QUEENS’s UNIVERESITY COLLEGE POST GRADUATED OF MBA

INDIVIDUAL ASSIGNMENT FOR MANAGEMENT INFORMATIONSISTEM

ID No-026/15

Submitted to AMOGNE (DOCTER)

Addis Ababa Ethiopia

Date February 2024

 1) Risk and Return

A.Introduction to risk and return The term return refers to income from a security after a defined
period either in the form of interest, dividend, or market appreciation in security value. On the other
hand, risk refers to uncertainty over the future to get this return. In simple words, it is a probability of
getting return on security.

The concept of risk and return makes reference to the possible economic loss or gain from investing
in securities. A gain made by an investor is referred to as a return on their investment. Conversely,
the risk signifies the chance or odds that the investor is going to lose money.

Stand-alone risk is defined and measured assuming an investment will be held in isolation. Stand-
alone risk can be measured by the degree of “tightness” of the return distribution. One common
measure of stand-alone risk is the standard deviation of the return distribution, usually represented by
a lowercase sigma,

The total risk of a portfolio (as measured by the standard deviation of returns) consists of two types of
risk: unsystematic risk and systematic risk. If we have a large enough portfolio it is possible to
eliminate the unsystematic risk. However, the systematic risk will remain.

The risk-return relationship is explained in two separate back-to-back articles in this month’s issue.
This approach has been taken as the risk-return story is included in two separate but interconnected
parts of the syllabus. We need to understand the principles that underpin portfolio theory, before we
can appreciate the creation of the Capital Asset Pricing Model (CAPM).

n this article on portfolio theory we will review the reason why investors should establish portfolios. This is
neatly captured in the old saying ‘don’t put all your eggs in one basket’. The logic is that an investor who puts
all of their funds into one investment risks everything on the performance of that individual investment. A wiser
policy would be to spread the funds over several investments (establish a portfolio) so that the unexpected
losses from one investment may be offset to some extent by the unexpected gains from another. Thus the key
motivation in establishing a portfolio is the reduction of risk. We shall see that it is possible to maintain returns
(the good) while reducing risk (the bad)

UNDERSTANDING AN NPV CALCULATION FROM AN INVESTOR’S PERSPECTIVE

1
Risk-free return
The risk-free return is the return required by investors to compensate them for investing in a risk-free
investment. The risk-free return compensates investors for inflation and consumption preference, ie
the fact that they are deprived from using their funds while tied up in the investment. The return on
treasury bills is often used as a surrogate for the risk-free rate.
Risk Risk premium
Risk simply means that the future actual return may vary from the expected return. If an investor
undertakes a risky investment he needs to receive a return greater than the risk-free rate in order to
compensate him. The more risky the investment the greater the compensation required. This is not

surprising and it is what we would expect from risk- averse investors

SYSTEMATIC AND UNSYSTEMATIC RISK

The total risk of a portfolio (as measured by the standard deviation of returns) consists of two types of
risk: unsystematic risk and systematic risk. If we have a large enough portfolio it is possible to
eliminate the unsystematic risk.

2
Unsystematic/Specific risk: refers to the impact on a company’s cash flows of largely random
events like industrial relations problems, equipment failure, R&D achievements, changes in the senior
management team etc. In a portfolio, such random factors tend to cancel as the number of
investments in the portfolio increase.

Systematic/Market risk: general economic factors are those macro -economic factors that affect the
cash flows of all companies in the stock market in a consistent manner, eg a country’s rate of
economic growth, corporate tax rates, unemployment levels, and interest rates. Since these factors
cause returns to move in the same direction they cannot cancel out. Therefore, systematic/market
risk remains present in all portfolios.

2. Long-term Financing and capital structure

Capital structure describes the mix of a firm's long-term capital, which is a combination of debt and
equity. Capital structure is a type of funding that supports a company's growth and related assets.
Sometimes it's referred to as capitalization structure or simply capitalization

Long-term Financing
The Sources of Long Term Finance are those sources from where the funds are raised for a longer period of time, usually
more than a year. Long term financing is required for modernization, expansion, diversification and development of
business operations.

Sources of Long Term Finance Equity Shares Preference Shares, Retained earnings, Debentures or bonds, Loans from
banks and financial institutions, Venture capital financing and Lease financing

3
Long-term finance can be defined as any financial instrument with maturity exceeding one year (such as bank loans,
bonds, leasing and other forms of debt finance), and public and private equity instruments.

Capital structure is the particular combination of debt and equity used by a company to finance its overall operations
and growth. Equity capital arises from ownership shares in a company and claims to its future cash flows and profits.

The optimal capital structure of a company refers to the proportion in which it structures its equity and debt.
It is designed to maintain the perfect balance between maximizing the wealth and worth of the company and
minimizing its cost of capital

The Risk is defined in Webster’s as “a hazard; a peril; exposure to loss or injury.” Thus, risk refers to
the chance that some unfavorable event will occur. If you engage in skydiving, you are taking a
chance with your life—skydiving is risky. If you bet on the horses, you are risking your money. If
you invest in speculative stocks (or, really, any stock), you are taking a risk in the hope of making an
appreciable return. An asset’s risk can be analyzed in two ways:

(1) on a stand-alone basis, where the asset is considered in isolation, and

(2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio. Thus, an
asset’s stand-alone risk is the risk an investor would face if he or she held only this one asset.
Obviously, most assets are held in portfolios, but it is necessary to understand stand-alone risk in
order to understand risk in a portfolio context. To illustrate the riskiness of financial assets, suppose
an investor buys $100,000 of short-term Treasury bills with an expected return of 5 percent. In this
case, the rate of return on the investment, 5 percent, can be estimated quite precisely, and the
investment is defined as being essentially risk free. However, if the $100,000 were invested in the
stock of a company just being organized to prospect for oil in the mid-Atlantic, then the investment’s
return could not be Risk

From your reading you should be aware that modern financial theory defines investors (including
management) as rational, risk-averse investors who seek maximum returns at minimum risk. But
throughout our example, we have a statistical-behavioral paradox based on the symmetric normality
of returns and their depth of variability around the mean, however we define it.

