Key Concepts in Corporate Finance and Investment

Posted on Dec 22, 2024 in Economy

1. Capital Budgeting

Capital budgeting is the process by which a business evaluates and selects long-term investment projects to determine their profitability and alignment with the firm’s strategic objectives. This involves estimating future cash flows, assessing risks, and deciding whether the investment is worthwhile.

Characteristics of capital budgeting:

  • Long-term focus: It involves decisions about projects or assets that generate returns over several years.
  • Large capital outlays: Significant financial resources are usually required.
  • Irreversible decisions: Capital budgeting decisions are often difficult or costly to reverse.
  • Risk and uncertainty: Long-term investments involve greater risk due to unpredictable future conditions.
  • Impact on profitability and growth: Decisions affect a firm’s profitability, growth, and competitive position.

2. Cost of Capital and Investor Returns

A firm’s cost of capital represents the minimum return it must earn on its investments to satisfy its financing sources (debt and equity holders). It is closely related to investors’ required rates of return, as follows:

  • The cost of equity reflects the return equity investors demand.
  • The cost of debt reflects the return required by lenders.

A firm’s weighted average cost of capital (WACC) is a combination of the cost of equity and debt, weighted by their proportions in the capital structure. WACC must meet or exceed investors’ required rates of return to maintain their confidence and attract further investments.

3. Understanding Bond Ratings

Bond ratings are assessments of a bond issuer’s creditworthiness, provided by rating agencies such as Standard & Poor’s, Moody’s, or Fitch. These ratings indicate the likelihood of timely repayment of interest and principal and reflect the bond’s risk level.

Categories:

  • Investment-grade bonds (e.g., AAA, AA, A, BBB): Low risk, suitable for risk-averse investors.
  • Speculative-grade or junk bonds (e.g., BB, B, CCC): Higher risk but offer higher potential returns.

4. Zero-Coupon Bonds as Investments

A zero-coupon bond does not pay periodic interest but is sold at a deep discount to its face value. An investor might find it attractive because:

  • Predictable returns: They know the exact amount they will receive at maturity.
  • High growth potential: It allows investors to accumulate wealth as the bond appreciates in value over time.
  • Tax planning: Interest accrues but is not received until maturity, which may help defer taxes for some investors (depending on tax jurisdiction).
  • Portfolio diversification: It provides a different risk-return profile compared to traditional coupon-paying bonds.

5. Degree of Combined Leverage Explained

The degree of combined leverage (DCL) measures the sensitivity of a firm’s earnings per share (EPS) to changes in sales revenue. It combines the effects of both operating leverage (fixed costs) and financial leverage (interest costs), showing the cumulative risk associated with the firm’s cost structure.

Formula:

DCL = DOL * DFL

Where:

  • DOL (Degree of Operating Leverage): Sensitivity of operating income to sales changes.
  • DFL (Degree of Financial Leverage): Sensitivity of EPS to operating income changes.

6. Business Risk and Leverage in Income

Business risk: Arises from the inherent variability in operating income due to factors such as market demand, competition, and cost structure. It is reflected in the volatility of operating income (EBIT).

Operating leverage: Refers to the use of fixed costs in a firm’s operations. A high proportion of fixed costs amplifies changes in operating income for a given change in sales, increasing business risk.

Financial leverage: Refers to the use of debt in the capital structure. Higher debt levels increase interest expense, making net income and EPS more sensitive to changes in operating income.

7. Combined Leverage: Linking Income and EPS

Combined leverage links operating leverage and financial leverage, illustrating the compounding effect of fixed operating and financing costs on earnings per share (EPS).

  • Operating leverage magnifies changes in sales into larger proportional changes in operating income (EBIT).
  • Financial leverage further magnifies these changes in EBIT into larger proportional changes in EPS due to fixed interest costs.

This combined effect means that small changes in sales can result in significant fluctuations in EPS, highlighting the firm’s overall risk exposure.

8. Net Present Value and Project Selection

The Net Present Value (NPV) of a project is the sum of the present values of all cash inflows and outflows associated with the project, discounted at the firm’s cost of capital.

Formula:

NPV = ∑ (Cash Inflows – Cash Outflows) / (1 + r)^t – Initial Investment

Where r is the discount rate (cost of capital) and t is time.

Usage in decision-making:

  • If NPV > 0, the project adds value and should be accepted.
  • If NPV < 0, the project decreases value and should be rejected.
  • When comparing multiple projects, the one with the highest positive NPV is typically preferred, as it provides the greatest increase in shareholder wealth.