The Cost

of Capital

1
 Learning Goals
Sources of capital
Cost of each type of funding
Calculation of the weighted average cost
of capital (WACC)
Construction and use of the marginal cost
of capital schedule (MCC)

2
Factors Affecting the Cost of
Capital
General Economic Conditions
Affect interest rates
Market Conditions
Affect risk premiums
Operating Decisions
Affect business risk
Financial Decisions
Affect financial risk
Amount of Financing
Affect flotation costs and market price
of security
3
 Weighted Cost of Capital Model
Compute the cost of each source of
capital
Determine percentage of each source of
capital in the optimal capital structure
Calculate Weighted Average Cost of
Capital (WACC)

4
1. Compute Cost of Debt
Required rate of return for creditors
Same cost found in Chapter 12 as yield to
maturity on bonds (kd).
e.g. Suppose that a company issues bonds
with a before tax cost of 10%.
Since interest payments are tax deductible,
the true cost of the debt is the after tax cost.
If the companys tax rate (state and federal
combined) is 40%, the after tax cost of debt
AT kd = 10%(1-.4) = 6%.

5
 2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
Dividend (Dp)
Required rate kp =

Market Price (PP) - F

Example: You can issue preferred stock for a net

price of $42 and the preferred stock pays a

$5
Thedividend.
cost of preferred stock:

$5.00
kp =
$42.00
= 11.90%
6
 3. Compute Cost of Common
Equity
Two Types of Common Equity Financing
Retained Earnings (internal common
equity)
Issuing new shares of common stock
(external common equity)

7
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Management should retain earnings
only
if they earn as much as stockholders
next best investment opportunity of
the
same risk.
Cost of Internal Equity = opportunity
cost of common stockholders funds.
Two methods to determine
Dividend Growth Model
Capital Asset Pricing Model 8
3. Compute Cost of Common Equity

Cost of Internal Common Stock Equity

Dividend Growth Model

D1
kS = + g
P0

9
3. Compute Cost of Common Equity
Cost of Internal Common Stock Equity
Dividend Growth Model

D1
kS = + g
P0

Example:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%.

10
3. Compute Cost of Common Equity
Cost of Internal Common Stock Equity
Dividend Growth Model

D1
kS = + g
P0
Example:
The market price of a share of common stock is $60.
The dividend just paid is $3, and the expected growth
rate is 10%.

kS = 3(1+0.10) + .10 =.155 = 15.5%

60
11
3. Compute Cost of Common Equity
Cost of Internal Common Stock Equity
Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM kRF)

12
3. Compute Cost of Common Equity

Cost of Internal Common Stock Equity

Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

13
3. Compute Cost of Common Equity
Cost of Internal Common Stock Equity
Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

kS = 5% + 1.2(13% 5%) = 14.6%

14
3. Compute Cost of Common Equity

Cost of New Common Stock

Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
kn = + g
P0 - F

15
3. Compute Cost of Common Equity
Cost of New Common Stock
Must adjust the Dividend Growth Model
equation for floatation costs of the new
common shares.
D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
16
 3. Compute Cost of Common Equity
Cost of New Common Stock
Must adjust the Dividend Growth Model
equation for floatation costs of the new
common shares.
D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs will
be 12%. D = $3.00 and estimated growth is 10%,
0

Price is $60 as before.

kn = 3(1+0.10) + .10 = .1625 = 16.25%
52.80 17
Weighted Average Cost of Capital

Gallagher Corporation estimates the following

costs for each component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%

Gallaghers tax rate is 40% 18

Weighted Average Cost of Capital
If using retained earnings to finance the
common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

19
Weighted Average Cost of Capital

If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

Assume that Gallaghers desired capital

structure is 40% debt, 10% preferred and
50% common equity.

20
Weighted Average Cost of Capital

If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

Assume that Gallaghers desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09% 21
Weighted Average Cost of Capital

If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

22
Weighted Average Cost of Capital

If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%

23
 Marginal Cost of Capital
Gallaghers weighted average cost will
change if one component cost of capital
changes.
This may occur when a firm raises a
particularly large amount of capital such
that investors think that the firm is riskier.
The WACC of the next dollar of capital
raised in called the marginal cost of
capital (MCC).

24
 Graphing the MCC curve
Assume now that Gallagher Corporation
has $100,000 in retained earnings with
which to finance its capital budget.
We can calculate the point at which they
will need to issue new equity since we
know that Gallaghers desired capital
structure calls for 50% common equity .

25
 Graphing the MCC curve
Assume now that Gallagher Corporation
has $100,000 in retained earnings with
which to finance its capital budget.
We can calculate the point at which they
will need to issue new equity since we
know that Gallaghers desired capital
structure calls for 50% common equity.

