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Capital Budgeting Overview 1 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 firm’s cost of capital (Chap 10) based on the firm’s optimal capital structure using a decision-making valuation technique which depends on the company’s 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 3M’s Cost of Capital Air Jordan’s Divisional Cost of Capital 2

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Chapter 10 Learning Objectives 3 Describe the concepts underlying the firm’s 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 firm’s weighted average cost of capital. Adjust the firm’s 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 4 The firm’s cost of raising new funds The weighted average of the cost of individual types of funding One possible decision rule is to compare a project’s expected return to the cost of the funds that would be used to finance the purchase of the project Accept if : project’s expected return > cost of capital

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Cost of Capital Terms 5 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 6 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 firm’s capital structure

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Component Cost of Debt 7 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 company’s marginal tax rate r d can be estimated by finding the YTM on the company’s existing bonds

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Cost of Debt Example 8 We want to estimate the cost of debt for 3M which has a marginal tax rate of 35%. We find the following bond quote. CoName Rate PriceMat. Date 3M5.7103.43Mar. 15, 2037 Annual coupon rate = 5.7%, n = 30 years, Price = 103.43% of par value, Semiannual coupons Find YTM

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3M’s Cost of Debt 9

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Cost of Preferred Stock, r p 10 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 11 3M wants to sell new preferred stock. The par value will be $25 a share and 3M decides they will pay an annual dividend yield of 7.5%. 3M’s advisors say the stock will sell for a price of $26 if the dividend yield is 7.5%. What is the cost of this new preferred stock?

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Cost of Retained Earnings, r s 12 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 company’s stock price is in equilibrium.

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The CAPM Approach to the Cost of Retained Earnings 13 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 4.9%, and the required market return is 13.4%. What would 3M’s CAPM cost of retained earnings be if its beta is 0.85

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Discounted Cash Flow Approach for the Cost of Retained Earnings 14 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 3M 15 Recent Stock Price = $77.00, Last Dividend = $1.84, expected constant growth rate in dividends = 7%

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What to do about the different cost of retained earnings estimates? 16 CAPM: 12.1% DCF: 9.6% 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 Let’s average the two estimates and go with 10.9% for our r s estimate.

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Adjusting for flotation costs of new security issues. 17 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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3M’s estimated cost of newly issued common equity, r e 18 Let’s go back to our original DCF estimates: P 0 : $77, D 0 : $1.84, g = 7% Assume new stock can be sold at the current market price and 3M will incur a 20% floatation cost per share. r e = [$1.84(1.07)/$77(1-0.20)] + 7% = 10.2% DCF r s = 9.6%. Difference = 0.6% So, if we want to use our average CAPM/DCF estimate for r s, then the r e estimate would be 10.9% +0.6% = 11.5%

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Weighted Average Cost of Capital, WACC 19 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 firm’s capital structure What is 3M’s WACC if their market value target capital structure is 15% debt, 5% preferred stock, and 80% common equity financing through retained earnings?

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3M’s Weighted Average Cost of Capital, WACC 20 Recall our previous estimates for 3M. r d (1-T) = 3.6%, r p = 7.2%, r s = 10.9% w d = 15% or 0.15, w p = 5% or 0.05, w c = 80% or 0.8

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When to use new common stock (external equity) financing: retained earnings breakpoint 21 3M’s projected net income = $3.4 billion, dividend payout ratio = 41%, 80% common equity financing. Retained earnings = NI(1-dividend payout) Retained Earnings Breakpoint = RE/w c

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3M’s Weighted Average Cost of Capital, WACC with r e 22 Recall our previous estimates for 3M r d (1-T) = 3.6%, r p = 7.2%, r e = 11.5% w d = 15% or 0.15, w ps = 5% or 0.05, w c = 80% or 0.8

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What factors influence a company’s composite WACC? 23 Market conditions. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

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Some Problems in estimating Cost of Capital 24 Small firms without dividends: DCF approach is out. Firms that aren’t 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 25 The WACC is for average risk projects. A company should adjust their WACC upward for more risky projects and downward for less risky projects = project’s 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 26 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 project’s beta Note: investing in projects that have more or less beta (or market) risk than average will change the firm’s overall beta and required return.

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Risk and the Cost of Capital 27

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Jordan Air Inc.: a Divisional Cost of Capital Example 28 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 29 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 Golf’s beta of 1.6.

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Jordan Air’s Apparel Division’s Cost of Capital Calculation 30 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 Air’s Golf Division’s Cost of Capital Calculation 31 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 Golf’s beta of 1.6.

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