336 Capital Budgeting Decision Criteria

# 336 Capital Budgeting Decision Criteria - Capital Budgeting...

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Capital Budgeting: Decision Criteria I. The Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WACC) is the average required rate of return of all long-term sources of financing used by the corporation , including: The common stockholders’ required rate of return. r CS The preferred stockholders’ required rate of return. r PS The creditors’ required rate of return. r D WACC = W CS x r CS + W PS x r PS + W D x r D (1-t) The WACC is the discount rate used for evaluating projects in capital budgeting. The Target Capital Structure is the right mix of debt and equity that minimizes the WACC, and thereby maximizes the value of the firm. Use the target capital structure to compute weights for WACC. If you don’t know the target, use the current market values to determine the weights for WACC. A. Cost of Common Stock: The CAPM Approach: r CS = RF+ Beta CS [r M – RF] The Bond Yield plus Equity Risk Premium Approach: r CS = Yield on Bond AAA + Equity Risk Premium The Discounted Cash Flow Approach: r CS = D 1 / P 0 + g B. Cost of Preferred Stock: The simplest cost to estimate due to the non-changing, perpetual cash flows. . r PS = D/ P 0 C. Cost of Debt: The cost of debt is the yield to maturity on the bonds of the company. Note: This Fin 336: Capital Budgeting: Decision Criteria, p. 1

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is the before-tax cost of debt! Use the yield to maturity on current debt since it reflects the return that investors are currently requiring on the company’s debt (The current cost of debt) D. Putting it All Together: the WACC WACC = W CS x r CS + W PS x r PS + W D x r D (1-t) Example Zaino Brothers, Inc. needs a total of \$10,000 for operations in 2001. The firm currently has \$5,000. Joe Zaino talks some friends (Rosie and Bubba) into helping out. Bubba wants greater security. Rosie is willing to trade off security for a higher rate of return. A B C D DxC DxB Capital Invested Financing Investor’s Weighted Investor’s Provider Capital Weight RRR RRR \$ Return Joe \$5,000 0.50 0.15 .075 \$750 Rosie \$3,000 0.30 0.10 .030 \$300 Bubba* \$2,000 0.20 0.05 .010 \$100 ====== === === ===== ===== \$10,000 1.00 0.115 \$1,150 * This is the before-tax cost of debt to the company WACC = W S x r S + W PS x r PS + W D x r D (1-t) W CS = S/(CS+PS+D) = 5,000/10,000= .5 W PS = PS/(CS+PS+D) = 3,000/10,000= .3 W D = D/(CS+PS+D) = 2,000/10,000= .2 WACC = .5(.15) + .3(.10) + .2(.05)(1-.395) = .111 II. The WACC & the Investment Opportunity Schedule - If component costs are constant (r CS , r D , and r PS ), and the target capital structure remains unchanged, then the WACC also doesn’t change. Fin 336: Capital Budgeting: Decision Criteria, p. 2
- The company in this situation would always discount projects using the same WACC regardless of how large they got or how much funds they needed to raise. % Cost of capital

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336 Capital Budgeting Decision Criteria - Capital Budgeting...

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