Breakpoint = Available Retained Earnings

Percentage of Total
26
Graphing the MCC curve
Breakpoint = ($100,000)/.5 = $200,000

27
 Making Decisions Using MCC

Marginal weighted cost of capital curve:

Weighted Cost of Capital

13%

12% 11.72%
11.09%
11%
Using
Usinginternal
internal Using
Usingnew
new
10% common
commonequity
equity common
commonequity
equity
0 100,000 200,000 300,000 400,000
Total Financing

28
Making Decisions Using MCC
Graph MIRRs of potential projects

Marginal weighted cost of capital curve:

Weighted Cost of Capital

12%

11% Project 1
MIRR = Project 2 Project 3
10% 12.4% MIRR = MIRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing 29
 Making Decisions Using MCC
Graph IRRs of potential projects
Graph MCC Curve
Marginal weighted cost of capital curve:
11.72%
Weighted Cost of Capital

12%
11.09%
11% Project 1
IRR = Project 2 Project 3
10% 12.4% IRR = IRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing 30
 Making Decisions Using MCC
Graph IRRs of potential projects
Graph MCC Curve
Choose projects whose IRR is above the weighted
marginal cost of capital
Marginal weighted cost of capital curve:
11.72%
Weighted Cost of Capital

12%
11.09%
11% Project 1
IRR = 12.4% Project 2 Project 3
10% IRR = 12.1% IRR = 11.5%

9% Accept Projects #1 & #2

0 100,000 200,000 300,000 400,000
Total Financing 31
 Answer the following questions and do the following
problems and include them in you ECP Notes.
If the cost of new common equity is higher than the cost of internal equity,
why would a firm choose to issue new common stock?

Why is it important to use a firms MCC and not a firms initial WACC to
evaluate investments?

Calculate the AT kd, ks, kn for the following information:

Loan rates for this firm = 9%
Growth rate of dividends = 4%
Tax rate = 30%
Common Dividends at t1 = $ 4.00
Price of Common Stock = $35.00
Flotation costs = 6%

Your firms ks is 10%, the cost of debt is 6% before taxes, and the tax rate is
40%. Given the following balance sheet, calculate the firms after tax WACC:

Total assets = $25,000

Total debt = 15,000
Total equity = 10,000
32
Your firm is in the 30% tax bracket with a before-tax required rate of
return on its equity of 13% and on its debt of 10%. If the firm uses 60%
equity and 40% debt financing, calculate its after-tax WACC.

Would a firm use WACC or MCC to identify which new capital budgeting
projects should be selected? Why?

A firm's before tax cost of debt on any new issue is 9%; the cost to issue
new preferred stock is 8%. This appears to conflict with the risk/return
relationship. How can this pricing exist?

What determines whether to use the dividend growth model approach or

the CAPM approach to calculate the cost of equity?

33
Capital Budgeting
Decision Methods

1
 Learning Objectives
The capital budgeting process.
Calculation of payback, NPV, IRR, and
MIRR for proposed projects.
Capital rationing.
Measurement of risk in capital
budgeting and how to deal with it.

2
The Capital Budgeting Process

Capital Budgeting is the process of

evaluating proposed investment
projects for a firm.
Managers must determine which
projects are acceptable and must
rank mutually exclusive projects by
order of desirability to the firm.
3
 The Accept/Reject Decision
Four methods:
Payback Period
years to recoup the initial investment
Net Present Value (NPV)
change in value of firm if project is under taken
Internal Rate of Return (IRR)
projected percent rate of return project will
earn
Modified Internal Rate of Return (MIRR)
4
Capital Budgeting Methods
Consider Projects A and B that have
the following expected cashflows?

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
5
Capital Budgeting Methods
What is the payback for Project A?

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

6
 Capital Budgeting Methods
What is the payback for Project A?
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

Cumulative CF -6,500 -3,000 +500
7
 Capital Budgeting Methods
What is the payback for Project A?
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600 Payback in
4 3,500 10,000 2.9 years

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

Cumulative CF -6,500 -3,000 +500 8
Capital Budgeting Methods
What is the payback for Project B?
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000

9
Capital Budgeting Methods
What is the payback for Project B?
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000 Payback in
3.4 years

0 1 2 3 4

(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400 +5,600 10
 Payback Decision Rule
Accept project if payback is less than
the companys predetermined
maximum.
If company has determined that it
requires payback in three years or
less, then you would:
accept Project A
reject Project B 11
 Capital Budgeting Methods
Net Present Value

Present Value of all costs and benefits

(measured in terms of incremental
cash flows) of a project.
Concept is similar to Discounted
Cashflow model for valuing securities
but subtracts the cost of the project.
12
 Capital Budgeting Methods
Net Present Value
Present Value of all costs and benefits (measured
in terms of incremental cash flows) of a project.
Concept is similar to Discounted Cashflow model
for valuing securities but subtracts of cost of
project.

