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08: Page 1 of 33 MODULE 08 CAPITAL BUDGETING 2. THE OPPORTUNITY COST OF CAPITAL Chance favors the ready mind, so this module shows you one part of the successful capital-budgeting process, estimating and using the opportunity cost of capital to the company. We’ll leave the other part, calculating expected rates of return on investment, to the next module. Ideas and calculations in this module build on Modules 4–6 where you studied the concept of returns and how to calculate them. Module 7 introduced you to the area of capital budgeting and the cash flows surrounding the capital -budgeting decision. In this module, you see investor required rates of return applied to decisions inside of the company. Each return you studied previously becomes part of the return management applies to proposed projects. This module begins by looking at the trees, that is, by looking at the individual costs of financing to a company. It includes not only the usual long-term sources of debt and equity, but also short-term debt because it is typically part of a company’s permanent financing. The module then changes its view to the forest, that is, to the way financial managers combine individual costs into a useful average. When you finish this module, you should be able to do the following: 1. Recognize the need to use market values to estimate the cost of each component of capital to a company. 2. Calculate the effective cost to an issuer of a new bond issue by using yield to maturity based on proceeds. 3. Estimate the effective cost of preferred-stock financing with the Gordon (constant- growth) model based on proceeds. 4. Estimate the effective cost of internal equity (earnings retained) using the capital asset pricing model (CAPM) and Gordon model. 5. Determine the effective cost of external equity (new issue of common stock) using the Gordon model based on proceeds. 6. Measure the average cost of new financing for proposed capital projects after converting each individual cost into an effective rate; distinguish between incremental and marginal costs of capital. 7. Know the uncontrollable and controllable forces on the cost of capital to a company and the usefulness of the marginal cost of capital in evaluating proposed capital projects. 8. Recognize the optimal capital structure as a target in affecting the value of the company and how a company wobbles around this target over time. THE ROLE OF THE MARGINAL COST OF CAPITAL Financial managers go to a great deal of trouble to calculate the cost of each component of capital and then to combine components into a useful average. The goal isn’t merely to find the resulting marginal cost of capital (MCC), but to find a value useful for decision making. For a company to remain in business and operate profitably, managers must select investment projects that produce positive cash flows adjusted for opportunity Marginal cost of capital Estimated opportunity cost of the final dollar raised in optimal (best) proportions of debt and equity
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08: Page 2 of 33 cost. That’s consistent with agency theory— managers are agents of shareholders and
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