Explain the following: What are the redeeming qualities and shortcomings of the

Question

Explain the following:

What are the redeeming qualities and shortcomings of the internal rate of return (IRR) method in capital budgeting analysis?

Explain in detail what the weighted average cost of capital (WACC) is and the role it plays in capital budgeting.

Explain why the opportunity cost and net working capital (NWC) are included, while the financing costs and sunk costs are NOT in the cash flow analysis.

What are flotation costs and why they must be included in the initial cost of a project? Explain in detail.

Tell me the differences between the standard deviation and beta in the measurement of risk in the capital market.

Explanation / Answer

The Internal Rate of Return
The IRR, or internal rate of return, is defined as the discount rate that makes NPV = 0. Like the NPV process, it starts by identifying all cash inflows and outflows. However, instead of relying on external data (i.e. a discount rate), the IRR is purely a function of the inflows and outflows of that project. The IRR rule states that projects or investments are accepted when the project's IRR exceeds a hurdle rate. Depending on the application, the hurdle rate may be defined as the weighted average cost of capital.

Example:
Suppose that a project costs $10 million today, and will provide a $15 million payoff three years from now, we use the FV of a single-sum formula and solve for r to compute the IRR.

IRR = (FV/PV)1/N -1 = (15 million/10 million)1/3 - 1 = (1.5) 1/3 - 1 = (1.1447) - 1 = 0.1447, or 14.47%

In this case, as long as our hurdle rate is less than 14.47%, we green light the project

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summed:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project.

There are several components that must be identified when looking at incremental cash flows: the initial outlay, cash flows from taking on the project, terminal cost (or value) and the scale and timing of the project. A positive incremental cash flow is a good indication that an organization should spend some time and money investing in the project.

Incremental Cash Flow and Capital Budgeting
When determining incremental cash flows from a new project, several problems arise: sunk costs, opportunity costs, externalities and cannibalization.

1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and should not be considered when making capital-budgeting decisions.

Suppose Newco is considering whether to make an addition to its current plant to increase production. To determine if the new addition is worthwhile, Newco hired a consulting firm for $50,000 to analyze the addition and the effect it will have on production. The $50,000 is considered a sunk cost. If the project is rejected, the $50,000 will still be paid, and if the project is accepted, the $50,000 will not affect the future cash flows of the addition.

2. Opportunity Cost
This is the cost of not going forward with a project or the cash outflows that will not be earned as a result of utilizing an asset for another alternative. For example, the opportunity cost of Newco's new addition considered above is the cost of the land on which the company is considering putting the new plant addition. As such, it should be included in the analysis of the project.

3. Externality
In the consideration of incremental cash flows of a new project, there may be effects on the existing operations of the company to consider, known as "externalities." For example, the addition to Newco's plant is for the purpose of producing a new product. It must be considered whether the new product may actually take away or add to sales of the existing product.

4. Cannibalization
Cannibalization is the type of externality where the new project takes sales away from the existing product.

What is a 'Flotation Cost'

Flotation costs are incurred by a publicly traded company when it issues new securities, and includes expenses such as underwriting fees, legal fees and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from a new issue. Flotation costs, expected return on equity, dividend payments and the percentage of earnings the company expects to retain are all part of the equation to calculate a company's cost of new equity.

BREAKING DOWN 'Flotation Cost'

Companies raise capital in two ways: bonds and loans or equity. Some companies prefer issuing bonds or obtaining a loan, especially when interest rates are low. Other companies prefer equity because it does not need to be paid back. That said, there is a significant cost of equity, especially new equity. The cost of new equity, or newly issued common stock, includes the costs associated with raising new equity, such as investment banking and legal fees. The difference between the cost of equity and the cost of new equity is the flotation cost. The flotation cost is a percentage of the issue price and is incorporated into the price with a reduction.

Calculating the Cost of Float in New Equity

The equation for calculating the cost of new equity using the dividend growth rate is:

(Dividend / (Price * (1-Flotation Cost) ) + Growth Rate

Dividend = the dividend in the next period

Price = the issue price of one share of stock

Flotation Cost = the ratio of flotation cost to the price

Growth Rate = the dividend growth rate.

What is 'Standard Deviation'

Standard deviation is a measure of the dispersion of a set of data from its mean; more spread-apart data has a higher deviation. Standard deviation is calculated as the square root of variance. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility.

BREAKING DOWN 'Standard Deviation'

Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock has a high standard deviation, while the deviation of a stable blue-chip stock is lower. A large dispersion indicates how much the return on the fund is deviating from the expected normal returns.

Investment firms report the standard deviation of their mutual funds and other products. In the finance industry, standard deviation is one of the key fundamental risk measures that analysts, portfolio managers, wealth advisors and financial planners use. Also, because it is easy to understand, this statistic is often reported to the end clients and investors on a regular basis.

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