Capital Structure

Financial decision-makers must find answers to important questions, including;

* What long-term investments should the firm undertake (capital budgeting) and how will investment and finance decisions affect the firm's value (valuation)?

* How can cash be raised for the required investments? This is known as the 'financing decision' (cost of capital, capital structure and leasing).

* How will the firm manage its day-to-day cash and financial affairs (short-term financing and net working capital)?

The Capital Budgeting Mini Case presents a financial decision of acquiring another corporation. Two choices are available; Corporation A and Corporation B, the cost of each choice is $250,000, and acquiring both corporations is not an option. The primary goal of any company is to create value for its shareholders and as such, the most important job of the financial manager is to create value from the company's capital budgeting,

Financial managers must be particularly aware of the timing of cash flows (the 'time value of money') and associated risks. This financial decision-maker will use projected cash flows to determine whether acquiring Corporation A or Corporation B (i.e. NPV and IRR) is the best choice. If acquisition does not generate positive cash flow, the company is effectively providing finance for the acquired corporation.

Capital Budgeting Decisions

Many business opportunities involve sacrificing current earnings for future profits (opportunity cost). For the acquisition to be worth pursuing, it must generate a higher rate of return than what could be earned in the capital markets (Jaffe et al., 2002:200). When assessing capital budgeting projects, financial decision makers typically use discounted cash flow methods such as Net Present Value (NPV) or Internal Rate of Return (IRR).

Net Present Value (NPV)

The most commonly used technique for financial decision making is Net Present Value (NPV) analysis. NPV is the present value of future cash returns, discounted at the appropriate market interest rate, minus the present value of the cost of investment. NPV includes the current cost of the investment in determining its value and not simply what it will return. The NPV rule that should be used by decision-makers is that an investment is worth making if it has a positive NPV and should be rejected if it has a negative NPV. An investment with a positive NPV is worth undertaking because doing so is essentially the same as receiving cash payments equal to the NPV (Jaffe et al., 2002:59,926).

Using the discount rate as the required rate of return, the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows. A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC)

NPV = PVB - PVC

To calculate the NPV (Net Present Value), I discounted the cash flow at discount rate of 10% for Corporation A and a discount rate of 11% for Corporation B. By using the discount rate I conducted a test to see if the project is expected to earn our minimum desired rate of return. Here are my decision rules:

If the NPV is: Benefits vs. Costs Should we expect to earn at least

our minimum rate of return? Accept the

investment?

Positive Benefits > Costs Yes, more than Accept

Zero Benefits = Costs Exactly equal to Indifferent

Negative Benefits < Costs No, less than Reject

In the Capital Budgeting Mini Case, Corporation A's NPV is equal to 20,979 and Corporation B's NPV is equal to 40,252. Corporation B is the better selection because:

(1) The benefits are greater than the costs

(2) Expect to earn at least the minimum rate of return and more

Whilst, Jaffe et al. (2002:140,157) argue that "the NPV approach is the best one for evaluating capital budgeting projects" alternative methods exist, of which the Internal Rate of Return (IRR) method has "redeemable qualities". IRR is the rate at which the NPV of the project is equal to zero and investment decision becomes "accept the project if IRR is greater than the discount rate, [and] reject the project if IRR is less than the discount rate" (Jaffe et al., 2002:147). Jaffe et al. (2002:146) argues that IRR is the "most important alternative to the NPV approach", because it is independent of the prevailing capital market interest rate in its attempt to resolve an internal (or intrinsic) rate that is dependent only on the cash flows from the project.

Internal Rate of Return (IRR)

Importantly, IRR is a method for determining value that does not depend on the determination of a discount rate. This method requires the calculation of a discount rate such that the discounted value of future cost-benefit flows exactly equals the initial investment. Dean (1951 in Smith, 1986:8) recommends that the company make investment decisions by "looking to the capital markets for the firm's cost of capital, accepting each project with an internal rate of return and exceeds this market-determined cost of capital". As such, to apply the IRR reference must be made to the discount rate in order to arrive at a decision.

Theoretically, the NPV and IRR techniques arrive at the same investment decision and an investor can be indifferent as to which method is used. NPV is positive for discount rates below the IRR and negative for projects above the IRR. As such, the IRR rule coincides with the NPV rule and if a company accepts projects when the discount rate is less then the IRR, the company will simultaneously be accepting positive NPV projects and vice versa (Jaffe et al., 2002:149).

Under normal circumstances (where the initial outflows of an independent project are followed by a series of inflows), IRR always reaches the same conclusion as NPV. However, several problems occur with the IRR approach in more complicated, real world situations. Although rare, some projects have large initial cash inflows followed by a series of outflows (i.e. advanced bookings for a future service) and are functionally equivalent to borrowing.