NPV
NPV == PV
PV of
of Inflows
Inflows -- Initial
Initial Investment
Investment
CF1 CF2 CFn
NPV = + + Initial
(1+ k)1 . (1+ k ) n
13
(1+ k)2 Investment
Capital Budgeting Methods

What is the P R O J E C T
Time A B
NPV for 0 (10,000) (10,000)
Project B? 1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%

0 1 2 3 4

(10,000) 500 500 4,600 10,000

14
Capital Budgeting Methods

P R O J E C T
What is the Time A B
NPV for 0 (10,000.) (10,000.)
1 3,500 500
Project B? 2 3,500 500
3 3,500 4,600
k=10% 4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000

455
$500
15
(1.10)1
Capital Budgeting Methods
P R O J E C T
What is the Time A B
NPV for 0 (10,000.) (10,000.)
1 3,500 500
Project B? 2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%

0 1 2 3 4

(10,000) 500 500 4,600 10,000

455 $500
(1.10) 2 16
413
Capital Budgeting Methods
P R O J E C T
Time A B
What is the 0 (10,000.) (10,000.)
1 3,500 500
NPV for 2 3,500 500
Project B? 3 3,500 4,600
k=10% 4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000

455 $500
(1.10) 2
$4,600
413
(1.10) 3 17
3,456
Capital Budgeting Methods
P R O J E C T
Time A B
What is the 0 (10,000.) (10,000.)
NPV for 1 3,500 500
Project B? 2 3,500 500
3 3,500 4,600
k=10% 4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000

455 $500
$10,000
(1.10) 2
$4,600 (1.10) 4
413
(1.10) 3 18
3,456
6,830
Capital Budgeting Methods
P R O J E C T
Time A B
What is the 0 (10,000.) (10,000.)
1 3,500 500
NPV for 2 3,500 500
Project B? 3 3,500 4,600
4 3,500 10,000
k=10%

0 1 2 3 4

(10,000) 500 500 4,600 10,000

455

413
3,456 19
6,830
$11,154
 P R O J E C T
Time A B
What is the 0 (10,000.) (10,000.)
1 3,500 500
NPV for 2 3,500 500
Project B? 3 3,500 4,600
4 3,500 10,000
k=10%

0 1 2 3 4

(10,000) 500 500 4,600 10,000

455
PV Benefits > PV Costs
413
$11,154 > $ 10,000
3,456
20
6,830
$11,154
 P R O J E C T
Time A B
What is the 0 (10,000.) (10,000.)
NPV for 1 3,500 500
Project B? 2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%

0 1 2 3 4

(10,000) 500 500 4,600 10,000

455

413 PV Benefits > PV Costs NPV > $0

3,456 $11,154 > $ 10,000 $1,154 > $0
6,830
21
$11,154 - $10,000 = $1,154 = NPV
 Financial Calculator:
Additional Keys used to
enter Cash Flows and
compute the Net Present
Value (NPV)

22
 Financial Calculator:

Additional Keys used

to enter Cash Flows
and compute the Net
P/YR
Present Value (NPV) CF NPV IRR

N I/Y PV PMT FV

Key used to enter expected cash flows in order of

their receipt.
Note: the initial investment (CF0) must be
entered as a negative number since it is an outflow.
23
 Financial Calculator:
Additional Keys used
to enter Cash Flows
and compute the Net P/YR
CF
Present Value (NPV) NPV IRR

N I/Y PV PMT FV

Key used to calculate the net present value of

the cashflows that have been entered in the
calculator.

24
 Financial Calculator:

Additional Keys
used to enter Cash
Flows and compute
the Net Present P/YR
CF NPV IRR
Value (NPV)
N I/Y PV PMT FV

Key used to calculate the internal rate of return

for the cashflows that have been entered in the
calculator. 25
 Calculate the NPV for Project B with calculator.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
P/YR
1 3,500 500
CF NPV IRR 2 3,500 500
3 3,500 4,600
N I/Y PV PMT FV 4 3,500 10,000

26
Calculate the NPV for Project B with calculator.

Keystrokes for TI BAII PLUS:

CF0 = -10,000
CF 10000 +/- ENTER
P/YR
CF NPV IRR

N I/Y PV PMT FV

27
Calculate the NPV for Project B with calculator.

500 ENTER
C01 = 500

Keystrokes for TI BAII PLUS:

P/YR
CF NPV IRR
CF 10000 +/- ENTER
N I/Y PV PMT FV

28
Calculate the NPV for Project B with calculator.

Keystrokes for TI BAII PLUS:

F01 = 2
CF 10000 +/- ENTER
P/YR
CF NPV IRR 500 ENTER

N I/Y PV PMT FV
2 ENTER

F stands for frequency. Enter 2 since there

are two adjacent payments of 500 in periods 1 and 2.
29
 Calculate the NPV for Project B with calculator.

