Capital+Budgeting+Technique+ +CC

1
Capital-Budgeting
Techniques
2
Capital Budgeting Concepts
Capital Budgeting involves evaluation of (and
decision about) projects. Which projects should be
accepted? Here, our goal is to accept a project
which maximizes the shareholder wealth. Benefits
are worth more than the cost.
The Capital Budgeting is based on forecasting.
Estimate future expected cash flows.
Evaluate project based on the evaluation method.
Classification of Projects
Mutually Exclusive - accept ONE project only
Independent - accept ALL profitable projects.
3
Cash Flows
Initial Cash Outlay - amount of capital spent to get
project going.
4
Cash Flows
project going.
If spend R10 million to build new plant then the Initial
Outlay (IO) = R10 million
CF0 = Cash Flow time 0 = -R10 million
5
Cash Flows
project going.
If spend R10 million to build new plant then the Initial
Outlay (IO) = R10 million
CF0 = Cash Flow time 0 = -R10 million
Annual Cash Inflows--after-tax CF
Cash inflows from the project
CFn = Sales - Costs

6
Capital Budgeting Methods
Payback Period
Number of years needed to recover your initial
outlay.
7
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
8
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

9
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

Cumulative CF -6,500
10
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

Cumulative CF -6,500 -3,000
11
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

Cumulative CF -6,500 -3,000 +500
12
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

Cumulative CF -6,500 -3,000 +500
Payback 2.86 years
13
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
14
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 500 500 4,600 10,000

15
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 500 500 4,600 10,000

Cumulative CF -9,500
16
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000
17
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400
18
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400 +5,600
19
Payback Period
outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400 +5,600
Payback = 3.44 years
20
Payback Period
outlay.
P R O J E C T Evaluation:
Time A B Company sets maximum
0 (10,000.) (10,000.) acceptable payback. If
1 3,500 500 Max PB = 3 years,
2 3,500 500
accept project A and
3 3,500 4,600
4 3,500 10,000
reject project C
0 1 2 3 4
(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400 +5,600
Payback 3.44 years
21
Payback Method
The payback method is not a good method as it does

not consider the time value of money.
Which project should you choose?
CF0 CF1 CF2 CF3

A -100,000 90,000 9,000 1,000
B -100,000 1,000 9,000 90,000
22
Payback Method
The Discounted payback method can correct this

shortcoming of the payback method.
To find the discounted pay back
(1) Find the PV of each cash flow on the time line.
(2) Find the payback using the discounted CF and
NOT the CF.
23
Payback Method
Also, the payback method is not a good method as
it does not consider the cash flows beyond the
payback period.

CF0 CF1 CF2 Cf3 CF4
A -100000 90000 10000 0 0
B -100000 90000 9000 80000 1000000
24
Payback Method
Also, the payback method is not a good method as it does
not consider the cash flows beyond the payback period.

CF0 CF1 CF2 Cf3 CF4
A -100,000 90,000 10,000 0 0
B -100,000 90,000 9,000 80,000 100,0000
These two shortcomings often result in an incorrect decisions.

25
Methods that consider time value of money and all

cash flows
Net Present Value:

Present Value of all costs and benefits of a project.
26
Net Present Value
Concept is similar to Intrinsic Value of a security but
subtracts cost of the project.
NPV = PV of Inflows - Initial Outlay

27
Net Present Value
Concept is similar to Intrinsic Value of a security but
subtracts of cost of project.
NPV = PV of Inflows - Initial Outlay
IO
CF1 CF2 CF3 CFn
NPV = (1+ k ) + (1+ k )2 + (1+ k)3
++(1+ k )n

28
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

29
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

R500
455 (1.10)
30
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

R500
455
(1.10) 2
413
31
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

455
R4,600
413
(1.10) 3
3,456
32
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

455
413
R10,000
3,456
(1.10) 4
6,830
33
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

455
413
3,456
6,830
R11,154
34
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

455
413 PV Benefits > PV Costs
3,456 R11,154 > R 10,000
6,830
R11,154
35
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 500 500 4,600 10,000

455
413 PV Benefits > PV Costs NPV > R0
3,456 R11,154 > R 10,000 R1,154 > R0
6,830
R11,154
R1,154 = NPV
36
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

37
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 10,000
38
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 10,000
PV of 3,500 Annuity for 4 years at 10%

39
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 10,000
= 3,500 x PVIFA 4,.10 - 10,000
= 11,095 10,000 = R1,095
40
NPV Decision Rules
If projects are independent then ACCEPT A & B
accept all projects with NPV 0.
41
NPV Decision Rules
If projects are independent then ACCEPT A & B
accept all projects with NPV 0.
If projects are mutually exclusive, ACCEPT B only
accept projects with higher NPV.
42
Net Present Value Profile
Graphs the Net Present Value of the project with
different required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
3,500 3,500 3,500 3,500

