12 The Capital Budgeting Decision Block, Hirt, and Danielsen •Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • • • • • Capital budgeting decision Cash flows in capital budgeting Payback method Net present value and internal rate of return Discount or cutoff rate as cost of capital Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-2 Capital Budgeting Decision – Administrative Considerations • Involves planning expenditures for project with minimum period of year or longer • Capital expenditure decision requires • Extensive planning • Coordination of different departments • Decisions affected by uncertainties involved in • • • • • Annual costs and inflows Product life Interest rates Economic conditions Technological changes Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-3 Capital Budgeting Decision – Administrative Considerations • Steps in decision-making process • • • • Search for investment opportunities Data collection Evaluation and decision making Reevaluation and adjustment Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-4 Capital Budgeting Procedures Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-5 Accounting Flows versus Cash Flows • In capital budgeting decisions, emphasis on cash flows rather than earnings • Depreciation (noncash expenditure) added back to profit to determine cash flow generated • Emphasize proper evaluation techniques for best economic choices and maximizing longterm wealth Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-6 Cash Flow and Revised Cash Flow for Alston Corporation • Net earnings before and after taxes are zero, but company has $20,000 cash in bank Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-7 Methods of Ranking Investment Proposals • Three methods • Payback method • Internal rate of return • Net present value Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-8 Payback Method • Time required to recoup initial investment from Table 12-3: • Investment A recoups $10,000 initial investment at end of second year, while Investment B takes longer Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-9 Payback Method • Advantages • Easy to understand • Emphasizes liquidity • Useful in industries characterized by dynamic technological developments • Shortcomings • Does not consider time value of money • Ignores cash flows after cutoff period • Can not find optimum or most economic solution to capital budgeting problem Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-10 Net Present Value • Theoretically-valid model • Well understood, widely used • Sum of present values of all outflows and inflows for project • Usually discounted by firm’s Weighted Average Cost of Capital (WACC) Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-11 Net Present Value for Investments A and B Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-12 Internal Rate of Return (IRR) • Measures investment profitability as return percentage • Find interest rate (i) in time value of money problem • Value of i which makes NPV = 0 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-13 IRR for Investments A and B Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-14 Selection Strategy • For project to be potentially accepted • Profitability must equal or exceed cost of capital • Mutually-exclusive projects • Selecting one option precludes alternatives • Non-mutually-exclusive projects • Alternatives providing return in excess of cost of capital selected Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-15 Selection Strategy • For Investment A and B, assume 10% capital, Investment B accepted if alternatives mutually exclusive, both qualify if not • IRR and NPV methods call for same decision with some exceptions • Two rules • If investment has positive NPV, IRR exceeds of cost of capital • In certain cases, methods give different answers in selecting best investment Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-16 Reinvestment Assumption • IRR • All inflows from given investment can be reinvested at Internal Rate of Return (IRR) • May be unrealistic to assume reinvestment at equally high rate • NPV • Makes more conservative assumption that each inflow can be reinvested at cost of capital or discount rate • Allows for certain consistency as inflows from each project are assumed to have same investment opportunity Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-17 The Reinvestment Assumption – IRR and NPV Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-18 Modified Internal Rate of Return (MIRR) • Combines reinvestment assumption of NPV method with IRR method • Discount rate that equates final value of inflows with investment Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-19 MIRR for Investment B Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-20 Capital Rationing • Artificial constraint on funds invested in given period • Only projects with highest NPV accepted • Reasons for capital rationing • Fear of too much growth • Hesitation to use external sources of financing • Can hinder firm from achieving maximum profitability Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-21 Net Present Value Profile • Graphical representation of net present value of project at different discount rates • Aspects to consider • NPV at zero discount rate • NPV as determined by normal discount rate (such as cost of capital) • IRR for project Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-22 Net Present Value Profile – Graphic Representation Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-23 Net Present Value Profile with Crossover Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-24 The Rules of Depreciation • Assets classified into nine categories to determine allowable depreciation • Each