Capital Budgeting Model: Risk-Return Relationship, Cost Of Capital Calculation, Capital Budgeting Worksheet

High-risk ventures should have expectations of high returns; low risk ventures will be expected to have a lower rate of return. Both must be made attractive to investors. Below graph demonstrates the relationship between the risk and return expected for a new line, extending a current line, and the modification or change of a product line or cost reduction programs.

From this relationship, a function can be derived to estimate the discount rate. The discount rate, or the necessary return for a project, is equal to the cost of capital plus the risk premium:

Required return = Cost of capital + Risk

The most important criterion in the calculation of a capital budgeting model is the required return. This number can be obtained by subjective estimation or by analytical methods that offer a means of estimating risk. But risk is mostly a perception in the mind of investors.

When considering the cost of capital to be used for the generation of net present value numbers, you should be concerned more with the incremental cost of capital for the project than with the overall cost of obtaining funds. It is the incremental cost of capital—the cost of financing this deal (internally or externally)—with which you are concerned when determining whether a project is cost justified. Nonetheless, it is also useful to know the company’s overall cost of capital, since each incremental funding decision will impact it. The next section describes how to calculate the cost of capital.

Components of the Cost of Capital

The components of the cost of capital are debt, preferred stock, and common stock. The least expensive of the three forms of funding is debt, followed by preferred stock and then common stock. Here we show how to calculate the cost of each of these three components of capital and then how to combine them into the weighted cost of capital.

When calculating the cost of debt, the key issue is that the interest expense is “tax deductible“. This means that the tax paid by the company is reduced by the tax rate multiplied by the interest expense. This concept is shown in the next example, where we assume that $1,000,000 of debt has a basic interest rate of 9.5 percent and the corporate tax rate is 35 percent.

Calculating the Interest Cost of Debt, Net of Taxes

Example:

The example clearly shows that the impact of taxes on the cost of debt significantly reduces the overall debt cost, thereby making this a most desirable form of funding. Preferred stock stands at a midway point between debt and common stock. The main feature shared by all kinds of preferred stock is that, under the tax laws, interest payments are treated as dividends instead of interest expense, which means that these payments are not tax deductible. This is a key issue, for it greatly increases the cost of funds for any company using this funding source. By way of comparison, if a company has a choice between issuing debt or preferred stock at the same rate, the difference in cost will be the tax savings on the debt. In the next example, a company issues $1,000,000 of debt and $1,000,000 of preferred stock, both at 9 percent interest rates, with an assumed 35 percent tax rate.

Debt cost = Principal × (interest rate × (1 - tax rate))
Debt cost = $1,000,000 × (9% × (1 - .35))
$58,500 = $1,000,000 × (9% × .65)

If the same information is used to calculate the cost of payments using preferred stock, we have this result:

Preferred stock interest cost = Principal × interest rate
Preferred stock interest cost = $1,000,000 × 9%
$90,000 = $1,000,000 × 9%

This example shows that the differential caused by the applicability of taxes to debt payments makes preferred stock a much more expensive alternative. The most difficult cost of funding to calculate by far is common stock, because there is no preset payment from which to derive a cost. One way to determine its cost is the capital asset pricing model (CAPM). This model derives the cost of common stock by determining the relative risk of holding the stock of a specific company as compared to a mix of all stocks in the market.

This risk is composed of three elements: The first is the return that any investor can expect from a risk-free investment, which usually is defined as the return on a government security. The secondelement is the return from a set of securities considered to have an average level of risk. This can be the average return on a large “market basket” of stocks, such as the Standard & Poor’s 500, the Dow Jones Industrials, or some other large cluster of stocks. The final element is a company’s beta, which defines the amount by which a specific stock’s returns vary from the returns of stocks with an average risk level. This information is provided by several of the major investment services, such as Value Line. A beta of 1.0 means that a specific stock is exactly as risky as the average stock, while a beta of 0.8 would represent a lower level of risk and a beta of 1.4 would be higher. When combined, this information yields the baseline return to be expected on any investment (the risk-free return), plus an added return that is based on the level of risk that an investor is assuming by purchasing a specific stock.

