CorpFin 1

Corporate Finance – I
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Mapping to Curriculum
 Reading 31: Introduction to Corporate Governance and Other ESG Considerations

 Reading 32: Capital Budgeting
 Reading 33: Cost of Capital

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc. 2
Reading 31 – Introduction to Corporate Governance and
Other ESG Considerations

Learning Outcomes
The candidate should be able to:

a. Describe corporate governance
b. Describe a company’s stakeholder groups and compare interests of stakeholder groups
c. Describe principal-agent and other relationships in corporate governance and the conflicts that may arise in
these relationships.
d. Describe stakeholder management
e. Describe mechanisms to manage stakeholder relationships and mitigate associated risks.
f. Describe functions and responsibilities of a company’s board of directors and its committees.
g. Describe market and non-market factors that can affect stakeholder relationships and corporate governance
h. Identify potential risks of poor governance and stakeholder management and identify benefits from effective
corporate governance and stakeholder management
i. Describe factors relevant to the analysis of corporate governance and stakeholder management
j. Describe environmental and social considerations in investment analysis
k. Describe how environmental, social and governance factors may be used in investment analysis.

Meaning of Corporate Governance
 The shareholders are not the managers – therefore there is a conflict of interest between
1. Owners & Management
2. Directors, Creditors, Employees, Customers, and other stakeholders
 Corporate Governance is the overall construct within which a company is managed
Corporate Governance = Governance of a Corporate
 To ensure that the interest of the shareholders is not compromised, there are various things put in place to
ensure this.
 Etiquette
 Code of Conduct
 Discipline
 Checks & balances (Internal Control)
 Charter of responsibilities
 An effective and sustained channel of communication with the shareholders is at the core of corporate
governance
Meaning of Corporate Governance (Contd.)
 Corporate Governance: the system of internal controls and procedures by which companies ensure
transparency in working and communicate effectively with all the stakeholders.
 It provides framework that defines the rights, roles and responsibilities of different groups –
1. Management
2. Controlling shareholders and
3. Minority or non controlling shareholders.
4. Board
 Minimizes and manages the conflicting interests between insiders and external shareholders.
 Good Practices in Corporate Governance

• Board members act in the best interests of the shareholders
• Company acts in a lawful and ethical manner in dealing with all stakeholders
• All shareholders have the same right to participate in the governance of the company and their rights are clearly
delineated and communicated
• Board acts independently from management and any other entities
• Appropriate controls and procedures are in place covering management’s operations.
• Company’s operating , financial, and governance activities are consistently reported to shareholders in a fair,
accurate, timely, reliable, relevant, complete and verifiable manner.
Company Stakeholders
1. Shareholders
2. Creditors
3. Managers and Employees
4. Board of directors
5. Customers
6. Suppliers
7. Governments/Regulators

The construct of Agency Problem
Shareholders
(Owners)
Directors
(Representative of owners to control employees)
Management
(Employees of company)

Other relationships
I. Controlling and minority relationship:-

• Straight voting rights
• Related party transactions
• Non-voting or limited voting rights
II. Manager and board relationships.
III. Shareholder versus creditor interests.
IV. Other stakeholder conflicts.

Stakeholder Management
 Includes recognizing, organizing, and understanding the interests of stakeholder groups and on that
premise dealing with the organization's associations with these groups.
 Mechanism:-
• General meetings
• Board of director mechanisms
• The Audit function
• Reporting and transparency
• Policies on related-party-transactions
• Remuneration policies
• Say on Pay
• Contractual agreement with creditors, Customers and suppliers
• Laws and regulations

Board of Directors (BOD)
 These are the representatives of the owners which are appointed at ensure the proper corporate governance
 The duty of the board is to act in the long term interest of the shareholders
 Three characteristics of BOD
1. Independence
2. Experience
3. Resources
 Basic features of an effective BOD

1. A majority of the board should be independent of the management
2. The board should meet regularly outside the presence of the management
3. The CEO Of the company should not be the chairman of the board.
4. The board should not consist of people who the company does business such as suppliers or customers.
5. Board members should also be qualified, have adequate experience, should regularly attend meetings.

Frequency of Board Elections
Things to be considered
1. Shareowners may elect board members
a) Every year or for
b) staggered multiple-year terms
2. The board has filled a vacancy for the remainder of a board member’s term without receiving shareowner
approval at the next annual general meeting
3. Shareowners can vote to remove a board member under certain circumstances
4. The board is appropriate size for the facts and circumstances of the company.

Committees of the Board
1. Audit Committee:- To Ensure that financial information reported by the company to the shareholders is
complete, accurate, reliable, relevant and timely.
2. Governance Committee:- The essential part of the governance board of trustees is to guarantee that the
organization embraces good corporate governance practices.
3. Remuneration Committee:-
• Its responsible for ensuring that compensation and other awards encourage executive management to act in
ways that enhance the company’s long term profitability and value.
• Include only independent board members on the committee
• Linking executive compensation to the long term profitability of the company
4. Nominations Committee:- To distinguish candidates who are met all requirements to serve as directors and
suggests their nomination for election by shareholders
5. Risk Committee:- The committee oversees establishing enterprise risk management plans and monitors
their implementation.
6. Investment Committee:- The board surveys material investment opportunities proposed by administration
and considers their suitability for the organization

Stakeholder relationships and corporate governance
Market factors:-
 Shareholder engagement
 Shareholder activism
 Competition and takeovers
Non-market factors:-
 Legal environment
 The Media
 The corporate governance industry

Risk and benefits
Shortcomings in stakeholder management systems or the appropriation of poor administration structures can
make various risks for stakeholders and an organization.
 Weak control system
 Ineffective decision making
 Legal, Regulatory, and Reputational Risks
 Default and Bankruptcy risk
A good governance structure can be reflected in operational efficiency, improved control forms, better monetary
execution, and lower levels of risk.
 Operational efficiency
 Improved Control
 Better Operating and Financial Performance
 Lower Default Risk and cost of debt

ESG
ESG integration is the act of considering ecological, social, and administration elements in the speculation
procedure.
 Negative screening is the most common ESG investment strategy. It refers to the practice of excluding
certain sectors, such as companies engaged in fossil fuel extraction or production, or excluding companies
that violate accepted standards in such areas as human rights or environmental concerns.
 Positive screening intends to distinguish organizations that grasp strong ESG-related standards in their
operations and procedures.
 Thematic investing strategies commonly consider a single factor, for example, vitality productivity or
environmental change.

