are • Debt capital • Equity capital • Retained earnings • Depreciation reserves • Leasing

7. Debt Capital • Involves both short and long-term • Interest must be paid to capital providers and by a specified time • Lenders do not share in profits • Borrower may be required to pledge some type of security • Terms may limit the use of borrowed funds • Terms may also restrict further borrowing • Loan interest is a tax-deductible expense for the firm

8. Equity Capital • Supplied and used by owners in expectation of profit • No assurance that profit will be made or that investment capital will be recovered • No limitations placed on the use of funds • No explicit cost for use of such capital; therefore, not tax deductible for firm • Expected rate-of-return must be high enough, at an acceptable risk, to be attractive to potential investors

9. Retained Earnings • Profits that are reinvested in the business instead of being paid as dividends to owners • Keeping some portion of the company’s profit • Reduces the immediate amount of dividends per share • Increases the book value of the stock • Results in greater future dividends and / or market resale value of the stock

10. Depreciation Reserves • Set aside out of revenue as an allowance for the replacement of equipment and other assets • Provide a revolving investment fund that may be used to the best possible advantage • An important source of capital for financing new projects within existing firm • Required capital is available for replacing essential equipment when the time for replacement arrives

11. Leasing • A way of acquiring use of an asset without capital expenditure for purchase • A form of contract that establishes conditions under which asset owner conveys the use and associated costs to the lessee • A method of achieving benefits of capital investment without actually acquiring additional debt • Leasing cost are tax deductible

12. Cost of Debt Capital • Proportion of debt capital must be maintained below a level which would adversely affect the market value of the firm’s common stock • Vary by type of company • Components of debt capital are short-term loans and long-term bonds • Discussed in the following slide

13. Loans (Short-term Debt) • Usually for periods less than five years and frequently for less than two years • Sources are banks, insurance companies, retirement systems, other lending institutions • Used a note to define promise to repay, amount of borrowed funds, interest, etc. • Lending institution may require tangible value as security

14. Loans (Short-term Debt) • Assuming all interest payments and income taxes paid by firm are paid on annual basis, after-tax cost of capital CL = iL(1 – t) • CL = after-tax cost of capital for a loan • iL =rate of interest per year paid on the loan • t = effective (marginal) income tax

15. Bonds (Long-term Debt) • A long-term note given to the lender by the borrower • Bondholder has no voice in affairs of business and is not entitled to a share of profits • Face value or par value of a bond is the amount (I.e., $1,000, $10,000, etc… ) for which bond is issued • When face value is repaid, bond is retired or redeemed • Interest rate quoted on the bond is the bond rate • The periodic interest payment due is computed as the face value times the bond interest rate per period

16. Bonds (Long-term Debt) • Annual after-tax cost of capital for a bond [ Zr + (Z –P +Se) / N + Ae ] (1- t) CB =---------------------------------------------------- (Z + P – Se) / 2 • Z = face (par) value of bond; • r = bond rate (nominal interest) per year; • N = Number of years until bond is retired (redeemed); • Se = initial selling expense associated with the bond; • P = Actual selling price of the bond) [if P<Z, the bond is sold at a discount (to par value), and if P>Z, the bond is sold at a premium]; • Ae = annual administrative expenses associated with bond; • t = effective (marginal) income tax rate

17. Example • Assume the initial selling expenses of the bond issue is 1.17% of the par (face) value; the annual administrative expense of servicing the bond issue is 3.1% of the annual interests costs; and the corporation’s marginal (effective) income-tax rate is 39.6%. Based on this additional information, what is the after-tax cost of capital to the corporation of the bond issue?

18. Cost of Equity Capital • Acquired through the sale of stock. • Purchasers of the stock are part owners usually called stockholders • Stockholders are entitled to a share of the profits • Are not liable for the debts of the corporation • Because the life of a corporation is continuous, long-term investments can be made • Makes debt capital easier to obtain, and at a lower interest cost

19. Types of Stocks • Many types of stocks • Common stock • represents ordinary ownership without special guarantees of return on investment • Preferred stock • has certain privileges over common stock • Dividends on common stock are not paid until the fixed percentage return on preferred stock has been paid

20. Dividend Valuation Model • Value of a share of common stock can be approximated by the PW of future cash receipts • P0 = selling price of a share of stock • Div = annual dividend for past year • Current price of a share of common stock equals PW of an assumed indefinite series of dividend receipts P0 = Div (P / A, ea,  ) = Div / ea • After-tax cost of equity (common stock) ea = Div / P0 • If future price of security is expected to grow at a rate of ‘g’ each year ea = Div / P0 + g

21. Example • The Yog Manufacturing Company’s common stock is presently selling for $32 per share, and annual dividends have been constant at $2.40 per share. If an investor believes that the price of a share of common stock will grow at 5% per year into the foreseeable future, what is the approximate cost of common stock equity to Yog? What assumptions did you make?