The calculation of the equity cost of capital using the CAPM methodology is relatively simple, once all components of the equation are available. For example: If the risk-free cost of capital is 5 percent, the return on the Dow Jones Industrials is 12 percent, and Royal Bali Cemerlang’s beta is 1.5, the cost of equity for Royal Bali Cemerlang would be:

Cost of equity capital = Risk-free return + Beta (Average stock return - risk free return)
Cost of equity capital = 5% + 1.5 (12% - 5%)
Cost of equity capital = 5% + 1.5 × 7%
Cost of equity capital = 5% + 10.5%
Cost of equity capital = 15.5%

Although the example uses a rather high beta that increases the cost of the stock, it is evident that, far from being an inexpensive form of funding, common stock is actually the most expensive, given the size of returns that investors demand in exchange for putting their money at risk with a company.

Now that we have derived the costs of debt, preferred stock, and common stock, it is time to assemble all three costs into a “Weighted Cost of Capital“. This section is structured in an example format, showing the method by which the weighted cost of capital of the Royal Bali Cemerlang Corporation is calculated.

The chief financial officer of the Royal Bali Cemerlang Corporation, Mr. Lie, is interested in determining the company’s weighted cost of capital, to be used to ensure that projects have a sufficient return on investment, which will keep the company from going to seed.

There are two debt offerings on the books:

The first is $1,000,000 that was sold below par value, which garnered $980,000 in cash proceeds. The company must pay interest of 8.5 percent on this debt. The second is for $3,000,000 and was sold at par, but included legal fees of $25,000. The interest rate on this debt is 10 percent. There is also $2,500,000 of preferred stock on the books, which requires annual interest (or dividend) payments amounting to 9 percent of the amount contributed to the company by investors.

Finally, there is $4,000,000 of common stock on the books. The risk-free rate of interest, as defined by the return on current government securities, is 6 percent, while the return expected from a typical market basket of related stocks is 12 percent. The company’s beta is 1.2, and it currently pays income taxes at a marginal rate of 35 percent. What is the Royal Bali Company’s weighted cost of capital?

The method we will use is to separate the percentage cost of each form of funding and then calculate the weighted cost of capital, based on the amount of funding and percentage cost of each of the above forms of funding. We begin with the first debt item, which was $1,000,000 of debt that was sold for $20,000 less than par value, at 8.5 percent debt. The marginal income tax rate is 35 percent.

The calculation is:

We employ the same method for the second debt instrument, for which there is $3,000,000 of debt that was sold at par. Legal fees of $25,000 are incurred to place the debt, which pays 10 percent interest. The marginal income tax rate remains at 35 percent. The calculation is:

Having completed the interest expense for the two debt offerings, we move on to the cost of the preferred stock. As noted, there is $2,500,000 of preferred stock on the books, with an interest rate of 9 percent. The marginal corporate income tax does not apply, since the interest payments are treated like dividends and are not deductible. The calculation is the simplest of all, for the answer is 9 percent, since there is no income tax to confuse the issue.

To arrive at the cost of equity capital, we take from the example a return on risk-free securities of 6 percent, a return of 12 percent that is expected from a typical market basket of related stocks, and a beta of 1.2. We then plug this information into the formula to arrive at the cost of equity capital:

Cost of equity capital = Risk-free return + Beta (Average stock return – risk free return)
Cost of equity capital = 6% + 1.2 (12% - 6%)
Cost of equity capital = 13.2%

Now that we know the cost of each type of funding, it is a simple matter to construct a table listing the amount of each type of funding and its related cost, which we can quickly sum to arrive at a weighted cost of capital. The weighted cost of capital is 9.75 percent.

Capital Budgeting Worksheet

Below is a common “Capital Budgeting Worksheet”, have a look the worksheet:

How To Fill Out The Capital Budgeting Worksheet?

