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6. Capital budgeting

The firms cost of capital is equal to the expected return on a portfolio of all the company's existing securities. In absence of corporate taxation the company cost of capital is a weighted average of the expected return on debt and equity:

The firm's cost of capital can be used as the discount rate for the average-risk of the firm's projects.

Cost of capital in practice

Cost of capitalism defined as the weighted average of the expected return on debit and equity

To estimate company cost of capital involves four steps:

1. Determine cost debt

- Interest rate for bank loans

- Yield to maturity for bonds

2. Determine cost of equity

- Find beta on the stock and determine the expected return using CAPM: r = r + 3 ( r — r )

equity risk free "equity market risk free

- Beta can be estimate d by pitting the return on the stock against the return on the market, and, fit a regression line to through the points. The slope on this line is the estimate of beta .

3. Find the debt and equity ratios

- Debt and equity ratios should be calculated by using market value (rather than book value) of debt and equity.

4. Insert into the weighted average cost of capital formula

6.1. Cost of capital with preferred stocks

Some firm has issued preferred stocks. In this case the required return on the preferred stocks should be included in the company's cost of capital.

Where firm value equals the sum of the market value of debt, common, and preferred stocks.

The cost of preferred stocks can be calculated by realizing that a preferred stock promises to pay a fixed dividend forever. Hence, the market value of a preferred share is equal to the present value of a perpetuity paying the constant dividend:

Solving for r yields the cost of preferred stocks:

Thus, the cost of a preferred stock is equal to the dividend yield.

6.2. Cost of capital for new projects

A new investment project should be evaluated based on its risk, not on company cost of capital. The company cost of capital is the average discount rate across projects. Thus, if we use company cost of capital to evaluate a new project we might:

- Reject good low-risk projects

- Accept poor high-risk projects

True cost of capital depends on project risk. However, many projects can be treated as average risk. Moreover, the company cost of capital provide a good starting reference to evaluate project risk

6.3. Alternative methods to adjust for risk

An alternative way to eliminate risk is to convert expected cash flows to certainty equivalents. A certainty equivalent is the (certain) cash flow which you are willing to swap an expected but uncertain cash flow for. The certain cash flow has exactly the same present value as an expected but uncertain cash flow. The certain cash flow is equal to

39) Certain cash flow = PV (1 + r)

Where PV is the present value of the uncertain cash flow and r is the interest rate.

6.4. Capital budgeting in practice

Capital budgeting consists of two parts; 1) Estimate the cash flows, and 2) Estimate opportunity cost of capital. Thus, knowing which cash flows to include in the capital budgeting decision is as crucial as finding the right discount factor.

6.4.1. What to discount?

1. Only cash flows are relevant

- Cash flows are not accounting profits

2. Relevant cash flows are incremental

- Include all incidental effects

- Include the effect of imputation

- Include working capital requirements

- Forget sunk costs

- Include opportunity costs

- Beware of allocated overhead costs

6.4.2. Calculating free cash flows

Investors care about free cash flows as these measures the amount of cash that the firm can return to investors after making all investments necessary for future growth. Free cash flows differ from net income, as free cash flows are

- Calculated before interest

- Excluding depreciation

- Including capital expenditures and investments in working capital

Free cash flows can be calculated using information available in the income statement and balance sheet:

40) Free cash flow — profit after tax + depreciation + investment in fixed assets + investment in working capital

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