İŞLETME FİNANSI II - Deneme Sınavı - 9

Investment consists all kinds of spendings made for acquiring, sustaining, and increasing production factors.

In many textbooks, capital budgeting activity is explained as a process, consisting of a number of stages. Megginson et al. (2010) briefly explain this process in three basic steps:

Projects A and B are mutually exclusive. If the company pursues A, it cannot also afford to pursue B and vice versa.

If the company pursues A, it cannot also afford to pursue B and vice versa. Project C, however, is independent. Regardless of which other project is pursued, the company can still afford to pursue C as well. The acceptance of either A or B does not impact the viability of C, and the acceptance of C does not impact the viability of either of the other projects.

Contingent projects are the type of projects in which approval or rejection of a project is contingent on approval or rejection of another project.

Competitive advantage refers to a firm’s attribute that may allow the firm to generate economic profits.

Incremental cash flow refers to a change in a firm’s net cash flow attributable to an investment project.

Net present value of a project is the sum of present value of all cash inflaws and cash outflows of a project over its life.

Internal rate of return is the rate of return that causes the net present value of a project to be zero.

Effect of the exercise (strike) price of the option in stock options is the effect of the present value of the delayed capital expenditure of future cost savings in real options.

Bankruptcy risk refers to the likelihood that a company will be unable to meet its debt obligations.

The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt.

There are many factors affecting the business risk of a firm, however, to summarize we can cite the following:
• Shifts in the demand for the products/ services of the company. Higher volatility of demand for the products/services of the firm escalates the business risk.
• Fluctuations in the sales price due to market volatility. Firms operating in markets with high output price variations are prone to higher business risk.
• Changes in input costs. Uncertainty and excessive volatility in input costs raise the business risk.

• The cost structure of the company, especially the level of the fixed costs in total costs which are measured by the degree of operating leverage (DOL). If the DOL
is high, the firm will be exposed to higher business risk.
• The ability to adapt cost-effective measures to changes in both the input costs and output prices. Some firms can quickly implement cost-effective processes to adjust
to the fluctuations in input costs or output prices. This ability reduces the business risk faced by the company.

Financial leverage is an indicator of financial risk and occurs in case of borrowing

The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors.

Franco Modigliani and Merton Miller (MM) are the founders of modern capital structure theory. Their first article (1958) is one of the most influential studies in academia. MM’s study is based on the following assumptions:
1. Capital markets are perfect with rational investors that can freely buy and sell assets.
2. Investors have homogenous expectations.
3. There are no bankruptcy costs.
4. There are no taxes.
5. There are no transaction costs in financial asset trading.
6. Investors and companies can borrow at the same rate with no restrictions.
7. All investors can access the same information as the managers of a company without paying any information cost.
8. Operating income (EBIT) is not affected by the use of debt.
9. All earnings are distributed to stockholders as dividends (dividend payout ratio is 100%).
10. Well-informed investors have the option of arbitrage.

Not only bankruptcy, but the possibility of financial distress can also create problems leading to higher interest rates, contractions in credit purchases, employee jump ship and loss of customers. Therefore, financial distress or bankruptcy costs refrain firms from abundant debt financing. Especially firms with higher business risk should rely less on debt financing.

Asymmetric information occurs when one party from a financial transaction has different information than the other.

Agency theory suggests that agency problems may arise if managers (agents) pursue different objectives other than those of the shareholders (principals). Shareholders seek for wealth maximization which can be attained by the maximization of the value of the firm. However, managers often waste shareholders’ wealth by consuming perquisites or
investing in pet projects

Other factors that affect the capital structure are industry-specific factors, environment-specific factors, and firm-specific factors.