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The cost of capital to be used in capital budgeting decision is the hurdle rate for project valuation. Cost Cost of capital Return IRR
k
ˆ k
Reject Accept
2
General Picture:
Concept of Cost of capital used in capital budgeting Component Cost of Capital
Cost Cost Cost Cost of of of of debt preferred stock retained earnings newly issued common equity
CHAPTER 6
THE COST OF CAPTITAL
Importance of Cost of Capital
In order to maximize a firm’s value, all inputs must be minimized, and measuring is the base point . Capital budgeting decision require an estimate of the cost of capital. It is the hurdle rate for choice. Other decision in financial management require information on the cost of capital. Such as leasing, bond refunding and working capital management .
9
▲Suppose you determine that the stock of company X has equally uncertain prospects. X’s current stock price is $95.65, and depending on the state of the economy at the end of the year, the price will be as follows: ♣SLUMP $80 ♣NORMAL $110 ♣BOOM $140
♣
18
Capital Components
Portion of short-term interestbearing debt that is considered to be permanent financing All long-term debt All preferred stock, and All common equity
The MCC Schedule
Weighted average cost of capital Capital component break point
3
Concept of Cost of Capital Used in Capital Budgeting
The Hurdle Rate
13
Why Using Financing Mix?
Firm’s operations: demand capital Capital Market: bond Preferred stock Common stock Investors: supply capital
Cost of capital for management is required rate of return of investors.
17
▲ For permanent financing purpose:
♣Deliberately used to finance long-term investments,which s quite risky. it is not common among well-managed firms. ♣Included when estimating WACC
Spontaneous Current Liability
▲Non-interest-bearing liabilities which spontaneously generated current liabilities from normal operations, such as: accounts payable, accrued wages and accrued taxes.
7
Cost
Investment Outlay
Return
Value of Project
CF0
CF0 V0
Project
V0
Reject
( NP V 0)
CF V0 0 ( NP V 0)
Accept
8
Example
▲You are offered the following opportunity: invest $100,000 today, and depending on the state of the economy at the end of the year, you will receive one of the following payoffs: ♣SLUMP $80,000 ♣NORMAL $110,000 ♣BOOM $140,000 and there is an equal chance of each outcome.
10
Stock X
80 110 140 ˆ CFX $110 3 ˆ 110 95.65 15% k 95.65 ˆ 80,000 110,000 140,000 $110,000 CFP 3 110,000 PVP $95,650 1 15%
Project
Equivalent investment alternatives
5
When you discount the project’s expected cash flow at its opportunity cost of capital,the resulting present value is the amount investors (including your own company’s shareholders)would be willing to pay for the project.
12
Financing Mix
Portfolio Effects
▲Cost of capital is a facet of implications of the ability to group assets into portfolios in financial management. ▲Portfolio Effects influence a firm’s cost of capital, because
Portfolio effects can reduce the riskness of a security; Required rate of return depend on risk; A firm’s cost of capital is determined by the riskness of its securities.
Primary sources of capital for capital 19 expansion
Tax Effects
All component costs are expressed on an after-tax basis . Why? Stockholders are concerned primarily with the cash flows that are available for their use, namely, cash flows after corporate taxes have been paid.
15
▲These dollar amount will partially offset the increase in current assets, which is subtracted from the amount that would otherwise be required to finance the project.
20
If management want to maximize stockholder well-being and the price of its stock, all analyses must fully reflect the impact of taxes.
The most common approach to capital budgeting is to include any tax benefits in the WACC rather than in the cash flows.
4
ˆ kk
Project
ˆ k k
The Opportunity Cost
The opportunity cost of capital for an investment project is the expected rate of return demanded by investors in common stock or other securities subject to the same risks as the project.
This project should be rejected due to the fact of $100 000 $95,650 ,
11
The Weighted Average Cost Of Capital
The cost of capital to be used in capital budgeting decision is the weighted average of the various types of capital the firm uses, typically debt, preferred stock, and common equity. WACC = w1k1+w2k2+….+wnkn The primary use of WACC is to establish the firm’s opportunity cost of capital for capital budgeting purposes.
6
Any time you find and launch a positive–NPV project (a project with present value exceeding its required cash outlay) you have made your company’s stockholders better off.
Portfolio effect can help investors reduce their investment risk, which in turn lower the required rate of return. 14
How to Treat Current Liabilities When Estimating WACC?
Conclusion: Not included in WACC estimating.