class referred to as Modified Accelerated Cost Recovery System (MACRS) category • Some references made to Asset Depreciation Range (ADR)— expected physical life of asset or class of assets Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-25 Categories for Depreciation Write-Off Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-26 Depreciation Percentages (Expressed in Decimals) Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-27 Depreciation Schedule Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-28 Actual Investment Decision — Example • Assume • $50,000 depreciation of machinery with six-year productive life • Produces $18,500 income for first three years before deductions for depreciation and taxes • In last three years, income before depreciation and taxes $12,000 • Corporate tax rate 35% and cost of capital 10% • For each year • Depreciation subtracted from earnings before depreciation and taxes to arrive at earnings before taxes • Taxes subtracted to determine earnings after taxes • Depreciation added to earnings to arrive at cash flows Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-29 Cash Flow Related to Purchase of Machinery Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-30 Net Present Value Analysis Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-31 The Replacement Decision • Investment decision for new technology • Includes several additions to basic investment situation • Sale of old machine • Tax consequences • Can be analyzed by • Total analysis of both old and new machines • Incremental analysis of cash-flow changes between old and new machines Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-32 Sale of Old Asset • Cash inflow from sale of old asset based on sales price and related tax factors • For tax factors, book value of old asset compared with sales price to find taxable gain or loss • Loss can be written off against other income for corporation • Gain taxed at corporation’s normal rate Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-33 Book Value of Old Asset and Net Cost of New Asset Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-34 Incremental Depreciation Benefits • Cash flow analysis on basis of • • • Incremental gain in depreciation Related tax-shield benefits Cost savings Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-35 Cost-Savings Benefits Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-36 Present Value of the Total Incremental Benefits Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-37 Elective Expensing • Businesses can write off certain tangible properties in purchased year for up to $250,000 under 2008 Economic Stimulus Act • Beneficial to small businesses • Allowance phased out dollar for dollar when total property purchases exceed $800,000 in one year Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 12-38 13 Risk and Capital Budgeting Block, Hirt, and Danielsen Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • • • • Risk in capital budgeting Risk aversion Risk and rate of return Risk assessment – simulation models and decision trees • Impact of individual risky project on total risk of firm Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-2 Definition of Risk in Capital Budgeting • Risk defined in terms of variability of possible outcomes from given investment • Risk measures — losses and uncertainty Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-3 Variability and Risk • Three investment proposals illustrated in following slide • All investments in illustration have same expected value • Investment C is most risky due to variability Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-4 Variability and Risk Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-5 The Concept of Risk-Averse • Risk avoidance unless adequate compensation made • Most investors and managers are risk-averse • Prefer relative certainty as opposed to uncertainty • Expect higher value or return for risky investments Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-6 Actual Measurement of Risk • Basic statistical devices used ഥ = σ 𝐷𝑃 • Expected value: 𝐷 ഥ )2 𝑃 • Standard deviation: σ = σ(𝐷 − 𝐷 𝜎 • Coefficient of variation: 𝑉 = 𝐷ഥ Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-7 Probability Distribution with Differing Degrees of Risk • Larger standard deviation means greater risk Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-8 Probability Distribution with Differing Degrees of Risk • Direct comparison of standard deviations not helpful if expected values of investments differ • Standard deviation of $600 with expected value of $6,000 indicates less risk than standard deviation of $190 with expected value of $600 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-9 Coefficient of Variation (V) • Size difficulty can be eliminated by introducing coefficient of variation (V) • Formula: 𝑉 = 𝜎 ഥ 𝐷 • The larger the coefficient, the greater the risk Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-10 Risk Measure — Beta (β) • Risk measure widely used with portfolios of common stock • Measures volatility of returns on individual stock relative to returns on stock market index Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-11 Betas for Five-Year Period (Ending January 2013) Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-12 Risk and the Capital Budgeting Process • Informed investor or manager differentiates between • Investments that produce ‘certain’ returns • Investments that produce expected value of return, but have high coefficient of variation Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-13 Risk-Adjusted Discount Rate • Different capital-expenditure proposals with different risk levels require different discount rates • Project with