Keystrokes for TI BAII PLUS:

CF 10000 +/- ENTER

C02 = 4600
500 ENTER

P/YR
2 ENTER
CF NPV IRR
4600 ENTER
N I/Y PV PMT FV

30
 Calculate the NPV for Project B with calculator.

Keystrokes for TI BAII PLUS:

F02 = 1 CF 10000 +/- ENTER
500 ENTER
P/YR
CF NPV IRR 2 ENTER
N I/Y PV PMT FV 4600 ENTER
1 ENTER
31
 Calculate the NPV for Project B with calculator.

Keystrokes for TI BAII PLUS:

C03 = 10000 CF 10000 +/- ENTER

500 ENTER
P/YR
CF NPV IRR 2 ENTER
N I/Y PV PMT FV
4600 ENTER
1 ENTER
10000 ENTER
32
 Calculate the NPV for Project B with calculator.

Keystrokes for TI BAII PLUS:

CF 10000 +/- ENTER

F03 = 1
500 ENTER

P/YR
2 ENTER
CF NPV IRR
4600 ENTER
N I/Y PV PMT FV
1 ENTER
10000 ENTER
33
1 ENTER
Calculate the NPV for Project B with calculator.

Keystrokes for TI BAII PLUS:

I = 10
NPV 10 ENTER
P/YR
CF NPV IRR

N I/Y PV PMT FV k = 10%

34
 Calculate the NPV for Project B with calculator.

NPV = 1,153.95 Keystrokes for TI BAII PLUS:

NPV 10 ENTER
P/YR
CF NPV IRR CPT
N I/Y PV PMT FV

The net present value of Project B = $1,154

as we calculated previously.
35
 NPV Decision Rule

Accept the project if the NPV is

greater than or equal to 0.

Example:
>0 Accept
NPVA = $1,095
> 0 Accept
NPV B = $1,154
If projects are independent, accept both projects.
If projects are mutually exclusive, accept the project 36

with the higher NPV.

 Capital Budgeting Methods
IRR (Internal Rate of Return)
IRR is the discount rate that forces the NPV
to equal zero.
It is the rate of return on the project given
its initial investment and future cash flows.
The IRR is the rate earned only if all CFs are
reinvested at the IRR rate.

37
 Calculate the IRR for Project B with calculator.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
P/YR 2 3,500 500
CF NPV IRR
3 3,500 4,600
N I/Y PV PMT FV
4 3,500 10,000

39
 Calculate the IRR for Project B with calculator.

P R O J E C T
Time A B
IRR = 13.5% 0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
P/YR 3 3,500 4,600
CF NPV IRR
4 3,500 10,000
N I/Y PV PMT FV
Enter CFs as for NPV

IRR CPT
40
 IRR Decision Rule
Accept the project if the IRR is greater
than or equal to the required rate of
return (k).
Reject the project if the IRR is less than
the required rate of return (k).

Example:
k = 10%
> 10% Accept
IRRA = 14.96%
> 10% Accept
IRRB = 13.50% 41
 Capital Budgeting Methods
MIRR (Modified Internal Rate of Return)
This is the discount rate which causes the
projects PV of the outflows to equal the
projects TV (terminal value) of the inflows.

TVinflows
PVoutflow =
(1 + MIRR)n
Assumes cash inflows are reinvested at k, the
safe re-investment rate.
MIRR avoids the problem of multiple IRRs.
We accept if MIRR > the required rate of return.
42
 P R O J E C T
What is the Time A B
MIRR for 0 (10,000.) (10,000.)
1 3,500 500
Project B? 2 3,500 500
3 3,500 4,600
4 3,500 10,000
Safe =2%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

(10,000)/(1.02)0 500(1.02)3 500(1.02)2 4,600(1.02)1 10,000(1.02)0

10,000
4,692
520
531
(10,000) 15,743 15,743 43
10,000 =
(1 + MIRR)4 MIRR = .12 = 12%
 Calculate the MIRR for Project B with calculator.
Step 1. Calculate NPV using cash inflows

Keystrokes for TI BAII PLUS:

CF 0 +/- ENTER
500 ENTER
2 ENTER
P/YR
CF NPV IRR 4600 ENTER
N I/Y PV PMT FV
1 ENTER
10000 ENTER
1 ENTER
44
 Calculate the MIRR for Project B with calculator.
Step 1. Calculate NPV using cash inflows

Keystrokes for TI BAII PLUS:

NPV = 14,544 NPV 2 ENTER

P/YR
CPT
CF NPV IRR

N I/Y PV PMT FV

The net present value of Project B cash inflows = $14,544

(use as PV)
45
 Calculate the MIRR for Project B with calculator.