ESCo still cannot conclude which project is less risky. Explained simply, one standard deviation from
the mean, should it opt for project A with the likelihood of €12,000 (compared to only €9,000 from
project D) or project D with an equal likelihood of €81,000 (compared to €66,000 from project A)?

Whilst project A maximizes downside returns there is also an equal probability that project D
maximizes upside returns. So, is project A less risky than project D?

4
Below the mean, risk aversion would select the former, (why?). Above the mean, project D is clearly
more attractive, (to whom?). Presumably, rational, risk-averse investors would say “yes” to project A.
But those prepared to gamble would opt for project D?

B.stand-alone risk and return

Risky assets rarely produce their expected rates of return—generally, risky assets earn either more or
less than was originally expected. Indeed, if assets always produced their expected returns, they
would not be risky. Investment risk, then, is related to the probability of actually earning a low or
negative return— the greater the chance of a low or negative return, the riskier the investment.
However, risk can be defined more precisely, and we do so in the next section

Stand-Alone Risk The risk an investor would face if he or she held only one asset. estimated
precisely. One might analyze the situation and conclude that the expected rate of return, in a
statistical sense, is 20 percent, but the investor should also recognize that the actual rate of return
could range from, say, 1,000 percent to 100 percent. Because there is a significant danger of actually
earning much less than the expected return, the stock would be relatively risky. No investment will be
undertaken unless the expected rate of return is high enough to compensate the investor for the
perceived risk of the investment. In our example, it is clear that few if any investors would be willing
to buy the oil company’s stock if its expected return were the same as that of the T-bill.

PROBABILITY DISTRIBUTIONS

An event’s probability is defined as the chance that the event will occur. For example, a weather
forecaster might state, “There is a 40 percent chance of rain today and a 60 percent chance that it will
not rain.” If all possible events, or outcomes, are listed, and if a probability is assigned to each event,
the listing is called a probability distribution. For our weather forecast, we could set up the following
probability distribution:

OUTCOME PROBABILITY (1) (2) Rain 0.4 40% No rain 0.6 60% 1.0 100%

The possible outcomes are listed in Column 1, while the probabilities of these outcomes, expressed
both as decimals and as percentages, are given in Column 2. Notice that the probabilities must sum to
1.0, or 100 percent. Probabilities can also be assigned to the possible outcomes (or returns) from an
investment. If you buy a bond, you expect to receive interest on the bond plus a return of your
original investment, and those payments will provide you with a rate of return on your investment.
The possible outcomes from this investment are (1) that the issuer will make the required payments or
(2) that the issuer will default on the payments.

If you invest in a stock instead of buying a bond, you will again expect to earn a return on your
money. A stock’s return will come from dividends plus capital gains. Again, the riskier the stock—
which means the higher the probability that the firm will fail to perform as you expected—the higher
the expected return must be to induce you to invest in the stock. With this in mind, consider the

5
possible rates of return (dividend yield plus capital gain or loss) that you might earn next year on a
$10,000 investment in the stock of either Martin Products Inc. or U.S. Water Company.

Probability Distribution A listing of all possible outcomes, or events, with a probability (chance of
occurrence) assigned to each outcome.

C. Risk and return of a portfolio

Manufactures and distributes computer terminals and equipment for the rapidly growing data
transmission industry. Because it faces intense competition, its new products may or may not be
competitive in the marketplace, so its future earnings cannot be predicted very well. Indeed, some
new company could develop better products and literally bankrupt Martin. U.S. Water, on the other
hand, supplies an essential service, and because it has city franchises that protect it from competition,
its sales and profits are relatively stable and predictable. The rate-of-return probability distributions
for the two companies are shown in Table 6-1. There is a 30 percent chance of strong demand, in
which case both companies will have high earnings, pay high dividends, and enjoy capital gains.
There is a 40 percent probability of normal demand and moderate returns, and there is a 30 percent
probability of weak demand, which will mean low earnings and dividends as well as capital losses.
Notice, however, that Martin Products’ rate of return could vary far more widely than that of U.S.
Water. There is a fairly high probability that the value of Martin’s stock will drop substantially,
resulting in a 70 percent loss, while there is no chance of a loss for U.S. Water.2

2) Long-term Financing and capital structure

a. Long-term Financing

The final plan will therefore implicitly contain different goals in different areas and also satisfy many
constraints. For this reason, such a plan need not be a dispassionate assessment of what we think the
future will bring; it may instead be a means of reconciling thFinancial planning forces the firm to
think about the future. We have examined a number of features of the planning process. We described
what financial planning can accomplish and the components of a financial model. We went on to
develop the relationship between growth and financing needs, and we discussed how a financial
planning model is useful in exploring that relationship. Corporate financial planning should not
become a purely mechanical activity. If it does, it will probably focus on the wrong things. In
particular, plans all too often are formulated in terms of a growth target with no explicit linkage to
value creation, and they frequently are overly concerned with accounting statements. Nevertheless,
the alternative to financial planning is stumbling into the future. Perhaps the immortal Yogi Berra
(the baseball catcher, not the cartoon character) put it best when he said, “Ya gotta watch out if you
don’t know where you’re goin’. You just might not get there.” Skandia retains

b 1 .3337 66.63% of net income.

Return on assets is $247.5/3,100 7.98%.

The internal growth rate is: 5.62%

6
Return on equity for Skandia is $247.5/800 30.94%,

so we can calculate the sustainable growth rate as:25.97%

1. Sales Forecast Why do you think most long-term financial planning begins with sales forecasts?
Put differently, why are future sales the key input?

2. Long Range Financial Planning Would long-range financial planning be more important for a
capital intensive company, such as a heavy equipment manufacturer, or an import-export business?
Why?

3. External Financing Needed Testa burger, Inc., uses no external financing and maintains a positive
retention ratio. When sales grow by 15 percent, the firm has a negative projected EFN. What does
this tell you about the firm’s internal growth rate? How about the sustainable growth rate? At this
same level of sales growth, what will happen to the projected EFN if the retention ratio is increased?
What if the retention ratio is decreased? What happens to the projected EFN if the firm pays out all of
its earnings in the form of dividends?

