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SJ10203 5/26/2014
Assis K. Sem 2 2013-2014 1
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.
SJ10203 5/26/2014
Assis K. Sem 2 2013-2014 2
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.
SJ10203 5/26/2014
Assis K. Sem 2 2013-2014 3
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)
SJ10203 5/26/2014
Assis K. Sem 2 2013-2014 4
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
SJ10203 5/26/2014
Assis K. Sem 2 2013-2014 5
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
SJ10203 5/26/2014
Assis K. Sem 2 2013-2014 6
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?