Reading 32 – Capital Budgeting

Learning Outcomes

a. Describe the capital budgeting process and distinguish among the various categories of capital projects;
b. Describe the basic principles of capital budgeting;
c. Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project
sequencing, and capital rationing;
d. Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted
payback period, and profitability index (PI) of a single capital project;
e. Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually
exclusive projects, and describe the problems associated with each of the evaluation methods;
f. Describe expected relations among an investment’s NPV, company value, and share price.

Different Types of Decisions in Corporate Finance
 Investing
 Financing
 Dividend

Meaning and Process of Capital Budgeting
Why Capital Budgeting?

The objective of every business or company is to create long-term profitability out of the capital it receives from
multiples sources, namely debt and equity holders. Capital budgeting is aimed at the allocation of such capital in
the long-term projects or investments.
As long-term projects span across multiple years, the cash inflows and cash outflows of all the years during the
life time of projects are taken into account.
There are different techniques used in this assessment of financial feasibility of such projects, some of them use
the concept of TMV while others do not prefer to.
The reason why TMV should be used can be cited through the following example:
 If we purchase a pen for $100 today and sell it for $120 today, we can clearly recognize that is a profitable
transaction and we should undertake it.
 However, in the transactions where we invest money today, but receive cash inflows over the years, we are
unable to determine the profitability and cannot directly determine whether we should undertake the project
because ‘time value of money’ gets involved, or not.
 Hence, when cash outflows and inflows of a project extend to multiple periods, we need to apply the capital
budgeting process to determine feasibility of the transaction.

Meaning and Process of Capital Budgeting
Capital Budgeting (Process of identifying and evaluating Capital Projects):

 Refers to planning for proposed capital outlays and financing of these outlays;
 Evaluating Projects for which cash flows will be received over a period longer than a year and
 Decision should be consistent with the goal of maximizing the shareholder’s value.
Capital project:
 Project involving a huge sum of money outflow to purchase a capital asset (long-term asset for use) and
 Typical cash flow pattern – Outflow at the initial level followed by a stream of Cash Inflows in the future.

Capital Budgeting Process
Step 1 Generating Ideas Raising Money is

 Generate ideas from inside or outside of the company not a part of Capital
Budgeting.
Step 2 Analyzing Individual Proposals

 Collect information and analyze the profitability of alternative projects
Step 3 Planning the Capital Budget

 Analyze the fit of the proposed projects with the company’s strategy
Step 4
Monitoring and Post-auditing
Compare expected and realized results and explain any deviations

Examples of Capital Projects
Different examples of Capital Projects:

1. Replacement projects: Replacing old equipment with new one (cash flows can be predicted with more
certainty)
2. Expansion projects: Expanding current production capacity (comparatively requires more analysis to
determine the cash flows)
3. New product or services: Introducing new product or service (more rigorous analysis is required to find out
cash flows, carries more risks)
4. Regulatory, safety and environmental: Required by government or some external party; may generate no
revenue
5. Other projects: Risky projects difficult to analyze by the usual method (R&D) or pet projects of someone in
the company (CEO buying a private jet)
Project Sequencing:
 Sequenced through time, so that investing in a project creates the option to invest in the future projec
 Example: A chemical company can first select a project to establish the chemical plant and then to use the
excess heat of chemicals it can establish a chemical power plant.

Different Types of Project
1. Mutually Exclusive Projects:

• One Project can only be selected from a set of projects.
• Acceptance of one would imply the rejection of the other.
• Compete directly with each other:
a) Either old machinery can be repaired, or be replaced by a new machinery;
b) Purchase of a laptop – Either Dell or HP.
2. Independent Projects:
• These projects can be selected irrespective of the other project.
• Acceptance of one project DOES NOT mean the rejection of the other.
• DO NOT Compete directly with each other:
a) Entering a new market – South Africa and Egypt – BOTH can be done at the same time;
b) Purchase of CDs – Moser Baer and Sony – BOTH can be done at the same time.

Techniques of Capital Budgeting
 The methods which are used to evaluate the project based on its cash flows are known as the techniques of
capital budgeting.
 There are five main techniques of capital budgeting:
1. Payback Period (PBP)/(DPBP);
2. Net Present value (NPV);
3. Profitability Index (PI);
4. Internal Rate of Return (IRR) and
5. Average Accounting Rate.
 Each technique has a different mathematical construct to evaluate the project. Each of these have their
limitations and advantages, vis-à-vis other techniques.
 Due to a difference in the basic construct, the evaluation result may be DIFFERENT.

Tech 1 – Payback Period (PBP)
 It is the time taken to recover the initial cost of an investment.

 Decision Criteria: Shorter the PBP, better is the project.
 It is more widely used in industries where the lifecycle of the project is very short.
 PBP is used when an investor is more interested in capital preservation, rather than in earning interest.
 Limitations: Project A Project B
• Cash flows post the PBP are not considered. Year CFAT Year CFAT
• Time Value of money is ignored. 0 -3000 0 -3000
• Profitability of the project is ignored (unlike NPV). 1 1,500 1 600
 Payback Period For A 2 1,200 2 900
= 2 + (3000-2700)/900 = 2.33 3 900 3 1,200
Payback Period For B 4 600 4 1,500
= 3 + ( 3000-2700)/1500 = 3.20 5 1,000 5 1000
Initial Investment - 3,000
Cash flow needed to Cash flow needed to
recover capital in recover capital in PBP 2.33 3.20
the final year of the final year of
recovery recovery Payback Period is a good measure of liquidity. Also,
since PBP ignores the terminal or salvage value, it is a
poor measure of Profitability.
Tech 1 – Improved – Discounted PBP
 The discounted payback method uses the present value of the project's estimated cash flows.
 It is the number of years it takes a project to recover its initial investment in the present value terms.
 It is always greater than the payback period without discounting.
 Limitations:
• Cash flows post the DPBP are not considered.
• Profitability of the project is ignored (unlike NPV).