NPV(0%) = (1+ 0 ) + (1+ 0)2 + (1+ 0 )3 + (1+ 0)4 10,000
= R4,000
43
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
NPV(5%) = 3,500 + 3,500 2+ 3,500 +

3
3,500
4
10,000
(1+ .05 ) (1+ .05) (1+ .05 ) (1+ .05)
= R2,411
44
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
NPV(10%) = 3,500 + 3,500 2+ 3,500 +

3
3,500
4
10,000
(1+ .10 ) (1+ .10) (1+ .10 ) (1+ .10)
= R1,095
45
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
NPV(15%) = 3,500 + 3,500 2+ 3,500 +

3
3,500
4
10,000
(1+ .15 ) (1+ .15) (1+ .15 ) (1+ .15)
= R7.58
46
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
NPV(20%) = 3,500 + 3,500 2+ 3,500 +

3
3,500
4
10,000
(1+ .20 ) (1+ .20) (1+ .20 ) (1+ .20)
= R939
47
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
Connect the Points

48
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
500
NPV(0%) = + 500 + 4,600 3 + 10,000 10,000
(1+ 0 ) (1+ 0)2 (1+ 0 ) 4
(1+ 0)
= R5,600
49
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
500
NPV(5%) = + 500 2
+ 4,600
3
+ 10,000
4
10,000
(1+.05) (1+.05) (1+ .05) (1+ .05)
= R3,130
50
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
500
NPV(10%) = + 500 2
+ 4,600
3
+ 10,000
4
10,000
(1+.10) (1+.10) (1+ .10) (1+ .10)
= R1.154
51
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
500
NPV(15%) = + 500 2
+ 4,600
3
+ 10,000
4
10,000
(1+.15) (1+.15) (1+ .15) (1+ .15)
= R445
52
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
Project B 1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
Connect the Points

53
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
Project B 1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000
0 Cost of Capital
5% 10% 15% 20%
54
Compare NPV of the two projects for different
required rates
6,000
Crossover point
N
P Project B
V
3,000
Project A
0 Cost of Capital
5% 10% 15% 20%
55
required rates
6,000
Crossover point
N
P Project B
V
3,000
For any discount rate <

crossover point choose B Project A
0 Cost of Capital
5% 10% 15% 20%
56
required rates
6,000
Crossover point
N
P Project B
V
For any discount rate >

3,000 crossover point choose A
For any discount rate <

crossover point choose B Project A
0 Cost of Capital
5% 10% 15% 20%
57
Internal Rate of Return
Measures the rate of return that will make the PV of
future CF equal to the initial outlay.
Definition:
The IRR is that discount rate at which
NPV = 0
IRR is like the YTM. It is the same cocept but

the term YTM is used only for bonds.
58
The IRR is the discount rate at which NPV = 0
6,000
N
P
Project B
V
3,000
NPV = $0
0 Cost of Capital
5% 10% 15% 20%
59
Or, the IRR is the discount rate at which NPV = 0
6,000
N
P
Project B
V
3,000
NPV = R0 IRRA 15%
IRRB 14%
0 Cost of Capital
5% 10% 15% 20%
60
Determine the mathematical solution for IRR
61
0 = NPV = CF1
+ CF2
(1+ IRR ) (1+ IRR )2 ++ CFn
(1+ IRR )n IO
62
0 = NPV = CF1
+ CF2
(1+ IRR ) (1+ IRR )2 ++ CFn
(1+ IRR )n IO
IO = CF1
+ CF2
(1+ IRR ) (1+ IRR )2
CFn
++(1+ IRR )n
Outflow = PV of Inflows
63
0 = NPV = CF1
+ CF2
(1+ IRR ) (1+ IRR )2 ++ CFn
(1+ IRR )n IO
IO = CF1
+ CF2
(1+ IRR ) (1+ IRR )2
CFn
++(1+ IRR )n
Outflow = PV of Inflows
Solve for Discount Rates
64
Internal Rate of Return 6,000
For Project B N Project B
P
V
Cannot solve for IRR
directly, must use Trial & 3,000
Error
IRRB 14%
0 Cost of Capital
5% 10% 15% 20%
10,000 = 500 + 500

