Projects and Their
Valuation
The Cost of Capital, Capital Budgeting
Lecture # 4
The Cost of Capital
Capital Components
• Capital components are sources of funding that come from investors.
• Accounts payable, accruals, and deferred taxes are not sources of
funding that come from investors, so they are not included in the
calculation of the cost of capital.
• We do adjust for these items when calculating the cash flows of a
project, but not when calculating the cost of capital.
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Historical (Embedded) Costs vs.
New (Marginal) Costs
• The cost of capital is used primarily to make decisions which involve
raising and investing new capital.
• So, we should focus on marginal costs.
What types of long-term capital do firms use?
• Long-term debt
• Preferred stock
• Common equity
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Cost of Debt
• Method 1: Ask an investment banker what the coupon rate would be
on new debt.
• Method 2: Find the bond rating for the company and use the yield on
other bonds with a similar rating.
• Method 3: Find the yield on the company’s debt, if it has any.
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Cost of Debt
• The required rate of return on investment of the lenders of a company
• We ignore accounts payable, accrued expenses, and other obligations not
having an explicit interest cost
• The after-tax cost of debt can be denoted as:
Example: If we assume that MicroDrive’s marginal federal-plus-state tax
rate is 40% and 9% interest rate is offered by a bank, then its after-tax cost
of debt is will be?
Cost of Preferred Stock
• Cost of preferred stock (capital): The required rate of return on
investment of the preferred shareholders of the company
• The cost of preferred stock is a function of its stated dividend
• Most corporations that issue preferred stock fully intend to pay the
stated dividend
• The market-required return for this stock, or simply the yield on
preferred stock, serves as our estimate of the cost of preferred stock
Here, is annual dividend, is the current market price and is the cost
associated.
Cost of Preferred Stock
• Preferred dividends are not deductible, so no tax adjustment.
• Nominal is used.
• Flotation costs for preferred are significant, so are reflected. Hence, net
price will be used. The resultant equation will be:
Here, is the flotation cost as a percentage of proceeds.
Example: Assume MicroDrive has preferred stock that pays an $8
dividend per share and sells for $100 per share. If MicroDrive issued new
shares of preferred, then it would incur an underwriting (or flotation)
cost of 2.5%, find the cost of PS.
What are the two ways that companies can
raise common equity?
• Directly, by issuing new shares of common stock.
• Indirectly, by reinvesting earnings that are not paid out as dividends
(i.e., retaining earnings).
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Why is there a cost for reinvested
earnings?
• Earnings can be reinvested or paid out as dividends.
• Investors could buy other securities, earn a return.
• Thus, there is an opportunity cost if earnings are reinvested.
• Opportunity cost: The return stockholders could earn on alternative
investments of equal risk.
• They could buy similar stocks and earn rs, or company could
repurchase its own stock and earn rs. So, rs, is the cost of reinvested
earnings and it is the cost of equity.
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Cost of Equity
• The cost of equity capital is by far the most difficult cost to measure
• Equity capital can be raised either internally by retaining earnings or
externally by selling common stock
• In theory, the cost of both may be thought of as the minimum rate of
return that the company must earn on the equity-financed portion of an
investment project in order to leave the market price of the firm’s
common stock unchanged
• If the firm invests in projects having an expected return less than this
required return, the market price of the stock will suffer over the long run
• There are three well known approaches to estimate cost of equity
• Dividend Discount Model Approach
• Capital-Asset Pricing Model Approach
• Before-Tax Cost of Debt Plus Risk Premium Approach
Cost of Equity
Cost of Equity: Capital-Asset Pricing Model Approach (CAPM)
Example:
Estimate the cost of equity of a hypothetical firm for today using CAPM
when KIBOR today is 10.32%, PSX today is 12.47, yesterday was 12.31
an systematics risk of the firm is 0.4895.
Final Project
Covering 10 marks, to be submitted before examination period
Determining the Weights for the
WACC
• The weights are the percentages of the firm that will be financed by
each component.