4. EFN and Growth Rates Broslofski Co. maintain a positive retention ratio and keep its debt-equity
ratio constant every year. When sales grow by 20 percent, the firm has a negative projected EFN.
What does this tell you about the firm’s sustainable growth rate? Do you know, with certainty, if the
internal growth rate is greater than or less than 20 percent? Why? What happens to the projected EFN
if the retention ratio is increased? What if the retention ratio is decreased? What if the retention ratio
is zero? Use the following information to answer the next six questions: A small business called The
Grandmother Calendar Company began selling personalized photo calendar kits in 1992. The kits
were a hit, and sales soon sharply exceeded forecasts. The rush of orders created a huge backlog, so
the company leased more space and expanded capacity, but it still could not keep up with demand.
Equipment failed from overuse and quality suffered. Working capital was drained to expand
production, and, at the same time, payments from customers were often delayed until the product was
shipped. Unable to deliver on orders, the company became so strapped for cash that employee
paychecks began to bounce. Finally, out of cash, the company ceased operations entirely in January
1995.

5. Product Sales Do you think the company would have suffered the same fate if its product had been
less popular? Why or why not?

6. Cash Flow The Grandmother Calendar Company clearly had a cash flow problem. what was the
impact of customers ‘not paying until orders were shipped?

Concepts Review and Critical Thinking Questions.3094.6663 1.3094.6663

b. The concept of capital structure

The previous exercise illustrates why rational risk averse investors prefer the ordinary shares of
higher geared companies when economic conditions are good or improving but switch to lower
geared firms when recession looms. Both strategies represent a rational risk-return trade off because.

7
Ordinary shares represent a more speculative investment when there is a contractual obligation on the
part of the company to pay periodic interest on debt - As a general rule, the higher the gearing and
more uncertain a firm’s overall profitability (EBIT) the greater the fluctuation in dividends plus
reserves.

As we mentioned earlier, the returns to debt and equity holders are interdependent, stemming from
the same resources. So, what we are observing is the transfer of business risk to shareholders who
must bear the inconsistency of returns as the firm gears up. Thus, it would seem that management
should finance its investments so that the shareholders, to whom they are ultimately responsible,
receive the highest return for a given level of earnings and risk. And this is where MM disagree with
traditional theorists.

c. Theories of capital structure

Initially, when a firm borrows, shareholder wealth (dividend plus capital gain) can be increased if the
effective cost of debt is lower than the original earnings yield. In efficient capital markets such an
assumption is not unrealistic:

Debt holders receive a guaranteed return and in the unlikely event of liquidation are usually given
security in the form of a prior charge over the assets. - From an entity viewpoint, debt interest
qualifies for tax relief Irrespective of the financing source, the same overall income is characterised
by the same degree of business risk. What has changed is the mode of financing which increases the
investors’ return in the form of EPS at minimum financial risk. So, if this creates demand for equity
and its market price rises proportionately, the equity capitalisation rate should remain constant. For
the company, the beneficial effects of cheaper financing therefore outweigh the costs and as a
consequence, its overall cost of capital (WACC) falls and total market value rises.

Of course, the net benefits of gearing cannot be maintained indefinitely. As a firm introduces more
debt into its capital structure, shareholders soon become exposed to greater financial risk (irrespective
of dividend policy and EPS), even if there is no realistic chance of liquidation. So much so, that the
demand for equity tails off and its price begins to fall, taking total corporate value with it. At this
point, WACC begins to rise.

The increased financial risk of higher gearing arises because the returns to debt and equity holders are
interdependent stemming from the same investment. Because of the contractual obligation to pay
interest, any variability in operating income (EBIT) caused by business risk is therefore transferred to
the shareholders who must bear the inconsistency of returns. This is amplified as the gearing ratio
rises. To compensate for a higher level of financial risk, shareholders require a higher yield on their
investment, thereby producing a lower capitalised value of earnings available for distribution (i.e.
lower share price). At extremely high levels of gearing the situation may be further aggravated by
debt holders. They too, may require ever-higher rates of interest per cent as their investment takes on
the characteristics of equity and no longer represents a prior claim on either the firm’s income or
assets

8
3) Investment Decisions (Capital Budgeting decisions)

a. The concept of capital budgeting

A number of factors combine to make capital budgeting perhaps the most im-portant function
financial managers and their staffs must perform. First, since

The results of capital budgeting decisions continue for many years, the firm Loses some of its
flexibility. For example, the purchase of an asset with an economic life of 10 years “locks in” the firm
for a 10-year period. Further, because asset expansion is based on expected future sales, a decision to
buy an asset that is expected to last 10 years requires a 10-year sales forecast. Finally, a firm’s capital
budgeting decisions define its strategic direction, because moves into new products, services, or
markets must be preceded by capital expenditures.

An erroneous forecast of asset requirements can have serious consequences.

If the firm invests too much, it will incur unnecessarily high depreciation and Capital Budgeting.

The process of planning expenditures on assets whose cash flows are expected to extend beyond one
year.based on a careful capital budgeting analysis. Hopkins will certainly try to impose the same type
of discipline at Lucent. With this in mind as you read this chapter, think about how companies such
as Boeing and Lucent use capital budgeting analysis to make better investment decisions. Departure.

At the same time, Hopkins has stepped into tough situation at Lucent, where the once high-flying
company has recently seen sharp declines in its stock price. Boeing’s new CFO, Michael Sears,
appears to be continuing the policies that Hopkins put in place. In the future, each of Boeing’s
investment decisions will be 507 other expenses. On the other hand, if it does not invest enough, two
problems may arise. First, its equipment and computer software may not be sufficiently modern to
enable it to produce competitively. Second, if it has inadequate capacity, it may lose market share to
rival firms, and regaining lost customers requires heavy selling expenses, price reductions, or product
improvements, all of which are costly.

