Capital Budgeting Corporate Strategies

Question

Berk and DeMarzo (2020) exemplify the variances between the three key approaches companies utilize for capital budgeting with leverage and within imperfect markets. These approaches comprise the Weighted Average Cost of Capital (WACC) method, the Adjusted Present Value (APV) Method, and the Flow-to-Equity (FTE) Method.

The Weighted Average Cost of Capital method

WACC refers to a weighted average of the cost of debt, the cost of equity, and also the cost of preference shares. Importantly, these weights are the proportion of the capital amount obtained from every component, respective to the total market value (Hillier et al., 2019). Two key suppositions are made concerning WACC. First, it is assumed that the capital structure does not change. That it is supposed that the firm’s capital structure will continue to be the same in time. The second supposition that is made is that business risk does not change. It is assumed that business risk will prevail to be the same over time, even after the acceptance of a new project. From a realistic perspective, the risk will change when a firm experiences expansion or invests in a new market (Hillier et al., 2019).

Strengths

1. The WACC is a ratio that can apply to all new projects taken up by the company. It is reasonable for the company to accept or reject a project when a comparison is made concerning one unified cost of capital.

2. WACC enables a firm to make rapid decisions through the comparison of the profitability of the project with WACC. Due to the ease in its computation, the outcomes can be obtained in a minimal time.

3. Being the minimum return rate, the WACC can be utilized to replace the hurdle rate for some firms (Peterson and Fabozzi, 2002).

Weaknesses

1. WACC supposes that the firm’s capital structure will remain intact over time. Nonetheless, the capital structure is expected to change when a project is accepted. Since new projects can either be financed by equity or debt, it is anticipated that the WACC will change.

2. WACC computation always relies on the firm’s debt and equity ratio. Therefore, it becomes the distinctive WACC solely for this firm. It is significantly problematic to obtain a firm in a similar sector with a similar debt and equity ratio. For this reason, it isn’t very worthy to compare the WACC of the firm to that of other firms (Peterson and Fabozzi, 2002).

The Adjusted Present Value method

The Adjusted Present Value (APV) method is used for capital budgeting and valuation of projects. This method takes into consideration the net present value (NPV), in addition to the present value of debt financing costs. These debt financing costs comprise financial subsidies, interest tax shields, as well as costs of debt issuance (Hillier et al., 2019). The adjusted present value (APV) approach initially values the project based on equity. The after-tax cash flows of the project under all-equity financing also referred to as unleveled cash flows, are positioned on the numerator section of the capital budgeting equation. What is positioned on the denominator section of the equation, assuming that the financing is fully provided through equity? After that, the net present value of the debt is added. In this case, the net present value of the debt is probably the summation of bankruptcy costs, tax effects, floatation expenses, and interest subsidies (Hillier et al., 2019).

Strengths

1. It encompasses a step-by-step approach and therefore renders a proper understanding of the components of the decision.

2. This approach can be utilized in evaluating any financing package

3. It is considered more straightforward than making an adjustment to the WACC, which can be significantly challenging and complicated (Peterson and Fabozzi, 2002).

Weaknesses

1. The method is based on Miller and Modigliani’s tax theory. As a result, it overlooks agency costs, tax exhaustion, and bankruptcy risk.

2. The method is based on Miller and Modigliani’s tax theory. As a result, it supposes that debt is risk-free and irredeemable (Peterson and Fabozzi, 2002).

The Flow-to-Equity method

The flow to equity method encompasses discounting the after-tax cash flow from a specific project to the levered firm’s shareholders. The levered cash flow refers to the residual to shareholders after the interest deduction. In this case, the discounting rate is the capital cost to the levered firm’s shareholders. Concerning a firm with leverage, the discount rate must be greater than the cost of capital for a firm unlevered (Hillier et al., 2019).

Strengths

1. This method can determine the strength of a company’s financials and the firm’s earning potential.

2. The approach can play a significant role in identifying risks such as debt and liquidity levels.

3. Different from WACC, this approach facilitates comparative analysis both amongst companies and within industries (Fabozzi and Peterson, 2002).

Weaknesses

1. It is lengthier compared to other methods and necessitates extensive collection of data.

2. This approach accounts for dividends as deductions from the income generated instead of increasing income. Furthermore, this approach overlooks market value (Peterson and Fabozzi, 2002).

Question 2

Concerning financial management, it is financially prudent for firms to try to ensure that the manager’s interests align with the interests of the shareholders. Based on Berk and DeMarzo (2020), it was determined that there are numerous instances of agency conflict or conflict between management and owners of a company. There are different mechanisms that companies could utilize to facilitate the alignment of the interests of both the owners of the company and its managers.

Companies can implement an executive compensation policy. Three extensive principles should be taken into consideration for an executive compensation plan. First of all, the plan ought to e designed to guarantee the alignment of longstanding interests between the shareowners of the firm and the executive management. Secondly, the program should comprise a mixture of cash and equity compensation. Third, the compensation program should always be transparent (Seal, 2006).

