The Cost of Capital and Capital Budgeting

Ch. 9 to 11, 4th meeting

 WACC
 Capital budgeting
 Methods to evaluate projects profitability
 Risk in capital budgeting
 Real options

1 The cost of capital and capital budgeting

 Factors affecting project profitability
Project Project
Project
Sales
Op. Req. Fin. Interest Project Market
Rev
Costs & Invest- Decs. rate risk risk
Tax ments

Project cost of
Project FCF
capital (r)

NPV of the project

𝑁𝑃𝑉 =¿
2 The cost of capital and capital budgeting
 What sources of long-term capital do firms
use?

Long-Term
Capital

Long-Term Preferred Common

Debt Stock Stock

Retained New Common

Earnings Stock

3 The cost of capital and capital budgeting

 The logic of the weighted average cost of
capital
Firms are truly profitable if and only if their income
exceeds the cost of capital of all the capital they use to
finance their operations (that’s why EVA is designed).
Firms might raise their capital in forms of common equity,
debt, preferred stock and the combination.
Each source of financing has its cost of capital. So we have
cost of equity, cost of debt, and cost of preferred stock.
The combination of financing, therefore, will generate the
combination of cost of capital which is termed as the
weighted average cost of capital (WACC). In slide 2 it is
reflected by r.

4 The cost of capital and capital budgeting

 Why we need to estimate WACC?
The firm’s primary objective is to maximize
shareholders value, and firms can increase
shareholders value by investing in projects that
earn more than the cost of capital (remember an
economic principle; an investment is profitable if
the benefits is greater than the costs?)
For this reason, the cost of capital (WACC) is also
referred to as a hurdle rate (an investment is
acceptable if it earns more than its hurdle rate).

5 The cost of capital and capital budgeting

 Calculating the weighted average cost of
capital
WACC = wdrd(1-T) + wprp + wsrs
 The w’s refer to the firm’s capital structure weights.
 The r’s refer to the cost of each component.
 rd = interest rate on the firm’s new debt = before tax cost of debt.
 rd(1-T) = after tax cost of debt, where T is the firm’s marginal tax
rate
 rp = cost of preferred stock
 rs = cost of equity
 WACC the weighted average cost of capital
 In Indonesia preferred stock is seldom used. Therefore
WACC mostly is = wdrd(1-T) + wsrs

6 The cost of capital and capital budgeting

 Some points to remember when using
WACC
Should our analysis focus on before-tax or after-tax
capital costs?
Stockholders focus on after tax cash flows. Therefore, we
should focus on after tax capital costs, i.e. use after tax
costs of capital in WACC. Only rd needs adjustment,
because interest is tax deductible.
Should our analysis focus on historical (embedded)
costs or new (marginal) costs?
The cost of capital is used primarily to make decisions
that involve raising new capital. So, focus on today’s
marginal costs (for WACC).

7 The cost of capital and capital budgeting

 How are the weights determined?
WACC = wdrd(1-T) + wprp + wsrs

Use accounting numbers or market value (book vs.

market weights)?
Conceptually market value weight should be used but
due to the availability of data sometimes book value
weight is used
Use actual numbers or target capital structure?
Use target (or optimal) capital structure for the weight
because it minimizes WACC, hence firm should operate
on that structure
8 The cost of capital and capital budgeting
 How to estimate cost of debt (rd)?
 A 5-year, 12% annual coupon bond sells for 96.482% (from the par
value). What is the cost of debt (rd)?
 We can formulate, 96.482 = Σ 12/(1+rd)t where t = 1 to 5
 Using trial and error (or excel or financial calculator) we obtain rd =
13%
 Remember rd is equal to the rate of return required by investors who’d
like to buy the bond
 Suppose the corporate income tax rate (=T) is 30%. Therefore rd(1-T) =
13% (1-0.3) = 9.1%
 Because interest is a deductible expense, it produces tax savings that
reduce the net cost of debt, making the after-tax cost of debt less than the
before-tax cost. Since we are concerned with after-tax cash flows the cost
of debt should be based on after tax basis to make them comparable.

9 The cost of capital and capital budgeting

 What is cost of preferred stock?
The rate of return investors require on the firm’s
preferred stock.
Suppose a 12%-preferred stock, nominal Rp.1,000,
sold at Rp.857. What is cost of the preferred stock?
This means that the stock distributes dividend of Rp.120
annually. Therefore rp = Rp.120/Rp.857 = 14%
Remember this cost is not adjusted for tax because
dividend of preferred stocks is not tax deductible
To investors preferred stock is riskier than debt

10 The cost of capital and capital budgeting

 Cost of equity
Two types of equity, namely (1) retained earnings,
and (2) new equity
rs is the marginal cost of common equity using
retained earnings.
The rate of return investors require on the firm’s
common equity using new equity is re.
Where re> rs. The difference between the two costs
is caused by floatation (issuing) costs (we will see
it later).