normal amount of risk discounted at cost of capital • Project with greater than normal risk discounted at higher rate • Risk assumed to be measured by coefficient of variation (V) Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-14 Relationship of Risk to Discount Rate • Example of increasing risk-aversion at higher levels of risk and potential return Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-15 Increasing Risk over Time • Accurate forecasting becomes more difficult farther out in time • Unexpected events • Create higher standard deviation in cash flows • Increase risk associated with long-lived projects • Use of progressively higher discount rates to compensate for risk penalizes later cash flows more than earlier ones Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-16 Qualitative Measures • Setting up risk classes based on qualitative considerations • Equates discount rate to perceived risk Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-17 Capital Budgeting Analysis • Investment B preferred based on NPV calculation without considering risk factor Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-18 Capital-Budgeting Decision Adjusted for Risk— Example • Assume • Investment A calls for addition to normal product line, assigned 10% discount rate • Investment B represents new product in foreign market, must carry 20% discount rate to adjust for large risk component Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-19 Capital-Budgeting Decision Adjusted for Risk— Example • Investment A is only acceptable alternative after adjusting for risk factor Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-20 Simulation Models • Deal with uncertainties involved in forecasting outcome of capital budgeting projects or other decisions • Computers enable simulation of various economic and financial outcomes using number of variables • Monte Carlo model uses random variable for inputs • Rely on repetition of same random process as many as several hundred times Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-21 Simulation Models • Have ability to test various combinations of events • Used to test possible changes in variable conditions included in process • Allow planner to ask “what if” questions • Driven by sales forecasts, with assumptions to derive income statements and balance sheets • Generate probability acceptance curves for capital budgeting decisions Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-22 Simulation Flow Chart Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-23 Decision Trees • Help lay out sequence of possible decisions • Present tabular or graphical comparison between investment choices • Provide important analytical process Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-24 Decision Trees • Assume a firm is considering two choices • Project A— Expand semiconductor production for sale to end users • Project B— Enter highly competitive personal computer market using firm’s technology • Both projects cost $60 million, with different net present value (NPV) and risk • Project A— High likelihood of positive rate of return, reasonable expectation of long-term growth • Project B— Stiff competition may result in loss of more money or higher profit if sales high Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-25 Decision Trees Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-26 The Portfolio Effect • Considers impact of given investment proposal on overall firm risk • Firm planning to invest in building products industry carrying high degree of risk • Primary business in manufacture of electronic components for industrial use • Investing firm could alter cyclical fluctuations inherent in primary business, reduce overall risk exposure • Could reduce standard deviation for entire company • Overall risk exposure might diminish Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-27 Portfolio Risk • Investment may change overall risk of firm depending on relationship to other investments • Highly-correlated investments — do not diversify against risk • Negatively-correlated investments — greater risk reduction • Uncorrelated investments — some risk reduction Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-28 Coefficient of Correlation • Represents extent of correlation among various projects and investments • May take on values anywhere from -1 to +1 • Real world – more likely measure between -.2 negative correlation and +.3 positive correlation • Risk can be reduced by • Combining risky assets with low-risk or negatively correlated assets Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-29 Coefficient of Correlation — Two Merger Candidates • Merger with Negative Correlation Inc. appears to be best decision Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-30 Evaluation of Combinations • Two primary objectives in choosing combinations • Achieve highest possible return at given risk level • Provide lowest possible risk at given return level • Determining position of firm on efficient frontier • Willingness to take larger risks for superior returns • Make conservative selection Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-31 Risk-Return Trade-Offs • Best opportunities fall along left-most sector (line C–F–G) • Points to right less desirable Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-32 The Share Price Effect • Firm risk impacts share prices • When firm takes unnecessary or undesirable risks • Higher discount rate and lower valuation may be assigned to stock in market • Higher profits could have opposite impact on stock price if such profits result from risky ventures • Overall firm valuation could decrease with increase in coefficient of variation or beta Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 