+ 4,600 + 10,000
(1+ IRR ) (1+ IRR )2 (1+ IRR )3 (1+ IRR )4
65
P
V
Error
IRRB 14%
0 Cost of Capital
5% 10% 15% 20%
10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 14%
? 500
10,000 = + 500 2 + 4,600 3+ 10,000 4
(1+ .14 ) (1+ .14) (1+ .14 ) (1+ .14 )
66
P
V
Error
IRRB 14%
0 Cost of Capital
5% 10% 15% 20%
10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 14%
? 500
10,000 = + 500 2 + 4,600 3+ 10,000 4
(1+ .14 ) (1+ .14) (1+ .14 ) (1+ .14 )
?
10,000 = 9,849 PV of Inflows too low, try lower rate
67
P
V
Error
IRRB 14%
0 Cost of Capital
5% 10% 15% 20%
10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 13%
? 500
10,000 = + 500 2 + 4,600 3+ 10,000 4
(1+ .13 ) (1+ .13) (1+ .13 ) (1+ .13 )
68
P
V
Error
IRRB 14%
0 Cost of Capital
5% 10% 15% 20%
10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 13%
? 500
10,000 = + 500 2 + 4,600 3+ 10,000 4
(1+ .13 ) (1+ .13) (1+ .13 ) (1+ .13 )
?
10,000 = 10,155
69
P
V
Error
IRRB 14%
0 Cost of Capital
5% 10% 15% 20%
10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 13%
? 500
10,000 = + 500 2 + 4,600 3+ 10,000 4
(1+ .13 ) (1+ .13) (1+ .13 ) (1+ .13 )
?
10,000 = 10,155 13% < IRR < 14%
70
Decision Rule for Internal Rate of Return
Independent Projects
Accept Projects with
IRR required rate
Mutually Exclusive Projects

Accept project with highest
IRR required rate
71
Profitability Index
Very Similar to Net Present Value
PI = PV of Inflows
Initial Outlay
72
Profitability Index
PI = PV of Inflows
Initial Outlay
Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.
73
Profitability Index
PI = PV of Inflows
Initial Outlay
Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.
CF1 CF2 CF3 CFn

(1+ k ) + (1+ k )2 + (1+ k )3++(1+ k )n
PI =
IO
74
Profitability Index for Project B P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
4 3,500 10,000
75
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000
76
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000
Profitability Index for Project A
3,500 x PVIFA 4, .10

PI =
10,000
77
Profitability Index for Project B
P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000
Profitability Index for Project A

1 1
3,500(.10 .10(1+.10) )
4
PI =
10,000
11,095
PI = = 1.1095
10,000
78
Profitability Index Decision Rules
Independent Projects
Accept Project if PI 1
Mutually Exclusive Projects
Accept Highest PI 1 Project
79
Comparison of Methods
Project A Project B Choose

Payback < 3 years < 4 years A
NPV R1,095 R1,154 B
IRR 14.96% 13.50% A
PI 1.1095 1.1154 B
80
Time Value of Money
Payback - Does not adjust for timing differences
(ignore Discounted Payback)
NPV, IRR and PI take into account the time value of
money
81
Time Value of Money
money
Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur
after the Payback Period.
82
Time Value of Money
money
Project 1
0 1 2
(10,000) 5,000 5,000

83
Time Value of Money
NPV, IRR and PI take into account the time value
of money
Project 1
0 1 2
Both Projects have
(10,000) 5,000 5,000
Identical Payback
Project 2
0 1 2 3
(10,000) 5,000 5,000 10,000

84
NPV & PI indicated accept Project B while IRR indicated that
Project A should be accepted. Why?
Sometimes there is a conflict between the decisions based on
NPV and IRR methods.
The conflict arises if there is difference in the timing of CFs or
sizes of the projects (or both).
The cause of the conflict is the underlying reinvestment rate
assumption.
Reinvestment Rate Assumptions
NPV assumes cash flows are reinvested at the required
rate, k.
IRR assumes cash flows are reinvested at IRR.
Reinvestment Rate of k more realistic as most projects earn
approximately k (due to competition)
NPV is the Better Method for project evaluation
85
IRR
Because of its unreasonable reinvestment rate assumption, IRR

method can result in bad decisions.
Another problem with IRR is that if the sign of the cash flow
changes more than once, there is a possibility of multiple IRR.
The problem of unreasonable assumption can be addressed by

using Modified IRR
86
Exercises
87
The Cost of Capital
Sources of capital
Cost of each type of funding
Calculation of the weighted average cost of capital
(WACC)
88
Factors Affecting the Cost of Capital
General Economic Conditions
Affect interest rates
Market Conditions
Affect risk premiums
Operating Decisions
Affect business risk
Financial Decisions
Affect financial risk
Amount of Financing
Affect flotation costs and market price of security
89
Weighted Cost of Capital Model
Compute the cost of each source of capital
Determine percentage of each source of capital in
the optimal capital structure
Calculate Weighted Average Cost of Capital
(WACC)
90
Compute Cost of Debt
Required rate of return for creditors
yield to maturity on bonds (kd).
e.g. Suppose that a company issues bonds with a before tax
cost of 10%.
Since interest payments are tax deductible, the true cost of the
debt is the after tax cost.
If the companys tax rate (state and federal combined) is 40%,
the after tax cost of debt
AT kd = 10%(1-.4) = 6%.
91
Compute Cost Preferred Stock

