Dr. NICHOLAS WATSON

Capital Budgeting

 

This week's presentation will focus on Week 5 outline.  It will include: Investing in Capital Asset • Net Present Value and Other  • Making Capital Investment Decision  • The Modigliani and Miller irrelevance proposition.

 

Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented:

• Payback Period

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

A Capital Budgeting decision rule should satisfy the following criteria:

• Must consider all of the project's cash flows.

• Must consider the Time Value of Money

• Must always lead to the correct decision when choosing among Mutually Exclusive Projects.

 

GO HERE TO READ FURTHER AND THEN WATCH VIDEO ONE BELOW.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

TAKE  A FIVE MINUTE BREAK BEFORE MOVING TO VIDEO 2!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

THE FINAL VIDEO ON CAPITAL BUDGETING IS BELOW.  IF YOU NEED A BREAK PLEASE TAKE IT NOW!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Modigliani and Miller irrelevance proposition 
 

Financial Leverage And Capital Structure Policy - Modigliani And Miller's Capital Structure Theories

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs.

Modigliani and Miller's Tradeoff Theory of Leverage
The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments - that is, because interest paid on debt is tax deductible, issuing bonds effectively reduces a company's tax liability. Paying dividends on equity, however, does not. Thought of another way, the actual rate of interest companies pay on the bonds they issue is less than the nominal rate of interest because of the tax savings. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.

In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure, which comes from the tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes, and thus the tax benefit of interest payments, are recognized. watch summay below.