Chapter 9 The Cost of Capital on a balance sheet left side use of funds assets right side source of funds cost of capital Sources of capital long term debt preferred stock common stock no control Factors affecting the cost of capital general economic conditions affect interest rates investors want more capital cost increases market conditions affect risk premiums higher interest rates less investment decisions we make operating decisions affect business risk financial decisions affect financial risk amount of financing affect flotation costs and market price of security Cost of each type of funding Cost of debt the interest demanded by bond investors after firm borrows money by issuing bonds required rate of return for creditors YTM total return bond 1 interest coupon pmt 2 price vs par sales price debt is a contract Cost of preferred stock rate of return investors require on a company s new preferred stock plus cost of issuing the stock cost to raise a dollar of preferred stock higher than before tax cost of debt b c more risk more return Cost of internal common equity required rate of return on funds supplied by existing common stockholders retained earnings capital from existing stockholders internal for companies that pay regular dividends that grow at a constant rate Dividend Growth Model present value of a continuing stream of future dividends for firms with a changing rate no dividends or managers that believe market risk is relevant Capital Asset Pricing Model rate of return that investors demand according to nondiversifiable risk Cost of Equity from New Common Stock cost incurred by a company when new common stock is sold capital from issuing new stock external cost includes expected return and flotation costs higher than retained Calculation of the weighted average cost of capital WACC mean of all component costs of capital weighted according to the percentage of each component in the firm s optimal capital structure capital structure mixture of capital used to finance a firm s assets Construction and use of the marginal cost of capital schedule MCC weighted average cost will change if one component cost of capital changes flotation costs from new stock too heavy of a debt low after new funds WACC of the next dollar of capital raised Breakpoint point at which new equity will need to be issued at a higher cost debt break points equity break point choose companies whose IRR is above MCC Curve Chapter 10 The capital budgeting process process of evaluating proposed large long term investment projects for a firm managers must determine which projects are acceptable and rank mutually exclusive projects by order of desirability to the firm independent do not compete ex warehouse and telephone mutually exclusive compete ex two copiers xerox vs toshiba based on incremental cash flows cash flows if investment is taken on initial investment additional cash Stages in Capital Budgeting Process 1 Finding projects 2 Estimating the incremental cash flows associated with projects 3 Evaluating and selecting projects 4 Implementing and monitoring projects Payback years to recoup the initial investment measured in time years disadvantages no time value of money ignores cash flows after payback period to calculate add projected positive cash flows until sum equals amount of project s initial investment find payback period number of time periods it will take so that cash inflows cash outflows initial investment accept if payback is less than the company s predetermined maximum Net Present Value NPV change in value of firm if project is undertaken value maximization PV of inflows initial investment measured in terms of incremental cash flows dollars present value of all costs and benefits of a project change in value disadvantages not persuasive or understood not easily comparable in dollars not percents to calculate USE CF initial CFo enter in CFn s and Fn s NPV when I given k lower I higher NPV accept if NPV is greater than or equal to 0 for independent accept both for mutually exclusive accept higher NPV NPV Profile project at different assumed required rates of return steep slope more sensitive to WACC crossover point shows ranking conflict Internal Rate of Return IRR projected percent rate of return project will earn estimated rate of return easy to compare focuses on all cash flows adjusts for time value of money disadvantages does not show value ex 100 of 5 or 50 of 1000 project may have more than one IRR or none IRR reinvestment assumption only if you reinvest higher or equal to IRR to calculate USE CF initial CFo enter in CFn s and Fn s IRR accept if IRR is greater than or equal to required rate of return k hurdle rate independent both if one passes mutually exclusive ranking conflict NPV opposite of IRR choose Modified Internal Rate of Return MIRR highest NPV NPV is KING discount rate which causes the project s PV of the outflows to equal the project s Terminal Value TV of the inflows a way around IRR reinvestment assumption assumes cash inflows are reinvested at k the cost of capital avoids multiple IRR s to calculate 1 TV terminal value of inflows set CFo 0 NPV PVinflow WACC I Y N given Use PVinflow to find FV 2 Calculate PV of outflows PVoutflow in 3 Solve for I Y using the PV from step 2 and FV from step 1 PVoutflow FVstep1 N ALWAYS LESS THAN IRR Capital rationing practice of placing a dollar limit on the total size of the capital budget may not be consistent with maximizing shareholder value but necessary sometimes for other reasons choose between projects by selecting combination that yields highest Measurement of risk in capital budgeting and how to deal with it NPV w o exceeding capital budget limit needs to be considered in comparing projects w different levels of risk discount rate can be adjusted for risk when NPV is used hurdle rate can be adjusted when IRR is used no equation to solve policy decision RADRs Measurement calculate coefficient of variation of returns of the firm s asset portfolio with the project and without it Step 1 Find CV of existing Step 2 Find the expected return of the new portfolio existing new Step 3 Find standard deviation of the new portfolio existing new Step 4 Find the CV of the new portfolio Step 5 Compare the CV of the portfolio with and without the new project included difference between two CVs is measure of the risk of new project Comparing Risky Projects firms often compensate by adjusting discount rate to calculate NPV higher risk