Capital Budgeting Overview

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Capital Budgeting Overview

• Capital Budgeting is the set of valuation
  techniques for real asset investment decisions.
• Capital Budgeting Steps
• estimating expected future cash flows for the
  proposed real asset investment (Chap 12)
• estimating the firms cost of capital (Chap 10)
  based on the firms optimal capital structure
• using a decision-making valuation technique which
  depends on the companys cost of capital to
  decide whether to accept or reject the proposed
  investment (Chap 11)

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Chapter 10The Cost of Capital

• Estimating 3Ms Cost of Capital
• Air Jordans Divisional Cost of Capital

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Chapter 10 Learning Objectives

• Describe the concepts underlying the firms cost
  of capital (known as weighted average cost of
  capital) and the purpose for its calculation.
• Calculate the after-tax cost of debt, preferred
  stock and common equity.
• Calculate a firms weighted average cost of
  capital.
• Adjust the firms cost of capital on a by
  division or by project basis.
• Use the cost of capital to evaluate new
  investment opportunities.

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Cost of Capital

• The firms cost of raising new funds
• The weighted average of the cost of individual
  types of funding
• One possible decision rule is to compare a
  projects expected return to the cost of the
  funds that would be used to finance the purchase
  of the project
• Accept if projects expected return gt cost of
  capital

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Cost of Capital Terms

• Capital Component type of financing such as
  debt, preferred stock, and common equity
• rd cost of new debt, before tax
• rd(1-T) after-tax component cost of debt
• rp component cost of new preferred stock
• rs component cost of retained earnings(or
  internal equity, same as rS used in Chapters 8
  and 9

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More Cost of Capital Terms

• re component stock of external equity raised
  through selling new common stock
• WACC wdrd(1-T) wprp wcrs the weighted
  average cost ot capital which is the weighted
  average of the individual component costs of
  capital
• wi the fraction of capital component i used in
  the firms capital structure

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Component Cost of Debt

• Remember, a corporation can deduct their interest
  expense for tax purposes
• Therefore, the component cost of debt is the
  after-tax interest rate on new debt
• rd(1-T)
• where T is the companys marginal tax rate
• rd can be estimated by finding the YTM on the
  companys existing bonds

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Cost of Debt Example

• We want to estimate the cost of debt for 3M which
  has a marginal tax rate of 35. We find the
  following bond quote.
• CoName Rate Price Mat. Date
• 3M 5.7 103.43 Mar. 15, 2037
• Annual coupon rate 5.7, n 30 years , Price
  103.43 of par value, Semiannual coupons
• Find YTM

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3Ms Cost of Debt
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Cost of Preferred Stock, rp

• Cost of new preferred stock
• rp Dp / Pp
• Dp annual preferred stock dividend
• Pp price per share from sale of preferred stock
  
• Preferred Stock Characteristics
• Par Value, Annual Dividend Rate( of Par)
• generally no voting rights must be paid
  dividends before common dividends can be paid

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Cost of Preferred Stock Example

• 3M wants to sell new preferred stock. The par
  value will be 25 a share and 3M decides they
  will pay an annual dividend yield of 7.5. 3Ms
  advisors say the stock will sell for a price of
  26 if the dividend yield is 7.5. What is the
  cost of this new preferred stock?

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Cost of Retained Earnings, rs

• 3 different approaches can be used to estimate
  the cost of retained earnings, but I hate the
  Bond Yield Plus Risk Premium Approach. So,
  ignore it.
• The 2 remaining approaches assume that the
  companys stock price is in equilibrium.

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The CAPM Approach to the Cost of Retained Earnings

• The CAPM Approach is the required rate of return
  from Chapter 8.
• rs rRF (rM - rRF)bi
• Example The risk free rate is 4.9, and the
  required market return is 13.4. What would 3Ms
  CAPM cost of retained earnings be if its beta is
  0.85

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Discounted Cash Flow Approach for the Cost of
Retained Earnings

• The expected return formula derived from the
  constant growth stock valuation model.
• rs D1 / P0 g D0(1g)/P0 g
• In practice The tough part is estimating g.
• Security analysts projections of g can be used.
• According to the journal, Financial Management,
  these projections are a good source for growth
  rate estimates.

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DCF estimate for the Cost of Retained Earnings
for 3M

• Recent Stock Price 77.00,
• Last Dividend 1.84,
• expected constant growth rate in dividends 7

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What to do about the different cost of retained
earnings estimates?

• CAPM 12.1
• DCF 9.6
• Average the two or choose one or the other?
• Choosing DCF estimate makes for an easier cost of
  new common stock (external equity) estimate.
• However, if you wanted to be conservative, go
  with the higher estimate. Aggressive, go with
  lower estimate
• Lets average the two estimates and go with 10.9
  for our rs estimate.

