The board of directors is a mechanism to protect the interest of the shareholders against the managers who may otherwise seek private benefits in running the corporation. If the CEO (the management) at the same time serves as the chairman of the board, this structure will aggravate the conflicts of interest as the management may exert its own interests instead of the shareholder interests in the board meetings.
The conflicts between shareholders and debt-holders arise due to the different payoff structures and seniority of debt and equity. In the covenants, the debt-holders may specify the risk level of projects and details about payback arrangement beforehand.
Inclusion of a major shareholder on the board would reduce the conflicts of interest between the shareholders and the managers, because now the managers are being monitored by a board member who is at the same time a major shareholder.
When changes in signs leading to multiple IRR, none of these IRR can be used as the discount rate to make the capital budgeting decision, unless we use the modified IRR (MIRR) that handles the multiple IRR problem by combining cash flows until only one change in sign remains. Otherwise, the best criterion that we should use to make our decision of capital budgeting is the NPV criterion.
If there are multiple IRR we cannot use the IRR criterion. Instead we should use the NPV criterion to decide whether we should undertake the project or not.
NPV and IRR will not always lead to the same capital budgeting decision. Although both methods use identical cash flows, NPV assumes cash flows are reinvested at the given discount rate, while IRR assumes cash flows are reinvested at IRR.
When the scale of one project is smaller than the other, the IRR method yields results that are biased to. When the scales of projects are significantly different, we should use a modified version of the IRR method, or use the NPV rule. wards smaller scale project.
We would then benefit from choosing the project with a shorter payback period, to increase the liquidity and decrease the risk.
The payback period as a capital budgeting rule ignores the cash flows after the initial investment is paid off. It also ignores the time value of cash flows.
However, the cash flows afterwards should be considered when capital budgeting decisions need to be taken. In addition, cash flows should also be discounted to get their present value. Discounted payback period corrects for this drawback but still ignores the cash flows generated after initial investment is paid back.
PI = (Yr1 + Yr2 + Yr3) / Yr0 = 0.86. Reject the project because PI<1.
IRR =1/PB = C/I Accept the project of its IRR > Cost of Capital
Clearly when D/E decreases, βequity will decrease.
COST OF DEBT:
Market Value of Debt (1) = 4,000 * $1000 * 1.05 = $4,200,000
Market Value of Debt (1) = 1,000 * $1000 * 1.00 = $1,000,000
Market Value of Debt Outstanding = $4,200,000 + $1,000,000 = $5,200,000
Weight of Debt (1) = $4,200,000 / $5,200,000 = 0.82
Weight of Debt (2) = $1,000,000 / $5,200,000 = 0.18
Cost of Debt = 0.82*6% + 0.18*5% = 5.81%
WACC = share of debt * cost of debt * (1-T) + share of equity * cost of equity
A decrease in net working capital will lead to a cash inflow because it is added to operating cash flow in the computation of cash inflow.
An increase in accounts receivable will lead to cash outflow through the increase of net working capital that is in return subtracted from operating cash flow in the computation of free cash flow.
An increase in depreciation will lead to a cash inflow, through tax savings due to depreciation tax shield.
A decrease in the cost of goods sold