I n Chapters 8 through 10, we discussed and practiced techniques for
I n Chapters 8 through 10, we discussed and practiced techniques for
valuing assets and weighing risk and return. These are all topics we will apply in Part Three of this book, when we turn to the methods and techniques used in making decisions about actual projects: capital bud- geting. In this chapter, we focus on a crucial element in both valuation and capital budgeting: the cost of capital.
The cost of capital is the return that must be provided for the use of an investor’s funds. If the funds are borrowed, the cost is related to the interest that must be paid on the loan. If the funds are equity, the cost is the return that investors expect, both from the stock’s price appreciation and dividends. From the investor’s point of view, the cost of capital is the same as the required rate of return, which we discussed in Chapter 10.
The required rate of return on an investment and its value are inter- twined. If you buy a bond, you expect to receive interest and the repay- ment of the principal in the future. The price you pay reflects your required rate of return. What determines your required rate? Your opportunity cost—the return you could have received on an investment with similar risk. Suppose that after you buy this bond, market interest rates increase. Your own required rate of return also rises. When your required rate of return increases, the value of your bond’s future interest and principal fall since the discount rate—the rate you use to translate future cash flows into today’s value—increases. The discount rate increases because its is a reflection of market interest rates.
The cost of capital and the required rate of return are marginal con- cepts. That is, the cost of capital is the cost associated with raising one more dollar of capital, whereas the required rate of return is the return expected on one more dollar invested. For example, suppose I have already borrowed $10,000, promising to pay 5% interest per year. And suppose
THE FUNDAMENTALS OF VALUATION
that if I need to borrow any more, I would have to pay 6% per year of the amount I borrow above $10,000. Six percent is the marginal cost. The cost of what we have already borrowed is history, sort of. How much we have already borrowed and what we committed ourselves to pay will influence what we will have to pay to borrow further. That’s because the more you are already paying for your borrowings, the greater the rate lenders will require to lend you more. That’s why when we analyze the cost of a new investment, we should be thinking about the marginal costs of capital.
To make investment decisions of any kind, we need to know the cost of capital. In economics, you learned that a firm should produce goods to the point where the firm’s marginal benefit from producing them equals the marginal cost to produce them. At that level of production, profit is maximized.
It’s the same in investment and financing decisions: Invest in a project until the marginal cost of funds to invest is equal to the marginal benefit the project provides. The benefit from an investment is its return, which we refer to as its internal rate of return (from the investor’s perspective) or the marginal efficiency of capital (from the firm’s perspective). This means that managers keep on raising funds to invest in projects until the marginal cost of these funds is equal to the marginal benefit (which decreases as we take on more and more projects). Therefore, you need to know the marginal cost of funds before you can determine how much to invest in projects in your attempt to maximize shareholder wealth.
When we refer to the cost of capital for a firm, we are usually refer- ring to the cost of financing its assets. In other words, we mean the cost of capital for all the firm’s projects taken together and, hence, the cost of capital for the average project risk of the firm.
When we refer to the cost of capital of a project, we are referring to the cost of capital that reflects the risk of that project. So why determine the cost of capital for the firm as a whole? For two reasons.
First, the cost of capital for the firm is often used as a starting point (a benchmark) for determining the cost of capital for a specific project. The firm’s cost of capital is adjusted upward or downward depending on whether the project’s risk is more than or less than the firm’s typical project.
Second, many of a firm’s projects have risk similar to the risk of the firm as a whole. So the cost of capital of the firm is a reasonable approx- imation for the cost of capital of one of its projects that are under con- sideration for investment.
A firm’s cost of capital is the cost of its long-term sources of funds: debt, preferred stock, and common stock. And the cost of each source reflects the risk of the assets the firm invests in. A firm that invests in assets having little risk will be able to bear lower costs of capital than a firm that invests in assets having a high risk. For example, a discount
The Cost of Capital
retail store has much less risk than an oil drilling firm. Moreover, the cost of each source of funds reflects the hierarchy of the risk associated with its seniority over the other sources. For a given firm, the cost of funds raised through debt is less than the cost of funds from preferred stock which, in turn, is less than the cost of funds from common stock. Why? Because creditors have seniority over preferred shareholders, who have seniority over common shareholders. If there are difficulties in meeting obligations, the creditors receive their promised interest and principal before the preferred shareholders who, in turn, receive their promised dividends before the common shareholders.
For a given firm, debt is less risky than preferred stock, which is less risky than common stock. Therefore, preferred shareholders require a greater return than the creditors and common shareholders require a greater return than preferred shareholders.
Figuring out the cost of capital requires us to first determine the cost of each source of capital we expect the firm to use, along with the rela- tive amounts of each source of capital we expect the firm to raise. Then we can determine the marginal cost of raising additional capital.
We can do this in three steps: Step 1: Determine the proportions of each source to be raised as capital.
Step 2: Determine the marginal cost of each source. Step 3: Calculate the weighted average cost of capital.
In this chapter, we look at each step. We first discuss how to determine the proportion of each source of capital to be used in our calculations. Then we calculate the cost of each source. The proportions of each source must be determined before calculating the cost of each source since the proportions may affect the costs of the sources of capital.
We then put together the cost and proportions of each source to cal- culate the firm’s marginal cost of capital. We also demonstrate the calcu- lations of the marginal cost of capital for an actual company, showing just how much judgment and how many assumptions go into calculating the cost of capital. That is, we show that it’s an estimate. We will use this information in Part Three when we evaluate capital projects.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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