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Adjusting for flotation costs of new security
issues.

• Include flotation costs for funds raised for a
  project as an additional initial cost of the
  project. OR adjust the component cost of
  capital.
• For example, for selling new common preferred
  stock.
• ke D1 / P0(1 - F) g kp D/P0(1 - F)
• where F flotation(underwriting) cost
• P0(1 - F) is the net price per share the company
  actually receives from selling new stock

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3Ms estimated cost of newly issued common equity
, re

• Lets go back to our original DCF estimates
• P0 77, D0 1.84, g 7
• Assume new stock can be sold at the current
  market price and 3M will incur a 20 floatation
  cost per share.
• re 1.84(1.07)/77(1-0.20) 7 10.2
• DCF rs 9.6. Difference 0.6
• So, if we want to use our average CAPM/DCF
  estimate for rs, then the re estimate would be
  10.9 0.6 11.5

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Weighted Average Cost of Capital, WACC

• WACC wdrd(1-T) wp rp wc rs
• wi the fraction of capital component i used in
  the firms capital structure
• What is 3Ms WACC if their market value target
  capital structure is 15 debt, 5 preferred
  stock, and 80 common equity financing through
  retained earnings?

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3Ms Weighted Average Cost of Capital, WACC

• Recall our previous estimates for 3M.
• rd(1-T) 3.6 , rp 7.2 , rs 10.9
• wd 15 or 0.15, wp 5 or 0.05, wc 80 or 0.8

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When to use new common stock (external equity)
financing retained earnings breakpoint

• 3Ms projected net income 3.4 billion,
  dividend payout ratio 41, 80 common equity
  financing.
• Retained earnings NI(1-dividend payout)
• Retained Earnings Breakpoint RE/wc

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3Ms Weighted Average Cost of Capital, WACC with
re

• Recall our previous estimates for 3M
• rd(1-T) 3.6 , rp 7.2 , re 11.5
• wd 15 or 0.15, wps 5 or 0.05, wc 80 or
  0.8

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What factors influence a companys composite WACC?

• Market conditions.
• The firms capital structure and dividend policy.
• The firms investment policy. Firms with riskier
  projects generally have a higher WACC.

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Some Problems in estimating Cost of Capital

• Small firms without dividends DCF approach is
  out.
• Firms that arent publicly traded no beta data,
  CAPM approach is difficult.
• What about depreciation? Large source of funds.
  Cost of depreciation funds WACC with RE.
• WACC is just for average risk projects.

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Adjusting for project risk

• The WACC is for average risk projects.
• A company should adjust their WACC upward for
  more risky projects and downward for less risky
  projects projects Risk-Adjusted Cost of
  Capital.
• A company can also make this adjustment on a
  divisional basis as well.

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Using the CAPM for Risk-adjusted Cost of Capital

• Can use this model to estimate a project cost of
  capital, rpr
• rpr rRF (rM - rRF)bpr
• where bP is the projects beta
• Note investing in projects that have more or
  less beta (or market) risk than average will
  change the firms overall beta and required
  return.

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Risk and the Cost of Capital
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Jordan Air Inc. a Divisional Cost of Capital
Example

• Jordan Air is a sporting goods apparel company
  which has recently divested itself from the
  sports franchise ownership business.
• Jordan Air is starting a golf equipment division
  to go along with its sports apparel division.
• The company uses only debt and common equity
  financing and thinks they should use different
  cost of capital for each division.

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Jordan Air Inc. a Divisional Cost of Capital
Example

• The company has a 40 tax rate and uses the CAPM
  method for estimating the cost of common equity.
  
• Apparel Division 35 debt and 65 equity
  financing. Before-tax cost of debt is 8. Beta
  1.2.
• Golf Division 40 debt and 60 equity financing.
  Before-tax cost of debt 8.5. Estimated beta
  to Callaway Golfs beta of 1.6.

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Jordan Airs Apparel Divisions Cost of Capital
Calculation

• The company has a 40 tax rate and uses the CAPM
  method for estimating the cost of equity with rRF
  5, RPm 8.
• Apparel Division 35 debt and 65 equity
  financing. Before-tax cost of debt is 8. Beta
  1.2.

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Jordan Airs Golf Divisions Cost of Capital
Calculation

• The company has a 40 tax rate and uses the CAPM
  method for estimating the cost of equity with rRF
  5, RPm 8.
• Golf Division 40 debt and 60 equity financing.
  Before-tax cost of debt 8.5. Estimated beta
  to Callaway Golfs beta of 1.6.