# Lecture 4 - Capital Budgeting Elena Simintzi COMM 370...

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Capital Budgeting Elena Simintzi COMM 370 Lecture 4: Cost of Capital 1

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Capital Budgeting Ø Key Question: How should a firm chose investment projects to create value for its shareholders? Answer: Accept all projects with positive NPV. } What do we need to calculate the NPV? Free Cash Flows (FCFs) Discount rate Lecture 4: Cost of Capital 2
Lecture 4: Cost of Capital 3

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The cost of capital (or discount rate) for a project is its required return Required return = cost of capital = discount rate The required return for any stream of cash flows (from an asset or project) depends on the systematic risk of the cash flows of the asset or project: o The required return to an investor is the same as the cost to the company – if a firm’s equity has a 10% required return in the market, i.e. the stock dividends have a systematic risk that has to be compensated with a 10% return, the cost of equity financing to the company is 10% o If we have a firm, our cost of capital provides us with an indication of how the market views the risk of our assets and/or projects Cost of Capital Lecture 4: Cost of Capital 4
What determines the cost of capital of a project? Answer: cost of capital = required return, so the cost of capital is determined by the SYSTEMATIC RISK of the project If we believe in the validity of the CAPM, we need to calculate the beta of the project, plug it into the CAPM and calculate the cost of capital In principle, each project should be evaluated at its own opportunity cost of capital (not that of the firm as a whole). Cost of Capital Lecture 4: Cost of Capital 5

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Problem: it s difficult to calculate the beta of the project, as we don t have historical data! What can we do? A shortcut is to ASSUME that the systematic risk of the project is the same as the systematic risk of the firm, i.e. that the systematic risk of the project is the same as the systematic risk of the typical project that the firm has undertaken in the past That allows us to BACK OUT the cost of capital of the project by looking at the cost of capital of the overall firm s assets How do we get the cost of capital of the firm s assets? By looking at its capital structure (mix of debt and equity) and the cost of capital for equity and debt – we will see exactly how to do it today Cost of Capital Lecture 4: Cost of Capital 6
Ø To back out the cost of capital for the firm s assets, we need the following things: } The capital structure of the company (how much of the total assets is financed by equity, how much by debt) } The cost of equity capital } The cost of debt capital } Remember: FCF = Cash flow to Shareholders + Cash flow to Creditors } The cost of capital for the firm’s assets reflects the systematic risk of the FCF; the cost of equity capital reflects the systematic risk of the CF to shareholders, while the cost of debt capital reflects the systematic risk of the CF to creditors }

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