Example Problem
Project A Project B
Discounted Discounted
Year CFAT Year CFAT
CF @ 6% CF @ 6%
0 -3000 -3000 0 -3000 -3000
1 1,500 1415 1 600 566
2 1,200 1068 2 900 801
3 900 756 3 1,200 1008
4 600 475 4 1,500 1188
5 1000 747 5 1000 747
Initial Investment - 3,000 ; Cost of capital is
6%
DPBP ? ?

Solution
Payback Period For A

= 2 + (3000-2483)/756 = 2.68
Payback Period For B
= 3 + (3000-2375)/1188 = 3.53

Tech 2 – Average Accounting Rate of Return (AAR)
 AAR = Average net income / Average book value

 AAR can be easily calculated and is easy to understand.
 However, it has a few disadvantages:
• It is based on accounting income and not cash flows; and
• It does not account for time value of money.

Example Problem
A firm invests project for $100000 with 5 years life. The asset is depreciated on a straight line basis and is
expected to produce the following net income for the firm:
Year PAT
1 20000
2 30000
3 10000
4 15000
5 25000
ARR ?

Solution
(20000+30000+10000+15000+25000)/ 5
AAR= =40%
(10000−0)/2
Tech 3 – Net Present Value (NPV)
 NPV is the profitability of the project on a present value basis. Few discount all the CFs to PV and then
compare them.
 As the name suggests, it is the NET difference between the present value of Cash inflows and the present
value of cash outflows discounted at the required rate of return.
 NPV = PVCI – PVCO
 As a conventional pattern of cash flow, PVCI can be expressed as:
 Where,
• CFt = after tax cash flow at time t;
• k = required rate of return for project.
 Decision criteria:
IF… DECISION
NPV > 0 The project may be accepted.
NPV < 0 The project should be rejected.
The Company is indifferent to the acceptance or rejection of the project.
NPV = 0
The project does not add any value to the shareholder.

Example Problem
Project A Project B
Year CFAT Year CFAT
0 -3000 0 -3000
1 1,500 1 600
2 1,200 2 900
3 900 3 1,200
4 600 4 1,500
5 1000 5 1000
Initial Investment - 3,000; Cost of capital is 6%
NPV ? ?

Solution
Where:
CF0 = initial investment outlay (a negative cash flow)
CFt = after-tax cash flow at time t
k = required rate of return for project
Demo of Calculator Keys (for project A):

Clear CF keys by pressing CF 2nd Clear. Press CF
CF0 = -3000, CF1 = 1500, CF2 = 1200, CF3 = 900, CF4 = 600, CF5 = 1000
Press down arrow key, I=6, CPT NPV.
After applying the above functions in calculator, we get:
NPV of Project A = 1461.26
NPV of Project B = 1309.98
Project A will be selected as it is more profitable and will add greater value to the shareholder’s wealth in
comparison to Project B.

Example Problem
 Choosing the correct rate of discount is crucial for effective project evaluation process.
Project C
Year CFAT
1 10,000
2 11,000
3 10,500
4 14,000
5 12,500
Initial Investment – 48,000
WACC is 6%, NPV = ?
WACC is 10%, NPV = ?

Solution
 Answer 1:
NPV Project A Project B
1,820.91 5,563.20
 Answer 2:
After Tax Cost of Capital NPV

6% 469.96
10% (4,605.67)
Observation: As the cost of capital (discount rate) increases, NPV reduces because cash flows are
discounted at a higher rate, and hence have lesser present value.

Basic Principles of Capital Budgeting
1. Evaluation of decisions is based on cash flows, not on the accounting income.
2. Cash flows are analysed on an after-tax basis, because shareholders get the benefit from profit after tax
only. Please note that:
Cash flows After Tax is NOT EQUAL to Net Income. (PAT from Income Statement).
3. Evaluation is based on Incremental Cash Flows.

• Difference between the cash flows with project and those without the project under consideration. This cash
flows should be taken for analysis and not the total cash flows.
4. Timing of cash flows affects decisions because of time value of money.

• Earlier cash flows are more valuable than future cash flows.
5. A project must earn equal to, or more than, its opportunity Cost to be accepted (like a benchmark).
• Opportunity Costs is the profit that would have earned through the next best project.
• E.g.: Investment in Stocks versus Interest Income in an FD

Basic Principles of Capital Budgeting (Cont.)
6. Sunk Costs do not play any role in Capital Budgeting –

• It is the cost which cannot be recovered (whether the project is selected or not).
• E.g.: Money paid to the market research firm for determining demand for a new product, purchase price of the
old machinery which is now contemplated should be replaced.
7. Externalities MUST be considered while evaluating a project –
• It is the effect of the investment on other aspects besides the investment itself.
• It can be a negative impact or a Positive Impact.
• Cannibalization: One product of a company eating over the share of another product of the same company, for
example: Maruti Suzuki’s Alto model’s sale being impacted due to the launch of A-Star model.
8. Financing costs (like interest rate) are not considered as a part of the cash flows, because they are already
considered in project's hurdle rate (required rate of return).
9. Pattern of Cash Flows:
a) Conventional Cash flow – One initial cash outflow which is followed by a series of inflows; and
b) Nonconventional Cash Flows – Cash flows can flip from positive to negative after the initial outflow.

10. Role of Depreciation –

• Depreciation is a non-cash expense, hence does not play any active role in determining CF.
• However, since it is a tax deductible expense, it leads to tax saving.
• Reduced tax outflow is deemed to a cash inflow.
• Two approaches to calculate CFAT
1. CFAT = PBDT *(1 - T) + Dep x T
2. CFAT = PAT + Dep
11. Gain or Loss on Capital Asset –

• Whenever a capital asset is sold, gain/loss is calculated.
• Gain (or Loss) = Scrap or Sale value - Book Value (on the date of Sale)
• This capital gain (or loss) is taxable, thus results into additional taxes (or tax savings).
• Net Cash Flow in case of:
1. Gain = Sale Value – additional taxes
2. Loss = Sale value + Tax Savings (deemed inflow)

12. Working Capital Adjustment:

• In case a new capital asset is purchased, there is a change warranted in the operational or working capital
requirement also.
• E.g., a bigger machinery will –
‒ Need more stock of Raw material – Additional Raw Material;
‒ Will have more WIP at any point in time – Additional WIP;
‒ Will produce more finished output – Additional finished goods;
‒ Overall, more investments are required in the Working capital.
• Adjustments required are:
1. Treat the ADDITIONAL working capital as cash out flow at To (as part of the initial cash flow).
2. Treat the same amount as cash inflow at the end of the project (as part of the terminal value).