[1]. Column 1 is used to list the estimated net annual cash inflows and outflows. Misestimating or underestimating in early years is more damaging than incorrect estimates of amounts in the distant future as a result of the discount factor. Thus, greater significance is placed on cash flows in the beginning periods. The initial outflow usually will be in year zero, which means as of Day 1 of the project period. Therefore, the discount factor is 1.0000 because that is current dollars. (Remember that for most discounting tables, all cash flows are assumed to occur at the end of each year. Although this may be an unrealistic assumption in that carrying costs may be incurred throughout the year, these carrying costs can be calculated and added to the net cash outflows to predict more accurately the total first year cost).

The initial investment includes not only the usual items, such as plant and equipment, but also investments in inventory, accounts receivable, training, product introduction, and the expenses for administrative changes and accounting. The next section provides a more detailed list of cash flow items to check in the capital budgeting proposals.

For new products, annual inflows that stay level without fluctuations should usually be suspect because the actual patterns seldom occur this way.

[2]. In column 2, cash adjustments should include such items as buildups of accounts receivable and inventories. This allows recognition of the actual cash flows in appropriate years. For example, a new product line may build up $500,000 in inventories in the first year, which may not be recovered in cash inflow until the end of the product’s life cycle. Taxes and the treatment of expenses and income for tax purposes must be considered and adjusted for in the model. For example, increases in receivables and inventories are examples of adjustments that affect current tax liabilities and must be considered in the calculation of estimated taxes. Inventories require cash in the year purchased but have tax effects when used or sold. Receivables may be taxable in the year sales are made, even though not collected until later periods.

Also, the effect of investment tax credits and other project related tax deductions should be included for the period in which the cash impact occurs.

[3]. Depreciation is included solely for the purpose of considering its effect on taxes. The model uses only cash flows and the items affecting cash flows. Depreciation expense is a non-cash item in the current period. If depreciation has already been “expensed” in the operating cash flows of column 1, then an adjustment is necessary to ensure that it is not double counted. In the model, the full cost of the investment is made in period 0. Showing the allocation of that cost again through depreciation will count it twice.

[4]. Column 4 calculates the taxable portion of the inflows. Care must be taken to determine the appropriate tax consequences, as the goal of the model is to determine after-tax cash flows.

[5]. Column 5 is used for the calculation of tax, which must be subtracted from cash flows.

[6]. Column 6 is the after-tax cash flow to be used in the various capital budgeting models for the evaluation of the proposals.

Futher worth reading about capital budgeting:

Capital Budgeting

Capital Budget Evaluation –Cash Flow and Capital Budget Proposal

Capital Budgeting EvaluationWorksheet – Improving Estimates

Additional Worth Considering Aspects On Capital BudgetEvaluation

Source:

accounting-financial-tax.com/2008/09/capital-budgeting-model-risk-return-relationship-cost-of-capital-calculation-capital-budgeting-worksheet/

Capital Budgeting

Budgets, a frequently used tool, have been around for a long time. Operating budgets seem to be the most common. Although seldom used to their potential, operating budgets are ordinarily among the first budgets attempted. The numbers for these budgets are not difficult to obtain, and most managers will give at least some credence to their usefulness. Cash budgets are not greatly different from operating budgets in their preparation and use. In cash budgeting, attention is focused on the receipt and expenditure of cash. However, cash budgets often are limited to use by fewer people within a business and often are not formalized until required by shortages of cash or the high cost of maintaining cash reserves. In periods of better financial conditions, the inefficiency of having too much cash often is overlooked.

As a result, cash budgets sometimes fall into disuse during periods of prosperity. Capital budgeting, however, does not fare well with many businesspeople. This is due in part to the difficulties of preparing a capital budget. Estimates of cash flows must be pushed farther into the future and unfamiliar terms, such as weighted average cost of capital and internal rate of return, creep into the terminology. The calculations associated with these terms are often unfamiliar; many businesspeople have learned to operate with no formal capital budget.

However, used properly, a capital budgeting process can help to reduce the risk of making the wrong decision. Capital budgeting is useful as a decision tool. Accountants, and some of your staff and some managers, probably have been trained to make the calculations necessary for determinations of present Investing in values, internal rates of return, and payback periods. The critical work is the gathering of the information necessary to make the capital budgeting process more understandable and useful to the business.

