Capital budgeting
Weighted average cost of capital is the least rate of return that investors expect. It is computed by obtaining the component cost of each source of capital which is then multiplied by the weight or the proportion of the source of capital in the whole capital structure. The weighted capital component costs are added to obtain the WACC. WACC is used as the discounting rate of projects to determine the NPV of an investment project. A positive NPV will be obtained if the rate of return on an investment is higher than the weighted average cost of capital. This implies the company is able to settle claims of all debt holders while increasing the wealth of shareholders. In a case where the WACC is lower than the rate of return on a project, NPV of the project is expected to be negative. The company will not be able to satisfy claims of debt holders.
In this scenario, the WACC is 15% while the yield on the 10 year treasury notes is 8.5%. Investing $ 50 million in the treasury notes will result in a negative NPV because the rate of return of 8.5% is lower than the weighted average cost of capital of 15%. Therefore, it will not be prudent to invest the $50 million in treasury notes since the company may face liquidity problems and potential bankruptcy in future. However, investing in treasury notes is a less risk investment with certainty in returns compared to typical investment projects. The treasurer could therefore invest part of the $ 50 million in treasury notes and the rest of it in risky projects that are likely to have higher returns. The risk of uncertainty in returns of the risky projects will be hedged by the investment in treasury notes which are relatively risk free .
NPV = (14,000 x PVIFA 10%, 5 years+27,000XPVIF10%,10 years)- Initial Investment
Initial Investment = NPV + (14,000 x PVIFA 10%, 5 years+27,000XPVIF10%, 10 years)
Initial Investment = 0 + 14,000*3.7908 + 27,000*0.5645 = $ 68,312.7
Depreciation tax shield can be defined as the cash savings by companies on investment income on tax paid by utilizing depreciation deductions. Although depreciation is a non cash flow expense it is an allowable deduction for tax purposes. Deducting depreciation from income results reduces the taxable income and subsequently the tax that would accrue from the investment income. The higher the deprecation tax shield the higher the saving. The depreciation tax shield benefit depends on the depreciation expense and the income or corporate tax rate. Financial managers are normally interested in cash flow items only however depreciation is a non-cash flow expense. Therefore, the common practice among financial managers is to deduct depreciation and add it back after computing the tax that would accrue so as to minimize cash outflows in form of income taxes .
Depreciation tax shield benefit represents a reduction in the tax paid by a company on project. In case an investment project is subject to taxes, without depreciation, the company would have a lower Net Present Value since none of its income will be shielded from tax. Tax is cash out flow which reduces the Net present value of a project. Therefore, if there were no taxes, projects would have a higher Net Present Value. The increase in the NPV would be equal to the tax that would have been paid on the project. However, without taxes depreciation tax shield will be irrelevant since the company will not need to shield any portion of its income from taxes to reduce cash outflow in form of taxes. In such a case where there are no taxes depreciation is completely ignored by financial managers.
References
Damodaran, A. (2010). Applied Corporate Finance (3, illustrated ed.). New York: John Wiley and Sons.
Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2004). Corporate financial management (2, illustrated ed.). New Jersey: Prentice Hall.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (2, illustrated ed.). New York: SAGE.
