individual by RAshid⎝⏠⏝⏠⎠Ahmed


What is capital budgeting?

Analysis of potential additions to fixed assets.
In deciding whether to accept or reject a new project, firm needs a
benchmark to compare profitability of the project.

It is the discount rate the firm will use to compare different cash flows a
project will generate.

Another interpretation of this discount rate is that it is the minimum % return
a firm needs to earn from a project so that the project is an acceptable one.
In other words, the firm must earn at least this rate on its investments just to
compensate investors for the use of their money.


Every source of capital has its required return.
Weighted average of these required returns gives us the discount
rate we have described above. It is called the weighted average
cost of capital (WACC).

It is not valid to use the WACC directly for all the projects of the
firm. The WACC reflects the required rate for a typical investment
with average risk. An investment’s cost of capital should be found
by adjusting WACC to reflect the investment’s risk.

Components of WACC

What types of capital do firms use?

   Debt
   Preferred stock
   Common equity:
                        Retained earnings
                        New common stock

    Two important points

    We can calculate WACC on before-tax or after-tax basis.

     Since the after-tax WACC shows the net cost we should use
     it in our calculations.

    In finding component costs, we can either use the historical
     figures (costs we had in financing old projects) or we can
     try to estimate current costs (costs if we decide raise new
     capital to be used in new projects).

     It is obvious that we should use the current values.

Cost of equity
Cost of Retained Earnings
Why is there a cost for retained earnings?

    Earnings can be retained and reinvested or paid out as
    With dividends, investors could buy other securities, earn a
    Thus, there is an opportunity cost if earnings are retained.
    Opportunity cost: The return stockholders could earn on
     alternative investments of equal risk.
    Stockholders could buy similar stocks and earn ks. So, ks is
     the cost of retained earnings.

Three Approaches

  CAPM Approach
ks = kRF + (kM – kRF) b

  Bond Yield plus Risk-Premium Approach
ks = kd + RP

  Discounted Cash Flow Approach
ks = D1/P0 + g

CAPM Approach

What’s the cost of common equity based on the CAPM   ?

Given: kRF = 7%, RPM = 6%, b = 1.2

ks = kRF + (kM – kRF )b
    = 7.0% + (6.0%)*1.2 = 14.2%.

    Discounted Cash Flow Approach

    What’s the DCF cost of common equity, ks?
    Given: D0 = $4.19; P0 = $50; g =5%.

           ˆ   D       D (1  g)
           ks  1  g  0        g
               P0         P0

           =                0.05  0.088  0.05  13.8%

bond-yield-plus-risk-premium method
Find ks using the own-bond-yield-plus-risk-premium method.

recall kd = 10%, assume RP = 4%

ks = kd + RP = 10.0% + 4.0% = 14.0%

What’s a reasonable final estimate of ks ?

Method           Estimate
CAPM              14.2%
DCF               13.8%
kd + RP           14.0%
Average           14.0%

Why is the cost of retained earnings cheaper
than the cost of issuing new common stock?

   When a company issues new common stock they also have to
    pay flotation costs to the underwriter.

   Issuing new common stock may send a negative signal to the
    capital markets, which may depress stock price.

Flotation Costs
The costs associated with issuing new securities are called
floatation cost.

compensation to underwriters (direct cost)
filing fees, legal fees (direct cost)
costs of management time spent working on the new issue (indirect cost)

Two approaches that can be used to account for flotation costs:

   Include the flotation costs as part of the project’s up-front cost. This
    reduces the project’s estimated return.

   Adjust the cost of capital to include flotation costs. This is most
    commonly done by incorporating flotation costs in the DCF model.

DCF approach gave ks=13.8%
New common, F = 15%:

Comments about flotation costs:

   Flotation costs depend on the risk of the firm and the type of
    capital being raised.

   The flotation costs are highest for common equity. However,
    since most firms issue equity infrequently, the per-project cost
    is fairly small.

   We will frequently ignore flotation costs when calculating the

Cost of debt

For our firm, 15-year, 12% semiannual bond
sells for $1,153.72. What’s kd?

Cost of debt

Why is the cost of debt 10%, rather than 12%?
if the firm were to issue new bonds with time-to-maturity of 15 years, then
to be able to sell those new bonds at par value the coupon rate of those
bonds should be 10%. Thus 10% is current cost of borrowing.

Interest is tax deductible, so

    kd AT = kd BT(1 – T) = 10%(1 – 0.40) = 6%.

    Use nominal rate.
    Flotation costs small. Ignore.

Cost of preferred stock

What’s the cost of preferred stock?
The firm has outstanding preferred stock

  Pp = $111.10; 10% Quarterly ; Par = $100.

Cost of preferred stock

   Preferred dividends are not tax deductible, so no tax
    adjustment. Just kp.
   Nominal kp is used.
   Our calculation ignores flotation costs.


   Each firm has an optimal capital structure:
   Advantage of issuing debt: tax deductibility
   Disadvantage of issuing debt: increased likelihood of bankruptcy
   Some debt can reduce the agency problem between managers
    and stockholders by reducing free cash flow.
   We will be given optimal (target) capital structure of the firm

What’s the firm’s WACC (ignoring flotation costs)?

 WACC = wdkd(1 – T) + wpkp + wsks
      = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
      = 1.8% + 0.9% + 8.4% = 11.1%.

    Weights should be based on market values of securities that
     provide capital.
    If firm’s book value weights are close to market value weights
     then either of these can be used.

Adjusting WACC for risk

Consider two firms H (high risk) and L (low risk) and
two projects A and B
WACCL=8%          WACCH=12%
Expected return: project A=10.5% project B=9.5%

Divisional and project cost of capital

   Same logic holds for divisions within a firm
   Should the company use the WACC as the hurdle rate for each of its
   NO! The WACC reflects the risk of an average project undertaken by
    the firm. Therefore, the WACC only represents the “hurdle rate” for a
    typical project with average risk.
   Different projects have different risks. The project’s WACC should be
    adjusted to reflect the project’s risk.

A firm has two divisions L and H of equal size.
WACCL= 7%                WACCH=13%
WACC= 0.5*7% + 0.5*13% = 10%
There are two projects to be evaluated. One for division L,
and another for division H.

But how is risk measured?

1. Stand-alone risk
2. Corporate or within-firm risk
3. Market (beta) risk

Which measure is the best?
Which measure is the easiest to calculate?

     Best risk measure
   A project’s cash flows will be correlated with the cash flows of the
    firm (excluding CFs of the project)
    So project may provide diversification benefits. 2 is better than 1.

   Shareholders are probably well-diversified. i.e. they should only care
    about market risk. 3 is better than 2.

Unfortunately, market risk appears to be the most difficult to estimate.

If we can find beta of the project, we can calculate the cost of equity
by using the SML. Then WACC can be found by adding the remaining
cost components.

How to estimate beta of the project?

Pure play method: Identify firms whose only business is to produce
the product in question.

Use average of betas of these firms.


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