Life Cycles

Products and projects, like people, have life cycles, as shown below:

They all go through similar stages: conception, birth, growth, maturity, decline, and ultimately death. Each stage requires a certain degree of attention. The applicability of capital budgeting concepts to new projects or new products extends beyond application to new ventures. It can be used to consider the replacement of existing product lines and even to cost reductions in existing lines in the current or future periods.

Capital Budgeting Sequence

Four basic sets of actions occur in a capital budgeting plan: (1) proposal solicitation or generation, (2) evaluation, (3) implementation, and (4) follow up. We shall examine each in some detail.

Action-1: Proposal Solicitation or Generation

1. The first step in proposal generation is evaluation of your present status. Many factors should be considered when making an evaluation of status. It is particularly important to pay attention to your position with respect to the availability of management talent, technological talent, financial and market positions, sources of labor, and the availability of markets for your product. Example: Assume you manufacture heavy cast-iron cylinders for which “the market” is located in south-eastern-un-belt-states. Therefore, one particularly important factor is the cost of transportation of the product to the ultimate user. At least two alternatives are available: Locate the plant in the area where the product is consumed or acquire manufacturing facilities on low cost transportation networks, such as rail or water. Another option may be to redesign the product. For example, assume you find that you can manufacture the cylinders out of aluminum with the installation of a tooled steel sleeve instead of the cast-iron cylinder. The product now requires different raw materials, different processing and handling, and different packaging and shipping. The new product may change your marketing plans, and a proposal for capital expenditures may result.
2. The questions that you should answer are standard business planning questions: “What do we do best?” and “Where are we going?” These require an evaluation of your business plan. The objectives formulated as a result of these questions may point out potential projects requiring capital expenditures. Decisions relative to capital expenditures may be made at various levels within the organization depending on their size and significance. Rules for decision making should be in Long-Term Assets and Capital Budgeting consistently applied at whatever level of management you have established.
3. Cost reduction programs may be a rich source of capital budgeting projects. Cost reduction programs generally carry with them less risk than any other form of project, because they have obvious cost justifications. Potential payback periods and returns on investments can be calculated readily because the programs are intended to improve the cost efficiency of existing projects. Such programs, if adopted, help make employees feel that they are a part of the decision-making process, because a large part of these proposals usually are generated from line employees.
4. Ideas from employees and customers are also often low-risk sources for increased profitability. Marketing or sales personnel meet with customers on a regular basis. They should be able to determine current market needs and may assess demands not being met. Often these opportunities can be exploited with little additional cost to you. By taking advantage of unmet market needs head-on, competition can be avoided and you may successfully expand your market presence. To encourage new ideas and market opportunities, you may use either or both of these avenues: (a) Encourage entrepreneurship by allowing self-interest to work for you. Monetary incentive programs for sales staff and other employees are extremely effective in generating growth-producing ideas. (b) Survey customer needs on a regular basis to learn of potential growth possibilities.
5. Competitors are often a good source of potential growth producing ideas. Sometimes it is beneficial to let competitors pioneer certain new products. Letting them take the risks often eliminates these products from your consideration as a result of their lack of profitability or outright product failure. Of course, this gives the competitor a head start on successful ventures.
6. Product matrix analysis sometimes will disclose holes in the market.
7. Often new ideas are available through purchase from independent research and development (R&D) firms or may be generated by your own R&D efforts.
8. Trade shows, conventions, seminars, and publications are good sources of potential ideas. In this case, you are not paying for the development of ideas but instead are picking other people’s brains.
9. You may decide on vertical growth—being your own supplier or marketer. Supplying yourself with components, services, or raw materials is a source of potential profit. Setting up your own distribution network outlets can be profitable as well. For example, some utilities have diversified into fields such as coal production and transportation in order to guarantee a source of supply and to reduce the risk associated with fuel cost variations. In this way, vertical integration provides them with additional revenue-producing sources of unregulated profit. Some natural gas utilities sell gas appliances. Being “the gas company” gives them an entrée for marketing the appliances. Customers trust a company that provides gas to know which are the best gas appliances.
10. You may want to grow horizontally through product diversification or buying of competitors.
11. You can expand the use of current technologies. Constantly ask: “What can we do with what we know or what we do best?” How adaptable is the current technology to meet new product innovation or new processes? The opportunity here is to have growth-producing ideas with minimal risks. If you have learned to utilize your technologies efficiently, further endeavors with known technologies generally carry less risk than ventures into new and yet untried technologies.
12. Expand the use of your existing equipment. In-place equipment may not be fully utilized. Increased utilization through subcontracting and selling of time on equipment or process capabilities will better utilize existing capital resources with little additional risk. More use of the fixed-cost base increases efficiency and at the same time produces additional cash flows.

