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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 10
The Cost of Capital
Estimating Coca-colas 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 > cost of
capital
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Cost of Capital Terms
Capital Component = type of financing such
as debt, preferred stock, and common equity
r
d
= cost of new debt, before tax
r
d
(1-T) = after-tax component cost of debt
r
p
= component cost of new preferred stock
r
s
= component cost of retained earnings(or
internal equity, same as r
S
used in Chapters 8
and 9
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More Cost of Capital Terms
r
e
= component stock of external equity raised
through selling new common stock
WACC = w
d
r
d
(1-T) + w
p
r
p
+ w
c
r
s
= the
weighted average cost ot capital which is the
weighted average of the individual component
costs of capital
w
i
= 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
r
d
(1-T)
where T is the companys marginal tax rate
r
d
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 Coke
which has a marginal tax rate of 35%. We find
the following bond quote.
CoName Rate Price Mat. Date
Coke 7.0 109.80 Nov 1, 2021
Annual coupon rate = 7%, n = 15 years , Price =
109.8% of par value, Semiannual coupons
Find YTM
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Cokes Cost of Debt

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Cost of Preferred Stock, r
p

Cost of new preferred stock
r
p
= D
p
/ P
p

D
p
= annual preferred stock dividend
P
p
= 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
Coca-cola wants to sell new preferred stock.
The par value will be $25 a share and Coke
decides they will pay an annual dividend yield
of 7.8%. Cokes advisors say the stock will sell
for a price of $26 if the dividend yield is 7.8%.
What is the cost of this new preferred stock?

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Cost of Retained Earnings, r
s

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.
r
s
= r
RF
+ (r
M
- r
RF
)b
i

Example: The risk free rate is 5%, and the
expected market return is 13.6%. What would
Cokes CAPM cost of retained earnings be if
its beta is 0.60
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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.
r
s
= D
1
/ P
0
+ g = D
0
(1+g)/P
0
+ 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 Coca-Cola
Recent Stock Price = $46.87,
Last Dividend = $1.24,
expected constant growth rate in dividends =
7.5%
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What to do about the different cost of
retained earnings estimates?
CAPM: 10.2%
DCF: 10.3%
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
Since there isnt much difference, lets go with the
slightly higher DCF of 10.3% for r
s
.
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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.
k
e
= D
1
/ P
0
(1 - F) + g; k
p
= D/P
0
(1 - F)
where F = flotation(underwriting) cost %
P
0
(1 - F) is the net price per share the company
actually receives from selling new stock
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Coca-colas estimated cost of newly
issued common equity , r
e
Lets go back to our original DCF estimates:
P
0
: $46.87, D
0
: $1.24, g = 7.5%
Assume new stock can be sold at the current market
price and Coke will incur a 20% floatation cost per
share.
r
e
= [$1.24(1.075)/$46.87(1-0.20)] + 7.5% = 11.1%
DCF r
s
= 10.3%. Difference = 0.8%
So, if you want to use the CAPM estimate for r
s
, then
your r
e
estimate would be 10.2% +0.8% = 11.0%

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Weighted Average Cost of Capital,
WACC
WACC = w
d
r
d
(1-T) + w
p
r
p
+ w
c
r
s
w
i
= the fraction of capital component i used
in the firms capital structure
What is Cokes WACC if their market value
target capital structure is 20% debt, 10%
preferred stock, and 70% common equity
financing through retained earnings?
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Coca-Colas Weighted Average Cost
of Capital, WACC
Recall our previous estimates for Coke.
r
d
(1-T) = 3.9% , r
p
= 7.5% , r
s
= 10.3%
w
d
= 20% or 0.2, w
p
= 10% or 0.1, w
c
= 70%
or 0.7
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When to use new common stock (external
equity) financing: retained earnings breakpoint
Cokes projected net income = $5.5 billion,
dividend payout ratio = 54%, 70% common
equity financing.
Retained earnings = NI(1-dividend payout)
Retained Earnings Breakpoint = RE/w
c

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Coca-Colas Weighted Average Cost
of Capital, WACC with r
e
Recall our previous estimates for Coca-Cola
r
d
(1-T) = 3.9% , r
p
= 7.5% , r
e
= 11.1%
w
d
= 20% or 0.2, w
ps
= 10% or 0.1, w
c
= 70%
or 0.7
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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, r
pr

r
pr
= r
RF
+ (r
M
- r
RF
)b
pr

where b
P
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
Rate of Return
(%)
WACC
Rejection Region
Acceptance Region
Risk
L
B
A
H
12.0
8.0
10.0
10.5
9.5
0 Risk
L
Risk
A
Risk
H
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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 r
RF
= 5%, RP
m
= 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 r
RF
= 5%, RP
m
= 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.