Timing is also important capital assets must be available when they are needed. Edward Ford,
executive vice-president of Western Design, a decorative tile company, gave the authors an
illustration of the importance of capital budgeting. His firm tried to operate near capacity most of the
time. During a four year period, Western experienced intermittent spurts in the demand for its
products, which forced it to turn away orders. After these sharp increases in demand, Western would
add capacity by renting an additional building, then purchasing and in-stalling the appropriate
equipment. It would take six to eight months to get the additional capacity ready, but by then demand
had dried up other firms with available capacity had already taken an increased share of the market.
Once Western began to properly forecast demand and plan its capacity requirements a year or so in
advance, it was able to maintain and even increase its market share.

9
Effective capital budgeting can improve both the timing and the quality of asset acquisitions. If a firm
forecasts its needs for capital assets in advance, it can purchase and install the assets before they are
needed.

Unfortunately, many firms do not order capital goods until existing assets are approaching full-
capacity usage. If sales increase because of an increase in general market demand, all firms in the
industry will tend to order capital goods at about the same time.

Risk is defined in Webster’s as “a hazard; a peril; exposure to loss or injury.” Thus, risk refers to the
chance that some unfavorable event will occur. If you engage in skydiving, you are taking a chance
with your life—skydiving is risky. If you bet on the horses, you are risking your money. If you invest
in speculative stocks (or, really, any stock), you are taking a risk in the hope of making an
appreciable return. An asset’s risk can be analyzed in two ways: (1) on a stand-alone basis, where the
asset is considered in isolation, and (2) on a portfolio basis, where the asset is held as one of a number
of assets in a portfolio. Thus, an asset’s stand-alone risk is the risk an investor would face if he or she
held only this one asset. Obviously, most assets are held in portfolios, but it is necessary to
understand stand-alone risk in order to understand risk in a portfolio context. To illustrate the
riskiness of financial assets, suppose an investor buys $100,000 of short-term Treasury bills with an
expected return of 5 percent. In this case, the rate of return on the investment, 5 percent, can be
estimated quite precisely, and the investment is defined as being essentially risk free. However, if the
$100,000 were invested in the stock of a company just being organized to prospect for oil in the mid-
Atlantic, then the investment’s return could not be Risk Risk is defined in Webster’s as “a hazard; a
peril; exposure to loss or injury.” Thus, risk refers to the chance that some unfavorable event will
occur. If you engage in skydiving, you are taking a chance with your life—skydiving is risky. If you
bet on the horses, you are risking your money. If you invest in speculative stocks (or, really, any
stock), you are taking a risk in the hope of making an appreciable return. An asset’s risk can be
analyzed in two ways: (1) on a stand-alone basis, where the asset is considered in isolation, and (2) on
a portfolio basis, where the asset is held as one of a number of assets in a portfolio. Thus, an asset’s
stand-alone risk is the risk an investor would face if he or she held only this one asset. Obviously,
most assets are held in portfolios, but it is necessary to understand stand-alone risk in order to
understand risk in a portfolio context. To illustrate the riskiness of financial assets, suppose an
investor buys $100,000 of short-term Treasury bills with an expected return of 5 percent. In this case,
the rate of return on the investment, 5 percent, can be estimated quite precisely, and the investment is
defined as being essentially risk free. However, if the $100,000 were invested in the stock of a
company just being organized to prospect for oil in the mid-Atlantic, then the investment’s return
could not be Risk

The firm that foresees its needs and purchases capital assets during slack periods can avoid these
problems. Note, though, that if a firm forecasts an increase in de-mand and then expands to meet the
anticipated demand, but sales do not in-crease, it will be saddled with excess capacity and high costs,
which can lead to

losses or even bankruptcy. Thus, an accurate sales forecast is critical.

10
Capital budgeting typically involves substantial expenditures, and before afirm can spend a large
amount of money, it must have the funds lined up large amounts of money are not available
automatically. Therefore, a firm con-templating a major capital expenditure program should plan its
financing far enough in advance to be sure funds are available.

Finance graduates who go into investments often work for a brokerage house such as Merrill Lynch,
either in sales or as a security analyst. Others work for banks, mutual funds, or insurance companies
in the management of their investment portfolios; for financial consulting firms advising individual
investors or pension funds on how to invest their capital; for investment banks whose primary
function is to help businessesraisenewcapital;orasfinancialplanners

whosejobistohelpindividualsdeveloplong-termfinancialgoalsandportfolios. The three main functions

in the investments area are sales, analyzing individual securities, and determining the optimal mix of
securities for a given investor.

If we assume that the strategic objective of corporate financial management is the maximisation of
shareholders’ wealth, the firm requires a consistent model for analysing the profitability of proposed
investments, which should incorporate an appropriate criterion for their acceptance or rejection. we
examined four common techniques for selecting capital projects where a choice is made between
alternatives.

The managerial investment function and finance function are linked by the company’s WACC. You
will recall that from a financial perspective, it represents the overall cost incurred in the acquisition of
funds. A complex concept, it not only concerns explicit interest on borrowings or dividends paid to
shareholders. Companies also finance their operations by utilising funds from a variety of sources,
both long and short term, at an implicit or opportunity cost, notably retained earnings, without which
companies would presumably have to raise funds elsewhere. In addition, there are implicit costs
associated with depreciation and other non-cash expenses. These too, represent retentions that are
available for reinvestment.

Finally, in terms of the corporate investment decision, we reconciled the NPV maximisation of all a
firm’s projects with EVA and MVA maximisation using WACC as an appropriate cut-off rate for
investment.

In our ideal world characterised by rational investors and perfect markets, the strategic objectives of
financial management relative to the investment and finance decisions that enhance shareholder
wealth can be characterised as follows

Funds from any source should only be invested in capital projects if their marginal yield at least
equals the rate of return that the finance provider can earn elsewhere on comparable investments of
equivalent risk

- Payback (PB) is useful for calculating how quickly a project’s cash flows recoups its capital cost but
says nothing about its overall profitability or how it compares with other projects. - Accounting Rate

11
of Return (ARR) focuses on project profitability but contains serious computational defects, which
relate to accounting conventions, ignores the true net cash inflow and also the time value of money.

