Capital Budgeting

Bonds (8 questions)

Companies often raise capital by issuing bonds. A bond is a specific type of loan where the company only makes interest payments at the end of each period. The principal remains the same throughout the bond period and is only paid upon maturity. From the company’s perspective, the cash-flow associated with a bond is illustrated below:

• M: Face value (or par value). The price at which the bond is sold to investors when it was initially issued. This is also the amount that is redeemed upon maturity.

• C: Coupon. Amount paid at the end of each period (i.e., interest).

• N: Number of periods until maturity.

Shares (6 questions)

A company can also raise capital by issuing new shares to allow investors to be co-owners of the company. Investing in the shares of a company is risky since returns are not guaranteed and losses are possible.

Cost of capital (8 questions)

A company may obtain capital by issuing both bonds and shares. Here, we look at how the cost of obtaining this capital can be computed and used to determine if a company should undertake a project or not.

Suppose the company obtained $4 million by issuing $3 million worth of bonds and $1 million worth of shares. The bonds pay 4% annual coupon payments. Assume that investors are able to get 2% returns on their investments risk free, the overall stock market is expected to generate 10% returns on investments and β_S = 0.5 for this company. Tax rate is 17%.

Capital allocation (4 questions)

Previously we have seen that for individual projects, a project should only be undertaken if its present value is greater than 0. Here, we consider the setting where the company has a fixed budget to undertake multiple projects. In particular, we are interested in obtaining a portfolio of projects that maximizes total present value. In this section, we review the equations that are associated with this problem.

For simplicity, we assume that all projects only require capital investments at period 0 and generate positive cash flows from period 1 onwards. Assume that there are N possible projects to select from. Let B_j denote the present value of project j, C_j denote the capital investment required for project j and C denote the total budget available. In addition, let X_j denote a binary variable such that X_j = 0 if project j is not undertaken and X_j = 1 if project j is undertaken.