Tech 4 – Profitability Index (PI)
 PI is the INDEXED return earned by the project over its initial cash outflow.
 PI is the present value of a project's future cash flows divided by the initial cash outlay.
 Decision criteria:
• If PI > 1.0, accept the project or
 If NPV is >0, PI >1
• If PI < 1.0, reject the project.
 If NPV is <0, PI <1

Example Problem
Project A Project B
Year CFAT Year CFAT
0 -3000 0 -3000
1 1,500 1 600
2 1,200 2 900
3 900 3 1,200
4 600 4 1,500
5 1000 5 1000
Initial Investment -3,000; Cost of capital is 6%
PI ? ?

Solution
Project A Project B
Year CFAT Year CFAT
0 -3000 0 -3000
1 1,500 1 600
2 1,200 2 900
3 900 3 1,200
4 600 4 1,500
5 1000 5 1000
Initial Investment -3,000; Cost of capital is 6%
PI 4461.26/3000 = 1.49 4310/3000 = 1.43

Tech 5 – Internal Rate of Return (IRR)
 IRR is the return that can be earned on the capital invested.

• It is the MWR (Discounted Cash Flow Application).
 From a mathematical perspective, IRR is the discount rate that equals the present value of the incremental
after-tax cash inflows to the initial cost of the project.
 In equation form, this is expressed as: PV (Cash Inflow) = PV (Cash Outflow)
 Decision Criteria:
• If IRR > the required rate of return, accept the project.
• If IRR < the required rate of return, reject the project.

Example Problem
Project A Project B
Year CFAT Year CFAT
0 -3000 0 -3000
1 1,500 1 600
2 1,200 2 900
3 900 3 1,200
4 600 4 1,500
5 1000 5 1000
Initial Investment -3,000
IRR ? ?

Solution
Demo of calculator keys (for project A):

Clear CF keys by pressing CF 2nd Clear Clear. Press CF.
Cfo = -3000, CF1 = 1500, CF2 = 1200, CF3 = 900, CF4 = 600, CF5 = 1000
IRR CPT
IRR (for project A): 25.04%
IRR (for project B): 19.25%

NPV Profile
 NPV Profile is the graph that shows a project’s NPV as a function of various discount rates.
• NPV on Y-axis and Discount Rate on X-axis.
 The discount rate where NPV is 0, is the IRR.
 When discount rate = 0, NPV reflects the undiscounted difference between inflows and outflows.
NPV
A preferred
over B
A
B preferred
Crossover Rate over A
B
IRR of B
IRR of A
Rate
A is preferable B is preferable

NPV Profile
 A’s cash inflows are farther as compared to B’s cash inflows.

 As a result, the impact of rate hike is more prominent in case of A’s NPV, as compared to B’s NPV.
 For most of the projects, the NPV and IRR rule will yield the same result. In some cases (like the one above),
while IRR of B > IRR of A, A will have a higher NPV before crossover rate, and B will have higher NPV after
the crossover rate. However, the most appropriate and theoretically sound criterion is NPV.

IRR vs NPV
 For conventional projects, the NPV and IRR will yield the same result on whether to invest or not to invest.
 NPV and IRR may give conflicting results for different project sizes. Thus, choose NPV.
 NPV is theoretically the best method. However, a limitation is that it does not include any consideration to the
size of the project. For example, an NPV of $100 is good for project costing $1000, but not so great for a
project costing $1 million.
 Advantage of IRR is that it measures profitability as a percentage of the return on the investment.
 Limitations of IRR:
• IRR might give conflicting project ranking as compared to NPV for mutually exclusive project.
• Multiple IRR may be there in case of unconventional cash flow pattern.
• No IRR may be there in a few cases.
• IRR assumes that yearly returns are invested at the IRR. This may not always be possible.

Ranking Conflicts: NPV vs IRR – Points to Remember
The NPV and IRR methods may rank projects differently.

 If projects are independent, accept if NPV > 0 produces the same result as when IRR > r.
 If projects are mutually exclusive, accept if NPV > 0 may produce a different result than when IRR > r.
Drawback of IRR and why NPV is preferred:

The source of the problem is different reinvestment rate assumptions.
 Net present value: Reinvest cash flows at the required rate of return.
 Internal rate of return: Reinvest cash flows at the internal rate of return.
The problem is evident when there are different patterns of cash flows or different scales of cash flows.

Preference of Capital Budgeting Methods
Gist:
1) In terms of consistency with owners’ wealth maximization, NPV and IRR are preferred over other methods.
2) Larger companies tend to prefer NPV and IRR over the payback period method.
3) The payback period is still used, despite its failings.
4) The NPV is the estimated added value from investing in the project; therefore, this added value should be
reflected in the company’s stock price.

Other Concepts – NPV and Share Price
 NPV is the addition to shareholders’ wealth (at To) by taking an action and discounting its CFs using WACC.
 Wealth of the shareholders is measured by the share price.
 Therefore by Fundamental Analysis, NPV is an addition in the Market capitalization at To.
 The value of the company is the value of the existing investments, plus the NPV of all future investments.
 If a project has an NPV of $250 Mn and the current value of the company is $5,000 Mn (100 Mn outstanding
shares), the total market cap will increase by $250 Mn.
• Share price should increase by $2.5 ($250 Mn divided by 100Mn).
• New share price will be $50 + $2.5 = $52.5.
Because of speculations and other forces prevailing in the capital market,

the above relation might not always hold true.

Other Concepts – Capital Rationing
 Firms/Companies have fixed amount of capital to allocate amongst capital projects.

 Capital rationing is the allocation of this fixed amount of capital among the set of available projects, such
that the selection will maximize shareholder’s wealth.
 Projects with negative NPVs are to be discarded, irrespective of the availability of capital.
1. Hard capital rationing – funds allocated to the manager of capital project cannot be increased.
2. Soft capital rationing – manager of the capital project is allowed to increase the allocated capital budget,
provided they can justify the creation of the shareholder’s value on that additional capital before the senior
management.
Profitability Index is used to rank projects on the basis of their relative returns.