When the time value of money is incorporated into investment decisions using discounted cash flow
(DCF) techniques based on Present Value (PV), the real economic return differs from the accounting
return (ARR). So, the remainder of our companion chapter explained how DCF is built into
investment appraisal using one of two PV models:

- Internal Rate of Return (IRR) - Net Present Value (NPV).

In practice, which of these models management choose to maximise project profitability (and
hopefully wealth) often depends on how they define “profitability”. If management’s objective is to
maximise the rate of return in percentage terms they will use IRR. On the other hand, if management
wish to maximise profit in absolute cash terms they will use NPV.

But as we shall discover in this chapter and the next, if management’s over-arching objective is
wealth maximisation then the IRR may be sub-optimal relative to NPV. The problem occurs when
ranking projects in the presence of capital rationing, if projects are mutually exclusive and a choice
must be made between alternativesFive key methods are used to rank projects and to decide whether
or not they should be accepted for inclusion in the capital budget: (1) payback, (2) discounted
payback, (3) net present value (NPV), (4) internal rate of return (IRR),
and(5)modifiedinternalrateofreturn(MIRR).Wewillexplainhoweachranking criterion is calculated, and
then we will evaluate how well each performs in terms of identifying those projects that will
maximize the firm’s stock price. We use the cash flow data shown in Figure 11-1 for Projects S and L
to illustrate each method. Also, we assume that the projects are equally risky. Note that the cash
flows, CFt, are expected values, and that they have been adjusted to reflect taxes, depreciation, and
salvage values. Further, since many projects require an investment in both fixed assets and working
capital, the investment outlays shown as CF0 include any necessary changes in net operating working

CAPITAL BUDGETING DECISION RULES

List the six steps in the capital budgeting process, and compare them with the steps in security
valuation.a CF0 represents the net investment outlay, or initial cost.link between capital budgeting
and stock values: The more effective the firm’s capital budgeting procedures, the higher its stock
price.

capital.1 Finally, we assume that all cash flows occur at the end of the designated year. Incidentally,
the S stands for short and the L for long: Project S is a short-term project in the sense that its cash
inflows come in sooner than L’s.

PAYBACK PERIOD

The payback period, defined as the expected number of years required to recover the original
investment, was the first formal method used to evaluate capital budgeting projects.

12
 1. Enter CF0 1000 in your calculator. (You do not need to use the cash flow register; just have your
display show 1,000.)

2. Now add CF1 500 to find the cumulative cash flow at the end of Year 1. The result is 500.

3. Now add CF2 400 to find the cumulative cash flow at the end of Year 2. This is 100.

4. Now add CF3 300 to find the cumulative cash flow at the end of Year 3. This is 200.

5. We see that by the end of Year 3 the cumulative inflows have more than recovered the initial
outflow. Thus, the payback occurred during the third year. If the $300 of inflows come in evenly
during Year 3, then the exact payback period can be found as follows:

1 The most difficult part of the capital budgeting process is estimating the relevant cash flows. For
simplicity, the net cash flows are treated as a given in this chapter, which allows us to focus on the
capital budgeting decision rules. However, in Chapter 12 we will discuss cash flow estimation in
detail. Also, note that working capital is defined as the firm’s current assets, and that net operating
working capital is current assets minus non-interest-bearing liabilities.

Payback Period The length of time required for an investment’s net revenues to cover its cost.

513

The shorter the payback period, the better. Therefore, if the firm required a payback of three years or
less, Project S would be accepted but Project L would be rejected. If the projects were mutually
exclusive, S would be ranked over L because S has the shorter payback. Mutually exclusive means
that if one project is taken on, the other must be rejected. For example, the installation of a conveyor-
belt system in a warehouse and the purchase of a fleet of forklifts for the same warehouse would be
mutually exclusive projects—accepting one implies rejection of the other. Independent projects are
projects whose cash flows are independent of one another. Some firms use a variant of the regular
payback, the discounted payback period, which is similar to the regular payback period except that
the expected cash flows are discounted by the project’s cost of capital. Thus, the discounted payback
period is defined as the number of years required to recover the investment from discounted net cash
flows. Figure 11-3 contains the discounted net cash flows for Projects S and L, assuming both
projects have a cost of capital of 10 percent. To construct Figure 11-3, each cash inflow is divided by
(1 k)t (1.10)t, where t is the year in which the cash flow occurs and k is the project’s cost of capital.
After three years, Project S will have generated $1,011 in discounted cash inflows. Since the cost is
$1,000, the discounted payback is just under three years, or, to be precise, 2 ($214/$225) 2.95 years.
Project L’s discounted payback is 3.88 years: Discounted paybackS 2.0 $214/$225 2.95 years.
Discounted paybackL 3.0$360/$410 3.88 years. For Projects S and L, the rankings are the same
regardless of which payback method is used; that is, Project S is preferred to Project L, and Project S
would still be selected if the firm were to require a discounted payback of three years or less. Often,
however, the regular and the discounted paybacks produce conflicting rankings. Note that the
payback is a type of “breakeven” calculation in the sense that if cash flows come in at the expected
rate until the payback year, then the project

13
willbreakeven.However,theregularpaybackdoesnotconsiderthecostofcapital—no cost for the debt or
equity used to undertake the project is reflected in the cash flows or the calculation. The discounted
payback does consider capital costs—it shows the breakeven year after covering debt and equity
costs.

CAPITAL BUDGETING DECISION RULES

Mutually Exclusive Projects A set of projects where only one can be accepted.

Independent Projects Projects whose cash flows are not affected by the acceptance or non-acceptance
of other projects.

Discounted Payback Period The length of time required for an investment’s cash flows, discounted at
the investment’s cost of capital, to cover its cost.

