CHAPTER 14

CAPITAL FINANCING
AND ALLOCATION
 CAPITAL BUDGETING

To produce goods and services,

the first thing an entrepreneurial
firm must do is obtain capital
funds from investors and lenders
 CAPITAL ALLOCATION

After obtaining funds, the

entrepreneurial firm must invest
these funds in equipment, tools
and other resources
 ADDITIONAL WEALTH
Revenues from the engineering
and other capital projects must
earn an adequate return on funds
invested in terms of profit for a
firm to achieve economic growth
and be competitive in the future
CAPITAL FINANCING FUNCTION
• Determines the amount of new funds needed from
investors, lenders, and internal sources (I.e.,
depreciation and retained earnings) to support new
capital projects
• Decides on the sources of new externally acquired
funds (I.e., issuing additional stock, selling bonds,
obtaining loans, etc…)
• This function also insures that the total amount of
new funds and the ratio of debt to equity capital is
commensurate with the financial status of the firm
and balanced with the current and future capital
investment requirements
 CAPITAL ALLOCATION FUNCTION
• Selects engineering projects for
implementation based on constraints of total
capital investment during capital financing
considerations
• Capital allocation activities begin in various
company organizations --departments,
operating divisions, research and
development, etc…
• During each capital budgeting cycle, these
organizations plan, evaluate and recommend
projects for funding and implementation
 COMBINED SCOPE OF CAPITAL
FINANCING AND ALLOCATION
FUNCTIONS
1. Acquisition of financial resources
2. Establishment of minimum economic
acceptability requirements
3. Identification and evaluation of capital
Projects
4. Selection of projects for implementation
5. Postaudit reviews
 SOURCES OF CAPITAL
Debt Capital
• Involves both short and long-term borrowing of funds
• Interest must be paid to capital providers and the debt
must be repaid by a specified time
• Capital providers do not share in any profits resulting from
capital use
• Borrower may be required to pledge some type of security
to ensure money will be repaid
• Terms of loan may limit the use of borrowed funds
• Terms may also restrict further borrowing
• Loan interest is a tax-deductible expense for the firm
 SOURCES OF CAPITAL
Equity Capital
• Supplied and used by owners in expectation of
profit
• No assurance that profit will be made or that
investment capital will be recovered
• No limitations placed on the use of funds
• No explicit cost for use of such capital; therefore,
not tax deductible for firm
• Expected rate-of-return must be high enough, at
an acceptable risk, to be attractive to potential
investors
 SOURCES OF CAPITAL
Retained Earnings
• Profits that are reinvested in the business instead
of being paid as dividends to owners
• Retention of some of company’s profits reduces
the immediate amount of dividends per share,
increases the book value of the stock, and results
in greater future dividends and / or market resale
value of the stock
• While some investors expect more of the profit a
company earns, many prefer to have some of the
profits retained and reinvested to help increase
the value of their stock
 SOURCES OF CAPITAL
Depreciation Reserves
• Set aside out of revenue as an allowance
for the replacement of equipment and other
depreciable assets
• Depreciation funds provide a revolving
investment fund that may be used to the
best possible advantage
• A source of capital for financing new
projects within existing firm, so long as
required capital is available for replacing
essential equipment as required
 SOURCES OF CAPITAL
Leasing
• A way of acquiring use of an asset without capital
expenditure for purchase
• A form of contract that establishes conditions
under which asset owner conveys use, and
associated costs,of the asset to the lessee
• A method of achieving benefits of capital
investment witout actually acquiring additional
debt ot equity capital
• Leasing costs are tax deductible from operating
income
 COST OF DEBT CAPITAL
• The debt part of the capital structure
leverages the equity part by increasing the
total funds available for capital projects and
wealth of the firm
• Proportion of debt capital, however, must be
maintained below a level which would
adversely affect the market value of the
firm’s common stock
– Varies by type of company
 LOANS (SHORT-TERM DEBT)
• Usually for periods less than five years and
frequently for less than two years
• Sources are banks, insurance companies,
retirement systems, other lending institutions
• Financial instrument – line of credit or short-term
note – defines promise to repay, amount of
borrowed funds, interest , some prearranged
repayment schedule
• Lending institution may require tangible value as
security or the certainty that borrowers financial
position presents minimal risk
 LOANS (SHORT-TERM DEBT)
Assuming all interest payments and
income taxes paid by firm are paid on
annual basis, after-tax cost of capital
CL = iL(1 – t)
CL = after-tax cost of capital for a loan
iL = rate of interest per year paid on the loan
t = effective (marginal) income tax rate
 BONDS (LONG-TERM DEBT)
• A long-term note given to the lender by the borrower,
stipulating the terms of repayment and other conditions
• In return for the money loaned, the company promises to
repay the loan (bond) and interest upon it at a specified
rate
• As long as interest is paid, bondholder has no voice in
affairs of business and is not entitled to a share of profits
• Face value or par value of a bond is the amount (I.e.,
$1,000, $10,000, etc… ) for which bond is issued
• When face value is repaid, bond is retired or redeemed
• Interest rate quoted on the bond is the bond rate
• The periodic interest payment due is computed as the face
value times the bond interest rate per period
 BONDS (LONG-TERM DEBT)
Annual After-Tax Cost of Capital
[ Zr + (Z –P +Se) / N + Ae ] (1- t)
CB = (Z + P – Se) / 2
Z = face (par) value of bond
r = bond rate (nominal interest) per year
N = Number of years until bond is retired (redeemed)
Se = initial selling expense associated with the bond
P = Actual selling price of the bond) [if P<Z, the bond is sold
at a discount (to par value), and if P>Z, the bond is sold at
a premium]
Ae = annual administrative expenses associated with bond
t = effective (marginal) income tax rate
 BONDS (LONG-TERM DEBT)
Annual After-Tax Cost of Capital
[ Zr + (Z –P +Se) / N + Ae ] (1- t)
CB = (Z + P – Se) / 2
Numerator is the after-tax cost of the bond based on the
annual interest expenses plus annualized amount (over
the life of the bond) of any discount or premium and
initial selling expenses plus the annual administrative
expenses
Denominator is the average investment in the bond over its
life
 BOND RETIREMENT
• A systematic program for repayment of a bond
issue when it becomes due gives assurance to
bondholders and makes bonds more attractive to
the public
• To do this a company periodically sets aside
definite sums, that with interest, will accumulate to
the amount needed to retire the bonds when they
are due
• A sinking fund is most typically used for this
procedure
 CORPORATION
• A corporation is a fictitious being,
recognized by law, that can pursue almost
any type business transaction that a real
person can .
• It operates under a state-granted charter
which allow certain rights and privileges,
and is subject to certain restrictions.
• Special taxes may be assessed against it.
 COST OF EQUITY CAPITAL
• Equity capital for a corporation is acquired through the
sale of stock.
• Purchasers of the stock are part owners, usually called
stockholders, of the corporation.
• Although stockholders are entitled to a share of the profits,
they are typically not liable for the debts of the corporation.
• Stockholders are never compelled to suffer any loss
beyond the value of their stock.
• The continuous or indefinite corporation life is conducive
to long-term investments and a degree of certainty
• This makes debt capital easier to obtain, and at a lower
interest cost
 COMMON STOCK

