Capital Budgeting

Approaches:

Common Assumptions:

1. All investers has similar expectation.

2. Markets are perfect and efficient so there will be no transaction and information cost.

3.  The firm's cost of capital is constant over time and is not affected by the amount of funds          invested in capital projects

4. All projects have same degree of risk as the firm overall

5. Management must set benchmarks for the evaluation of capital expenditure

    eg: pay back period, Rate of return

6. Investement opportunities are independent of each other.

7. Borrowing and lending rates are equal.

There are 4 approaches to evaluate the Capital Budget.

1. Net Income Approach (commercial real estate)

2. Net Operating Approach

3. Traditional approach

4. Miller and Modigliani's approach.

 Net Income Approach

 The net income approach makes the simplest assumptions, that neither creditors nor investors increase their required rates of return as a company takes on debt. The cost of capital declines as higher-cost equity is replaced with lower-cost debt. This approach concludes that the optimal financing mix is all debt.

 Assumptions:

      * Change in Capital structure does not make any change in business risk of company and there is no    

             financial risk

 implications: 

                a. Cost of debit and cost of equity in a given risk class will remain constant and not affected by change in capital structure.

              ===> i. For a zero debt firm, cost of equity and overall capital is same

         Ke= Ko

             ===> As company introduces more and more debt in its capital structure, the overall cost of capital decreases at decreasing rate so the value of firm increases.

     

 Net Operating Approach

The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mix¾any mix is as good as any other.

Assumptions:  

  1. Cost of debt remain constant with change in d/e ratio.

  2. cost of equtiy increases with increase of Debt capital structure.

3. Overall cost of capital remain  constant.

   Implications:

   =====>i. for Zero debt company  Ke= Ko

  =====>ii. In a given risk category, firms with different capital structure will have same cost of debt and 

cost of captial

Traditional Approach

 The traditional approach assumes that both creditors and investors increase their required rates of return as a company takes on debt. At first this increase is small, and the weighting toward lower-cost debt pushes the cost of capital down. Eventually, the rate at which creditors and investors increase their required rates of return accelerates and dominates the weighting toward debt, pushing the cost of capital back upward. The result is that the cost of capital declines with debt and reaches a minimum point before rising again. This approach concludes that there is a optimal financing mix consisting of some debt and some equity.

Assumptions:

1. When a capital structure is changed cost of debt and cost of equity change. At loc D/E ratio cost of debt and equity are relatively low.

As more the debt is introduced, the cost of debt, cost of equity will rise.

Cost of debt increases at marginal stage initially but after it will start rising fast. Ke also increases at increasing rate.

===> Initial stages althrough individual ke and Kd marginally increase, then Ko starts increasing. As more debt is inroduces, the Ko tends to decline to certain stage after which it starts increasing. According to traditional approach there is an optimum capital structure.

Miller and Modigliani's Approach

A financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing or spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets much more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.

It explains from behavioural point of view of stand taken by Net operation approache. ie,, change in capital will not affect value of firm.

Assumptions

1. Security can be purchased

2. Markets are competative.

3. no transaction and info cost.

4. All have homogeneous expectations.

5. No cost of rising.

6. Fund can change captial structure without additional cost.

7. Individual invester can be at same cost at corporate standard.