Projects S and L: Discounted Payback Period

Net cash flow Discounted NCF (at 10%) Cumulative discounted NCF Net cash flow Discounted NCF
(at 10%) Cumulative discounted NCF

THE BASICS OF CAPITAL BUDGETING

An important drawback of both the payback and discounted payback methods is that they ignore cash
flows that are paid or received after the payback period. For example, consider two projects, X and Y,
each of which requires an up-front cash outflow of $3,000, so CF0 $3,000. Assume that both projects
have a cost of capital of 10 percent. Project X is expected to produce cash inflows of $1,000 each of
the next four years, while Project Y will produce no cash flows the first four years but then generate a
cash inflow of $1,000,000 five years from now. Common sense suggests that Project Y creates more
value for the firm’s shareholders, yet its payback and discounted payback make it look worse than
Project X. Consequently, both payback methods have serious deficiencies. Therefore, we will not
dwell on the finer points of payback analysis.2 Although the payback method has some serious faults
as a ranking criterion, it does provide information on how long funds will be tied up in a project.
Thus, the shorter the payback period, other things held constant, the greater the project’s liquidity.
Also, since cash flows expected in the distant future are generally riskier than near-term cash flows,
the payback is often used as an indicator of a project’s riskiness

b. Investment appraisal techniques

If we assume that the strategic objective of corporate financial management is the maximisation of
shareholders’ wealth, the firm requires a consistent model for analysing the profitability of proposed
investments, which should incorporate an appropriate criterion for their acceptance or rejection. In
Chapter Two of SFM (our companion text) we examined four common techniques for selecting
capital projects where a choice is made between alternatives.

- Payback (PB) is useful for calculating how quickly a project’s cash flows recoups its capital cost but
says nothing about its overall profitability or how it compares with other projects. - Accounting Rate

14
of Return (ARR) focuses on project profitability but contains serious computational defects, which
relate to accounting conventions, ignores the true net cash inflow and also the time value of money.

When the time value of money is incorporated into investment decisions using discounted cash flow
(DCF) techniques based on Present Value (PV), the real economic return differs from the accounting
return (ARR). So, the remainder of our companion chapter explained how DCF is built into
investment appraisal using one of two PV models:

- Internal Rate of Return (IRR) - Net Present Value (NPV).

In practice, which of these models management choose to maximise project profitability (and
hopefully wealth) often depends on how they define “profitability”. If management’s objective is to
maximise the rate of return in percentage terms they will use IRR. On the other hand, if management
wish to maximise profit in absolute cash terms they will use NPV.

But as we shall discover in this chapter and the next, if management’s over-arching objective is
wealth maximisation then the IRR may be sub-optimal relative to NPV. The problem occurs when
ranking projects in the presence of capital rationing, if projects are mutually exclusive and a choice
must be made between alternatives

c. Non-Discounting Cash Flow

I. Discounted cash flow criteria A. Net present value (NPV). The NPV of an investment is the
difference between its market value and its cost. The NPV rule is to take a project if its NPV is
positive. NPV is frequently estimated by calculating the present value of the future cash flows (to
estimate market value) and then subtracting the cost. NPV has no serious flaws; it is the preferred
decision criterion. B. Internal rate of return (IRR). The IRR is the discount rate that makes the
estimated NPV of an investment equal to zero; it is sometimes called the discounted cash flow (DCF)
return. The IRR rule is to take a project when its IRR exceeds the required return. IRR is closely
related to NPV, and it leads to exactly the same decisions as NPV for conventional, independent
projects. When project cash flows are not conventional, there may be no IRR or there may be more
than one. More seriously, the IRR cannot be used to rank mutually exclusive projects; the project
with the highest IRR is not necessarily the preferred investment. C. Profitability index (PI). The PI,
also called the benefit-cost ratio, is the ratio of present value to cost. The PI rule is to take an
investment if the index exceeds 1. The PI measures the present value of an investment per dollar
invested. It is quite similar to NPV, but, like IRR, it cannot be used to rank mutually exclusive
projects. However, it is sometimes used to rank projects when a firm has more positive NPV
investments than it can currently finance. II. Payback criteria A. Payback period. The payback period
is the length of time until the sum of an investment’s cash flows equals its cost. The payback period
rule is to take a project if its payback is less than some cutoff. The payback period is a flawed
criterion, primarily because it ignores risk, the time value of money, and cash flows beyond the cutoff
point. B. Discounted payback period. The discounted payback period is the length of time until the
sum of an investment’s discounted cash flows equals its cost. The discounted payback period rule is
to take an investment if the discounted payback is less than some cutoff. The discounted payback rule

15
is flawed, primarily because it ignores cash flows after the cutoff. III. Accounting criterion A.
Average accounting return (AAR). The AAR is a measure of accounting profit relative to book value.
It is not related to the IRR, but it is similar to the accounting return on assets (ROA) measure in
Chapter 3. The AAR rule is to take an investment if its AAR exceeds a benchmark AAR. The AAR is
seriously flawed for a variety of reasons, and it has little to recommend it.

d. Discounted Cash Flow Techniques

As the flaws in the payback were recognized, people began to search for waysto improve the
effectiveness of project evaluations. One such method is the netpresent value (NPV) method, which
relies on discounted cash flow (DCF)techniques. To implement this approach, we proceed as follows:

1. Find the present value of each cash flow, including both inflows and out-flows, discounted at the
project’s cost of capital.

2. Sum these discounted cash flows; this sum is defined as the project’s NPV.

3. If the NPV is positive, the project should be accepted, while if the NPVis negative, it should be
rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV
should be chosen.

The implication is that inward cash flows can be reinvested at the hypothetical interest rate used to
finance the project and in the calculation of a zero NPV. Moreover, this borrowing-reinvestment rate
is assumed to be constant over a project’s life. Unfortunately, relax either assumption and the IRR
will change.

Because the precise derivation of a project’s IRR present a number of computational and conceptual
problems, you may have concluded (quite correctly) that a real rather than assumed cut-off rate for
investment should be incorporated directly into present value calculations. Presumably, if a project’s

NPV based on a real rate is positive, we should accept it. Negativity would signal rejection, unless
other considerations (perhaps non-financial) outweigh the emergence of a residual cash deface

Why is the particular discount rate that equates a project’s cost with the present value of its receipts
(the IRR) so special? The reason is based on this logic:

(1)The IRR on a project is its expected rate of return.

