chap10 - Capital Budgeting Overview 1 Capital Budgeting is...

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Capital Budgeting Overview 1 Capital Budgeting is the set of valuation techniques for real asset investment decisions. Capital Budgeting Steps a estimating expected future cash flows for the proposed real asset investment (Chap 12) a estimating the firm’s cost of capital (Chap 10) based on the firm’s optimal capital structure a using a decision-making valuation technique which depends on the company’s cost of capital to decide whether to accept or reject the proposed investment (Chap 11)
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CHAPTER 10 THE COST OF CAPITAL Estimating Caterpillar’s Cost of Capital Air Jordan’s Divisional Cost of Capital 2
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Chapter 10 Learning Objectives 3 Describe the concepts underlying the firm’s cost of capital (known as weighted average cost of capital) and the purpose for its calculation. Calculate the after-tax cost of debt, preferred stock and common equity. Calculate a firm’s weighted average cost of capital. Adjust the firm’s cost of capital on a by division or by project basis. Use the cost of capital to evaluate new investment opportunities.
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Cost of Capital 4 The firm’s cost of raising new funds The weighted average of the cost of individual types of funding One possible decision rule is to compare a project’s expected return to the cost of the funds that would be used to finance the purchase of the project Accept if : project’s expected return > cost of capital
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Cost of Capital Terms 5 Capital Component = type of financing such as debt, preferred stock, and common equity r d = cost of new debt, before tax r d (1-T) = after-tax component cost of debt r p = component cost of new preferred stock r s = component cost of retained earnings(or internal equity, same as r S
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More Cost of Capital Terms 6 r e = component stock of external equity raised through selling new common stock WACC = w d r d (1-T) + w p r p + w c r s = the weighted average cost ot capital which is the weighted average of the individual component costs of capital w i = the fraction of capital component i used in the firm’s capital structure
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Component Cost of Debt 7 Remember, a corporation can deduct their interest expense for tax purposes Therefore, the component cost of debt is the after-tax interest rate on new debt r d (1-T) where T is the company’s marginal tax rate r d can be estimated by finding the YTM on the company’s existing bonds
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This note was uploaded on 02/14/2011 for the course FIN 221 taught by Professor Dyer during the Spring '09 term at University of Illinois, Urbana Champaign.

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chap10 - Capital Budgeting Overview 1 Capital Budgeting is...

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