Step 2. Calculate FV of cash inflows using previous NPV

This is the Terminal Value

Calculator Enter:
N = 4
FV = 15,743
I/YR = 2
PV = -14544
PMT = 0 CF NPV
P/YR
IRR
CPT FV = ?
N I/Y PV PMT FV

46
 Calculate the MIRR for Project B with calculator.
Step 3. Calculate MIRR using PV of outflows and calculated
Terminal Value.
Calculator Enter:
N = 4 MIRR 12.01
PV = -10000
PMT = 0 P/YR
FV = 15,743 CF NPV IRR

CPT I/YR = ?? N I/Y PV PMT FV

47
What is capital rationing?

Capital rationing is the practice of

placing a dollar limit on the total size
of the capital budget.
This practice may not be consistent
with maximizing shareholder value
but may be necessary for other
reasons.
Choose between projects by
selecting the combination of projects
that yields the highest total NPV
without exceeding the capital budget 54
limit.
Measurement of Project Risk

Calculate the coefficient of variation

of returns of the firms asset portfolio
with the project and without it.
This can be done by following a five
step process. Observe the following
example.

55
Measurement of Project Risk

Step 1: Find the CV of the Existing

Portfolio
Assume Company X has an existing rate of
return of 6% and standard deviation of 2%.

CV= Standard Deviation

Mean, or expected value
= .02
.06
= .3333, or 33.33% 56
 Measurement of Project Risk

Step 2: Find the Expected return of the

New Portfolio (Existing plus Proposed)
Assume the New Project (Y) has an IRR of
5.71% and a Standard Deviation of 2.89%
Assume further that Project Y will account for
10% of Xs overall investment.

E(Rp) = (wx x E(Rx)) + (wy x E(Ry))

= (.10 x .0571) + (.90 x .06)
= .00571 + .05400
57
= .05971, or 5.971%
 Measurement of Project Risk
Step 3: Find the Standard Deviation of the
New Portfolio (Existing plus Proposed).
Assume the proposed is uncorrelated with
the existing project. rxy = 0
p = [wx2x2 + wy2y2 + 2wxwyrxyxy]1/2
= [(.102)(.02892) + (.902)(.022) + (2)(.10)(.90)(0.0)(.0289)(02)]1/2
= [(.01)(.000835) + (.81)(.0004) + 0]1/2
= [.00000835 + .000324]1/2
= [.00033235]1/2 = .0182, or 1.82%
58
 Measurement of Project Risk

Step 4: Find the CV of the New

Portfolio (Existing plus Proposed)

CV= Standard Deviation

Mean, or expected value
= .0182
.05971
= .3048, or 30.48%

59
 Measurement of Project Risk

Step 5: Compare the CV of the

portfolio with and without the
Proposed Project.
The difference between the two
coefficients of variation is the measure
of risk of the capital budgeting project.

CV without Y CV with Y Change in CV

33.33% 30.48% -2.85

60
 Comparing risky projects using
risk adjusted discount rates
(RADRs)
Firms often compensate for risk by
adjusting the discount rate used to
calculate NPV.
Higher risk, use a higher discount rate.
Lower risk, use a lower discount rate
The risk adjusted discount rate
(RADR) can also be used as a risk
adjusted hurdle rate for IRR
comparisons. 61
 Non-simple Projects
Non-simple projects have one
or more negative future cash
flows after the initial
investment.

62
 Non-simple projects
How would a negative cash flow in
year 4 affect Project Zs NPV?
k=10%

0 1 2 3 4

(10,000) 5,000 5,000 5,000 -6,000

4,545

4,132
3,757
-4,098
8,336 - $10,000 = -$1,664 NPV
63
Project Z should be rejected in this case.
Mutually Exclusive Projects
With Unequal Lives
Mutually exclusive projects with
unequal project lives can be
compared by using two methods:
Replacement Chain
Equivalent Annual Annuity

68
 Replacement Chain
Approach
Assumes each project can be
replicated until a common period of
time has passed, allowing the
projects to be compared.
Example
Project Cheap Talk has a 3-year life, with
an NPV of $4,424.
Project Rolles Voice has a 12-year life,
with an NPV of $4,510.
69
 Replacement Chain
Approach
Project Cheap Talk could be repeated
four times during the life of Project
Rolles Voice.

The NPVs of Project Cheap Talk, in

years t3, t6, and t9, are discounted
back to year t0.

70
 Replacement Chain
Approach
The NPVs of Project Cheap Talk, in years
t3, t6, and t9, are discounted back to year
t0, which results in an NPV of $12,121.
k=10%
0 3 6 9

4,424 4,424 4,424 4,424

3,324
2,497
1,876
12,121
71
Equivalent Annual Annuity

Amount of the annuity payment that

would equal the same NPV as the
actual future cash flows of a project.
EAA = NPV
PVIFAk,n

72
Equivalent Annual Annuity

Project Cheap Talk

$4,244

((1-(1.1)-3) / .1)
= $1778.96
Project Rolles Voice
$4,510
((1-(1.1)-12) / .1)
73
= $661.90
 ECP Homework
1. The following net cash flows are projected for two separate projects. Your
required rate of return is 12%.