13-33 11 Cost of Capital Block, Hirt, and Danielsen Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • Cost of capital and its importance • Discount rates used to analyze investments • Valuation and application to bonds, preferred stock, and common stock • Minimum cost of capital • Increase in cost of capital with increase in utilization of finances Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-2 Cost of Capital • In corporate finance, investment is made for anticipated future return • Vital to know appropriate discount rate • Cost of acquiring funds • Earning return equal to acquisition costs – minimum acceptable return Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-3 The Overall Concept • Investment • Should not be judged against specific means of financing used to implement • Makes investment selection decisions inconsistent • Low-cost debt must be chosen carefully • May result in overall risk increase • May make all eventual forms of financing more expensive Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-4 Determination of Cost of Capital • Best understood through firm’s capital structure • After-tax costs of individual financing sources multiplied by weights assigned to them • Sum gives weighted-average cost Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-5 Cost of Debt • Measured by interest rate at which company raises new capital • Example: $1,000 bond paying $100 annual interest – 10% yield • Calculation complex if bond priced at discount or premium from par value • To determine cost of new debt in marketplace • Firm computes yield on currently outstanding debt Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-6 Approximate Yield to Maturity (Y') Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-7 Adjusting Yield for Tax Considerations • Yield to maturity indicates what firm must pay on before-tax basis • Interest payment on debt is tax deductible • True cost less than stated cost Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-8 Adjusting Yield for Tax Considerations • After-tax cost of debt Kd (Cost of debt) = Y(1 – T) • Yield = 10.84%; Tax rate = 35% Kd (Cost of debt) = Y(1 – T) Kd (Cost of debt) = 10.84% (1 – 0.35) = 10.84% × 0.65 = 7.05% Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-9 Cost of Preferred Stock • Constant annual payment with no maturity date for principal payment • Divide dividend payment by net price or proceeds received • Represents rate of return to preferred stockholders and annual cost to corporation for issue • Preferred stock dividend not tax deductible, no downward tax adjustment • Proceeds to firm equal selling price in market minus flotation cost Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-10 Cost of Preferred Stock • The cost of preferred stock is as follows Kp (Cost of preferred stock) = 𝐷𝑝 𝑃𝑝 − 𝐹 • Kp = Cost of preferred stock; Dp = Annual dividend on preferred stock; Pp = Price of preferred stock; F = Flotation, or selling cost • Annual dividend $10.50; preferred stock $100; flotation, or selling cost $4 Kp = 𝐷𝑝 𝑃𝑝 − 𝐹 = $10.50 $100−4 = $10.50 $96 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. = 10.94 11-11 Cost of Common Equity – Valuation Approach • In determining the cost of common stock, the firm must be sensitive to pricing and performance demands of current and future stockholders • Dividend valuation model: 𝐷1 𝑃0 = 𝐾𝑒 − 𝑔 • P0 = Price of the stock today • D1 = Dividend at the end of the year (or period) • Ke = Required rate of return; g = Constant growth rate in dividends • Assuming D1 = $2; P0 = $40, and g = 7%, Ke = 12% 𝐾𝑒 = 𝐷1 𝑃0 +𝑔 = $2 $4 + 7% = 5% + 7% = 12% Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-12 Alternate Calculation of the Required Return on Common Stock • Capital Asset Pricing Model (CAPM) • • • • Kj = Rf + β(Km − Rf) Kj = Required return on common stock Rf = Risk-free rate of return, usually the current rate on Treasury bill securities β = Beta coefficient (measures the historical volatility of an individual stock’s return relative to a stock market index Km = return in the market as measured by an approximate index • Assuming Rf = 5.5%, Km = 12%, β = 1.0, Kj would be: Kj = 5.5% + 1.0 (12% - 5.5%) = 5.5% + 1.0 (6.5%) Kj = 5.5% + 6.5% = 12% Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-13 Cost of Retained Earnings • Sources of capital for common stock equity • Purchaser of new shares – external source • Retained earnings – internal source • Represent present and past earnings of firm minus previously distributed dividends • Belong to current stockholders – paid as dividends or reinvested in firm • Reinvestments represent source of equity capital supplied by current stockholders • Opportunity cost involved Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-14 Cost of Retained Earnings • The cost of retained earnings is equivalent to the rate of return on the firm’s common cost representing the opportunity cost • Ke represents both the required rate of return on common stock, and the cost of equity in the form of retained earnings 𝐷1 𝐾𝑒 = +𝑔 𝑃0 • • • • Ke = Cost of common equity in the form of retained earnings D1 = Dividend at the end of the first year, $2 P0 = Price of stock today, $40 G = Constant growth rate in dividends, 7% 𝐷1 $2 𝐾𝑒 = +𝑔= + 7% = 5% + 7% = 12% 𝑃0 $4 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-15 Cost of New Common Stock • Slightly higher return than Ke expected • Represents required rate of return of present stockholders • Needed to cover distribution costs of new securities Cost of common equity in form of retained earnings = 𝐷1 𝐾𝑒 = +𝑔 𝑃0 Cost of new common stock 𝐷1 𝐾𝑛 = +𝑔 𝑃0 − 𝐹 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-16 Cost of New Common Stock • Assuming • D1 = $2 • P0 = $40 • F (Flotation or selling costs) = $4 • g = 7% $2 𝐾𝑛 = + 7% $40 − $4 $2 = + 7% $36 = 5.6% + 7% = 12.6% Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-17 Optimal Capital Structure – Weighting Costs • Desire to achieve minimum overall cost of capital • Calculated decisions required on appropriate weights for • Debt • Preferred stock • Common-stock financing • Capital mix determined by • Considering present capital structure • Ascertaining if current position optimal Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-18 Optimal Capital Structure – Weighting Costs • Assessment of different plans: • Firm able to initially reduce weighted average cost of capital with debt financing • Beyond Plan B, continued use of debt becomes unattractive and greatly increases costs of sources of financing Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-19 Cost of Capital Curve Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-20 Debt as a Percentage of Total Assets (2013) Selected Companies with Industry Designations Percent Forest Labs (pharmaceuticals) 23% Intel (semiconductors) 34% Pfizer (pharmaceuticals 56% ExxonMobil (integrated oil) 50% Microsoft (computers) 44% Home Depot (home repair products) 58% PepsiCo (soft drinks and snacks) 70% Hyatt Hotels (lodging) 37% Gannett (newspapers and publishing) 63% Delta Air Lines (air travel) Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 100% 11-21 Capital Acquisition and Investment Decision Making • Financial capital — bonds, preferred stock, common equity • Money raised by sale invested in • Real capital of firm, long-term productive assets of plant and equipment • To minimize equity cost, firm may sell common stock when prices are relatively high • Balance between debt and equity required to achieve minimum cost of capital Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-22 Cost of Capital Over Time Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-23 Cost of Capital in the Capital Budgeting Decision • Current cost of capital for each source of funds important for capital budgeting decision • Required rate of return will be weighted average cost of capital • Common stock value of firm will stay same or increase as long as firm earns cost of capital Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-24 Investment Projects Available to the Baker Corporation Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-25 Cost of Capital and Investment Projects for the Baker Corporation Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-26 The Marginal Cost of Capital • Market may demand higher cost of capital for each fund if large amount of financing required • Equity (ownership) capital represented by retained earnings • Retained earnings cannot grow indefinitely as firm’s capital must expand • Retained earnings limited to past and present earnings that can be redeployed into investments Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-27 The Marginal Cost of Capital • Assumptions: • 60% is amount of equity capital firm must maintain to keep balance between fixed-income securities and ownership interest • Firm has $23.40 million of retained earnings available for investment • Adequate retained earnings to support capital structure 𝑋= Retined earnings Percent of retained earnings in the capital structure • Where X represents size of capital structure that retained earnings will support $23.40 million 𝑋= = $39 million .60 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-28 Costs of Capital for Different Amounts of Financing Kmc in bottom right-hand portion of table represents marginal cost of capital Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-29 Increasing Marginal Cost of Capital • Both Kmc and Ka represent cost of capital • mc subscript after K indicates increase in marginal cost of capital • Increase because common equity now in form of new common stock rather than retained earnings • After-tax cost of new common stock more expensive than retained earnings because of flotation costs Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-30 Increasing Marginal Cost of Capital • Equation for cost of new common stock: 𝐾𝑛 = = 𝐷1 $2 +𝑔 = + 7% 𝑃0 − 𝐹 $40 − $4 $2 + 7% = 5.6% + 7% = 12.6% $36 • $50 million figure can be derived thus: Amount of lower−cost debt 𝑍= Percent of debt in capital structure 𝑍= $15 million = $50 million .30 • Where Z represents size of capital structure in which lowercost debt can be used Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-31 Cost of Capital for Increasing Amounts of Financing Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-32 Changes in the Marginal Costs of Capital Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-33 Marginal Cost of Capital and Baker Corporation Projects Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-34 Cost of Components in the Capital Structure Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-35 Performance of PAI and the Market Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-36 Linear Regression of Returns Between PAI and the Market Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-37 Linear Regression of Returns Between PAI and the Market • CAPM is expectational (ex ante) model, no guarantee historical data will recur • One area of empirical testing involves stability and predictability of beta coefficient based on historical data Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-38 The Security Market Line (SML) • Under CAPM model, investor expects extra return above that of riskless asset in order to justify additional risk • Security Market Line (SML) identifies risk-return trade-off of any common stock (asset) relative to company’s beta Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-39 