Knowledge Check

Knowledge Check
Which of the following is the least accurate about discounted payback period?
A. It ignores the terminal value
B. It is shorter than the regular payback period
C. It is the time taken by the present value of cash flows to equal the initial investment

Solution
Ans. (B) It is always greater than the regular payback period.

Knowledge Check
Which of the following statements is the least accurate?

A. If NPV for a project is negative, then its IRR can be positive
B. Cash flows in capital budgeting should include opportunity costs
C. Discounted payback period is smaller than the normal payback period

Solution
Ans. (C) If the cost of capital > IRR then NPV can be negative, whatever is the value of IRR.
Cash flows should include opportunity costs.
Discounted payback period is larger than the normal payback period, because future cash flows are discounted
and their PV is less than the undiscounted value.

Knowledge Check
A company X bought a machinery for $100 and expects to give the following cash inflow – Year 1: 50, Year 2: 40,
Year 3: 10, Year 4: 15.
The Required rate of return is 4%. Calculate the Payback Period and Discounted Payback Period.
A. 3 and 3.47
B. 3.47 and 3
C. 3 and 4

Solution
Ans. (A) The correct answer is 3 and 3.47.

Knowledge Check
Sigma Tech has a net worth of $4 million and Global Inc has a net worth of $500 million. Which of the following
methods of capital budgeting is the most likely to be used by these companies?
A. Sigma should use the NPV method
B. Global should use the discounted payback method
C. Sigma should follow the discounted payback method

Solution
Ans. (C) Sigma is a smaller company as compared to Global, and hence is more likely to follow the discounted
payback method.

Knowledge Check
In the capital budgeting process, three of the major steps are:

A. Analyze the project proposal, create firm wide capital budget and monitor decisions
B. Analyze the project proposal, raise capital, and monitor project performance
C. Analyze the project proposal, create firm wide capital budget and raise the capital

Solution
Ans. (A) Capital budgeting has 4 steps. In none of the steps, capital is raised in the capital budgeting process.

Knowledge Check
Which of the following costs is the least likely to be used in capital budgeting analysis?
A. Fees paid to a marketing research firm to estimate the demand for a new product prior to a decision on the
project
B. Cannibalization of its existing product market due to the launch of another product by a firm
C. The tax saving affect of depreciation cost

Solution
Ans. (A) Fees paid to a marketing research firm to estimate the demand for a new product prior to a decision on
the project is a sunk cost and should not be included in the capital budgeting analysis.

Knowledge Check
Which of the following is true about Cannibalization?

A. It’s a positive externality
B. It’s a negative externality
C. It’s not an externality

Solution
Ans. (B) The correct answer is that it is negative externality.

Knowledge Check
With regards to capital budgeting, an appropriate estimate of the incremental cash flows from a project is the
least likely to include:
A. Interest Costs
B. Externalities
C. Opportunity Costs

Solution
Ans. (A) The correct answer is Interest Costs.

Knowledge Check
The effects that the acceptance of a project may have on firm’s other cash flows is known as:
A. Opportunity Cost
B. Externalities
C. Sunk Cost

Solution
Ans. (B) Opportunity Cost: Cash flows that a firm will lose by undertaking the project is the effect that the
acceptance of a project may have on firm’s other cash flows. While the Sunk Cost are costs that cannot be
avoided, even if the project is not undertaken.

Reading 33 – Cost of Capital

Learning Outcomes

a. Calculate and interpret the weighted average cost of capital (WACC) of a company;
b. Describe how taxes affect the cost of capital from different capital sources;
c. Describe the use of target capital structure in estimating WACC and how target capital structure weights may
be determined;
d. Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the
optimal capital budget;
e. Explain the marginal cost of capital’s role in determining the net present value of a project;
f. Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating
approach;
g. Calculate and interpret the cost of noncallable, nonconvertible preferred stock;
h. Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend
discount model approach, and the bond-yield-plus risk-premium approach;
i. Calculate and interpret the beta and cost of capital for a project;
j. Describe uses of country risk premiums in estimating the cost of equity;

Learning Outcomes (Cont.)
k. Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to
additional capital, and calculate and interpret its break points;
l. Explain and demonstrate the correct treatment of flotation costs.

Context for Cost of Capital
 The three main decisions to be taken by a Finance Manager are: Common Objective:
• Financing Decision: How to raise the most optimum finance; To maximize
• Investment Decision: How to make the most optimum investments and Shareholders’ wealth
• Dividend Decision: How to distribute profits in the most optimum manner.
 Financing and Investing decisions are independent: There is no one-to-one relationship between every
action of the two decisions.
 In evaluating the investing decisions, there is the need for an opportunity cost against which the returns from
the project/asset can be compared with.
• This opportunity cost is the genesis of Cost of Capital.

Cost of Capital – Meaning
The different ways to understand the meaning of cost of capital:

1. The rate of return that the suppliers of capital, bondholders, and owners require as a compensation for their
contribution of capital;
2. The cost to finance assets of the firm;
3. The minimum rate which the assets of the firm must earn to add to shareholders’ wealth;
4. The opportunity cost which is used as a benchmark to evaluate capital projects and
5. WACC reflects the average risk of projects that make up the firm.

Different Components of Capital
The three main components of capital:

 Equity share (common equity);
 Preference Share (preferred stock) and
 Debt (bank loan, debentures or bonds).
Amount of Certainty of
Source of capital
return payment
1 Equity Not certain Not certain

Investor’s
risk
2 Preference Certain Not certain
3 Debt Certain Certain

Cost of Capital
Costs of
Capital
Cost of Cost of
Cost of Debt Preferred Common
Equity Equity
Variations
Return on Capital Asset Dividend Bond Yield
Yield to because of
Debt Rating Preferred Pricing Discount plus Risk
Maturity Callability,
Stock Model Model Premium
etc.

Cost of Debt Capital (Kd)
A. Company perspective:
• Interest rate at which firms can issue new debt (Kd) (this is generally used for perpetual debt):
B. Investor’s perspective: Investor’s YTM on existing debt (most preferred):

• The Yield to Maturity (YTM) is the annual return that an investor earns on a bond if the investor purchases the
bond now and holds it until maturity.
• YTM is the IRR from the point of view of the investor.
• YTM is to be used for calculation purposes and not coupon rate.
C. Alternate perspective: Debt Rating Approach
• To be used only when the current market price of debt is uncertain and cannot be used to estimate YTM.
• Compare the ratings and maturity of the debt to arrive at Kd (Matrix pricing).