11 The cost of capital and capital budgeting

 Three ways to determine the cost of common
equity, rs
 CAPM: rs = rRF + (rM – rRF) β

 DCF (Dividend model):

If constant growth model is appropriate,
rs = D1 / P0 + g

 Own-Bond-Yield-Plus-Risk Premium:
rs = rd + RP
 RP (= risk premium) is judgmental

12 The cost of capital and capital budgeting

 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.
Typically it is around 3-5% of the funds raised.
Issuing new common stock may send a negative
signal to the capital markets, which may depress
the stock price.
Remember we need to adjust ke to take into
account floatation costs

13 The cost of capital and capital budgeting

 Should the company use the composite WACC as the
hurdle rate for each of its projects?
NO! The composite 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.

14 The cost of capital and capital budgeting

 How to adjust project’s WACC to risk?
Here is the procedure;
Estimate project’s systematic risk (β) to determine the
cost of equity
Identify the cost of debt of the project.
Using target (or optimal) capital structure estimate the
WACC

15 The cost of capital and capital budgeting

 What is capital budgeting?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
Capital budgeting projects are created by firm

Should we
build this
plant?

16 The cost of capital and capital budgeting

 Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Calculate PV of cash inflows (using the cost of
capital) to estimate the asset’s value. This is equivalent
to finding the present value of a stock’s expected
future dividend
5. The PV of the expected cash inflows is compared with
the required outlay (costs of investment). If the PV of
the cash inflows ≥ the required outlay, the project is
profitable and should be accepted
17 The cost of capital and capital budgeting
 Capital budgeting methods
Average accounting rate of return (AARR)
Payback
Discounted payback
Net present value (NPV)
Profitability index (PI)
Internal rate of return (IRR)
Modified internal rate of return (MIRR)

Only NPV is discussed since conceptualy it is the most

consistent method with the obejctive of maximizing firm
value
18 The cost of capital and capital budgeting
 The project
(an example)
 Investment in fixed assets of Rp.1,000 million, 5 years of
economic life, no salvage value
 Estimates of revenues and costs & expenses / year
 Sales revenues Rp.900 million
 Costs and expenses (excluding depreciation)Rp.500 million
 Depreciation Rp.200 million
 Operating income Rp.200 million
 Income tax (30%) Rp. 60 million
 Net operating profit after tax (NOPAT) Rp.140 million
 The cost of capital (r) for the project is 16%
 Calculate AARR, Payback, Discounted Payback, NPV, PI,
IRR, and MIRR. See file Excel, FinMan_04_CapBudgeting
Methods_2016

19 The cost of capital and capital budgeting

 Comparison among the methods
Conceptually NPV is the most consistent method
with the objective of financial decisions.
However, some managers prefer to use IRR
because the result (which is expressed in
percentage) helps them in making judgmental
decision. This is the reason why MIRR is
introduced.

20 The cost of capital and capital budgeting

 Estimating cash flows
This is the most important, but the most difficult,
step.
Forecast errors are always possible. You can only
try to avoid bias in estimation.
The idea is to forecast cash flows correctly (i.e.
identifying the relevant cash flows) not accurately
(impossible in forecasting the future).
Two cardinal rules are; (1) Capital budgeting is
based on cash flows, not accounting income, and
(2) only incremental cash flows are relevant.
21 The cost of capital and capital budgeting
 Identifying the relevant cash flows
 Remember that project cash flow differs from accounting income
Free cash flow = After tax operating income + Depreciation – Capital
expenditure – Change in net working capital
 What are the relevant cash flows consist of?
 Costs of fixed assets (included shipping costs, installation costs, etc.)
 Non-cash charges, such as depreciation, must be added to net income when
estimating a project’s cash flow.
 Changes in net operating working capital. At the beginning of project’s life
net operating working capital adds the cost of investment. At the end of the
project’s life the investment in operating working capital will be returned.
 Interest expenses are not included in project cash flows. Financing effects
have already been taken into account by discounting cash flows at the
WACC. Deducting interest expense would be “double counting” financing
costs. See the appendix of (FinMan_04_Capital
Budgeting_Appendix_2016_Aug)

22 The cost of capital and capital budgeting

 Incremental cash flows:
The NCF attributable to an investment project
Three special problems in determining incremental
cash flows are;
Sunk cost. A sunk cost is an outlay that has already
occurred, hence is not affected by the decision. Forget sunk
costs, they are not included in the analysis.
Opportunity cost. This is the return of the best alternative
use of an asset. Must be included in the analysis.
Externalities. Effects of a project on cash flows in other
parts of the firm. Externalities can be positive (in the case of
complements) or negative (substitutes). When the impact is
negative, sometimes it’s also called cannibalization. Must be
taken into account in the analysis.

