Financial Management and Capital Budgeting
CHAPTER 1:
THE ROLE OF THE MANAGER:
It is all About Cash Flows: A firm generates cash flows by selling the goods and services produced by its productive assets and human capital. The firm can pay the remaining cash, called residual cash flows, to the owners as a cash dividend, or reinvest the cash in the business. A firm is illiquid when it fails to generate sufficient cash flows. Firms that are illiquid over time will be forced into bankruptcy by their creditors. In bankruptcy, the company will either be reorganized, or the company’s assets will be liquidated.
Three Fundamental Decisions in Financial Management
- The capital budgeting decision: Which productive assets should the firm buy?
- The financing decision: How should the firm finance or pay for assets?
- Working capital management decisions: How should day-to-day financial matters be managed?
MANAGING THE FINANCIAL FUNCTION:
Chief Executive Officer (CEO): Ultimate management responsibility and decision-making power in the firm. Reports directly to the board of directors, which is accountable to the company’s owners.
Chief Financial Officer (CFO): Responsible for the best possible financial analysis that is presented to the CEO. The Treasurer looks after the collection and disbursement of cash, invests excess cash, raises new capital, handles foreign exchange, and oversees the firm’s pension fund managers. The Internal Auditor is responsible for in-depth risk assessments, performing audits of high-risk areas.
External Auditors: Provide an independent annual audit of the firm’s financial statements & Ensure that the financial numbers are reasonably accurate, and accounting principles have been consistently applied. Audit Committee: Approves the external auditor’s fees and engagement letter.
THE GOAL OF THE FIRM: What Should Management Maximize? Minimizing risk or maximizing profits without regard to the other is not a successful strategy.
The main goal is to Maximize the Value of the Firm’s Stock Price. When analysts and investors determine the value of a firm’s stock, they consider: The size of the expected cash flows, The timing of the cash flows, The riskiness of the cash flows.
CHAPTER 2:
Capital-budgeting
decisions are the most important investment decisions made by management. The goal of these decisions is to select capital projects that will increase the value of the firm. Capital investments are important because they involve substantial cash outlays and, once made, are not easily reversed. Capital-budgeting techniques help management to systematically analyze potential business opportunities in order to decide which are worth undertaking.
Classification of Investment Projects
- Independent Projects: Projects are independent when their cash flows are unrelated.
- Mutually Exclusive Projects: When two projects are mutually exclusive, accepting one automatically precludes the other.
- Contingent Projects: Contingent projects are those where the acceptance of one project is dependent on another project.
Capital rationing implies that a firm does not have the resources necessary to fund all of the available projects. It implies that funding needs exceed funding resources. Thus, the available capital will be allocated to the projects that will benefit the firm and its shareholders the most.
NPV: It is a capital-budgeting technique that is consistent with the goal of maximizing shareholder wealth. The method estimates the amount by which the benefits or cash flows from a project exceeds the cost of the project in present value terms.
Five-step approach can be utilized to compute the NPV–>
- Determine the cost of the project.
- Estimate the project’s future cash flows over its forecasted life.
- Determine the riskiness of the project and estimate the appropriate cost of capital.
- Compute the project’s NPV.
- Make a decision: Accept the project if it produces a positive NPV or reject the project if NPV is negative.
Key advantages & disadvantages of NPV: uses discounted cash flow valuation, a direct measure of how much a capital project will increase the value of the firm & it is consistent with the goal of maximizing shareholders wealth.
IRR versus NPV: While the IRR has an intuitive appeal to managers because of the output being in the form of a return, the technique has some critical problems.
Payback Period: tool used for evaluating capital projects. It represents the number of years it takes for the cash flows from a project to recover the project’s initial investment.
Evaluating the Payback Rule: The standard payback period is widely used in business.
IRR: The IRR is an important and legitimate alternative to the NPV method.
AGENCY CONFLICTS:
Ownership & Control –> For large corporations, the ownership of the firm is spread over a huge number of shareholders and the firm’s owners may effectively have little control over management.
– Agency Relations: An agency relationship arises whenever one party, called the principal, hires another party, called the agent.
– Do Managers Really Want to Maximize Stock Price? Shareholders own the corporation, but managers control the money and have the opportunity to use it for their benefit.
Aligning the Interests of Management and Stockholders:
– Management Compensation: A significant portion of management compensation is tied to firm performance.
– Independent Board of Directors: Lack of board independence is a key factor in the misalignment between board members’ and stockholders’ interests.
– Sarbanes-Oxley and Other Regulatory Reforms: Greater Board Independence, Establish Internal Accounting Controls, Establish Ethics Program, Expand Audit Committee’s Oversight Powers.
CHAPTER 3: COST OF CAPITAL
The cost of capital is the minimum return that a capital-budgeting project must earn for it to be accepted. It is an opportunity cost since it reflects the rate of return investors can earn on financial assets of similar risk.
Cost of Debt is the required rate of return on investment of the lenders of a company.
Cost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company.
Cost of Equity Approaches: The cost of equity capital, ke, is the discount rate that equates the present value of all expected future dividends with the current market price of the stock.
Limitations of the WACC:
1. Weighting System: Marginal Capital Costs, Capital raised in different proportions than WACC.
2. Flotation Costs are the costs associated with issuing securities such as underwriting, legal, listing, and printing fees.
a. Adjustment to Initial Outlay
b. Adjustment to Discount Rate