• If possible, always use the target weights for the percentages of the
firm that will be financed with the various types of capital.
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Estimating Weights for the Capital
Structure
• If you don’t know the targets, it is better to estimate the weights
using current market values than current book values.
• If you don’t know the market value of debt, then it is usually
reasonable to use the book values of debt, especially if the debt is
short-term.
(More...)
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Overall Cost of Capital of the Firm
Weighted Average Cost of Capital (Tax free environment)
Overall Cost of Capital of the Firm
Weighted Average Cost of Capital (40% Tax is applicable)
Capital Budgeting
What is capital budgeting?
• Analysis of potential projects.
• Long-term decisions; involve large expenditures.
• Very important to firm’s future.
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Steps in Capital Budgeting
• Estimate cash flows (inflows & outflows).
• Assess risk of cash flows.
• Determine for project.
• Evaluate cash flows.
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Independent versus Mutually
Exclusive Projects
• Projects are:
• Independent, if the cash flows of one are unaffected by the acceptance of the
other.
• Mutually exclusive, if the cash flows of one can be adversely impacted by the
acceptance of the other.
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Cash Flows for Franchise L and
Franchise S
0 1 2 3
L’s CFs: 10%
-100.00 10 60 80
0 1 2 3
S’s CFs: 10%
-100.00 70 50 20
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NPV: Sum of the PVs of all cash
flows.
n CFt .
NPV = ∑ (1 + r)t
t=0
Cost often is CF0 and is negative.
n CFt .
NPV = ∑ (1 + r)t
- CF 0 .
t=1
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What’s Franchise L’s NPV?
0 1 2 3
L’s CFs: 10%
-100.00 10 60 80
9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
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Calculator Solution: Enter values in
CFLO register for L.
-100 CF0
10 CF1
60 CF2
80 CF3
10 I NPV = 18.78 = NPVL
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Rationale for the NPV Method
• NPV = PV inflows – Cost
• This is net gain in wealth, so accept project if NPV > 0.
• Choose between mutually exclusive projects on basis of higher
NPV. Adds most value.
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Using NPV method, which franchise(s)
should be accepted?
• If Franchise S and L are mutually exclusive, accept S because NPVs >
NPVL .
• If S & L are independent, accept both; NPV > 0.
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Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
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NPV: Enter r, solve for NPV.
n CFt
= NPV .
∑ (1 + r)t
t=0
IRR: Enter NPV = 0, solve for IRR.
n CFt
=0.
∑ (1 + IRR)t
t=0
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What’s Franchise L’s IRR?
0 1 2 3
IRR = ?
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV Enter CFs in CFLO, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
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Find IRR if CFs are constant:
0 1 2 3
-100 40 40 40
INPUTS 3 -100 40 0
N I/YR PV PMT FV
OUTPUT 9.70%
Or, with CFLO, enter CFs and press
IRR = 9.70%.
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Rationale for the IRR Method
• If IRR > WACC, then the project’s rate of return is greater than its
cost-- some return is left over to boost stockholders’ returns.
• Example:
WACC = 10%, IRR = 15%.
• So this project adds extra return to shareholders.
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Decisions on Projects S and L per
IRR
• If S and L are independent, accept both: IRRS > r and IRRL > r.
• If S and L are mutually exclusive, accept S because IRRS > IRRL .
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Construct NPV Profiles
• Enter CFs in CFLO and find NPVL and NPVS at different discount rates:
r NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5
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NPV Profile
50
L
40
Crossover
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Point = 8.7%
NPV ($)
20
S
10
IRRS = 23.6%
0
0 5 10 15 20 23.6
-10 Discount rate r (%)
IRRL = 18.1% 35
To Find the Crossover Rate
• Find cash flow differences between the projects. See data at
beginning of the case.
• Enter these differences in CFLO register, then press IRR. Crossover
rate = 8.68%, rounded to 8.7%.
• Can subtract S from L or vice versa, but easier to have first CF
negative.
• If profiles don’t cross, one project dominates the other.
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