23 The cost of capital and capital budgeting

 Evaluating capital budgeting projects
 A project might be a new expansion or a replacement project. In a new
expansion project, the incremental cash flows are simply the project’s
cash inflow and outflows. In a replacement project, the incremental
cash flows are the firm’s additional inflows and outflows that result
from investing in the new asset.
 Despite these differences, the cash flows typically include;
 Initial investment outlay, which consists of costs of fixed assets and net
operating working capital.
 Operating cash flows over the project’s life. Annual operating cash flows
equal to after tax operating income plus depreciation.
 Terminal year cash flows. At the end of project’s life some extra cash flows
are received. These include the salvage value of the fixed assets, adjusted
for tax, plus the return of the net operating working capital.

24 The cost of capital and capital budgeting

 Risk in capital budgeting
Conceptually, market risk is the most relevant risk.
However, some analysts also analyze total risk since
total risk affects creditors, customers, suppliers, and
employees. Therefore it should not be completely
ignored.
Methods for analyzing total risk are sensitivity
analysis, scenario analysis, and Monte Carlo
Simulation (see Chapter 11). These methods
incorporates risk in cash flow estimation while
adjusting market risk accomodate risk in discount rate.
(How financial analyst estimate cost of equity and
analyzing risk in Indonesia? See the texbook Ch.11)
25 The cost of capital and capital budgeting
 How to incorporate market risk in analysis
Estimate the project’s beta to determine cost of
equity for the project.
This step is relevant if the project has different
market risk compared to the existing firm’s
activity.
Calculate the project’s WACC, taking into account
the optimal financing scheme for the project.
Use the WACC to calculate the project’s NPV.

26 The cost of capital and capital budgeting

 Real options in the project
This means that an investor has options during the
project economic life (option to expand, and option
to abandon), or before the project starts (option to
start).
The following is an example of option to abandon.

27 The cost of capital and capital budgeting

 Abandonment option
The profitability of launching a new product may
depend on consumers acceptance toward the new
product.
If the product is accepted it will continue to be
produced but if it is rejected it will be abandoned.
This situation is known as “abandonment option”.

28 The cost of capital and capital budgeting

 Abandonment/shutdown option
Project Y needs investment of $200,000, at t = 0.
it is expected to produce after-tax net cash flows of
$80,000 annually for the next three year.
With the discount rate of 10%, what is the project
NPV?

r = 10%

-$200,000 80,000 80,000 80,000

NPV = -$1,052  not profitable

29 The cost of capital and capital budgeting

 Abandonment option
A closer look at cash flow estimates reveals that
the project Y net cash flows depends on consumers
acceptance of the product.
There is 60% probability that consumers will
accept the product and generate after tax net cash
flow (A-T net CFs) of $150,000 annually, and 40%
probability that consumers reject the product and
generate A-T net CFs of -$25,000 annually.

30 The cost of capital and capital budgeting

 Abandonment decision tree
150,000 150,000 150,000
60% prob.
-$200,000
-25,000 -25,000 -25,000
40% prob.
0 1 2 3
Years
 If the consumers accept the product,
NPV = $173,028
 If the consumers reject the product
NPV = -$262,171
 E(NPV) = 0.6(173,028) + 0.4(-262,171)
= -1,052

31 The cost of capital and capital budgeting

 Abandonment options available

Suppose the company can stop producing the

product after one year production, that is if the
consumers reject the product.
If the product is stopped, there will be no cash
outflows and inflows after the first year.

32 The cost of capital and capital budgeting

 NPV with abandonment option
150,000 150,000 150,000
60% prob.
-$200,000 0
-25,000 0
40% prob.
0 1 2 3
Years
 If consumers accept the project,
NPV = $173,028
 If consumers reject the product,
NPV = -$222,727
 E(NPV) = 0.6(173,028) + 0.4(-222,727)
= $14,726  profitable

33 The cost of capital and capital budgeting