Question

1. Understand the drawback of using the payback period to compare projects?
   • What are the basics of all components of capital?
   • What are the cost of retained earnings and why they are not free?
   • Why do we adjust the cost of debt?

Answer 1

Solution 1) Drawbacks of Payback period:

1. Payback Period is not based upon the principle of the time value of money.  
2. Since it does not include the time value money effect, thus, it ignores the risk associated with the project.
3. It does not include the cash flows that occur after the payback period. Example: Consider two projects A and B below:

Time	t=0	t=1	t=2	t=3	t=4	t=5
Cash Flows (Project A)	-1000	300	200	500	500	600
Cash Flows (Project B)	-1000	0	0	0	0	10,000

As per the payback period method, Project A is preferred while Project B is more profitable.

1. The payback period does not measure profitability. It is a measure of how quickly the invested amount is recovered back from the investment. Thus, it has to be used along with NPV or IRR method.

Solution 2: Any instrument through which a firm raises the financing is known as a component of capital. The components of capital are considered into two broader types:

• Equity
• Debt

Debt: It is referred to the source of capital raised by borrowing. On this debt, the company pas interest along with the principal repayment. This interest forms the cost of debt. In this source of financing, there is no transfer of ownership and the borrower is legally bounded to pay for the interest as well as the principal repayment even in case of losses.

Equity: In equity financing, the capital is raised by issuing the shares and transferring the ownership. Thus in equity, capital is raised by selling the stakes and thus, dilution of ownership takes place. In this case, the company is not liable to repay the money. The equity shareholders receive the return in the form of share appreciation and dividends. Dividends are the shareholder's proportion in the company's profits.

Solution 3: Retained Earnings are the profits retained by the company and are not distributed to the shareholders in the form of dividends. The cost of retained earnings is defined as the cost incurred by the company for using the retained earnings. The cost of retained earnings is less as compared to the cost of issuing the new equity because no floatation cost is involved in raising the capital through the retained earnings.

While neither interest nor dividend is to be paid on retained earnings but still the retained earnings are not considered as free. This is because there are some opportunity costs that are associated with the retained earnings. If these retained earnings were not used, this would have to be paid to shareholders as dividends. Thus, the dividends could be used by shareholders to invest in other investments. hence, there is some opportunity cost associated with the retained earnings, hence, the cost of retained earnings is not free.  

Solution 4: Let’s assume that a company pays $20,000 in interest for a given year. The $20,000 is an expense that the company is allowed to recognize before calculating the taxable income.

Let's Earnings before interest and tax (EBIT) = $100000

EBIT	100000
Interest	20000
Profit before tax	80000
Tax Expense (Tax rate is 30%)	24000
Net Income	56000

Interest expense reduces the company’s profits before tax by $20,000, and assuming a 30% tax rate, reduces profits after tax by only $14,000. This is because interest expense provides a tax shield of $6,000.

Tax shield = Interest expense * tax rate ($20,000 x 30% = 6,000).

Adjusting for the interest tax shield, the real after-tax cost of debt for the company is not really $20,000, but only $14,000. Tax savings are only realized on payments to holders of debt instruments.