16
Nonspontaneous current liability: such as short-term notes payable, bank loan
▲ For temporary financing purpose: ♣Used to support cyclical or seasonal fluctuations in working capital. ♣Excluded when estimating WACC
k
ˆ k
Reject Accept
2
General Picture:
Concept of Cost of capital used in capital budgeting Component Cost of Capital
Cost Cost Cost Cost of of of of debt preferred stock retained earnings newly issued common equity
CHAPTER 6
THE COST OF CAPTITAL
Importance of Cost of Capital
In order to maximize a firm’s value, all inputs must be minimized, and measuring is the base point . Capital budgeting decision require an estimate of the cost of capital. It is the hurdle rate for choice. Other decision in financial management require information on the cost of capital. Such as leasing, bond refunding and working capital management .
9
▲Suppose you determine that the stock of company X has equally uncertain prospects. X’s current stock price is $95.65, and depending on the state of the economy at the end of the year, the price will be as follows: ♣SLUMP $80 ♣NORMAL $110 ♣BOOM $140
♣
18
Capital Components
Portion of short-term interestbearing debt that is considered to be permanent financing All long-term debt All preferred stock, and All common equity
The MCC Schedule
Weighted average cost of capital Capital component break point
3
Concept of Cost of Capital Used in Capital Budgeting
The Hurdle Rate
13
Why Using Financing Mix?
Firm’s operations: demand capital Capital Market: bond Preferred stock Common stock Investors: supply capital
Cost of capital for management is required rate of return of investors.
17
▲ For permanent financing purpose:
♣Deliberately used to finance long-term investments,which s quite risky. it is not common among well-managed firms. ♣Included when estimating WACC
Spontaneous Current Liability
▲Non-interest-bearing liabilities which spontaneously generated current liabilities from normal operations, such as: accounts payable, accrued wages and accrued taxes.
7
Cost
Investment Outlay
Return
Value of Project
CF0
CF0 V0
Project
V0
Reject
( NP V 0)
CF V0 0 ( NP V 0)
Accept
8
Example
▲You are offered the following opportunity: invest $100,000 today, and depending on the state of the economy at the end of the year, you will receive one of the following payoffs: ♣SLUMP $80,000 ♣NORMAL $110,000 ♣BOOM $140,000 and there is an equal chance of each outcome.
10
Stock X
80 110 140 ˆ CFX $110 3 ˆ 110 95.65 15% k 95.65 ˆ 80,000 110,000 140,000 $110,000 CFP 3 110,000 PVP $95,650 1 15%
Project
Equivalent investment alternatives
5
When you discount the project’s expected cash flow at its opportunity cost of capital,the resulting present value is the amount investors (including your own company’s shareholders)would be willing to pay for the project.
12
Financing Mix
Portfolio Effects
▲Cost of capital is a facet of implications of the ability to group assets into portfolios in financial management. ▲Portfolio Effects influence a firm’s cost of capital, because
Portfolio effects can reduce the riskness of a security; Required rate of return depend on risk; A firm’s cost of capital is determined by the riskness of its securities.
Primary sources of capital for capital 19 expansion
Tax Effects
All component costs are expressed on an after-tax basis . Why? Stockholders are concerned primarily with the cash flows that are available for their use, namely, cash flows after corporate taxes have been paid.
15
▲These dollar amount will partially offset the increase in current assets, which is subtracted from the amount that would otherwise be required to finance the project.
20
If management want to maximize stockholder well-being and the price of its stock, all analyses must fully reflect the impact of taxes.
The most common approach to capital budgeting is to include any tax benefits in the WACC rather than in the cash flows.
4
ˆ kk
Project
ˆ k k
The Opportunity Cost
The opportunity cost of capital for an investment project is the expected rate of return demanded by investors in common stock or other securities subject to the same risks as the project.
This project should be rejected due to the fact of $100 000 $95,650 ,
11
The Weighted Average Cost Of Capital
The cost of capital to be used in capital budgeting decision is the weighted average of the various types of capital the firm uses, typically debt, preferred stock, and common equity. WACC = w1k1+w2k2+….+wnkn The primary use of WACC is to establish the firm’s opportunity cost of capital for capital budgeting purposes.
6
Any time you find and launch a positive–NPV project (a project with present value exceeding its required cash outlay) you have made your company’s stockholders better off.
Portfolio effect can help investors reduce their investment risk, which in turn lower the required rate of return. 14
How to Treat Current Liabilities When Estimating WACC?
Conclusion: Not included in WACC estimating.
16
Nonspontaneous current liability: such as short-term notes payable, bank loan
▲ For temporary financing purpose: ♣Used to support cyclical or seasonal fluctuations in working capital. ♣Excluded when estimating WACC