Capital Budgeting WACC = W
B. Cost of Preferred Stock:
C. Cost of Common Stock:
The CAPM Approach:
= RF+ Beta
The Bond Yield plus
Equity Risk Premium Approach:
= Yield on Bond
+ Equity Risk Premium
The Discounted Cash Flow Approach:
E. Equity BETA: The beta we use in the SML to estimate cost
of common stock takes into consideration both business risk and financial risk.
Common stockholders’ returns are used to calculate BETA, which is then used to calc req rate return on common stock of
= RF+ Beta
II. MCC & IOS
Companies use the same WACC for projects until the cost of new equity or debt increases, then we move to next WACC.
Marginal WACC: which
is WACC of the last dollar raised.
(Company) Needs $800 million in financing for next 5 yrs. Requirements: [Capital Structure:$800 million (total financing): Debt: 30% -- $240 M; Preferred
10% -- $80 M; Common Stock: 60% -- $480 M]
Co. estimates that retained earnings will provide only $120 million of the necessary funds.
New equity will have to provide the balance of $360 in
Point of total financing when SHE will run out of retained earnings and require new equity.
Since common equity accounts for 60% of total funds raised:
BREAK POINT x
.6 = retained earnings
BP x .6 =$120 million,
BP = 120/.6=$200 (IOS)
arranges potential capital investment projects from high to low expected return.
G. ACCOUNTING RATE OF RETURN (ARR) [EXAMPLE in 3 Steps lower right for data]
Average annual net income divided by average book value of investment during its life.
ARR = Average
Annual Income/Average Investment
Average Annual Income
is also (NOI).
is the average of asset book value each year
ARR Decision Rule: 1.Accept the project if ARR> targeted
ARR (hurdle rate) 2.Reject the project if ARR < targeted ARR (hurdle rate)
Advantages: Easy to understand Disadvantages: Ignores time value of money, disadvantage: rate of return is not comparable to
other yields, like a bond’s YTM or stock discount rates, Uses book values rather than cash flows for valuation, so valuation is based on historical costs rather than true cost of funds tied up in a project to
produce future value. Project has initial cost of $300,000 (investment) and following after-tax cash flows during its 3-year life.
(Assume straight-line depreciation)
Net Income (NI): (Revenues – Operating
Costs – Depreciation)(1-tax rate)
AVG ANNUAL INCOME (AAI):
Simple avg of NOI each yr>
AAI = (100,000 + 150,000 + 50,000)/3 =100,000
AVG. INVT: AVG. of Assets BV each YR> AI =
(300,000 + 200,000 + 100,000 + 0)/4 Line 2 =600,000/4= 150,000*
Line 3= (300,000 + 0)/2=150,000 (either way will work)
*Divide by four since asset is valued at beginning of 1
year, and 0 at end of
year (beginning of the 4
ACCOUNTING RATE OF RETURN ARR = AAI / AI = 100,000/150,000= .67
SECTION 2 LEVERAGE
I. BIZ and Financial Risk:
All Future Cash Flows/
Risk is volatility in the cash flows.
BIZ RISK is var. in cash flows to firm due to macro,industry,