ENGINEERING FINANCE
CSE 8363 / EF 720-N
Summer 2001
(Lectures # 9 & 10 )
Cost of Capital and Capital Budgeting
Capital budgeting
Opportunity cost of capital
Weighted average cost of capital (WACC)
Target capital structure
% Debt
% preferred stocks
% Common stock
Flotation cost
Cost of debt = kd (1 – T)
Cost of preferred stock =
= kps = Dps/Pn
Dps = Preferred dividend
Pn = Net issuing price
Cost of common stock = ks
Capital assets pricing model (CAPM)
ks = krf + (km – krf) * b1
krf = Risk free return (US Treas. Bond)
b1 = Stock’s beta coefficient
km = Current expected return on market
Bond yield + Risk premium approach
ks = Bond yield + Risk premium
Dividend yield + Growth rate or
DCF approach
P0 = D1/(ks –g)
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ks = D1/P0 + g
= D1/P0 + growth rate
Finance is in large part a matter of judgement and we simply must face that fact
WACC = Wd kd (1-T) + Wps * kps + Wcc*ks
Factors affecting WCC
Non-controllable – Interest rate & taxes
Controllable Factors
Capital structure policy
Dividend policy
Investment (capital budgeting) policy
Project Risks
Stand-alone risk
Corporate, or within-firm risk
Market or beta risk
Risk Adjusted Cost of Capital
Ks = krf + (km –krf) * b
Cost of Internally Generated Funds
(Depreciation etc.)
Internal cash flow = net income –
- Cash dividend + Depreciation
= Retained Earnings + Depr.
Problem Areas in Cost of Capital
Privately owned firms
Small businesses
Measurement problems
Projects of different riskiness
Capital structure weights
Capital Budgeting
Capital budgeting is one the most important function financial managers and their staff
perform. It is the whole process of analyzing projects and deciding which ones to include
in the capital budget.
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Forecast accuracy of asset requirements
Timing
Involves substantial expenditures
Capital budgeting projects are created by the firm
Strategic business plan
Importance of capable and imaginative executives and employees
Projects Types:
Replacement: maintenance of business
Replacement: cost reduction
Expansion of existing products or markets
Expansion into new products or markets
Safety and/or environment projects
Research and development
Other
The process of capital budgeting is very much similar to the security valuation process
Capital Budgeting Decision Rules
Payback period
Discounted payback
Net present value
Internal rate of return (IRR)
Modified IRR (NIRR)
An NPV of zero signifies that the project’s cash flows are just sufficient to repay the
invested capital and to provide the required rate of return on that capital
The IRR is defined as that discount rate which equates the present value of the project’s
expected cash flows to the present value of the project’s costs.
NPV vs. IRR
NPV Profiles
NPV ranking depends on the cost of capital
Independent projects
Mutually exclusive projects
Multiple IRRs
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Multiple IRRs arise when the project has non-normal cash flows (negative net cash flows
occur during some year after the project has been places in operation).
Modified Internal Rate of Return (MIRR)
MIRR is calculated by:
PV costs = PV terminal value
Profitability Index (PI)
It is also called Benefit/Cost ratio
B/C Ratio = PV Benefits/PV Costs
In practice all four methods plus PI are used in most capital budgeting decisions
Quantitative methods provide valuable information, but they should not be used as the
sole criteria for accept/reject decisions. They should be considered as an aid to informed
decisions but not as a substitute for sound management judgement
Business practices
The Post-Audit
It is very important to compare actual results with those predicted by the project’s
sponsors and understand why any differences occurred.
It serves several purposes:
Improve forecasts
Improve operations
Identify abandonment/ termination opportunities
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