Capital Budgeting |Course hero helper

Posted: February 16th, 2023

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 Go to www.TeachMeFinance.com and read topics:

· Cost of Capital, The Cost of Retained Earnings and The Weighted Average Cost of Capital

·  View: Capital Budgeting You Tube video: Capital Budgeting

Discussion 1 –  Capital Budgeting

Capital budgeting is a complicated process that is essential to good investment decisions by a company. Please give an example of a capital budgeting decision a company might need to make.

 

Are there examples in using the cost of capital in personal life? When or how have you compared the cost of getting money to the potential benefit of that money?

 

Once a business computes its cost of capital, discuss how a manager might decide whether to take on a project or not.  How are capital project investments prioritized?

Topics

The Firm’s Cost of Capital

Financial and Operating Leverage

Break-Even Analysis

 

The Firm’s Cost of Capital

In this section, we examine the theory, key concepts, and calculation of the firm’s weighted

average cost of capital and the advantages and disadvantages of each component of that cost to

the firm.

Definition of Cost of Capital

A firm’s cost of capital is the net price it must pay for its total mix of capital financing, both debt

and equity, after considering any tax impact and the floatation costs, which constitute all the

expenses directly related to arranging the financing. This price paid is the cost of capital to the

firm, and is governed, or constrained, primarily by the rate of return required by investors who

are willing to purchase the firm’s securities with the perceived risk associated with them.

The firm’s cost of capital is also the firm’s minimum required rate of return (or hurdle rate) on

any new capital investments. To accept any capital projects with a lower rate of return than the

cost of capital would result in a reduction of shareholder wealth because it would obviously cost

more to finance the capital investment than the return yielded. For most financial decision

making, the relevant cost of capital rate is the “marginal” weighted average cost of capital. This

cost represents the next best available, or marginal, increment of capital that the firm can raise

for future capital expenditures.

Calculating the Cost of Capital

A firm has access to three primary sources of long-term capital, some of which have variations.

These sources are:

1. debt financing market

2. preferred stock financing market

3. common stock financing market

 

 

The cost of capital of a firm equals the after-tax and after-flotation weighted average cost of the

individual components of its capital structure, with each component multiplied times its weight

in percent:

Types of Financing Marginal Costs Weight %

1 Debt financing kd wd

2 Preferred stock kps wps

3 Equity financing

3a —Retained earnings kcs wcs

3b —New common stock Kncs wncs

where:

kd = marginal cost of debt financing after tax and flotation costs

kps = marginal cost of preferred stock financing after tax and flotation costs

kcs = marginal cost of retained earnings financing after tax and flotation

costs

kncs = marginal cost of new common stock financing after tax and flotation

costs

and

wd = portion of debt financing to total capital financing in dollars

wps = portion of preferred stock financing to total capital financing in

dollars

wcs = portion of retained earnings financing to total capital financing in

dollars

wncs = portion of new common stock financing to total capital financing in

dollars

Note that in the above table we have broken the cost of capital for equity, ke, into two

subcomponents to account for the different cost structures. Retained earnings, kcs, accounts for

the current market value of previously issued common stock, and represents the charge assigned

to any use of retained earnings cash reserves. New issues of common stock that will incur

flotation costs are represented by Kncs.

As an example of computing component weights, the weight of the debt-financing component is

calculated as follows:

wd = $ debt/($ debt + $ preferred stock + $ retained earnings + $ new common stock)

The weight for the remaining components are calculated in a similar fashion. Using the above-

defined terms, the general formula for the weighted marginal cost of capital is:

 

 

kwacc = (wd)(kd) + (wps)(kps) + (wcs)(kcs) + (wncs)(kncs)

Or, to cover the fact that debt capital financing, alone of all the capital components, has a tax

shield impact (1 – Tc), we can expand the formula as shown below to incorporate th

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Introduction to the

Cost of Capital

The Basics of the Cost of Capital

Valuing Different Costs

Approaches to Calculating the Cost of Capital

The WACC

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• Defining the Cost of Capital

• Differences Between Required Return and the Cost of Capital

• Relationship Between Financial Policy and the Cost of Capital

The Basics of the Cost of Capital

Introduction to the Cost of Capital > The Basics of the Cost of Capital

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• If a project is of similar risk to a company’s average business activities, it is

reasonable to use the company’s average cost of capital as a basis for project

evaluation.

• A company’s securities typically include both debt and equity; therefore, one must

calculate both the cost of debt and the cost of equity to determine a company’s

cost of capital.

• Weighted average cost of capital takes into account the amount of financing that

comes through the use of debt and the use of equity.

• IRR is the rate of return that makes the net present value of all cash flows from an

investment equal zero.

Defining the Cost of Capital

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SOLUTION

Capital budgeting is the process of evaluating and selecting long-term investment projects that will generate cash flows in the future. These investments are typically large-scale projects such as building a new factory, expanding an existing business, or launching a new product line. Capital budgeting is a crucial process for businesses as it helps them allocate their financial resources in the most efficient and profitable way.

The capital budgeting process typically involves several steps, including:

  1. Identifying potential investment opportunities: Businesses need to identify potential investment opportunities that align with their long-term objectives and strategies. This can involve analyzing market trends, competitive forces, and customer needs.
  2. Estimating cash flows: The next step is to estimate the cash flows that the investment project will generate over its lifetime. This involves forecasting revenues, expenses, and capital expenditures.
  3. Evaluating the investment: Once the cash flows have been estimated, the investment project is evaluated using various financial metrics such as net present value (NPV), internal rate of return (IRR), and payback period. These metrics help businesses determine the expected profitability and risk associated with the investment.
  4. Making a decision: Based on the results of the evaluation, the business can then make a decision on whether to pursue the investment project or not.
  5. Monitoring and reviewing: After the investment project is underway, it is important to monitor its progress and review its performance to ensure that it is meeting its objectives and generating the expected returns.

Overall, capital budgeting is a critical process for businesses to make informed investment decisions that will help them achieve their long-term financial goals.

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