Year Project A Project B

0 ($150,000) ($400,000)
1 $30,000 $100,000
2 $30,000 $100,000
3 $30,000 $100,000
4 $30,000 $100,000
5 $30,000 $100,000
6 $30,000 $100,000

a. Calculate the payback period for each project.

b. Calculate the NPV of each project.
c. Calculate the MIRR of each project.
d. Which project(s) would you accept and why?
 ECP Homework
2. What is meant by risk adjusted discount rates?

3. Explain why the NPV method of capital budgeting is preferable over the
payback method.

4. A firm has a net present value of zero. Should the project be rejected?
Explain.

5. You have estimated the MIRR for a new project with the following probabilities:

Possible MIRR Value Probability

4% 5%
7% 15%
10% 15%
11% 50%
14% 15%

a. Calculate the expected MIRR of the project.

b. Calculate the standard deviation of the project.

c. Calculate the coefficient of variation.

d. Calculate the expected MIRR of the new portfolio with the new project. The
current
portfolio has an expected MIRR of 9% and a standard deviation of 3% and
Business
Valuation

98
 Learning Objectives

Understand the importance of business

valuation.
Understand the importance of stock and
bond valuation.
Learn to compute the value and yield to
maturity of bonds.
Learn to compute the value and expected
yield on preferred stock and common stock.
Learn to compute the value of a complete
business.
99
General Valuation Model

To develop a general model for valuing a

business, we consider three factors that
affect future earnings:
Size of cash flows
Timing of cash flows
Risk
We then apply the factors to the
Discounted Cash Flow (DCF) Model
(Equation 12-1)
100
 Bond Valuation Model
Bond Valuation is an application of
time value model introduced in
chapter 8.
The value of the bond is the present
value of the cash flows the investor
expects to receive.
What are the cashflows from a bond
investment?

101
 Bond Valuation Model

3 Types of Cash Flows

Amount paid to buy the bond (PV)
Coupon interest payments made to
the bondholders (PMT)
Repayment of Par value at end of
Bonds life (FV).

102
 Bond Valuation Model

3 Types of Cash Flows

Amount paid to buy the bond (PV)
Coupon interest payments made to
the bondholders (PMT)
Repayment of Par value at end of
Bonds life (FV).
Bonds time to maturity (N)
Discount rate (I/YR)
103
IBM Bond Wall Street Journal Information

Cur Net
Bonds Yld Vol Close Chg
AMR624 cv 6 91 -1
ATT 8.35s25 8.3 110 102 +
IBM 633/8 05 6.6 228 9655/8 -1/18
IBM 6 /8 09 6.6 228 96 /8 - /8
Kroger 9s99 8.8 74 1017/8 -

104
 IBM Bond Wall Street Journal
Information:

Cur Net
Bonds Yld Vol Close Chg
AMR624 cv 6 91 -1
ATT 8.35s25 8.3 110 102 +
IBM 633/8 05 6.6 228 9655/8 -1/18
IBM 6 /8 09 6.6 228 96 /8 - /8
Kroger 9s99 8.8 74 1017/8 -

Suppose
Suppose IBMIBM makes
makes annual
annual coupon
coupon payments.
payments. The The
person
person who
who buys
buys the
the bond
bond at
at the
the beginning
beginning of of 2005
2005
for
for $966.25
$966.25 will
will receive
receive 55 annual
annual coupon
coupon payments
payments
of
of $63.75
$63.75 each
each and
and aa $1,000
$1,000 principal
principal payment
payment in in 55
years
years (at
(at the
the end
end ofof 2009).
2009). Assume
Assume tt00 is
is the
the
beginning
beginning of of 2005.
2005. 105
 IBM Bond Timeline:

Cur Net
Bonds Yld Vol Close Chg
AMR624 cv 6 91 -1
ATT 8.35s25 8.3 110 102 +
IBM 633/8 05 6.6 228 9655/8 -1/18
IBM 6 /8 09 6.6 228 96 /8 - /8
Kroger 9s99 8.8 74 1017/8 -

Suppose
Suppose IBMIBM makes
makes annual
annual coupon
coupon payments.
payments. The The
person
person whowho buys
buys the
the bond
bond at
at the
the beginning
beginning of
of 2005
2005 for
for
$966.25
$966.25 will
will receive
receive 55 annual
annual coupon
coupon payments
payments of of
$63.75
$63.75 each
each andand aa $1,000
$1,000 principal
principal payment
payment inin 55 years
years
(at
(at the
the end
end of
of 2009).
2009).
2005 2006 2007 2008 2009
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00 106
IBM Bond Timeline:

2005 2006 2007 2008 2009

0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00

Compute
Computethe
theValue
Valuefor
forthe
theIBM
IBMBond
Bondgiven
giventhat
thatyou
you
require
requirean
an8%
8%return
returnon
onyour
yourinvestment.
investment.