Action-2: Evaluation of Proposals

After proposals have been generated, you must evaluate competing proposals in a consistent manner to determine which proposals merit further consideration. There are basically four steps in the evaluation process.

The most critical step is a qualitative evaluation: Is this proposal consistent with the strategic plan of the business? If not, no future consideration is necessary. If yes, further analysis is indicated. A lot of time, effort, and money can be wasted on things that do not fit the direction you are determined to go in.

Define the evaluation process. Set up a system that will be applied consistently for all proposals: (a)Estimate costs accurately and in the same way for all proposals, (b) Estimate the benefits consistently. (c) Use the same time constraints. (d) Use the same method for calculating the net benefits.

Qualify your information sources. When gathering information, you must evaluate the reliability and accuracy of the source of the information. For example: (a) Engineers often underestimate the time (and costs) necessary, (b) Salespeople frequently overestimate potential sales.  You should ask: (a) Who is providing the information? (b) How accurate were their last predictions? (c) How often have I relied on this source before? (d) Do my competitors use this same source?

Install the process. To install the process properly, all affected persons must understand how to use it: (a) Develop capital purchase evaluation forms to be used throughout the organization, (b) Explain the forms and the evaluation methods to all affected persons, (c) Use the system consistently to evaluate proposals, (d) Provide prompt responses to applicants as to why their proposals were or were not accepted.

Action-3: Implementation of a Proposal

In the implementation phase, effective project management requires a firm line of control. First, define responsibility. You need to know who will be responsible at various stages in the proposal’s implementation to ensure accountability and control. It is important to consider the time and the talent of the individuals involved and to match their abilities to the needs and responsibilities of each key position in the implementation process. Few things affect the failure or success of a product more than the match or mismatch of key personnel at critical steps in project implementation.

Next, establish checkpoints by setting goals and objectives for milestones at successive stages in the process. Review your decisions regularly, before the next costly step is taken and when progress can be compared with established standards. You may choose to terminate a proposal at some point short of completion if it appears that the project is exceeding cost projections or failing to meet benefit expectations.

It may be necessary to change the budget. This may seem a radical idea. However, if budgets are managed properly, changing a budget is nothing more than considering better data as they flow into the system. Budget changing should not become a self-fulfilling prophecy. Budgets are planning tools, and, as such, comparisons between actual performance and projected performance often will show how well or poorly your project is proceeding. Updating budgets for better control is useful in order to improve the quality of decision making for the project.

When budgets are used for control, regular feedback of information is needed. The establishment of reports is another critical element in the implementation phase. The amount of reporting is a function of balancing the risk of ignorance against the cost of reporting. When reports are generated on a regular basis, you can ensure maintenance of adequate control of the project.

Action-4: Follow-up

Neglect near the concluding stages of a project can result in unnecessary delays, increased risk, and higher costs for the discontinuation or normal termination of a product’s life cycle. In the follow-up step, you should review the assumptions under which the original project was accepted, determine how well those assumptions have been met, review the evaluation systems that were in place, and, finally, evaluate the implementation of the project. It is at this point that an overall review of a project will show you how well it was planned, how well the budget projected reality, and the necessary areas where improvement in the system will help better evaluate future proposals.

There is really no doubt that all projects eventually will find themselves in the decline phase of below graphic. Predicting when this will occur and planning appropriate actions for when it does can be time-and money-saving.

An important part of the follow-up step is the prediction of discontinuance or normal termination dates for the project. This allows for the timely introduction of proposals for the replacement project. Capital budgeting is cyclical, allowing you to control growth on a continuous basis. The follow-up stage naturally reverts back to proposal generation as each project approaches termination.

