Differences between capital budgeting decisions and capital structure decisions

Sample Solution

Exercise 1

Capital Budgeting vs. Capital Structure

• Capital Budgeting Decisions: These decisions involve allocating financial resources to long-term investments like new equipment, buildings, or product development. The goal is to select projects that maximize shareholder value by considering factors like expected cash flows, risk, and the project's impact on the company's future.

• Capital Structure Decisions: These decisions focus on the mix of financing sources a company uses, such as debt (bonds, loans) and equity (common stock, retained earnings). The objective is to find a balance that minimizes the company's overall cost of capital while maintaining financial stability.

Operating Lease vs. Capital Lease

• Operating Lease: Similar to renting, an operating lease allows a company to use an asset for a specific period without ownership. Lease payments are considered operating expenses and don't appear on the company's balance sheet as liabilities.

• Capital Lease: This type of lease functions more like a loan. The asset is effectively considered owned by the company on its balance sheet, and the lease obligation is recorded as a liability. Capital leases impact financial ratios and debt levels more significantly than operating leases.

Exercise 2

Assuming equal value of company and total assets:

Unfortunately, the information provided (balance sheet of ABC Ltd.) is missing for this exercise. However, we can still explain the concepts:

1. Par Value: This is the face value of a share of stock as stated in the company's charter. It might not reflect the actual market price.
2. Market Value: This is the current price at which a share is traded in the stock market.

Full Answer Section

Dividends and Share Repurchases:

We'll need the balance sheet to provide specific figures, but here's the general impact:

2. Dividend Payment:

• Total assets and shareholders' equity will decrease by $200,000.
• Par value remains unchanged, but market value might decrease depending on investor perception of the dividend.

3. Stock Repurchase:

• Total assets (cash) will decrease by $200,000.
• Shareholders' equity (retained earnings) will decrease by $200,000.
• The number of outstanding shares will decrease, potentially increasing the market value per share remaining.

Exercise 3

Rights Offering:

1. New Market Value:

   • Before: 300,000 shares * $20/share = $6,000,000
   • After: ($6,000,000 existing + 20,000 * $15) = $9,000,000 (assuming full subscription)

2. Ex-Rights Price:

   • This is the theoretical price of a share after the rights are detached and traded separately. Due to calculations involved, financial calculators or software are typically used.

3. Value of a Right:

   • This is the difference between the pre-rights offering price and the ex-rights price. It represents the value of the right to purchase additional shares at a discount.

Exercise 4

WACC (Weighted Average Cost of Capital):

This represents the overall cost of capital a company uses to finance its operations. Here's how to calculate it for BIGCO:

1. Cost of Equity (Ke):

   We can use the Capital Asset Pricing Model (CAPM):

   • Ke = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)
   • Ke = 4% + 1.2 * (6.5% - 4%) = 8.2%

2. Cost of Debt (Kd):

   • Kd = Coupon Rate * (1 - Tax Rate) = 6.5% * (1 - 0.25) = 4.875%

3. Weight of Equity (We):

   We need the total value of debt and equity to calculate weights accurately (missing from the provided information). Let's assume total equity (E) is 25 million € and total debt (D) is 75 million € (based on total assets and equity figures).

   • We = E / (E + D) = 25 / (25 + 75) = 0.25

4. Weight of Debt (Wd):

   • Wd = D / (E + D) = 75 / (25 + 75) = 0.75

5. WACC:

   • WACC = (We * Ke) + (Wd * Kd)