Chapter Capital Budgeting C H A P T E R

Chapter Objectives Define capital budgeting. Distinguish between the various techniques of capital budgeting. Understand the process of calculating the cost of capital. Calculate and use the weighted average cost of capital and the capital asset pricing model formulas. Understand how to make capital decisions. Distinguish between present value and net present value calculations. Understand payback rules such as the internal rate of return. Describe cash flow and the way that it works.

Key Terms Capital: The long-term funding that is necessary for the acquisition of fixed assets (Brigham & Ehrhardt, 2011). Capital budgeting: The process of making investments toward fixed assets, both tangible and intangible.

Key Terms (continued) Capital spending: Net spending on fixed assets. Net spending: The total money a business uses to acquire real assets, less the sale of previously owned real assets (Brigham & Ehrhardt, 2005).

Goal of Capital Budgeting The goal is to select those investment opportunities that are worth more than they cost. Businesses should invest in those projects that provide the greatest return on investment (ROI). –This may not always be true for nonprofit organizations.

The Cost of Capital Sport businesses can use four traditional methods of funding capital growth: –Debt (bonds and long-term loans) –Preferred stock –Common stock –Retained earnings All have one common trait: The persons or institutions that provide the capital expect—or demand—a return on investment (Brigham & Erhardt, 2011). These are also called capital components.

The Cost of Debt Cost of debt: The interest that is paid in addition to the principal that is borrowed. Debt is important because many smaller businesses raise most of their capital through this capital component, usually in the form of bank loans (Brigham & Ehrhardt, 2011). Example: If a company borrows $200,000 at an interest rate of 8%, the cost of debt is, excluding taxes, also 8%. –Because of tax savings, the cost of debt in this scenario could be reduced from $16,000 (8%) to $9,600.

Calculating the Cost of Debt D = R − (R x T) –D = cost of debt –R = interest rate paid to debt holder –T = marginal tax rate on interest payments Can also be written D = R x (1 − T) Assume that Speedway Motorsports borrows $1,000,000 at an interest rate of 6% and has a marginal tax rate of 40%. Their actual cost of debt will be: o D = 6% x (1 – 0.4) o D = 3.6%

Equity Capital can also be acquired through selling ownership in the business, also known as the issuance of equity. There are two classifications of equity: 1.Preferred stock 2.Common stock

Cost of Preferred Stock S = v / P S = cost of preferred stock v = preferred stock dividend P = net issue price Example: Speedway Motorsports wants to issue $20 million of new preferred stock. The new preferred stock will have a $100 par value and pay an annual dividend of $5 per share, and the flotation cost will be 4%. –The cost of preferred stock is then calculated as 5.208%.

Common Stock A firm can raise capital through two methods with common stock: 1.The issue of new common stock –Primary offering (new shares sold) –Secondary offering (company ownership sells off some of its shares) 2.Retained earnings –That would otherwise be used to pay common stockholder dividends

Capital Asset Pricing Model (CAPM) C = F + {(M − F) x B} C = expected cost of common stock M = expected rate of return for the overall market F = expected rate of return from a risk-free investment B = the company’s beta coefficient

Measuring Cost of Capital The most commonly used method to measure the cost of capital is the weighted average cost of capital (WACC). WACC focuses on determining the average cost of each capital component and weights each based on its contribution to the total capital amount. –In general, a sport business will maximize its value when it minimizes its WACC (Ross et al., 2008). To calculate the WACC, we must separate capital into each of the three potential capital sources: 1.Debt 2.Preferred stock 3.Common stock

WACC WACC = W D (D) + W S (S) + W C (C) W D = target weight for debt D = cost of debt W S = target weight for preferred stock S = cost of preferred stock W C = target weight for common stock C = cost of common stock

Trends in Stadium Financing Here are key points regarding stadiums in sports: Because of changes in facility design, a stadium such as FedEx Field in Washington, D.C., can produce substantially more revenue for the franchise (e.g., more luxury suites). Unlike other revenue sources, most stadium income is not shared equally among all franchises. –In the four major professional leagues, teams keep 100% of revenues from parking, concessions, advertising, and stadium naming rights. –New facilities are often built to maximize these revenue sources.

Capital Budgeting Decisions Considerations in making decisions to allocate capital funds: Importance of time –The present value of a future stream of income Net present value (NPV) = FI − RI –Present value of future income (FI) vs. required investment (RI) Payback rule –How long it will take a business to get its money back after investing in a capital project Discounted payback rule –Same as payback rule but discounted for future cash flows based on the opportunity cost of capital Internal rate of return –Initial cash investment analyzed compared to the present value of cash returns from the next best alternative

Measuring Relevant Cash Flow With respect to measuring incremental cash flows, there are several common errors financial managers make: Measuring sunk costs Measuring opportunity costs Failing to analyze the impact of any funding decision Failing to appreciate the impact of a capital decision on net working capital Double-counting interest payments

Questions for Class Discussion 1.Why is the capital structure of a business important? 2.What would happen if a business had too much in bonds or stocks as part of its capital structure? 3.Which funding option would be the most economical to issue if you were trying to raise $200 million? 4.What does flotation cost mean? 5.Why is the time value of money important? (continued)

Questions for Class Discussion (continued) 6.Why is the payback rule important when analyzing financial issues? 7.What does IRR mean? 8.If you were to make a capital-budgeting decision based on project cash flows, would you prefer to use NPV, the IRR method, the payback rule, or the discounted payback rule? Why would you use the method that you have selected? What is the advantage of using multiple methods? (continued)

Questions for Class Discussion (continued) 9.There are several methods for determining the cost of common stock. Which method do you think is the best, and why? 10.What is the present value of receiving $10 million in five years assuming that the discount factor is 3%?