Impact of Taxes
 Interest expense on the debt capital is an allowable expenditure for tax purposes >> results into tax savings.
 After-tax cost of debt = interest rate - tax savings = Kd - Kd(t) = Kd(1 - t)

Issues in Estimating the Cost of Debt
1. Fixed Rate Debt vs. Floating Rate Debt

• Estimating the cost of a floating rate security is difficult because the rate of interest is fluctuating over the life of
the debt—it depends not only on the current yields but also on future yields.
• The analyst may use the current term structure of interest rates and term structure theory to assign an average
cost to such instruments.
2. Debt with Embedded Options:

• Problems occur while valuing bonds using the call, conversion, or put options.
• Options affect the value of debt:
a. Callable bonds have higher yields than the similar non-callable bonds and
b. Putable bonds have lower yields than similar non-putable bonds.
• Analysts may use the YTM method if the future bonds to be issued with embedded options are similar to the
bonds already traded in the market.
• Otherwise, the YTM can be adjusted to reflect the embedded options.

Issues in Estimating the Cost of Debt (Cont.)
3. Non-rated Debt:
• If the company does not have any outstanding debt or rated bonds, then yields on the existing debt is not
available (YTM model fails).
• In such a case: Researchers arrive at a synthetic debt rating based on the financial ratios.
• It is inaccurate, since the information about the particular bond issues are not captured by the synthetic rating.

Example Problem
The organisation Greenwich Co., issued preferred stock which are now trading at $152 while the face value is
$100. The dividend rate is 5% and the tax rate is 30%.
Calculate the cost of preferred equity.

Solution
Dividend amount = 5% of $100 = $5

Cost of preferred equity = $5 / $152 = 3.29%
Note: Preference dividend is not an allowable expenditure for tax purpose. Hence, the tax shield is not
considered in the calculation of the cost.

Cost of Equity Capital (Ke)
The Ke can be calculated using three approaches:

1. Capital asset pricing model (CAPM);
2. Dividend discount model (DDM) and
3. Bond yield plus risk premium.
Each approach yields a different answer.
Impact of taxes
 Common Dividend is NOT an allowable expenditure for tax purposes as it DOES NOT result
into tax savings.

1. Capital Asset Pricing Model (CAPM)
Where:
 is the returns sensitivity of stock returns to changes in the market return;
 E(Rm) is the expected return on the market (index) and
 [ E(Rm)– Rf]is the expected market risk premium (compensation for extra risk taken).
Beta: It is the measure of systematic risk.
Important points:
1. Historical Equity Risk Premium: Equity risk premium observed over a long period of time is a good
indicator of the expected equity risk premium.
2. Limitations:
• The level of risk of the stock index may change over time.
• The risk aversion of investors may change over time.
• Estimates are sensitive to the method of estimation and the historical period covered.

2. Dividend Discount Model (DDM)
Where:
 D1: is the dividend expected after one year

 Po is the market price of the common share today
 G = sustained (constant) growth expected in dividends
G = (retention rate) x (return on equity) = (1 - payout rate) x (RoE)

3. Bond Yield Plus Risk Premium
Re = bond yield + Equity risk premium
 Analysts often use an ad hoc approach to estimate the required rate of return on equity.
 This is done by adding a risk premium (3–5% for investing in equity compared to debt) to market yield on the
same firm’s long-term debt.
 Example: Bond MF v/s Equity MF
Note: Bond yield is before tax (if after tax cost of firm is given, convert it to before tax).

Calculating Weighted Average of Cost of Capital
Cost Weight age
Debt Kd Wd
Preferred Stock Kps Wps
Equity Stock Ke We
WACC = Wd* Kd (1-t) + Wps* Kps + We* Ke

Methods of Calculating Weights used in WACC
Preference of weights should be:

1. Market values of Target Capital Structure;
2. Market Values of the Current Capital structure;
3. Industry averages as the target capital structure and
4. Book Values of the Current Capital structure.
The weights used in the WACC should be adjusted for:

5. Historical trends and
6. Any announcement by the company to alter its capital structure.

Example Problem
Suppose the Oxford Company has a capital structure composed of the following, in billions:
Debt €10
Common equity €40
If the before-tax cost of debt is 9%, the required rate of return on equity is 15%, and the marginal tax rate is 30%,
what is the Widget’s weighted average cost of capital?

Solution
WACC = [(0.20)(0.09)(1 – 0.30)] + [(0.8)(0.15)]

= 0.0126 + 0.120
= 0.1325, or 13.25%
Interpretation:
When the Oxford Company raises €1 more of capital, it will raise this capital in the proportions of 20% debt and
80% equity, and its cost will be 13.25%.

Marginal Cost of Capital – Coverage
1. Basic Explanation
2. Optimal Capital Budget
3. Break points
4. MCC Schedule

Marginal Cost of Capital – Basic Meaning
 MCC is the cost of incremental capital raised by the firm.

 In other words, what it would cost to raise additional funds for the potential investment project.
Examples of MCC:
 A company wants to raise capital for an expansion plan for setting up new factory.
 Although the existing debt is at 12%, any additional debt can be raised at 14%.
 New shares will involve an issue cost of $2.5 per share.

Optimal Capital Budget
The Optimal Capital Budget is that amount of capital raised and invested at which the marginal cost of capital is
equal to the marginal return of investing (similar to MC = MR in Economics).
1. Investment Opportunity Schedule – Returns to a company’s investment opportunities are generally

believed to decrease, as the company makes additional investments as represented by the Investment
Opportunity Schedule.
2. Marginal Cost of Capital: As the firm raises more capital, the cost of capital increases:
A. Cost of debt rises to account for the additional financial risk and
B. Cost of new equity is higher than the retained earnings due to floatation costs.
Project IRR
Cost of Capital%
Investment
Opportunity Marginal
Schedule Cost of
Capital
New Capital
raised($)
Optimal Capital Budget
Break Points
Break points occur when the cost of any one of the components of a company's cost of capital changes.
Example:
Amount of new Debt ($ Mn.) Kd(1-t) Amount of new Equity ($ Mn.) Ke
0–99 5.0% 0–199 7.00%
100–199 5.5% 200–399 8.50%
200–299 6.5% 400–599 11.00%
Capital Structure of 60% Equity and 40% Debt

For example, if the company is raising $ 100 Mn in new debt,
Break point = $ 100 Mn / 60% = $250 Mn
The inference is that the first break point in debt cost will occur when company raises $250 Mn in Total Capital.

