Chapter 11 - Capital Budgeting and Risk Analysis Chapter 12 - Cost of Capital

Tujuan Pembelajaran 1 Mahasiswa mampu untuk: Menjelaskan pengukuran risiko yang tepat untuk tujuan penganggara modal Menetapkan akseptabilitas dari suatu proyek baru dengan menggunakan baik metode certainty equivalent maupun metode risk-adjusted discount risk Menjelaskan penggunaan simulasi dan pohon probabilitas untuk mengimitasi kinerja proyek yang sedang dievaluasi

Pokok Bahasan 1 Risiko dan keputusan investasi Metode-metode untuk memasukkan risiko ke dalam penganggaran modal Pendekatan lain untuk mengevaluasi risiko dalam penganggaran modal

Tujuan Pembelajaran 2 Mahasiswa mampu untuk: Menjelaskan konsep yang mendasari biaya modal perusahaan dan tujuan perhitungannya Menghitung biaya modal setelah pajak untuk hutang, saham preferen dan saham biasa, serta biaya modal rata-rata tertimbang suatu perusahaan Menjelaskan prosedur untuk menaksir biaya modal pada perusahaan yang memiliki banyak divisi Menggunakan biaya modal untuk mengevaluasi investasi baru

Pokok Bahasan 2 Biaya Modal: Definisi dan Konsep kunci Menghitung biaya modal individual Biaya modal rata-rata tertimbang Menghitung Biaya Modal Divisi: Kasus Pepsico, Inc. Menggunakan cost of capital perusahaan untuk mengevaluasi investasi baru

Three Measures of a Project’s Risk Project Standing Alone Risk Risk diversified away within firm as this project is combined with firm’s other projects and assets. Project’s Contribution- to-Firm Risk Risk diversified away by shareholders as securities are combined to form diversified portfolio. Systematic Risk

Incorporating Risk into Capital Budgeting Two Methods: Certainty Equivalent Approach Risk-Adjusted Discount Rate

How can we adjust this model to take risk into account? NPV = - IO FCFt (1 + k) t n t=1 S Adjust the After-tax Cash Flows (ACFs), or Adjust the discount rate (k).

Certainty Equivalent Approach Adjusts the risky after-tax cash flows to certain cash flows. The idea: Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) Flow

Certainty Equivalent Approach Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) Flow Risky “safe” $1000 .95 $950

The greater the risk associated with a particular cash flow, the smaller the CE factor.

Certainty Equivalent Method NPV = - IO t ACFt (1 + krf) n t=1 S t

Certainty Equivalent Approach Steps: 1) Adjust all after-tax cash flows by certainty equivalent factors to get certain cash flows. 2) Discount the certain cash flows by the risk-free rate of interest.

Incorporating Risk into Capital Budgeting Risk-Adjusted Discount Rate

How can we adjust this model to take risk into account? NPV = - IO ACFt (1 + k) t n t=1 S Adjust the discount rate (k).

Risk-Adjusted Discount Rate Simply adjust the discount rate (k) to reflect higher risk. Riskier projects will use higher risk-adjusted discount rates. Calculate NPV using the new risk-adjusted discount rate.

Risk-Adjusted Discount Rate NPV = - IO FCFt (1 + k*) t n t=1 S

Risk-Adjusted Discount Rates How do we determine the appropriate risk-adjusted discount rate (k*) to use? Many firms set up risk classes to categorize different types of projects.

Risk Classes Risk RADR Class (k*) Project Type 1 12% Replace equipment, Expand current business 2 14% Related new products 3 16% Unrelated new products 4 24% Research & Development

Summary: Risk and Capital Budgeting You can adjust your capital budgeting methods for projects having different levels of risk by: Adjusting the discount rate used (risk-adjusted discount rate method), Measuring the project’s systematic risk, Analyzing computer simulation methods, Performing scenario analysis, and Performing sensitivity analysis.

Chapter 12 - Cost of Capital Ó 2005, Pearson Prentice Hall

Where we’ve been... Basic Skills: (Time value of money, Financial Statements) Investments: (Stocks, Bonds, Risk and Return) Corporate Finance: (The Investment Decision - Capital Budgeting)

The investment decision Assets Liabilities & Equity Current Assets Current Liabilities Fixed Assets Long-term Debt Preferred Stock Common Equity

Where we’re going... Corporate Finance: (The Financing Decision) Cost of capital Leverage Capital Structure Dividends

The financing decision Assets Liabilities & Equity Current Assets Current Liabilities Fixed Assets Long-term Debt Preferred Stock Common Equity

} Capital Structure Assets Liabilities & Equity Current assets Current Liabilities Long-term Debt Preferred Stock Common Equity } Capital Structure

Ch. 12 - Cost of Capital For Investors, the rate of return on a security is a benefit of investing. For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm. In other words, the cost of raising funds is the firm’s cost of capital.

How can the firm raise capital? Bonds Preferred Stock Common Stock Each of these offers a rate of return to investors. This return is a cost to the firm. “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources.

Cost of Debt

Cost of Debt For the issuing firm, the cost of debt is: the rate of return required by investors, adjusted for flotation costs (any costs associated with issuing new bonds), and adjusted for taxes.

Example: Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000

Example: Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 Now, suppose the firm pays $50,000 in dividends to the stockholders.

Example: Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

1 .066 = .10 (1 - .34) = - After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate Kd = kd (1 - T) .066 = .10 (1 - .34) 1 = -

Example: Cost of Debt Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. What is the pre-tax and after-tax cost of debt for Prescott Corporation?

Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 So, a 10% bond PV = 950 costs the firm solve: I = 10.61% = kd only 7% (with After-tax cost of debt: flotation costs) Kd = kd (1 - T) since the interest Kd = .1061 (1 - .34) is tax deductible. Kd = .07 = 7%

Cost of Preferred Stock Finding the cost of preferred stock is similar to finding the rate of return (from Chapter 8), except that we have to consider the flotation costs associated with issuing preferred stock.

Cost of Preferred Stock Recall: kp = = From the firm’s point of view: kp = = NPo = price - flotation costs! D Po Dividend Price D NPo Dividend Net Price

Example: Cost of Preferred If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?

Cost of Preferred Stock NPo Dividend Net Price kp = = = = 10.81% 8.00 74.00

Cost of Common Stock There are two sources of Common Equity: 1) Internal common equity (retained earnings). 2) External common equity (new common stock issue). Do these two sources have the same cost?

Cost of Internal Equity Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return. Why? If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.

Cost of Internal Equity 1) Dividend Growth Model kc = + g 2) Capital Asset Pricing Model (CAPM) kj = krf + j (km - krf ) D1 Po b

Cost of External Equity Dividend Growth Model knc = + g D1 NPo Net proceeds to the firm after flotation costs!

Weighted Cost of Capital The weighted cost of capital is just the weighted average cost of all of the financing sources.

Weighted Cost of Capital Source Cost Structure debt 6% 20% preferred 10% 10% common 16% 70%

Weighted Cost of Capital (20% debt, 10% preferred, 70% common) .20 (6%) + .10 (10%) + .70 (16%) = 13.4%

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