Chapter 16 Capital Budgeting Decisions

1. Chapter 16Capital Budgeting Decisions • Methods of Financing • Cost of Capital • Choice of Minimum Attractive Rate of Return • Capital Budgeting (c) 2001 Contemporary Engineering Economics

2. Methods of Financing • Equity Financing – Capital is coming from either retained earnings or funds raised from an issuance of stock • Debt Financing – Money raised through loans or by an issuance of bonds • Capital Structure – Well managed firms establish a target capital structure and strive to maintain the debt ratio (c) 2001 Contemporary Engineering Economics

3. Equity Financing • Flotation (discount) Costs: the expenses associated with issuing stock • Types of Equity Financing: • Retained earnings • Common stock Retained earnings + Preferred stock + Common stock (c) 2001 Contemporary Engineering Economics

4. Floatation Cost • Issue: Raise net $10 million • Stock price: $28 per share • Floatation cost: 6% of stock price • Question: How many shares to issue? • (0.06)($28)(X) = 1.68X • Sales proceeds – flotation cost = Net proceeds • 28X – 1.68X = $10,000,000 • 26.32X = $10,000,000 • X = 379,940 shares. • 1.68(379,940) = $638,300 (c) 2001 Contemporary Engineering Economics

5. Debt Financing • Bond Financing: • Incur floatation cost • No partial payment of principal • Only interest is paid each year (or semi-annually) • The principal (face value) is paid in a lump sum when the bond matures • Term Loan: • Involve an equal repayment arrangement. • May incur origination fee • Terms negotiated directly between the borrowing company and a financial institution Bond Financing + Term Loans (c) 2001 Contemporary Engineering Economics

6. Bond Financing (Example 16.2) • To net $10 million, SSI would have to sell • $10,000,000/(1- 0.018) = $10,183,300 • worth of bonds and pay $183,300 in flotation costs. Since the $1,000 • bond would be sold at a 1.5% discount, the total number of bonds to • be sold would be • $10,183,300/($985) = 10,338.38. • (b) For the bond financing , the annual interest is equal to • $10,338,380 (0.12) = $1,240,606 • Only the interest is paid each period, and thus the principal amount • owed remains unchanged. (c) 2001 Contemporary Engineering Economics

7. Cost of Capital • Cost of Equity (ie) – Opportunity cost associated with using shareholders’ capital • Cost of Debt (id) – Cost associated with borrowing capital from creditors • Cost of Capital (k) – Weighted average of ie and id Cost of Debt Cost of Capital Cost of Equity (c) 2001 Contemporary Engineering Economics

8. Cost of Equity • Cost of Retained Earnings (kr) • Cost of issuing New Common Stock(ke) • Cost of Preferred Stock (kp) • Cost of equity: weighted average of krke, and kp (c) 2001 Contemporary Engineering Economics

9. Calculating Cost of Equity Issuing New Common Stock Cost of Retained Earnings Cost of Equity Where Cr = amount of equity financed from retained earnings, Cc= amount of equity financed from issuing new stock, Cp = amount of equity financed from issuing preferred stock, and Ce = Cr + Cc + Cp Cost of Preferred Stock (c) 2001 Contemporary Engineering Economics

10. Example 16.4 Determining the Cost of Equity (c) 2001 Contemporary Engineering Economics

11. Cost of retained earnings: With D1= $5, g = 8%, and P0= $40 • Cost of new common stock: With D1= $5, g = 8%, and fc= 12.4% • Cost of preferred stock: With D*= $9, P*= 8%, and fc= 0.06 • Cost of equity: (c) 2001 Contemporary Engineering Economics

12. Cost of Debt (c) 2001 Contemporary Engineering Economics

13. Example 16.5 Determining the Cost of Debt Solution (c) 2001 Contemporary Engineering Economics

14. The Cost of Capital Cd= Total debt capital(such as bonds) in dollars, Ce=Total equity capital in dollars, V = Cd+ Ce, ie= Average equity interest rate per period considering all equity sources, id = After-tax average borrowing interest rate per period considering all debt sources, and k = Tax-adjusted weighted-average cost of capital. (c) 2001 Contemporary Engineering Economics

15. Marginal Cost of Capital (Example 16.6)  Given: Cd = $4 million, Ce = $6 million, V= $10 millions, id= 6.92%, ie=19.96%  Find: k • Comments: This 14.74% would be the marginal cost of capital that a company with this financial structure would expect to pay to raise $10 million. (c) 2001 Contemporary Engineering Economics