Marginal Cost of Capital Schedule
 MCC schedule depicts the WACC at different levels of additional financing.

 MCC schedule typically has an upward slope, because financing cost increases as the requirement for
additional financing increases:
• Kd rises as the existing debt may have a covenant that restricts the company from issuing the debt with similar
seniority as existing debt;
• Ke rises as debt increases, there is increased risk for the equity shareholders (financial leverage).
WACC
Amount of New Capital

Using WACC (or MCC) in Capital Budgeting
 If we chose to use the company’s WACC as discount rate in the calculation of the NPV of a project, we
assume the following:
a) The project has the same risk as the average-risk project of the company and
b) The project will have a constant target capital structure throughout its useful life.
 Companies may use an ad-hoc or a systematic approach for adjusting the WACC to evaluate new projects
with risks different than the risk of companies’ existing projects.

Other Topics – 1. Beta and Cost of Capital for a Project
 Project: This is a new venture by an existing company which is in addition to its other businesses.
 Beta (total systematic risk) is a combination of:

1. Operating risk and
2. Financial risk.
 Risk (and Beta) of a new project can be very different than the overall Risk (and Beta) of the firm.
 There is a need to evaluate risks (Beta) specific to the particular project to estimate the discount rate
(WACC), which is in turn to evaluate that particular project.
 Since each project is not represented by a publicly traded security, it is difficult to calculate the Project Beta.
 In order to estimate Beta for the Project, the Pure Play Method is USED.

Using Comparables to Estimate Beta – Flow
Un-lever the Re-Lever the

Estimate the Comparable’s Beta for the
Select a
Beta for the Beta to Project’s
Comparable
Comparable Estimate the Financial
Asset Beta Risk

Pure-Play Method
1. Identify company/group of companies comparable to the project, i.e., engaged ONLY in business similar to
that of the new project.
2. Un-lever the beta in step 1, since the benchmark company will have a different financial structure that also
impacts the Overall asset’s Operational risk. Through this step, we remove the financial risk and only the
operational risk remains. (All figures on RHS are for the benchmark company.)
1
Beta (Asset) = Beta (Equity)
1 + Debt/Equity (I – T)
3. Re-Lever: Now once you have adjusted the beta, then again reload the beta with financial risk of company
evaluating the project. (All figures on RHS are for the main subject company.)
The result is the Equity Beta of the target company, which encompasses its business and financial risk.
Debt (1-T)
Beta (Equity) = Beta (Asset or Project) 1 +
Equity

Example Problem
Consider the following information for the Company A and its comparable, Company B:
Company - A Company - B
Debt €10 €100
Equity €40 €200
Equity beta ? 1.4

What is the asset beta and equity beta for the Company A, based on the comparable company information and a
tax rate of 40% for both companies?

Solution
basset = 1.4 {1  [1 + (1 – 0.4)(100  200)]} = 1.4 × 0.76923 = 1.0769

bequity = 1.0769 [1 + (1 – 0.4)(10  40)] = 1.0769 × 1.15 = 1.2384
The beta of the Company A is 1.2384.

Example Problem
Acme Inc. is considering a project in the food distribution business. It has a D/E ratio of 2, a marginal tax rate of
40%, and its debt currently has a yield of 14%. While Balfor, a publicly traded firm that operates only in the food
distribution business, has a marginal tax rate of 30%, a D/E ratio of 1.5 and an equity beta of 0.9. The risk-free
rate is 5% and the expected return on the market portfolio is 12%. Calculate Balfor’s asset beta, the project’s
equity beta, and the appropriate WACC to use in evaluating the project.

Solution
Balfor’s asset beta:
bBaflor’s ASSET = 0.9
b Acme’s PROJECT = 0.439
Project cost of equity = 5% + 0.966(12%-5%) = 11.762%
To get the weights of debt and equity, use the D/E ratio and give equity a value of 1.
Here, D/E = 2, so if E = 1, D = 2. The weight for debt, D/(D + E), is 2/(2 + 1) = 2/3,
And the weight for equity, E/(D + E), is 1/(2 + 1) = 1/3. The appropriate WACC for the project is therefore:
(11.762%) + (14%) (1-0.4) = 9.52%

Other Important Points on Project Beta
Calculation of Beta:
1. Arriving at a beta for a publically traded company (to be used under Pure-Play Method) is easy.
2. For companies which are not publically traded, estimating a beta requires making proxy by using the
information on the project or company, combined with a beta of a publically traded company.
Challenges in estimating the beta of comparable company’s equity:

3. Beta is estimated using historical returns.
4. Affected by which index is chosen to represent the market return.
5. Adjustment needs to be made for the (believed) tendency of beta to revert towards 1 over time.
6. Beta of small-capitalized firms may need to be adjusted upward to reflect risk inherent in small firms that is
not captured by usual estimation methods.

Other Topics – 2. Country Equity Risk Premium (CRP)
Context: ‘β’ does not adequately capture the country risk of an emerging/developing market.
 We need to add a Country Risk Premium (CRP) to the market risk premium.
 Risk of investing in a developing country is measured by the sovereign yield spread, i.e., the difference in
yields between the developing country’s government bonds (denominated in local currency) and treasury
bonds of similar maturity.
 The above mentioned compensates only the bond risk. This is adjusted for the equity market risk by
adjusting it for the relative risk of equity markets to the bond markets.
Ke = Rf + ß [E(Rm) – Rf + CRP]
Consider Sovereign = Government
What is developing is a relative term.

Example Problem
Facts of the case:

 Pakistan’s 10 year G Sec Bond Yield = 16%
 India’s 10 year G Sec Bond yield = 10%
 Annualized SD of Pakistan stock market index = 40%
 Annualized SD of rupee denominated 10 year Pakistan’s G Sec bond = 15%
 Project Beta = 1.25
 E(Rm) = 15% and Rf = 8%
Calculate Ke for investing in Pakistan.