22. Retained Earnings • Normally assumed to be the same as for common stock • Retained and reinvested for future growth and increasing stockholder wealth

23. Weighted-Average Cost of Capital • Determined once the amount and explicit cost is established • Includes short-term debt, bond, retained earnings common stock, and preferred stock components

24. Leasing as a Source of Capital • Leasing is a business arrangement that makes assets available • Leasing is a source of capital generally regarded as a long-term liability • For corporations, rent paid is generally deductible as a business expense • Studies have shown no real income tax advantage in leasing

25. Leasing as a Source of Capital-Cont. • May or may not be savings in maintenance expenses, but simplifies maintenance problems • True advantage is in allowing a firm to obtain modern equipment • Provides a hedge against inflation and obsolescence

26. Cost of the Lease Alternative • After-tax cost of a lease Ik = Lk ( 1 - t ) • Ik = after-tax lease expense during year k • Lk = before-tax lease expense during year k • t = effective income-tax rate • If i is known and fixed, PW of the after-tax cost PWLease (i%) =Sk=1N[Lk (1 - t ) / ( 1 + i )k • Noted that the annual maintenance expenses are not included

27. Cost of Purchase Alternative • After-tax cost of equipment is a function of expected annual expenses, purchase price, book value, and expected market value • PW of after-tax cost of purchased equipme • I = capital investment • MV = expected market value at the end of year N • BVN = book value at the end of year N • i = interest rate per year • N = life of equipment in years • O&Mk = operating and maintenance expense during year k • t = effective income tax rate • dk = depreciation during year k • Note that market value, book value and depreciation amounts are negative because they reduce costs

28. Example • An existing piece of equipment has been performing poorly and needs replacing. More modern equipment can be purchased or it can be leased. If purchased, the equipment will cost $20,000 and have a depreciable life of 5 years with no market value. For simplicity, assume straight-line depreciation is used by the firm. Because of improved operating characteristics of the equipment, raw materials savings of $5,000 per year are expected to result relative to continued use of the present equipment. However, annual labor expenses for the new equipment will most likely increase by $2,000 and annual maintenance will go up by $1,000.

29. Capital Allocation • Allocate the obtained capital through activities that transform various types of resources into goods and services • Process of the capital-expenditure decision-masking is referred to capital allocation • Involves planning, evaluation, and management of capital projects

30. Linear Programming Formulations of Capital Allocation Problems • Linear programming is a mathematical procedure for maximizing ( or minimizing) a linear objective function, subject to one or more linear constraint equations • A useful technique for solving certain multi-period capital allocation problems • Objective function of the capital allocation problem • Bj* = net PW of investment opportunity • Xj = fraction of project j that is implemented during the planning period • Note Xj will normally be ‘0’ or ‘1’ • m = number of mutually exclusive combinations of projects

31. Linear Programming Formulations of Capital Allocation Problems • Notation used linear programming model • ckj = cash outlay (e.g., initial capital investment or annual operating budget) required for project j in time period k • Ck = maximum cash outlay that is permissible in time period k

32. LP Formulations • Two types of constraints • Limitations on cash outlays for period k of planning horizon Sj=1m ckXj< Ck 2. Interrelationships among projects: • If projects p, q, and r are mutually exclusive Xp + Xq + Xr< 1 2. If project r can be undertaken only if project s has already been selected Xr< Xs or Xr - Xs< 0 3. If projects u and v are mutually exclusive and project r is dependent (contingent) on acceptance of u and v xu + xv< 1 and xr< xu + xv

33. Example • Three alternatives are being considered for an engineering project. Their cash flow estimates are shown in the accompanying table. A and B are mutually exclusive, and C is an optional add-on feature to alternative A. Investment funds are limited to $5,000,000. Another constraint on this project is the engineering personnel needed to design and implement the solution. No more than 10,000 person-hours of engineering time can be committed to the project. Setup a linear integer programming formulation of this resource allocation problem

34. Example-Cont.