• Primary source of equity capital

used to finance a corporation’s
capital projects
• The value of common stock must
be a measure of the earnings
received and on factors related to
dividends and market price
 DIVIDEND VALUATION MODEL
• A simple approach for the valuation of common
stock and the estimation of per share rate of
return expected by the investor
• The current value of a share of common stock can
be approximated by the PW of future cash receipts
during an N-year ownership period
Div1 Div2 DivN PN
P0 ~ (1 + ea) + (1 + ea)2 + … + (1 + ea)N + (1 +ea)N
ea = rate of return per year required by common stockholders
P0 = current value of a share of common stock
PN = selling price of a share of common stock at the end of N
years
Divk = After-tax value of cash dividends received during year
k
 DIVIDEND VALUATION MODEL
• Incorporates two conservative assumptions:
– dividends are constant over the long term
– P0 = PN
• In this case, current price of a share of common
stock equals PW of an assumed indefinite series
of dividend receipts that remain constant
P0 = Div (P / A, ea,  ) = Div / ea
 AFTER-TAX COST OF
EQUITY
Given: P0 = selling price of a share of
common stock
Div = annual dividend for past
year
ea = Div / P0
If future price of security is expected to
grow at a rate of ‘g’ each year
ea = Div / P0 + g
 PREFERRED STOCK
• Represents ownership with additional privileges and
restrictions not assigned to a holder of common stock
• Preferred stockholders guaranteed a dividend on their
stock, usually a percentage of par value, before common
stockholders receive any return
• If corporation is dissolved, assets must be used to satisfy
claims of preferred stockholders before holders of
common stock
• Preferred stockholders usually have voting rights
• Because the dividend rate is fixed, preferred stock is a
more conservative investment than common stock, and
has many features of long-term bonds
 PREFERRED STOCK
• Because dividend rate is fixed, market value
is les likely to fluctuate
• After-tax cost of capital for preferred stock
(ep) can be approximated by dividing
guaranteed dividend (Divp -- paid out after
tax earnings) by the original par value of the
stock (Pp)
ep = Divp / Pp
 RETAINED EARNINGS
• Normally assumed to be the same as
for common stock
• These earnings are equity funds that
are retained and reinvested for future
growth and increasing stockholder
wealth
WEIGHTED-AVERAGE COST OF
CAPITAL
• A Weighted-Average Cost of Capital (WACC)
for a firm can be determined once the amount
and explicit cost is established for each debt
and equity component in the capital structure
• This includes short-term debt, bond, common
stock, and preferred stock components
• Retained earnings are also included; the cost
of these funds should be the same as cost of
common stock
WEIGHTED-AVERAGE COST OF
CAPITAL
• Depreciation funds (reserves), another source
of internal funds for investment, are not
included in the weighted average cost of
capital calculation.
• These funds are are assumed to replace the
need for additional debt and equity capital in
the same proportions as the present capital
structure, and have an opportunity cost equal
to the weighted average cost of capital.
 WACC TO MARR RELATIONSHIP
• If MARR were assumed less than WACC
implementing the project would result in
a decrease in the value of the firm:
• There would be no surplus earned above
the cost of capital invested in the project
– project would impact negatively on wealth of
firm
• WACC should be minimum value used
for MARR
 WACC TO MARR RELATIONSHIP
• If MARR were assumed greater than WACC
• Then best economic measure of equivalent
current value that would be added to the
firm by the project remains the PW value
calculated at i = WACC.
• Regardless of MARR, WACC is important
