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Investing in long-term assets:

The cost of capital

What is cost of capital?

A firms cost of capital is the rate that must be earned by

the firm at a given level of risk in order to satisfy its

investors.

It represents the overall cost of FINANCING to the firm,

which includes the COST OF DEBT and the COST OF

EQUITY.

It is the required rate of return that a firm must at least

earn to cover the cost of raising funds from its investors,

that is, the debt and equity holders.

It is normally used as the discount rate in analyzing an

investment or capital budgeting proposal.

What is WACC?

WACC weighted average COST OF CAPITAL

Is the average of the firms cost of funds from all investors, which

includes the creditors and stockholders.

It weighs each category of source of financing proportionately.

Factors affecting WACC

Factors the Firm Cannot Control

Interest rates

Tax rates

Factors the Firm Can Control

change its capital structure

change its dividend payout

How to compute the cost of DEBT?

Cost of debt is the rate that must be received by a company from

an investment to achieve the required rate of return for its

creditors. The creditors here refer to long-term creditors. It is

measured by the interest rate paid to bondholders.

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How to compute the cost of PREFERRED STOCK?

This is the rate of return that must be earned on preferred

stockholders investments to satisfy their required rate of return.

It is similar to the cost of debt in which a constant annual

payment is made, in this case, the annual dividend. However,

preferred stocks normally do not have a maturity period.

How to compute the cost of COMMON STOCK?

CAPM Approach

DCF Approach

Bond-Yield-plus-

Risk-Premium

Approach

Capital asset pricing model

Dividend-Yield-plus-Growth-Rate, or Dividend Growth Model, or Discounted Cash

Flow (DCF), Approach

How to compute the cost of COMMON STOCK? How to compute the cost of COMMON STOCK?

Investing in long-term assets:

The Basics of Capital Budgeting

What is capital budgeting?

Basically, capital budgeting is a decision-making process of

selecting and evaluating LONG-TERM INVESTMENT. In simple

terms, capital budgeting requires a firm to make decisions with

respect to investments in fixed asset investment. This will

require a substantial initial outlay, which is expected to

produce benefits over a period of more than one year.

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The capital budgeting process

1 Generating long-term investment proposals

2

Estimating the relevant after-tax incremental cash flows for these project proposals

3 Evaluating these cash flows

4 Selecting the project that will maximize shareholders wealth

5

Reevaluating these projects from time to time for control purposes and carrying out post-audits for completed projects

Project classifications or types of projects

Independent projects

A decision to accept one project will not affect the

decision to accept another

Mutually exclusive projects

A decision is made to choose only one project

from many being considered. A decision to

accept one will automatically mean a rejection of the others

Types of capital budgeting decisions

2. For replacement of existing assets

2. For replacement of existing assets 1. For expansion1. For expansion

Payback period

Does not take into consideration the time value of

money. Hence, it does not calculate the PV of cash

flow

Reflects the true timing of the benefits and costs of

the project proposed.

The earlier the payback, the better it is.

Discounted payback period NPV

The CF of the project will be discounted at a specific rate,

called either a discount rate, required rate of return, cost of

capital or WACC.

The rate is the MINIMUM required rate of return that must

be earned by a firm so that its share price will remain

unchanged

Accept if NPV is higher or equal to zero (positive)

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IRR Accept a project if the IRR the firms required rate of return or the firms cost

of capital

NPV versus IRR

NPV versus IRR Multiple IRRs

Conventional

CF versus Non-

conventional

CF

MIRR

IRR assumes that cash flows will be reinvested at the IRR, but that may not be correct

multiple IRR problem

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Procedures in estimating CF

Input DataInput Data

Depreciation ScheduleDepreciation Schedule

Salvage Value CalculationsSalvage Value Calculations

Projected Cash FlowsProjected Cash Flows

Appraisal of the Proposed ProjectAppraisal of the Proposed Project

Other points on CF analysis

Cash Flow versus Accounting IncomeCash Flow versus Accounting Income

Timing of Cash Flows (Annually, quarterly, monthly, weekly, daily)Timing of Cash Flows (Annually, quarterly, monthly, weekly, daily)

Incremental Cash Flows (if and only if)Incremental Cash Flows (if and only if)

Replacement Projects (Vs New project) more to cost saving)Replacement Projects (Vs New project) more to cost saving)

Sunk Costs (already spent eg R&D) (include could lead to incorrect decision)Sunk Costs (already spent eg R&D) (include could lead to incorrect decision)

Opportunity Costs (if use existing assets eg building)Opportunity Costs (if use existing assets eg building)

Externalities (eg environmental externalities positive or negative)Externalities (eg environmental externalities positive or negative)

Is risk analysis based on historical data or subjective

judgment?

Can sometimes use historical data, but generally cannot.

So risk analysis in capital budgeting is usually based on subjective judgments.

What does risk mean in capital budgeting?

Uncertainty about a projects future profitability.

Estimating project risk

Stand-alone risk

measured by the variability of the projects expected returns

Corporate, or within-firm, risk

measured by the projects impact on uncertainty about the firms future earnings.

Market, or beta, risk

measured by the projects effect on the firms beta coefficient

Measuring stand-alone risk

Sensitivity analysis

Scenario analysis

Monte Carlo simulation

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What is real option?

Real options exist when managers can influence the size and risk of a projects cash flows by taking different actions during the projects life in response to changing market conditions.

Alert managers always look for real options in projects.

Smarter managers try to create real options.

What is real option?

Abandonment/ shutdown options

Investment Timing options (When to begin?)

Expansion/ Growth options

Output flexibility options

Input flexibility

Types of real option?