16. Choice of MARR • Choice of MARR when Project Financing is Known • Choice of MARR when Project Financing is Unknown • Choice of MARR under Capital Rationing (c) 2001 Contemporary Engineering Economics

17. Choice of MARR when Project Financing is Known Explicit accounts For debt flows When you find the Net present worth of the project, use cost of equity (ie) as the discount rate. (c) 2001 Contemporary Engineering Economics

18. Choice of MARR when Project Financing is Unknown Without explicitly treating the debt flows, make a tax adjustment to the discount rate, using the weighted cost of capital k. (c) 2001 Contemporary Engineering Economics

19. Choice of MARR as a Function of Budget Borrowing rate (k) = 10% Lending rate (r) = 6% (c) 2001 Contemporary Engineering Economics

20. An Investment Opportunity Schedule 24 22 20 18 16 14 12 10 8 6 4 2 Project 1 Rate of return (%) Project 2 Project 3 Project 4 Project 5 Project 6 20% 15% 10% 8% 7% 4% 0 $20,000 $40,000 $60,000 Required capital budget (c) 2001 Contemporary Engineering Economics

21. A Choice of MARR under Capital Rationing 24 22 20 18 16 14 12 10 8 6 4 2 Borrowing rate (k) = 10% Lending rate (r) = 6% Project 1 Project 2 Rate of return (%) k = 10% Project 3 MARR Project 4 Project 5 Project 6 r = 6% 20% 15% 10% 8% 7% 4% 0 $20,000 $40,000 $60,000 Required capital budget (c) 2001 Contemporary Engineering Economics

22. Capital Budgeting • Evaluation of Multiple Investment Alternatives • Independent projects • Dependent projects • Capital Budgeting Decisions with Limited Budgets (c) 2001 Contemporary Engineering Economics

23. Independent Projects (c) 2001 Contemporary Engineering Economics

24. Mutually Exclusive Projects (c) 2001 Contemporary Engineering Economics

25. Contingent Projects (c) 2001 Contemporary Engineering Economics

26. Four Energy Saving Projects under Budget Constraints (Budget Limit = $250,000) (c) 2001 Contemporary Engineering Economics

27. Marginal Cost of Capital Schedule (MCC) and Investment Opportunity Schedule (OSC) (c) 2001 Contemporary Engineering Economics

28. Optimal Capital Budget (c) 2001 Contemporary Engineering Economics

29. Best Alt. Infeasible alternatives (c) 2001 Contemporary Engineering Economics

30. Summary • Methods of financing: 1. Equity financing uses retained earnings or funds raised from an issuance of stock to finance a capital. 2. Debt financing uses money raised through loans or by an issuance of bonds to finance a capital investment. • Companies do not simply borrow funds to finance projects. Well-managed firms usually establish a target capital structure and strive to maintain the debt ratio when individual projects are financed. (c) 2001 Contemporary Engineering Economics

31. The selection of an appropriate MARR depends generally upon the cost of capital—the rate the firm must pay to various sources for the use of capital. 1. The cost of equity (ie) is used when debt-financing methods and repayment schedules are known explicitly. 2. The cost of capital (k) is used when exact financing methods are unknown, but a firm keeps it capital structure on target. In this situation, a project’s after-tax cash flows contain no debt cash flows such as principal and interest payment (c) 2001 Contemporary Engineering Economics

32. The cost of the capital formula is a composite index reflecting the cost of funds raised from different sources. The formula is • The marginal cost of capital is defined as the cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised during a given period. (c) 2001 Contemporary Engineering Economics

33. Under conditions of capital rationing, the selection of MARR is more difficult, but generally the following possibilities exist: (c) 2001 Contemporary Engineering Economics

34. The cost of capital used in the capital budgeting process is determined at the intersection of the IOS and MCC schedules. • If the cost of capital at the intersection is used, then the firm will make correct accept/reject decisions, and its level of financing and investment will be optimal. This view assumes that the firm can invest and borrow at the rate where the two curves intersect. (c) 2001 Contemporary Engineering Economics

35. If a strict budget is placed in a capital budgeting problem and no projects can be taken in part, all feasible investment decision scenarios need to be enumerated. Depending upon each investment scenario, the cost of capital will also likely change. Our task is to find the best investment scenario in light of a changing cost of capital environment. As the number of projects to consider increases, we may eventually resort to a more advanced technique, such as a mathematical programming procedure. (c) 2001 Contemporary Engineering Economics