Cost to raise a dollar of preferred stock.
Dividend (Dp)
Required rate kp =
Market Price (PP)
Example: You can issue preferred stock for a net

price of R42 and the preferred stock pays a
R5 dividend.
The cost of preferred stock:
R5.00
kp =
R42.00
= 11.90%
91
92
Compute Cost of Common

Equity
Two Types of Common Equity Financing
Retained Earnings (internal common equity)
Issuing new shares of common stock (external
common equity)
92
93
Compute Cost of Common Equity

Cost of Internal Common Equity
Management should retain earnings only
if they earn as much as stockholders
next best investment opportunity of the
same risk.
Cost of Internal Equity = opportunity
cost of common stockholders funds.
Two methods to determine
Dividend Growth Model
Capital Asset Pricing Model
93
94

Cost of Internal Common Stock Equity
D1
kS = + g
P0
94
95

D1
kS = + g
P0
Example:
The market price of a share of common stock is
R60. The dividend just paid is R3, and the expected
growth rate is 10%.
95
96

D1
kS = + g
P0
Example:
The market price of a share of common stock is R60.
The dividend just paid is R3, and the expected growth
rate is 10%.
kS = 3(1+0.10) + .10 =.155 = 15.5%

60
96
97

kS = kRF + (kM kRF)
97
98

kS = kRF + (kM kRF)
Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
98
99

kS = kRF + (kM kRF)
Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
kS = 5% + 1.2(13% 5%) = 14.6%

99
100

Cost of New Common Stock
Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
D1
kn = + g
P0 - F
100
101

Must adjust the Dividend Growth Model
equation for floatation costs of the new
common shares.
D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = R3.00 and estimated growth
is 10%, Price is R60 as before.
101
102

Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs will
be 12%. D0 = R3.00 and estimated growth is 10%,
Price is R60 as before.
kn = 3(1+0.10) + .10 = .1625 = 16.25%

52.80 102
103
Weighted Average Cost of Capital

Gallagher Corporation estimates the following
costs for each component in its capital structure:
Source of Capital Cost
Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%
Gallaghers tax rate is 40% 103

104

If using retained earnings to finance the
common stock portion the capital structure:
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
104
105

Assume that Gallaghers desired capital

structure is 40% debt, 10% preferred and
50% common equity.
105
106

Assume that Gallaghers desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09% 106
107
If using a new equity issue to finance the

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%
107
108
Exercises

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1

CFn = Sales - Costs

(10,000) 3,500 3,500 3,500 3,500

(10,000) 3,500 3,500 3,500 3,500

(10,000) 3,500 3,500 3,500 3,500

(10,000) 3,500 3,500 3,500 3,500

(10,000) 3,500 3,500 3,500 3,500

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

The payback method is not a good method as it does

Which project should you choose?

CF0 CF1 CF2 CF3

The Discounted payback method can correct this

Which project should you choose?

Which project should you choose?

These two shortcomings often result in an incorrect decisions.

Methods that consider time value of money and all

Net Present Value:

NPV = PV of Inflows - Initial Outlay

NPV = PV of Inflows - Initial Outlay

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 500 500 4,600 10,000

(10,000) 3,500 3,500 3,500 3,500

(10,000) 3,500 3,500 3,500 3,500

(10,000) 3,500 3,500 3,500 3,500

PV of 3,500 Annuity for 4 years at 10%

(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500

NPV(5%) = 3,500 + 3,500 2+ 3,500 +

NPV(10%) = 3,500 + 3,500 2+ 3,500 +

NPV(15%) = 3,500 + 3,500 2+ 3,500 +

NPV(20%) = 3,500 + 3,500 2+ 3,500 +

Connect the Points

Connect the Points

For any discount rate <

For any discount rate >

For any discount rate <

IRR is like the YTM. It is the same cocept but

10,000 = 500 + 500

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

Mutually Exclusive Projects

Instead of Subtracting the Initial Outlay from the PV

Instead of Subtracting the Initial Outlay from the PV

CF1 CF2 CF3 CFn

Profitability Index for Project A

3,500 x PVIFA 4, .10

Profitability Index for Project A

Project A Project B Choose