363LecNote-Part4

363LecNote-Part4 - 7 The Cost of Capital and Capital...

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7 The Cost of Capital and Capital Budgeting 7.1 Capital Budgeting — Introduction We consider evaluation of various investment projects (investing in new production lines, etc.). Capital budgeting is a technique that helps you (a f nance manager of a f rm) decide which projects to pursue. In order to maximize shareholder wealth, man- agers need to: Identify potential investment opportunities. Select from many potential projects. Managers should accept projects that increase share- holder wealth. An illustrative example: Invest in a new airplane? Initial Investiment Capital expenditure itself + training etc. Increase in net working capital ( cash + inventories + receivables payables ) Incremental Cash Revenues and Expenses (Con- sider cannibalization and/or synnergies). Exclude f nancing costs (interest expenses, etc.) here. Add back depreciation (Depreciation is not a cash F ow). Deduct taxes. Consider additional investment needs (replace- ments, updates, etc.) Terminal value / Salvage value. More detailed analysis in FINA365 (by Professor Tsy- plakov).
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(cash f ows) 7.2 Review of Basic Accounting Balance Sheet of a Firm A F rm raises funds from the capital market, and invest the funds in various projects. Assets Liabilities Amount Weights Assets (various Long-term Debt Dw d = D V investments Preferred Stock E P w p = E p V and projects) Common Equity E C w e = E C V Total Value V 1 V = D + E P + E C .w d + w p + w e =1 . D E P + E C is often called the Debt-Equity ratio . We can think of a F rm as a portfolio of debt ( D ) (bonds), preferred stock ( E P ), and common stock ( E C ). Example Determine the weights and the Debt-Equity ratio, when Long-term debt $500 , 000 Preferred stock $20 , 000 Common stock $600 , 000 (Example)
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Income (Pro f t-Loss) Statement Example 1 A f rm borrowed $100 MM at 10% interest rate. An- nual interest expense is $10 MM. Tax rate for the f rm is 40%. Sales 200 Cost of Goods Sold ( )1 4 0 SGA expenses ( )3 0 EBIT 30 Interest Expenses ( 0 EBT 20 Taxes ( )8 Net Pro f t1 2 = Common stock holders get $12 MM. Example 2 A f rm issued $100 MM preferred stock at 10% divi- dend yield. Preferred dividend payments are $10 MM perannum .Taxratefo rthe f rm is 40%. Sales 200 Cost of Goods Sold ( 4 0 SGA expenses ( 0 EBIT 30 Interest Expenses ( )0 EBT 30 Taxes ( 2 Net Pro f 8 Preferred dividends ( 0 Net Pro f tlessPre f .D iv . 8 = Common stock holders get $8 MM. Why common stock holders get more when the f rm issue debts (rather than stocks)? 7.3 The Weighted Average Cost of Capi- tal (WACC) Suppose that weights, w d ,w p , and w e , are the propor- tions of debt, preferred stock, and equity in the f rm’s target capital structure ( f nancing mix). The WACC is given by:
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where R d : R p : R e : The WACC gives the relevant cost of capital ( the required rate of return )o fa f rm, after tax has been taken into account.
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This note was uploaded on 11/05/2011 for the course FINA 363 taught by Professor Masoudie during the Spring '10 term at South Carolina.

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363LecNote-Part4 - 7 The Cost of Capital and Capital...

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