The Security Market Line and Changing Interest Rates Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-40 The Security Market Line and Changing Investor Expectations • Pessimistic investors require larger premiums for assuming risks Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 11-41 Post #1 Nathaniel Petrick There are a few different methods for capital budgeting: payback method, net present value method, and IRR method. The payback method is short, quick, but limited. The payback method focuses on "the time required to recoup the initial investment". However, this does not take into account the gains made by such investments after the period. The net present value method is the most widely used method as it tends to work "theoretically" and "in practice" as noted in our text. This method takes into account investment and future consequences to figure out the actual present value of the money. The IRR or internal rate of return method is closely related to the net present value method as it tells you what rate of return make net present value equal to zero. When you know this you can easily figure out if a project will be profitable and relatively how profitable. Any project's rate of return that sets net present value over zero will be a worthwhile project to accept (Block, 2017, p. 384-389). Much of our calling in life as Christians is built on trust for the unknown, faith. This can be hard for business owners, as we want as many definitive answers as possible to base our financial decisions off of. However, as Christians first, we must recognize that the only worthwhile things God will ever ask us to do will not only require faith, but an abundance of faith. Our job is to take the plunge. When Proverbs 3:3-6 tells us to trust the Lord, it is coming from one of the wisest and wealthiest men to ever walk this earth, King Solomon. I believe this relates to capital budgeting because we can plan all day for the future. We are supposed to plan! However, King Solomon is reminding us that the most important thing that leads to success is trusting the Lord. This may mean trusting Him even when the numbers disagree. Block, S.B., Hirt, G.A., Danielsen, B.R. (2017). Foundations of Financial Management, Sixteenth Edition. New York, NY: McGraw-Hill Education. Post #2 Kimberly Stevens Capital costs are based on valuation techniques and are applied to bonds, preferred stock and common stock and a mix of financing is applied to get financing. The value could increase as larger amounts of financing are utilized. New ventures should be calculated comprehensively against the costs of capital to the firm since, “through an investment financed by low-cost debt might appear acceptable at first glance, the use of debt might increase the overall risk of the firm and eventually make all forms of financing more expensive(Hirt, Block, & Danielsen, 2010, p. 342).” Where net present value might be beneficial is when a company wants to analyze the profitability of a project investment or project. Cash inflow and outflow could be compared with a discount or return rate and timer periods. Profitability is desirable and internal rate of return should help calculate the potential of a new project. This discount rate may help calculate the net present value and possibility of future growth. The risk should be determined by many parts of the whole such as cash inflow, total investment costs, internal rate of return and number of periods. The return on investment should be calculated by the percentage of money recuperated verses the associated costs. Sometimes new products might not attract a marketable result and can have a long-term effect on the performance of a company as it recovers from those losses but when those loses are not as large and were expected then it can bear those losses comfortably (Krause, 2006, p. 1). One key to success, capital budgeting is a type of forecasting that calculates important figures for a firm if they are to make clear the liabilities of future business projects. Capital could be thought of as the cushion that might be able to protect a firm from taking the loss of its divisions. Financial forecasting of capital budgeting helps offset the dangers and uncertainty of risk taking in the enterprise. “Since the cost of erring in such decisions is quite high, managers need to anticipate the problems of decline earlier in order to have more options in their portfolio of strategies and, also, be able to divest sooner if that is their best strategic option (Harrigan, 1980, p. 34).” In the bible, Luke offers that “for which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it (Luke 14:28, Holy Bible, King James Version)?” Essentially, it is wise to make sure you have the budget for a new venture and make sure that you have calculated all costs, rates, and returns on investment and that you can recover comfortably if the project does not meet financial expectations. References Bible Gateway. (2010). Luke 14:28. In The Holy Bible: King James Version. Harrigan, K. R. (1980). Strategies for declining industries. Journal of Business Strategy (Pre1986), 1(000002), 34. Retrieved from http://eres.regent.edu:2048/login?url=https://search-proquestcom.ezproxy.regent.edu/docview/209891292?accountid=13479 Hirt, G., Block, S., & Danielsen, B. (2010). Cost of Capital. In Foundations of Financial Management (16th ed., p. 341). Retrieved from https://connect.mheducation.com/connect/hmEBook.do?setTab=sectionTabs Krause, A. (2006). Risk, capital requirements, and the asset structure of companies. Managerial Finance, 32(9), 1. Retrieved from https://doiorg.ezproxy.regent.edu/10.1108/03074350610681961
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