(2) If the internal rate of re-turn exceeds the cost of the funds used to finance the project, a surplus
remains after paying for the capital, and this surplus accrues to the firm’s stockholders.

(3) Therefore, taking on a project who’s IRR exceeds its cost of capital in-creases shareholders’
wealth. On the other hand, if the internal rate of return is less than the cost of capital, then taking on
the project imposes a cost on cur-rent stockholders. It is this “breakeven” characteristic that makes
the IRR useful in evaluating capital projects In many respects the NPV method is better than IRR, so
it is tempting to ex-plain NPV only, to state that it should be used to select projects, and to go onto

16
the next topic. However, the IRR method is familiar to many corporate ex-actives, it is widely
entrenched in industry, and it does have some virtues.

Hurdle Rate The discount rate (cost of capital)that the IRR must exceed if project is to be accepted.

What four capital budgeting ranking methods were discussed in this section?

Describe each method, and give the rationale for its use.

What two methods always lead to the same accept/reject decision for in dependent projects?

What two pieces of information does the payback period convey that are not conveyed by the other
methods?

T H E B A S I C S O F C A P I TA L B U D G E T I N G520

Therefore, it is important for you to understand the IRR method but also to be able to explain why, at
times, a project with a lower IRR may be preferable to a mutually exclusive alternative with a higher
IRR.NPV P R O F I L E S

A graph that plots a project’s NPV against cost of capital rates is defined as the project’s net present
value profile; profiles for Projects L and S are shown in

To construct NPV profiles, first note that at a zero cost of capital, the NPV is simply the total of the
project’s undiscounted cash flows.

Thus,

At azero cost of capital NPV S $300, and NPVL $400.

These values are plotted as the vertical axis intercepts in Figure 11-4. Next, we calculate the projects’
NPVs

at three costs of capital, 5, 10, and 15 percent, and plot these values. The four points

plotted on our graph for each project are shown at the bottom of the figure. 8

Recall that the IRR is defined as the discount rate at which a project’s

NPV equals zero.

E. Comparison of IRR and NPV

IRRS and IRR L in an earlier section, we can confirm the validity of the graph.

When we connect the data points, we have the net present value profiles.

NPV profiles can be very useful in project analysis, and we will use them often in the remainder of
the chapter. The net present value (NPV) method discounts all cash flows at the project’s cost of
capital and then sums those cash flows. The project is accepted if the NPV is positive.

17
 The internal rate of return (IRR) is defined as the discount rate that forces a project’s NPV to equal
zero. The project is accepted if the IRR is greater than the cost of capital.

The NPV and IRR methods make the same accept/reject decisions for independent projects, but if
projects are mutually exclusive, then ranking conflicts can arise. If conflicts arise, the NPV method
should be used.

The NPV and IRR methods are both superior to the payback, but NPV is superior to IRR.

The NPV method assumes that cash flows will be reinvested at the firm’s cost of capital, while the
IRR method assumes reinvestment at the project’s IRR. Reinvestment at the cost of capital is
generally a better assumption because it is closer to reality.

The modified IRR (MIRR) method corrects some of the problems with the regular IRR. MIRR
involves finding the terminal value (TV) of the cash inflows, compounded at the firm’s cost of
capital, and then determining the discount rate that forces the present value of the TV to equal the
present value of the outflows.

Sophisticated managers consider all of the project evaluation measures because each measure
provides a useful piece of information.

The post-audit is a key element of capital budgeting. By comparing actual results with predicted
results and then determining why differences occurred, decision makers can improve both their
operations and their forecasts of projects’ outcomes. Small firms tend to use the payback method
rather than a discounted cash flow method. This may be rational, because

(1) The cost of conducting Adcf analysis may outweigh the benefits for the Project being considered,

(2) The firm’s cost of capital cannot be estimated accurately, or

(3) The small-business owner may be considering nonmonetary goals.

4) Dividend Policy

A. Concepts of dividend

b. Dividend theories when deciding how much cash to distribute to stockholders, financial managers
must keep in mind that the firm’s objective is to maximize shareholder value. Consequently, the
target payout ratio—defined as the percentage of net income to be paid out as cash dividends—should
be based in large part on investors’ preferences for dividends versus capital gains: do investors prefer
(1) to have the firm distribute income as cash dividends or (2) to have it either repurchase stock or
else plow the earnings back into the business, both of which should result in capital gains? This
preference can be considered in terms of the constant growth stock valuation model

If the company increases the payout ratio, this raises D1. This increase in the numerator, taken alone,
would cause the stock price to rise. However, if D1 is raised, then less money will be available for
reinvestment, that will cause the expected growth rate to decline, and that will tend to lower the

18
stock’s price. Thus, any change in payout policy will have two opposing effects. Therefore, the firm’s
optimal dividend policy must strike a balance between current dividends and future growth so as to
maximize the stock price. In this section we examine three theories of investor preference: (1) the
dividend irrelevance theory, (2) the “bird-in-the-hand” theory, and (3) the tax preference theory.

DIVIDEND IRRELEVANCE THEORY

It has been argued that dividend policy has no effect on either the price of a firm’s stock or its cost of
capital. If dividend policy has no significant effects, then it would be irrelevant. The principal
proponents of the dividend irrelevance theory are Merton Miller and Franco Modigliani (MM).2
They argued that the firm’s value is determined only by its basic earning power and its business risk.
In other words, MM argued that the value of the firm depends only on the income produced by its
assets, not on how this income is split between dividends and retained earnings. To understand MM’s
argument that dividend policy is irrelevant, recognize that any shareholder can in theory construct his
or her own dividend policy. For example, if a firm does not pay dividends, a shareholder who wants a
5 percent dividend can “create” it by selling 5 percent of his or her stock. Conversely, if a company
pays a higher dividend than an investor desires, the D1 ks g

Target Payout Ratio The percentage of net income paid out as cash dividends.

