Capital budgeting is the process used by companies to determine and authorize capital spending on projects that require substantial capital investments or long-term projects (Bennouna, Meredith & Marchant, 2010). Mostly, cash flows are used in capital budgeting analysis instead of net income calculated using the accrual basis. Moreover, the cash flow calculation may be simplified to net income added to depreciation and amortization, or the estimated cash inflows from customers, gains from sale of assets and their salvage value, reduced costs, and cash outflows spend on capital investments, future repairs, equipment overhaul, interest and operating costs. The techniques used for capital budgeting are; payback period, internal rate of return, annual rate of return, net present value and profitability index (Bennouna et al., 2010)
AT&T Inc. is the second largest mobile telephone provider in the United States, with over 118.7 million subscribers. The corporation is listed at the NYSE and in 2013, it grew a revenue of $128.8 billion and made $34.8 billion in cash from its operations as well as $7 billion more from non-strategic asset disposal (AT&T, 2014).
Suppose AT&T wants to acquire communication equipment worth $150,000, which is expected to last for 7 years with a salvage value of $5000. The annual cash inflows are estimated at $250,000 while the cash outflows, 200,000. The payback period, PBP measures the time it would take a company to recover in cash its initial invested amount from a project. It is calculated by dividing the capital invested on the project by the net annual cash flows the project would generate (Bennouna et al., 2010). In case of unequal net annual cash inflows, the average of those inflows is used. PBP = capital investment/net average annual cash flow. Thus, 150,000/ (250,000 – 200000) = 3 years. The project should be accepted since it returns the investment in half its life time.
The internal rate of return, IRR is used to determine the interest yield of the intended capital project at which the net present value, NPV equals zero, whereby the net cash inflows’ present value equals the initial investment (Bennouna et al., 2010). If greater than the required rate of return, then the project is accepted. To determine the IRR, first the IRR factor is calculated, = proposed capital investment amount/net annual cash inflow. Then the factor is found in the present value of annuity of 1 with project life and number of periods on the table. Hence AT&T’s project will have an IRR of; 200,000/50,000 = 4 (factor), using the table on the seventh period, the IRR is 16%. Since the IRR is greater than the company’s rate of return of 7.75%, the project should be funded (AT&T, 2014).
The annual rate of return, ARR calculates a project’s expected profitability using accrual-based net income. The annual rate of return is a percentage that is compared to the required rate of return expected by the company (Bennouna et al., 2010). If the ARR is greater than the required rate of return, the project is accepted though the higher the ARR the higher the acceptability of the project. ARR = estimated annual income/average investment. Assuming that the project invested at $150,000 with a salvage value of $5,000 is expected to make an annual net income of $5,572, then the ARR would be 5.572/77,500 = 7.2%, thus the project should not be chosen as it is lower than the 7.75% rate of return.
Mutual funds pool investors’ money and invests it in bonds, stocks and money market instruments and securities. The owner of the mutual fund unit realizes a proportional share of the gains, income, expenses and losses. When investing in a mutual fund, one should choose that which has a track record of optimizing returns while minimizing risk to deliver the best possible combination of total return on investment and low volatility.
Mutual funds offer investors diversification of risk across assets based on their investment needs. They are also highly liquid, such that investors can sell their mutual fund on any business day and realize the current value on their investment. Moreover, mutual funds are convenient in terms of automatic withdrawal and periodic purchase plans, in addition to automatic reinvestment of dividends and interest. Tax is exempt on all income from mutual fund dividends. It would be worthwhile to invest in balanced funds as they invest a mix of equities and fixed income securities to minimize the risk and maximize returns. These funds split money among the diverse investments whether aggressive or conservative. Aggressive funds incorporate more equities than bonds while the conservative ones hold more bonds than equities.
An investor would benefit on investing in Eaton Vance tax-managed equity asset allocation A which incorporates a minimum of 65 percent of its assets on domestic tax manage equities, a maximum of 25 percent in tax-managed securities in small-cap or emerging firms. Moreover, this fund stipulates a maximum of 35 percent of its assets in foreign equities. The fund is reported to have returned 20.1 percent over the 2013 year period thus proving attractive to investors.
The weighted average cost of capital, WACC is the average interest rate a company is supposed to pay to finance its assets. It is actually the minimum average rate of return a company must earn on the current assets to satisfy the shareholders, creditors and investors (Bierman & Smidt, 2012). Moreover, it is based on company’s capital structure and be a combination of more than financing source, for instance, equity or debt finance.
The effective rate a company pays for its total debt is the cost of its debt, COD. It gives the investor an analysis of the riskiness of the company (Bierman & Smidt, 2012). This is because the higher it is, the higher the risk. AT&T’s cost of debt before tax = corporate bond rate of AT&T’s bond rating (AT&T, 2014).
AT&T, 2.5% = AT&T’s bonds “A- outlook stable” = 2.5% therefore the COD as of 5th February 2014 is 2.5%. The current tax rate is 22.77% thus the COD after tax = (COD before tax) (1-tax rate) = 0.025*(1-0.2277) = 1.93%. The cost of equity = risk free rate + Beta equity (Average market return – risk free rate). The risk free rate is same as U.S. 10 year bond = 2.70 percent, while the average market return is 7 percent, and the AT&T’s Beta = 0.48. The risk free rate is thus 2.70 + 0.48 (7-2.70) = 4.76%.
In calculating the weighted average cost of capital, WACC, common stock, preferred stock, bonds and all long-term debt is included (Bierman & Smidt, 2012). Moreover, as the WACC, Beta and return on equity go up, valuation decreases while risk increases. For AT&T, the tax rate= 22.77%, COD before tax = 2.5%, cost of equity = 4.76%, the total liabilities (debt) for 2013 = $186.305 billion, stock price for February 2014 = $31.94, and the outstanding shares = 5.283 billion (AT&T, 2014).
Equity = (price of the stock)*(outstanding shares) = $168.739 billion, debt + equity = $355.044 billion hence the WACC = (1 – tax rate)* debt (D/D+E) + equity (E/D+E) = (1 – 0.2277)* 0.025 (186.305/355.044) + 0.0476 (167.046/355.044) = 3.25%. This means that for every dollar AT&T finances, it pays 3.25% thus it must make 0.0325 dollars in addition to the cost of the investment for such an investment to be feasible.