107
 IBM Bond Timeline:
2005 2006 2007 2008 2009
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00

$63.75
$63.75Annuity
Annuityfor
for55years
years $1000
$1000Lump
LumpSum
Sumin
in55years
years

VB = (INT x PVIFAk,n) + (M x PVIFk,n

)

108
 IBM Bond Timeline:
2005 2006 2007 2008 2009
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00

$63.75
$63.75Annuity
Annuityfor
for55years
years $1000
$1000Lump
LumpSum
Sumin
in55years
years

VB = (INT x PVIFAk,n) + (M x PVIFk,n )

= 63.75(3.9927) + 1000(.6806)
= 254.53 + 680.60 = 935.13
109
 IBM Bond Timeline:
2005 2006 2007 2008 2009
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

$63.75 1000.00
$63.75Annuity
Annuityfor
for55years
years

$1000
$1000Lump
LumpSum
Sumin
in55years
years
935.12

.01 rounding
N I/YR PV PMT FV
difference
5 8 ? 63.75
1,000
110
 Most Bonds Pay Interest Semi-Annually:

e.g. semiannual coupon bond with 5 years

to maturity, 9% annual coupon rate.

Instead of 5 annual payments of $90, the bondholder

receives 10 semiannual payments of $45.

2005 2006 2007 2008 2009

0 1 2 3 4 5

45 45 45 45 45 45 45 45 45 45
1000
111
Most Bonds Pay Interest Semi-Annual
2005 2006 2007 2008 2009

0 1 2 3 4 5

45 45 45 45 45 45 45 45 45 45
1000
Compute
Computethethevalue
valueof
ofthe
thebond
bondgiven
giventhat
thatyou
you
require
requireaa10%
10%return
returnon
onyour
yourinvestment.
investment.

Since interest is received every 6 months, we need to use

semiannual compounding

VB = 45( PVIFA 10 periods,5% ) + 1000(PVIF10 periods, 5%)

Semi-Annual 10%
10%
Compounding 22

112
 Most Bonds Pay Interest Semi-Annually:
2005 2006 2007 2008 2009
0 1 2 3 4 5

45 45 45 45 45 45 45 45 45 45
1000
Compute
Computethethevalue
valueof
ofthe
thebond
bondgiven
giventhat
thatyou
you
require
requireaa10%
10%return
returnon
onyour
yourinvestment.
investment.

Since interest is received every 6 months, we need to use

semiannual compounding

VB = 45( PVIFA 10 periods,5% ) + 1000(PVIF10 periods, 5%)

= 45(7.7217) + 1000(.6139)
= 347.48 + 613.90 = 961.38
113
Calculator Solution:
2005 2006 2007 2008 200
0 1 2 3 4 5

45 45 45 45 45 45 45 45 45 45
1000

961.38

N I/YR PV PMT FV

10 5 ? 45 1,000
114
 Yield to Maturity
If an investor purchases a 6.375% annual
coupon bond today for $966.25 and holds
it until maturity (5 years), what is the
expected annual rate of return ?
2005 2006 2007 2008 2009
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

-966.25
1000.00
??
+ ??
966.25

115
 Yield to Maturity
If an investor purchases a 6.375% annual coupon
bond today for $966.25 and holds it until maturity
(5 years), what is the expected annual rate of
return ?
2005 2006 2007 2008 2009
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

-966.25
1000.00
??
+ ??
966.25 VB = 63.75(PVIFA5, x%) + 1000(PVIF5,x%)
Solve by trial and error.
116
 Yield to Maturity
2005 2006 2007 2008 2
0 1 2 3 4 5

-966.25 63.75 63.75 63.75 63.75 63.75

1000.00
Calculator Solution:
7.203%

N I/YR PV PMT FV

5 ? -966.25 63.75
1,000
117
 Yield to Maturity

2005 2006 2007 2008 20

0 1 2 3 4 5

-966.25 63.75 63.75 63.75 63.75 63.75

1000.00

If YTM > Coupon Rate bond Sells at a

DISCOUNT
If YTM < Coupon Rate bond Sells at a PREMIUM

118
 Interest Rate Risk

Bond Prices fluctuate over Time

As interest rates in the economy change,
required rates on bonds will also change
resulting in changing market prices.

Interest

VB
Rates

119
 Interest Rate Risk

Bond Prices fluctuate over Time

As interest rates in the economy change,
required rates on bonds will also change
resulting in changing market prices.

