Capital Budgeting

1. Steve Paulone Facilitator Capital Budgeting

2. Sources of capital • Two basic sources – stocks (equity – both common and preferred) and debt (loans or bonds) • Capital buys assets to produce revenue and profits to pay back your investors

3. WACC (Weighted Average Cost of Capital) • Each component of capital (debt, preferred, equity) has an individual cost. In order to have a measure to gauge the acceptability of investments most companies calculate a weighted average of the three components of capital. The weighted average cost of capital is simply breaking down the components of your capital structure.

4. WACC (Weighted Average Cost of Capital) D x Rd (1-t) + E x Re +P x Rp V V V Where: V = the total of Debt + Equity + Preferred or the value of the firm D is the market value of the firm’s debt E is the market value of the firm’s equity P is the market value of the firms preferred Rd (1-t) is the after tax cost of debt Re is the cost of equity Rp is the cost of preferred

5. WACC (Weighted Average Cost of Capital) This formula and its calculation look complicated but it is really very simple. Let’s look at an example. Assume: The firm has a capital structure consisting of $ 1,000,000 in debt and $1,000,000 in equity or 50% debt and 50% equity. Assume also that the cost of debt is 10% and the firm’s tax rate is 40%. Assume also that the cost of equity as determined by the capital asset pricing model is 12% The weighted average cost of capital is calculated as follows: V = $1,000,000 debt + $1,000,000 equity = $2,000,000 D = 1,000,000/2,000,000 = .50 V E = 1,000,000/2,000,000 = .50 V After tax cost of debt + .10 (1-.40) = .06 or 6% Weighted average cost of capital: 6% x .50 + 12% x.50 = 3% + 6% = 9%

6. WACC (Weighted Average Cost of Capital) • Note two things that happen when debt is included in the cost of capital calculation. First because interest payments on debt are tax deductible the actual cost of debt is lower than the stated coupon. Secondly, the inclusion of debt in the capital structure will lower the overall cost of capital. Because of these advantages many companies will include debt in their capital structure a strategy known as financial leverage.

7. Net Present Value The Basic Idea • Net present value – the difference between the market value of an investment and its cost. Estimating cost is usually straightforward; however, finding the market value of assets can be tricky. The principle is to find the market price of comparables. • Discounted cash flow (DCF) valuation – finding the market value of assets or their benefits by taking the present value of future cash flows, i.e., by estimating what the future cash flows would trade for in today’s dollars.

8. Net Present Value (NPV) NPV = Sum of the present value of future cash flows - initial outlay T0 T1 T2 T3 T4 T5 (1,200,000) +300,000 + 300,000 + 300,000 +300,000 +500,000 1.10 (1.10) ^2 (1.10) ^3 (1.10^4)(1.10) ^5 Discounting: (1,200,000) + 272,727 +247,933 + 225,394 +204,904 +310,461 Next we want to determine the Net Present Value or NPV of the investment. We do this by subtracting the initial outlay from the sum of the present value of the cash flows. NPV = 1,261,419 - 1,200,000 NPV = $61,419

9. Net Present Value (NPV) • As you can see the difference between the sum of the present value of the future cash flows ($1,261,419) and the initial investment ($1,200,000) is positive. The difference between the initial outlay and the sum of the cash flows is called the Net Present Value or NPV.Projects that have a positive net present value add economic value to the firm and should be accepted. Projects with negative net present values should be rejected. With this information we can state our first decision rule: • If the Net Present Value (NPV) is positive the company should accept the project.

10. The Payback Rule Defining the Rule • Payback period – length of time until the accumulated cash flows equal or exceed the original investment.Payback period rule – investment is acceptable if its calculated payback is less than some specified number of years. • Summary of the RuleAdvantages: • Easy to understand • Adjusts for uncertainty of later cash flows • Biased towards liquidity Disadvantages: • Ignores the time value of money • Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff date • Biased against long-term projects

11. The Internal Rate of Return • Problems with the IRR • Non-conventional cash flows – the sign of the cash flows changes more than once or the cash inflow comes first and outflows come later. • If the cash flows are of loan type, meaning money is received at the beginning and paid out over the life of the project, then the IRR is really a borrowing rate and lower is better. • If cash flows change sign more than once, then you will have multiple internal rates of return. This is problematic for the IRR rule; however, the NPV rule still works fine. • Mutually exclusive investment decisions – taking one project means another cannot be taken

12. The Internal Rate of Return • Redeeming Qualities of the IRR • People seem to prefer talking about rates of return to dollars of value • NPV requires a market discount rate, IRR relies only on the project cash flows, although you do need an estimate of a required return to make the final decision

13. The Internal Rate of Return • Internal rate of return (IRR) – the rate that makes the present value of the future cash flows equal to the initial cost or investment. In other words, the discount rate that gives a project a $0 NPV. • IRR decision rule – the investment is acceptable if its IRR exceeds the required return. • NPV and IRR comparison: If a project’s cash flows are conventional (costs are paid early and benefits are received over the life), and if the project is independent, then NPV and IRR will give the same accept or reject signal.