In this case, the policy would guide directors and executives in granting rewards to important personnel. Financial rewards and incentives for industrious personnel should be stimulated. Nonetheless, the rewards should be based on performance. Some aspects that should be included in the compensation policy should include a properly outlined amalgamation of the manager’s base salary, bonus, longstanding incentive corporation, and equity ownership. The firm’s philosophy concerns the dilution of current shareowners through the dispersal of compensation-based equity allowances (Anson et al., 2004).

The second principle makes certain that management is involved in the game. This implies that a firm’s shareowner should be prudent regarding the firm’s costs and residual cash flows to the firm’s equity holders. By creating shareowners based on the executive management compensation plan, it is most probable that the managers will act and operate in the best interests because they are also new shareholders. This aspect will benefit all equity investors (Anson et al., 2004).

Lastly, it is important for the plan to be understandable and coherent. This implies that investors ought not to be compelled to decode or translate any aspect of the proxy statement to comprehend the compensation of major executives. Rather, it should e transparent and plain, and if the executives’ compensation is plenty of money, it needs to be well outlined (Seal, 2006).

Question 3

Scenario analysis alludes to the process of forecasting the future value of an investment contingent on changes that may occur to existent variables. It necessitates one to explore the effect that various market conditions may have on the project or the investment in its entirety. Scenario analysis permits a more practical evaluation of prospective risk, instigating better decision-making. The approach places less emphasis on definitive results and more on predicting numerous conceivable outcomes that have validity, although ambiguous. Scenario analysis examines different outcomes placing them from the best-case to worst-case scenario (Ross, Westerfield, and Jaffe, 2005).

On the other hand, sensitivity analysis refers to the examination of how the result of a decision ends up being altered owing to the different input variations. Sensitivity analysis is utilized in circumstances dependent on one or several input variables. Also largely deemed as a “what-if” analysis, sensitivity analysis is beneficial, particularly for checking facts and rendering an in-depth forecast, as it considers the probability of either success or failure for variable scenarios (Damodaran, 2010).

The fundamental dissimilarity between these two approaches is that scenario analysis examines the outcome of changing one variable at a time. In contrast, sensitivity analysis simultaneously assesses the outcome of changing all conceivable variables. (Samonas, 2015). The following is a basic example of a project indicating how to execute both a sensitivity and scenario analysis in the evaluation of the project:

A college institution is considering the development of a new learning center that would include new lecture halls and a library on campus. As a result, the institution decides to run a financial forecasting model to determine the impact of its investment. Scenario analysis would be utilized to examine the base case, the best case, and the worst-case scenario. After that, a sensitivity analysis would facilitate more insightful information about one of these conceivable scenarios. Concerning this case, the college may be seeking to examine how a prospective 10 percent increase or decrease in revenue would impact its profitability if it implemented the investment. In this case, the method helps examine this revenue change’s flexible and inflexible costs. Bearing this in mind, carrying out a sensitivity analysis can enable the main executives of the college institution to obtain a clearer perspective and comprehension of the budget amount that would be optimal for such a project.

Question 4

When examining the Weighted Average Cost of Capital (WACC), companies utilize key constituents in estimating their hurdle rate. Based on the interview Berk and DeMarzo (2020), it was determined that Intel, as a company, takes into consideration several inputs when conducting a re-estimation of their WACC on an annual basis.

One of the key inputs to consider is the interest rates. The Fed has a massive impact on interest rates in the short-run and the WACC through the fed funds rate. It is important to remember that the fed funds rate is defined as the rate of interest at which one bank provides credit to funds maintained by the Federal Reserve to another bank overnight. When the Fed changes interest rates, it changes the risk-free rate, which theoretically refers to the rate of return for an investment that does not face any risks of experiencing financial losses (Ehrhardt & Brigham, 2016).

Significantly, when the federal funds rate is either increased or decreased, it can have a significant impact on a firm’s hurdle rate because the risk-free rate is a fundamental component in the computation of the cost of capital. It is imperative to remember that the interest paid by the company is equivalent to the risk-free rate in addition to its default premium. When the interest rates are increased, there is an immediate increment in the risk-free rate (Keith and Reilly, 2004). For instance, if the risk-free rate is 3 percent and the default premium for the company’s debt is 2 percent, then it implies that the hurdle rate used in computing the company’s WACC is 5 percent. If the Fed increases the rates to 3.5 percent, whereas the premium remains constant, it implies that the hurdle rate utilized in computing WACC is 5.5 percent. It is critical to note that a higher cost of capital might also heighten the risk of defaulting in the case of Intel as a company. That would cause a further increment in the default premium and increase the hurdle rate utilized for computing WACC.