Interest
Rates
VB
VB
Interest
Rates

120
 Valuing Preferred Stock
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close
Chg
s 42 29 QuakerOats OAT 1.143.3 24 5067 35 34 34 -
s 36 25 RJR Nabisco RN .08p ... 12 6263 29 2855/8 287/8 -
237/820 RJR Nab pfB 2.319.7 ... 966 24 23 /8 23 ...
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8
23 ...
7 5 RJR Nab pfC .60 9.4 ... 2248 6 6
63/08 -1/8 1 2 3

P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31

P0 = Value of Preferred Stock

= PV of ALL dividends discounted at

investors Required Rate of Return
121
 Valuing Preferred Stock
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close
Chg
s 42 29 QuakerOats OAT 1.143.3 24 5067 35 34 34 -
s 36 25 RJR Nabisco RN .08p ... 12 6263 29 2855/8 287/8 -
237/820 RJR Nab pfB 2.319.7 ... 966 24 23 /8 23 ...
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8
23 ...
7 5 RJR Nab pfC .60 9.4 ... 2248 6 6
63/08 -1/8 1 2 3

P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31

2.31 2.31 2.31
P0 = (1+ kp) +(1+ kp)2 +
(1+ kp)3 +

122
 Valuing Preferred Stock
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close
Chg
s 42 29 QuakerOats OAT 1.143.3 24 5067 35 34 34 -
s 36 25 RJR Nabisco RN .08p ... 12 6263 29 2855/8 287/8 -
237/820 RJR Nab pfB 2.319.7 ... 966 24 23 /8 23 ...
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8
23 ...
7 5 RJR Nab pfC .60 9.4 ... 2248 6 6
63/08 -1/8 1 2 3

P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31

2.31 2.31 2.31
P0 = (1+ kp) +
(1+ kp )2 +
(1+ kp )3 +
Dp 2.31
P0 =
kp = .10 = $23.10
123
 Valuing Individual Shares of
Common Stock
P0 = PV of ALL expected dividends discounted at investors
Required Rate of Return

0 1 2 3

P0 D1 D2 D3 D

D1 D2 D3
P0 = (1+ ks ) + (1+ ks )2 +
(1+ ks )3 +
Not
Notlike
likePreferred
PreferredStock
Stocksince
since DD00=
=DD11==DD22=
=DD33=
=DDNN,,therefore
therefore
the
thecash
cashflows
flowsare
areno
nolonger
longeran
anannuity.
annuity.

124
 Valuing Individual Shares of
Common Stock
P0 = PV of ALL expected dividends discounted at investors
Required Rate of Return

0 1 2 3

P0 D1 D2 D3 D
D1 D2 D3
P0 = (1+ ks ) + (1+ ks )2 +
(1+ ks )3 +
Investors
Investorsdo donot
notknow
know the
thevalues
valuesof
of
DD1,,DD2,,.... , DN. The future dividends must be
1 2 .... , DN. The future dividends must be
estimated.
estimated.

125
Constant Growth Dividend
Model
Assume that dividends grow at a constant rate
(g).

0 1 2 3

D0 D1=D0 (1+g) D2=D0 (1+g)D

2
3=D0 (1+g) D =D0 (1+g)
3

126
 Constant Growth Dividend
Model
Assume that dividends grow at a constant rate
(g).

0 1 2 3

D0 D1=D0 (1+g)D2=D0 (1+g)D

2
3=D0 (1+g) D =D0 (1+g)
3

D0 (1+ g) D0 (1+ g)2 D0 (1+ g)3

P0 = (1+ ks ) +
(1+ ks )2 +
(1+ ks )3
+
+ Reduces to:

D0(1+g) D1
P0 = ks g =
ks g Requires
Requires
kks > g
s> g
127
Constant Growth Dividend
Model
What is the value of a share of common stock if the
most recently paid dividend (D0) was $1.14 per share and
dividends are expected to grow at a rate of 7%?
Assume that you require a rate of return of 11%
on this investment.

D0(1+g) D1
P0 = ks g =
ks g

1.14(1+.07)
P0 = .11 .07 = $30.50
128
Valuing Total Stockholders
Equity
The Investors Cash Flow DCF Model
Investors Cash Flow is the amount that
is free to be distributed to debt
holders, preferred stockholders and
common stockholders.
Cash remaining after accounting for
expenses, taxes, capital expenditures
and new net working capital.

129
Calculating Intrinsic
Value
Coca Cola Example

130
 ECP Homework

1. Indicate which of the following bonds seems to be reported incorrectly with respect to
discount, premium, or par and explain why.

Bond Price Coupon Rate Yield to Maturity

A 105 9% 8%
B 100 6% 6%
C 101 5% 4.5%
D 102 0% 5%

2. What is the price of a ten-year $1,000 par-value bond with a 9% annual coupon rate and a
10% annual yield to maturity assuming semi-annual coupon payments?

3. You have an issue of preferred stock that is paying a $3 annual dividend. A fair rate of return
on this investment is calculated to be 13.5%. What is the value of this preferred stock issue?

4. Total assets of a firm are $1,000,000 and the total liabilities are $400,000. 500,000 shares of
common stock have been issued and 250,000 shares are outstanding. The market price of the
stock is $15 and net income for the past year was $150,000.
a.. Calculate the book value of the firm.
b. Calculate the book value per share.
c. Calculate the P/E ratio.

5. A firms common stock is currently selling for $12.50 per share. The required rate of return is
9% and the company will pay an annual dividend of $.50 per share one year from now which will
grow at a constant rate for the next several years. What is the growth rate?

131