Solution
Country Risk Premium:

=(16% - 10%) * (40%/ 15%) = 16%
Cost of Equity:
= 8% + 1.25(15% - 8% + 16%) = 36.75%

Other Topics – 3. Floatation costs
 Charges/fees are paid for raising external equity capital.

 This fees is paid to the investment bankers to the issue for their services in raising the capital.
 Amount of Flotation Costs
• Floatation costs for equity can range from 1.5% to 1.8%, based on the country of the issue and other factors.
• For debt and preferred stock that is : usually below 1%, the floatation costs are not included in the costs since it
is very low.
 Treatment of Floatation Costs

• Either increase the initial cost of the project (Better Method), or
• Incorporate floatation costs into the cost of capital (Not Preferred).

Example Problem
Facts of the case:

 Cash Outlay: $4 Million
 Annual after tax cash flows : $1.5 Million for 4 years
 Tax rate : 40%
 Before tax cost of debt: 7.5%
 MV of Equity: $35
 Expected Dividend next year ; $4
 Growth rate : 6%
 Capital Structure is 40:60 (Debt: Equity)
 Flotation Cost of equity: 4.5%
Calculate WACC and NPV.

Solution
 Out of the $4 Million cash outlay, 60%, that is $2.4 Million, is Equity and $1.6 is Debt.
 By adjusting the 4.5% floatation costs to this cast outlay, we have $4M + $2.4*4.5% = $4.108M.
 Using DDM, 35=4/(re-0.06) => re = 17.42%

 Given rd is 7.5%
 WACC = 0.6*17.42%+0.4*7.5%*(1-0.4)
= 12.25%
=0.3778 Million

Summary – Reading 33
Cost of Equity Capital Approaches: Categories of Projects : PV of future 𝑐𝑎𝑠h 𝑓𝑙𝑜𝑤𝑠 NPV
1. Capital asset pricing model (CAPM): PI = =1+
 Replacement projects CF 0 CF 0
 Expansion projects
 New Product or services 𝑛
2. Dividend Discount Model (DDM): CF1 CF2 CFn CF t
 Regulatory, safety and 𝑁𝑃𝑉=𝐶𝐹0+ + +…+ =∑
3. Bond yield plus risk premium environmental projects (1+k)1 (1+k)2 (1+k )n 𝑡=0 (1+k )t
PV of Future C 𝑎𝑠h 𝑓𝑙𝑜𝑤𝑠
The cost of preferred stock (K ps) is: 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥=
Internal Rate of Return : PV of Initial Investment
It is the discount rate that equates the
NPV to 0.
WACC = Wd *[(Kd(1-t)] + Wps*Kps + We*Ke
Required interest rate on a security = The payback period: the time period
taken to recover the initial cost of an NPV
nominal risk free rate + default risk
premium + liquidity premium + investment (Real life Example –
Cyclic Industries) A preferred
maturity risk premium A over B
Crossover B preferred
Rate over A
B
IRR of B
Rate
IRR of A
Amount of capital at which the componentscost of capitalchanges

Break Point=
Weight of the new component ∈the capital structure

Knowledge Check

Knowledge Check
If the Debt Outstanding is 20 Crs, while the:

 Common Equity stock outstanding is 40 Crs and
 Preferred Stock Outstanding is 30 Crs;
Calculate the Wd, Wps and We.

A. 0.22, 0.33, 0.44
B. 0.33, 0.22, 0.44
C. 0.44, 0.22 ,0.33

Solution
The correct answer is A. 0.22, 0.33, 0.44
Calculation:
Wd – Total Debt/ Total Capital (Equity + PS + Debt) = 20/90 = 0.22

Wps - Total Preference Shares/ Total Capital = 30/90 = 0.33
We - Total Equity/ Total Capital = 40/90 = 0.44

Knowledge Check
Kd = 8%, Kps = 9%, Kce = 10.5%, Wd = 35%, Wps = 15%, Wce = 50%, Tax rate = 40%
Using the given figures, calculate WACC:

A. 9.40%
B. 8.28%
C. 7.74%

Solution
The correct answer is B. 8.28%

• Answer A – takes before tax cost of debt
• Answer C – takes after tax cost of debt and Preferred stock

Knowledge Check
A stock whose market price is $60 is expected to declare a dividend of 60% (Face value $10). What is the Cost of
Equity if the dividends are projected to grow at a rate of 5%?
A. 65%
B. 15%
C. 5%

Solution
The correct answer is B. 15%

• Answer A – takes 60% dividend on market price instead of face value;
• Answer C – subtracts g instead of adding it to (D1/P0).

Knowledge Check
If the difference between the yields of Govt. bonds in India (developing country) is denominated in Rupee and the
treasury bonds of USA with the same maturity increases, then what will be the effect on the cost of equity of a
firm in India?
A. Increases
B. Decreases
C. No Impact

Solution
The correct answer is A. Increases – With the given scenario, the cost of equity of a firm in India increases.
• The relation between Sovereign yield risk and CRP is positive.

Thank You!
For queries, write to us at: care@edupristine.com


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Corporate Finance – I

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 Reading 31: Introduction to Corporate Governance and Other ESG Considerations

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The candidate should be able to:

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 Corporate Governance is the overall construct within which a company is managed

Corporate Governance = Governance of a Corporate

 Good Practices in Corporate Governance

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I. Controlling and minority relationship:-

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 Basic features of an effective BOD

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The candidate should be able to:

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Why Capital Budgeting?

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Capital Budgeting (Process of identifying and evaluating Capital Projects):

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Step 1 Generating Ideas Raising Money is

Step 2 Analyzing Individual Proposals

Step 3 Planning the Capital Budget

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Different examples of Capital Projects:

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1. Mutually Exclusive Projects:

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 It is the time taken to recover the initial cost of an investment.

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Payback Period For A

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 AAR = Average net income / Average book value

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Initial Investment - 3,000; Cost of capital is 6%

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Demo of Calculator Keys (for project A):

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NPV Project A Project B

After Tax Cost of Capital NPV

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1. Evaluation of decisions is based on cash flows, not on the accounting income.

3. Evaluation is based on Incremental Cash Flows.

4. Timing of cash flows affects decisions because of time value of money.

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6. Sunk Costs do not play any role in Capital Budgeting –

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10. Role of Depreciation –