A second factor that Intel has to consider for the hurdle rate is taxes. Notably, taxes have an apparent impact on the hurdle rate because the interest paid on debt levels is tax deductible. When there are higher corporate taxes, then the eventual WACC is lower. On the other hand, when there are lower corporate taxes, the WACC is higher (Ehrhardt & Brigham, 2016). There is also the aspect of market conditions, in that an increment in the stock market volatility results in an increment in the risk premium that investors demand. This consequently increases the cost of raising extra capital for the company. Nonetheless, it is pivotal for Intel to note that greater volatility is likely to diminish the value of existent equity, making it more cost-effective for the company to purchase back shares (Ehrhardt & Brigham, 2016).

Question 5

According to Berk and DeMarzo (2020), concerning perfect capital markets, financial transactions neither facilitate any addition to value nor destruction to value but rather signify a repackaging of risk and, therefore, return. Miller and Modigliani assert that a firm’s capital structure does not influence its overall value. Miller and Modigliani made two key propositions.

Concerning Proposition I, Miller and Modigliani make suppositions relating to perfectly efficient markets. Specifically, this supposition implies that firms operating in a setting where there are perfectly efficient markets do not make payment of taxes and that securities trading can be implemented without any transactional costs. The assumption made is also that bankruptcy can take place in such markets. However, there are no bankruptcy costs, and the market information is considered perfectly symmetrical (Rau, 2017).

Proposition I asserts that the firm’s capital structure does not affect its value. Considering that the computation of a firm’s value is done as the present value of the future cash flows, the capital structure cannot influence its value. Furthermore, firms do not pay for taxation within such perfectly efficient markets. As a result, if a firm is considered to have a fully leveraged capital structure, it does not attain any benefits from interest payments that are tax deductible (Baker and Martin, 2011).

Concerning Proposition II, Miller and Modigliani indicate a direct and proportional correlation between a firm’s equity cost and its leverage level. That is, when the leverage level increases, the company is likely to default on payments. Consequently, investors are more inclined to demand a higher cost of equity to be repaid for the extra risk (Baker and Martin, 2011).

Question 7

One of the arguments made by Miller and Modigliani is that within perfect capital markets, there is indifference amongst investors between the company distributing funds through dividends or share repurchases. A second key argument that Miller and Modigliani made is that within perfect capital markets, maintaining fixed the company’s investment policy, the company’s choice of dividend policy lacks relevance and fails to impact the initial share price.

My focus on this question will be linked to the decision between stock repurchases and dividend payouts. First, within a perfect capital market, when a firm pays out a dividend, its share price decreases by the amount of the divided at the time the stock commences to trade ex-dividend. Secondly, within capital markets, a share repurchase on the market does not have any impact on the stock price, and the stock price is equivalent to the cum-dividend price if a dividend had been paid out in its place (Handley, 2008). In perfect capital markets, there is indifference amongst investors between the company responsible for distributing funds via dividends or share repurchases. Through the reinvestment of dividends or selling shares, it becomes possible for the investors to replicate either payout approach on their own. Taking this into consideration, there are two investor preferences. If a company repurchases shares and the investor demands cash, then the investor can generate cash by selling shares. Alternatively, if the company pays out a dividend and the investor prefers stock, the dividend can be used to buy extra shares (Handley, 2008).

Considering all of this, it is possible to perceive how the assumptions made by Miller and Modigliani to support this hypothesis is susceptible to overgeneralizing what occurs. In perfect capital markets, holding fixed the investment policy of a company, the company’s choice of dividend policy is immaterial. It does not have any influence on the initial share price. This means that within a perfect capital market, the sort of payout does not have any relevance. In the actual world, it is realistic that capital markets are not perfect. Imperfections like taxes and transaction expenses determine the company’s payout policy (Jagannathan et al., 2018).

There is a misapprehension that share repurchases diminish the supply of shares and consequently set in motion increasing share prices. It is imperative to point out that when a company chooses to repurchase shares, two things take place. One, there is a reduction in the supply of shares; secondly, the value of the company’s assets decreases owing to expenses incurred in purchasing the sales. These two aspects usually offset one another and the share price ends up remaining the same without being changed. This is akin to the dilution myth. When a company implements the issuance of new shares, the share price does not decrease because cash generated due to the issue causes an increase in the value of the assets (Wesson et al., 2018).

Question 8

One of the key aspects that Berk and DeMarzo (2020) highlight is that certain industries have a likelihood of firms utilizing more debt or leverage within their capital structures as contrasted against others. A significant variance in the debt-to-equity ratio amongst industries and between companies within an industry encompasses dissimilar capital intensity levels between the firms. Another reason is that the firms could have different natures of businesses, which causes having high debt levels simpler for management (Harris, 1994). It is imperative to note that capital-intensive companies necessitate substantial financial resources and massive amounts of money to produce commodities and services. A fitting example is firms operating within the telecommunications industry. These sorts of companies are usually forced to make significant investments in infrastructure, setting up miles and miles of cabling to render consumers the services they need. On top of such primary capital expenditure, extra capital outlays include essential maintenance, growth of service areas, and advancements (Ross, Westerfield, and Jaffe, 2005).