Optimal Dividend Policy The dividend policy that strikes a balance between current dividends and
future growth and maximizes the firm’s stock price.

Dividend Irrelevance Theory The theory that a firm’s dividend policy has no effect on either its value
or its cost of capital.

2 Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,”
Journal of Business, October 1961, 411433.investor can use the unwanted dividends to buy additional
shares of the company’s stock. If investors could buy and sell shares and thus create their own
dividend policy without incurring costs, then the firm’s dividend policy would truly be irrelevant.
Note, though, that investors who want additional dividends must incur brokerage costs to sell shares,
and investors who do not want dividends must first pay taxes on the unwanted dividends and then
incur brokerage costs to purchase shares with the after-tax dividends. Since taxes and brokerage costs
certainly exist, dividend policy may well be relevant. In developing their dividend theory, MM made
a number of assumptions, especially the absence of taxes and brokerage costs. Obviously, taxes and
brokerage costs do exist, so the MM irrelevance theory may not be true. However, MM argued
(correctly) that all economic theories are based on simplifying assumptions, and that the validity of a
theory must be judged by empirical tests, not by the realism of its assumptions. We will discuss
empirical tests of MM’s dividend irrelevance theory shortly.

BIRD-IN-THE-HAND THEORY

The principal conclusion of MM’s dividend irrelevance theory is that dividend policy does not affect
the required rate of return on equity, ks. This conclusion has been hotly debated in academic circles.
In particular, Myron Gordon and John Lintner argued that ks decreases as the dividend payout is

19
increased because investors are less certain of receiving the capital gains that are supposed to result
from retaining earnings than they are of receiving dividend payments.3 Gordon and Lintner said, in
effect, that investors value a dollar of expected dividends more highly than a dollar of expected
capital gains because the dividend yield component, D1/P0, is less risky than the g component in the
total expected return equation, ks D1/P0 g. MM disagreed. They argued that ks is independent of
dividend policy, which implies that investors are indifferent between D1/P0 and g and, hence,
between dividends and capital gains. MM called the Gordon-Lintner argument the bird-in-the-hand
fallacy because, in MM’s view, most investors plan to reinvest their dividends in the stock of the
same or similar firms, and, in any event, the riskiness of the firm’s cash flows to investors in the long
run is determined by the riskiness of operating cash flows, not by dividend payout policy.

TAX PREFERENCE THEORY

There are three tax-related reasons for thinking that investors might prefer a low dividend payout to a
high payout: (1) Recall from Chapter 2 that long-term capital gains are taxed at a rate of 20 percent,
whereas dividend income is taxed at effective rates that go up to 39.6 percent. Therefore, wealthy
investors (who own most of the stock and receive most of the dividends) might prefer to have

3 Myron J. Gordon, “Optimal Investment and Financing Policy,” Journal of Finance, May 1963, 264–
272; and John Lintner, “Dividends, Earnings, Leverage, Stock Prices, and the Supply of Capital to
Corporations,” Review of Economics and Statistics, August 1962, 243–269.Bird-in-the-Hand Theory
MM’s name for the theory that a firm’s value will be maximized by setting a high dividend payout
ratio.

645companies retain and plow earnings back into the business. Earnings growth would presumably
lead to stock price increases, and thus lower-taxed capital gains would be substituted for higher-taxed
dividends. (2) Taxes are not paid on the gain until a stock is sold. Due to time value effects, a dollar
of taxes paid in the future has a lower effective cost than a dollar paid today. (3) If a stock is held by
someone until he or she dies, no capital gains tax is due at all—the beneficiaries who receive the
stock can use the stock’s value on the death day as their cost basis and thus completely escape the
capital gains tax. Because of these tax advantages, investors may prefer to have companies retain
most of their earnings. If so, investors would be willing to pay more for low-payout companies than
for otherwise similar high-payout companies.

THE THREE DIVIDEND POLICY THEORIES

(1) Miller and Modigliani’s dividend irrelevance theory,

(2) Gordon and Vintner’s bird-in the-hand theory, and

(3) The tax preference theory. To understand the three theories, consider the case of Hardin
Electronics, which has from its inception plowed all earnings back into the business and thus has
never paid a dividend. Hardin’s management is now reconsidering its dividend policy, and it wants to
adopt the policy that will maximize its stock price. Consider first the data presented below the graph.
Each row shows an alternative payout policy:

20
(1) Retain all earnings and pay out nothing, which is the present policy,

(2) Pay out 50 percent of earnings, and

(3) Pay out 100 percent of earnings. In the example, we assume that the company will have a 15
percent ROE regardless of which payout policy it follows, so with a book value per share of $30,

EPS will be 0.15($30) $4.50 under all payout policies.

4 Given an EPS of $4.50, dividends per share are shown in Column 3 under each payout policy.
Under the assumption of a constant ROE, the growth rate shown in Column 4 will be g (% Retained)
(ROE), and it will vary from 15 percent at a zero payout to zero at a 100 percent payout. For
example, if Hardin pays out 50 percent of its earnings, then its dividend growth rate will be g
0.5(15%) 7.5%.Columns 5, 6, and 7 show how the situation would look if MM’s irrelevance theory
were correct. Under this theory, neither the stock price nor the cost of equity would be affected by the
payout policy—the stock price would remain constant at $30, and ks would be stable at 15 percent.
Note that ks is found as the sum of the growth rate in Column 4 plus the dividend yield in Column 6.
Columns 8, 9, and 10 show the situation if the bird-in-the-hand theory were true. Under this theory,
investors prefer dividends, and the more of its earnings the company pays out, the higher its stock
price and the lower its cost of equity.

DIVIDENDS VERSUS CAPITAL GAINS: WHAT DO INVESTORS PREFER?

When the three theories were developed, it was assumed that a company’s investment opportunities
would be held constant and that if the company increased its dividends, its capital budget could be
funded by selling common stock. Conversely, if a high-payout company lowered its payout to the
point where earnings exceeded good investment opportunities, it was assumed that the company
would repurchase shares. Transactions costs were assumed to be immaterial. We maintain those
assumptions in our example

21
22