Week 5 Lecture Notes r60211

Week 5 Lecture Notes r60211 - Week 5 Lecture Notes 1...

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Week 5 Lecture Notes 1. Welcome to the Week 5 lecture. This lecture will discuss the cost of capital and capital budgeting. 2. The topics we will cover in this presentation include the cost of capital, discount rates used to analyze investments, the valuation and application to bonds and stocks, the capital budgeting decision, cash flows and methods for ranking investments. 3. There are several factors that determine the cost of capital to a firm. Is the company a new pharmaceutical firm? This would influence the risky of the potential profits. Is it a utility company? The profits would be more stable. The risk related to the earnings plays a role in the cost that investors are willing to take. Is the firm in a solid industry with a strong base of common stock holders? Does the firm have a heavy debt load? These factors influence the equity to debt mix that affect the earnings of a company. Is the firm secure in the industry sector? Do they have a strong financial backing of investors? The financial stability of the company affects the cost of capital. Lastly, the economic conditions in the market regarding interest rates play a role in the cost of financing debt. Together these factors determine the cost of investment that a firm must pay. 4. The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. The cost of capital determines how a firm can raise money through stock or financing. This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk. Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm’s bonds and stocks. If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profitabilities of different investments. When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability. Please note that the cost of capital involves the sources of funding that come from investors. Items listed on this slide, accounts payable, accruals and deferred taxes are not costs of capital. 5. Hurdle rates are the required rate of return used in capital budgeting. Simply put, hurdle rates are based on the firm’s WACC. To understand the concept of hurdle rates, think of it this way. A runner in track jumps over a hurdle. Projects that the firm is considering must “jump the hurdle” – or in other words – exceed the firm’s borrowing costs (WACC). If the project does not clear the hurdle, the firm will lose money on the project if they invest in it – and decrease the value of the firm. The hurdle rate is used by firms in capital budgeting analysis. Large companies, with divisions that have different levels of risk, may choose to have divisional hurdle rates. The hurdle rate for the firm represents
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Week 5 Lecture Notes r60211 - Week 5 Lecture Notes 1...

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