Futher worth reading about capital budgeting:

Capital Budgeting Model: Risk-Return Relationship, Cost OfCapital Calculation, Capital Budgeting Worksheet

Capital Budget Evaluation – Cash Flow and Capital BudgetProposal 

Capital Budgeting Evaluation Worksheet – ImprovingEstimates 

Additional Worth Considering Aspects On Capital BudgetEvaluation  

Source:

accounting-financial-tax.com/2008/09/capital-budgeting/

Capital Budget Evaluation – Cash Flow And Capital Budget Proposal

Here is a list of ten cash flow items to be considered in evaluating a capital budget proposal. This list is not intended to be exhaustive. However, these items should be carefully scrutinized for every proposal so that you can make a complete evaluation of appropriate costs:

1.    Plant and equipment items

2.    Installation and debugging of equipment and systems

3.    Inventories including consideration of: raw materials, work-in-process, finished goods, spare parts.

4.    Market research and product introduction

5.    Training

6.    System changes necessitated by engineering changes and product redesign

7.    Accounts receivable

8.    Accounts payable

9.    Taxes, to include: income, investment tax credits, property tax, credits.

10.  Cash and requirements for cash working capital

Inflation and Cash Flow Estimates

When estimating cash flows, inflation should be anticipated and taken into account. Often there is a tendency to assume that the price for the product and the associated costs will remain constant throughout the life of the project. Occasionally this assumption is made unwittingly, and future cash flows are estimated simply on the basis of existing prices. If anticipated inflation is embodied in the required return criteria, it is important that it also be reflected in the estimated cash flows from the product over the life of the project. To reflect cash flows properly in later periods, consider adjusting both the expected sales price and the expected costs by reasonable inflation numbers.

You may assume that if all proposals are evaluated without consideration of inflation, the decision matrix will be unchanged. This is not necessarily the case. As in the case for the generation of internal rates of return, inflation will change future cash flows relative to the year in which they occur by the inflation rate specific to that product or industry. Therefore, by not anticipating inflation and assigning values for particular future time periods, the decision model may be biased by not taking into account the different effects on cash inflows and outflows as a result of different rates of inflation.

As a result, the project selection may not be optimal. Discounted Cash Flow Because the primary concern is discounted cash flow, we should begin our discussion with the required rate of return. This rate is called by many names, including hurdle rate, cost of capital, interest rate, and discount rate.

Actually, hurdle rate is probably best. It implies a barrier, in terms of the return on investment, which the proposal must clear in order to be considered. The other names arise from the mistaken idea that the cost of capital or interest, which is the cost of some of the capital, is the criterion for judging the investment. A weighted average cost of capital has been suggested; for small businesses, it may not be difficult to calculate because of the limited sources of capital employed. However,neither the marginal cost of capital nor the weighted average cost of capital alone take into account other factors that should be considered in deciding on a required return or hurdle rate to be used, such as:

1.    The relative risk of this proposal to other proposals

2.    Other opportunities

3.    Return on other investments already made

4.    The company’s loan limit

There is no magic formula for the evaluation of all the relative factors used in arriving at a correct rate. However, you are encouraged to consider the following questions:

1.    How much return do you usually get?

2.    How much return can you reasonably expect to receive?

3.    How much does it cost you to borrow?

4.    How much should you penalize the proposal for the risk involved?

For many businesses, a simple formula for normal risk projects might be:

Discount rate = Centeral Bank Prime Interest Rate + 3 points (borrowing premium) + 4 to 6 points risk premium

This is, of course, a very rough rule of thumb and should be used with all appropriate caution!.

Futher worth reading about capital budgeting:

Capital Budgeting

Capital Budgeting Model: Risk-Return Relationship, Cost OfCapital Calculation, Capital Budgeting Worksheet

Capital Budgeting EvaluationWorksheet – Improving Estimates

Additional Worth Considering Aspects On Capital BudgetEvaluation

Source:

accounting-financial-tax.com/2008/09/capital-budget-evaluation-cash-flow-and-capital-budget-proposal/