Cost of Capital and Capital Budgeting Study Notes

7.1 Cost of Capital

• Definition of Cost of Capital:

  • A firm's cost of capital is the minimum return a firm must earn on its existing assets in order to voluntarily satisfy its investors.

• Opportunity Costs:

  • When creditors and shareholders provide capital, they incur an opportunity cost.

  • This cost is equal to the return they could have achieved from alternative investments with similar risks.

  • Because creditors have a primary claim on a firm's assets, their investment is less risky than that of shareholders, resulting in:

  • Creditors having a lower opportunity cost of debt compared to the opportunity cost of equity for shareholders.

• Firm's Cost of Equity and Cost of Debt:

  • Cost of Equity:

  • Defined as the return required by a firm's shareholders to compensate for the opportunity cost of buying shares.

  • Cost of Debt:

  • Defined as the return required by a firm's creditors to compensate for the opportunity cost of investing in the firm's debt.

• Weighted Average Cost of Capital (WACC):

  • Total cost of capital is calculated as a weighted average of the cost of equity and cost of debt.

  • WACC is crucial for determining the appropriate risk-adjusted discount rate for evaluating investment proposals.

  • Formula:
    WACC = rac{E}{(E + D)} imes Re + rac{D}{(E + D)} imes Rd imes (1-T)

  • Where:

    • E = Market value of equity

    • D = Market value of debt

    • Re = Cost of equity

    • Rd = Cost of debt

    • T = Corporate tax rate

• Application of WACC:

  • Used as the discount rate when evaluating new investments closely matching the average risk of the firm's existing assets.

  • Adjustments to the discount rate are required for projects with varying risk levels:

  • Projects riskier than existing assets will use a higher rate.

  • Conversely, projects less risky than existing assets will use a lower rate.

7.2 Weighted Average Cost of Capital (WACC)

• Definition:

  • WACC represents the return required on existing assets to meet minimum requirements of debt holders and shareholders.

  • WACC is calculated as a weighted average of the costs of debt and equity.

• WACC Formula:

  • WACC = rac{E}{(E + D)} imes Re + rac{D}{(E + D)} imes Rd imes (1-T)

• Factors in Calculation:

  • Cost of Debt:

  • Adjusted for tax due to the tax shield from interest payments.

  • Market versus Book Values:

  • Use market values for accurate reflection of opportunity costs.

  • Market cap for public firms calculated by ext{number of shares outstanding} imes ext{current market price}.

• Private Companies:

  • Average market-to-book ratios from peer firms can be applied to estimate the market value of equity:

  • ext{Market Value of Equity} hickapprox ext{Book Value of Equity} imes ext{Average Market-to-Book Ratio}.

• Cost of Debt Calculation:

  • For traded debt, the yield to maturity is used.

  • If not traded, use risk-free rate + credit spread.

  • For non-current fixed-interest debt, market values inferred from market prices; private holdings based on yield of similar firms.

• Book Value Approach:

  • If necessary, book value of debt can approximate market value; usually valid due to minimal difference in current liabilities.

7.3 Examples of WACC

• Cost of Debt Summary:

  • Use market value unless debt is non-tradable, then use book value.

  • Yield to maturity for bonds as cost of debt; interest rate for loans.

• Cost of Equity Summary:

  • Market cap calculation using:

  • Re = rac{D1}{P0} + g (Dividend Discount Model - DDM)

  • Re = Rf + B(Rm – Rf) or Re = Rf + B imes MRP (Capital Asset Pricing Model - CAPM).

• Cost of Preference Shares:

  • Using DDM:

  • Rp = rac{D1}{P0}.

7.4 Capital Budgeting

• Long-term Investment Cash Flows:

  • Characterized by an initial large negative cash flow for setup costs and ongoing operating cash flows.

  • Terminal cash flows stem from asset liquidation at project wind-up.

• Importance of Long-term Investments:

  • Involves significant, often irreversible capital commitments. Examples include fixed assets, R&D, and potential acquisitions.

• Capital Budgeting Process:

  • Involves evaluating long-term investment proposals and selecting among competing projects.

  • Notable historical example, Fairfax Media Ltd, showed poor long-term investments leading to decline.

• Investment Decision Criteria:

  • Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period (PBP), Accounting Rate of Return (ARR).

7.5 Net Present Value (NPV)

• Definition:

  • NPV calculates the net present value of future cash flows minus the initial investment cost.

• NPV Formula:
  NPV = ext{PV of future cash flows} - ext{Initial Cost}

• Discount Rate:

  • Reflects risk; larger discount for uncertain cash flows. NPV signifies change in shareholder wealth.

• Decision Rule:

  • Accept project if NPV > 0, reject if NPV < 0, indifferent at NPV = 0.

7.6 Internal Rate of Return (IRR)

• Definition:

  • IRR is the discount rate that sets the NPV to zero, basically identifying the break-even point.

• Decision Rule:

  • Accept the project if IRR > required rate, reject if IRR < required rate.

• Comparison with NPV:

  • While IRR resembles NPV decision rules, has drawbacks such as complexity in calculation and multi-IRR for non-traditional cash flows.

7.8 Payback Period (PBP)

• Definition:

  • PBP measures how long it takes for an investment to return its initial costs.

• Implementation Steps:

  1. Calculate the payback period.

  2. Compare PBP with a predetermined threshold to decide acceptance or rejection.

• Example:

  • Bakery considering a $5 million production line with a 5-year max payback accepts/rejects based on cumulative cash flows.

7.9 Accounting Rate of Return (ARR)

• Definition:

  • ARR is a financial ratio equating average after-tax profit with average book values of its assets.

• Formula:
  ARR = rac{ ext{Average Profit After Tax}}{ ext{Average Book Value of Assets}}

• Decision Rule:

  • Accept if ARR exceeds a set threshold, otherwise reject.

7.10 Dealing with Forecasting Risk

• Definition of Forecasting Risk:

  • The risk of poor investment decisions due to inaccurate cash flow forecasts.

• Analysis Approaches:

  1. Scenario Analysis: Multiple future scenarios created to assess impact on NPV.

  2. Sensitivity Analysis: Changes to a single cash flow are examined with others constant to assess NPV sensitivity.

• Example:

  • In the Sour Cactus Tequila, forecasts for sales and operating costs illustrate impacts on NPV under various scenarios maximizing accurate forecasts.

7.11 Summary of Capital Budgeting Techniques

• Comparison of Capital Budgeting Decision Tools:

  • NPV, IRR, PBP, ARR explained focusing on cash flows, timing, riskiness, and overall contribution to wealth maximization.