Lonni Steven Wilson, Medaille College chapter 11 Capital Budgeting

Key Chapter Objectives Define capital budgeting. Understand the process of calculating the cost of capital. Understand how to make capital decisions. Describe cash flow and how it works.

Key Terms capital — The long-term funding that is necessary for the acquisition of fixed assets (Brigham & Ehrhardt, 2005). capital budgeting — The process of making investments toward fixed assets, both tangible and intangible. 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).

Goals of Capital Budgeting To select investment opportunities that are worth more than they cost To invest in those projects that provide the greatest return on investment (ROI) The second point may not always be true, as in not-for-profit organizations.

Capital Components Sport businesses can use four traditional methods of funding capital growth: Debt (bonds and long-term loans) Preferred stock Common stock Retained earnings

Raising Capital: Debt Cost of debt Cost of debt is 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, 2005). From a case study in the text If the Smiths borrow $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 SMC borrows $1,000,000 at an interest rate of 6% and has a marginal tax rate of 40%. Their actual cost of debt is 3.6%: D = 6% x ( ) D = 3.6%

Raising Capital: The Issuance of 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: Preferred stock Common stock

Calculating the Cost of Preferred Stock S = v / P S = cost of preferred stock v = preferred stock dividend P = net issue price (continued)

Calculating the Cost of Preferred Stock (continued) Assume that the Stars want 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 follows: Refer to equation 11.3 on p. 199 of the text The cost of issuing new preferred stock for the Stars is 5.208%.

Raising Capital: Common Stock and Retained Earnings 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: Earnings that would otherwise be used to pay common stockholder dividends

Calculating the Cost of Common Stock Three methods are used to determine the cost of common stock: 1. Capital asset pricing model (CAPM) C = F + {(M - F) x B} C = expected cost of common stock F = expected rate of return from a risk-free investment M = expected rate of return for the overall market B = the company’s beta coefficient (continued)

Calculating the Cost of Common Stock (continued) 2. Bond yield plus risk premium model The cost of common stock may be closely related to the firm’s cost of debt. The cost of common stock will be several percentage points higher than the firm’s cost of debt because of the higher level of risk associated with stock. Thus, this method measures the cost of common stock as the yield from the firm’s bonds plus some risk premium (usually 3% to 5%). (continued)

Calculating the Cost of Common Stock (continued) 3. Dividend growth model (refer to equation 11.4 on p. 202 in the text) C = E / N + G C = required rate of return for stockholders (this serves as a measure of the cost of common stock) E = annual dividend payment (for simplicity, we assume that these payments are fixed at the same level each year) N = current price per share of the stock G = annual growth rate of dividends

Trends in Stadium Financing Some key points regarding sports stadiums follow: 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 Importance of time: The present value of a future stream of income Net present value: Present value of future income versus required investment 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 compared with the present value of cash returns from the next best alternative

Errors in Measuring Cash Flow 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 In-Class Discussion 1.Why is a business’ capital structure important? 2.Which funding option would be the most economical to issue if you were trying to raise $100 million? 3.What does flotation cost mean? 4.Why is the time value of money important?