Risk and return relationship in capital budgeting computations

Capital Budgeting Techniques, Importance and Example

Capital budgeting is really important when making important business decisions. Capital Cost Allowance And Depreciation; Cash Flow And Relationships Between Capital Market History; Return, Risk And The Security Market Line . Another type of project for which a basic IRR calculation is ineffective is a . Learn about: capital budgeting model, risk return relationship, cost of capital calculation, components of the cost of capital, calculating the. An understanding of the importance of capital budgeting in marketing and calculation of net present value and internal rate of return in decision making the risk, hence the return must be commensurate with the risk being undertaken.

Preferred stock stands at a midway point between debt and common stock.

Risk and Return

The main feature shared by all kinds of preferred stock is that, under the tax laws, interest payments are treated as dividends instead of interest expense, which means that these payments are not tax deductible.

This is a key issue, for it greatly increases the cost of funds for any company using this funding source. By way of comparison, if a company has a choice between issuing debt or preferred stock at the same rate, the difference in cost will be the tax savings on the debt.

The most difficult cost of funding to calculate by far is common stock, because there is no preset payment from which to derive a cost. One way to determine its cost is the capital asset pricing model CAPM. This model derives the cost of common stock by determining the relative risk of holding the stock of a specific company as compared to a mix of all stocks in the market.

This risk is composed of three elements: The first is the return that any investor can expect from a risk-free investment, which usually is defined as the return on a government security. The second element is the return from a set of securities considered to have an average level of risk. This information is provided by several of the major investment services, such as Value Line.

A beta of 1. When combined, this information yields the baseline return to be expected on any investment the risk-free returnplus an added return that is based on the level of risk that an investor is assuming by purchasing a specific stock. The calculation of the equity cost of capital using the CAPM methodology is relatively simple, once all components of the equation are available.

  • Capital Budgeting: Techniques & Importance

This section is structured in an example format, showing the method by which the weighted cost of capital of the Royal Bali Cemerlang Corporation is calculated. There are two debt offerings on the books: The company must pay interest of 8. The interest rate on this debt is 10 percent. The risk-free rate of interest, as defined by the return on current government securities, is 6 percent, while the return expected from a typical market basket of related stocks is 12 percent.

The method we will use is to separate the percentage cost of each form of funding and then calculate the weighted cost of capital, based on the amount of funding and percentage cost of each of the above forms of funding. The marginal income tax rate is 35 percent. Accounting rate of return method ARR: This method helps to overcome the disadvantages of the payback period method.

The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.

This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared.

Course: BUS Principles of Finance, Topic: Unit 4: Risk and Return

This technique takes into account the interest factor and the return after the payback period. This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate.

The present values of the cash inflow are compared to the original investment. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task.

BUS202: Principles of Finance

The equation for the net present value, assuming that all cash outflows are made in the initial year tgwill be: It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known. This is defined as the rate at which the net present value of the investment is zero.

The discounted cash inflow is equal to the discounted cash outflow.