and should be available for decision
making.
 LEASING AS A SOURCE OF
CAPITAL
• Leasing is a business arrangement that makes assets
available without initial capital investment costs of
purchase
• Leasing is a source of capital generally regarded as a long-
term liability, similar to a mortgage
• For corporations, rent paid on leased assets used in
business is generally deductible as a business expense
• Studies have shown no real income tax advantage in
leasing
• There may or may not be savings in maintenance expenses
through leasing, but simplifies maintenance problems
• True advantage in leasing is in allowing a firm to obtain
modern equipment that is subject to rapid technological
change -- a hedge against inflation and obsolescence
COST OF THE LEASE ALTERNATIVE
I k = Lk ( 1 - t )
Ik = after-tax lease expense during year k
Lk = before-tax lease expense during year k
t = effective income-tax rate
If i, the after-tax MARR is known and fixed,
PW of the after-tax cost of the lease
during a life of N years is
PWLease (i%) =Sk=1N[Lk (1 - t ) / ( 1 + i )k
Annual lease costs are borne by equipment supplier
COST OF PURCHASE ALTERNATIVE
• After-tax cost of equipment when
purchased is a function of
• expected annual expenses during life
of equipment
• purchase price
• book value
• and expected market value
COST OF PURCHASE ALTERNATIVE
MVN( 1 - t ) + tBV O&Mk( 1 - t ) - dk(t)
PWBuy(i%) = 1- ( 1 - I )N + Sk=1N ( 1 + i )k
I = capital investment
MV = expected market value at the end of year N
BVN = book value at the end of year N
i = interest rate per year
N = life of equipment in years
O&Mk = operating and maintenance expense during year k
t = effective income tax rate
dk = depreciation during year k
Note that market value, book value and depreciation
amounts are negative because they reduce costs
LINEAR PROGRAMMING FORMULATIONS OF
CAPITAL ALLOCATION PROBLEMS
• Linear programming is a mathematical procedure for
maximizing ( or minimizing) a linear objective function,
subject to one or more linear constraint equations
• A useful technique for solving certain multi-period capital
allocation problems when a firm is not able to implement
all projects that may increase PW.
Maximize net PW = Sj = 1mBj*Xj
Bj* = net PW of investment opportunity (project) j during the
planning period being considered
Xj = fraction of project j that is implemented during the
planning period (Note Xj will normally be ‘0’ or ‘1’)
m = number of mutually exclusive combinations of projects
under consideration
LINEAR PROGRAMMING FORMULATIONS OF
CAPITAL ALLOCATION PROBLEMS
In computing the net PW of each mutually exclusive
combination of projects, a MARR must be specified
Notation used in writing constraints for linear
programming
ckj = cash outlay (e.g., initial capital investment or
annual operating budget) required for project j in
time period k
Ck = maximum cash outlay that is permissible in time
period k
LINEAR PROGRAMMING FORMULATIONS OF
CAPITAL ALLOCATION PROBLEMS
Two types of constraints in capital budgeting problems

1. Limitations on cash outlays for

period k of planning horizon
Sj=1m ckXj < Ck
LINEAR PROGRAMMING FORMULATIONS OF
CAPITAL ALLOCATION PROBLEMS
Two types of constraints in capital budgeting problems
2. Interrelationships among projects:
a. If projects p,q and r are mutually exclusive
Xp + Xq + Xr < 1
b. If project r can be undertaken only if project s has
already been selected
Xr < Xs or Xr - Xs < 0
c. If projects u and v are mutually exclusive and project r is
dependent (contingent) on acceptance of u and v
xu + xv < 1
and
xr < xu + xv
CAPITAL BUDGETING PROCESS
OVERVIEW
1. Preliminary planning and cost of
capital
2. Annual capital budget and proposed
project portfolio
3. Capital expenditure policies and
evaluation procedure
4. Project implementation and postaudit
review
5. Communication