chapter
11
Capital Budgeting
Lonni Steven Wilson, Medaille College
Key Chapter Objectives
• Define capital budgeting.
• Understand the process of calculating the cost of
capital.
• Understand how to make capital decisions.
• Describe cash flow and how it works.
Key Terms
capital—The long-term funding that is necessary for the
acquisition of fixed assets (Brigham & Ehrhardt, 2005).
capital budgeting—The process of making investments
toward fixed assets, both tangible and intangible.
capital spending—Net spending on fixed assets.
net spending—The total money a business uses to acquire
real assets, less the sale of previously owned real assets
(Brigham & Ehrhardt, 2005).
Goals of Capital Budgeting
• To select investment opportunities that
are worth more than they cost
• To invest in those projects that provide
the greatest return on investment (ROI)
The second point may not always be
true, as in not-for-profit organizations.
Capital Components
Sport businesses can use four traditional
methods of funding capital growth:
• Debt (bonds and long-term loans)
• Preferred stock
• Common stock
• Retained earnings
Raising Capital: Debt
Cost of debt
• Cost of debt is the interest that is paid in addition
to the principal that is borrowed.
• Debt is important because many smaller
businesses raise most of their capital through this
capital component, usually in the form of bank
loans (Brigham & Ehrhardt, 2005).
From a case study in the text
• If the Smiths borrow $200,000 at an interest rate of
8%, the cost of debt is, excluding taxes, also 8%.
• Because of tax savings, the cost of debt in this
scenario could be reduced from $16,000 (8%) to
$9,600.
Calculating the Cost of Debt
• D = R - (R x T)
D = cost of debt
R = interest rate paid to debt holder
T = marginal tax rate on interest payments
• Can also be written D = R x (1 - T)
• Assume that SMC borrows $1,000,000 at an
interest rate of 6% and has a marginal tax rate of
40%. Their actual cost of debt is 3.6%:
D = 6% x (1 - 0.4)
D = 3.6%
Raising Capital: The Issuance of
Equity
Capital can also be acquired through
selling ownership in the business, also
known as the issuance of equity.
There are two classifications of
equity:
• Preferred stock
• Common stock
Calculating the Cost of Preferred
Stock
• S=v/P
S = cost of preferred stock
v = preferred stock dividend
P = net issue price
(continued)
Calculating the Cost of Preferred
Stock (continued)
• Assume that the Stars want to issue $20 million of
new preferred stock. The new preferred stock will
have a $100 par value and pay an annual dividend
of $5 per share, and the flotation cost will be 4%.
The cost of preferred stock is then calculated as
follows:
• Refer to equation 11.3 on p. 199 of the text
• The cost of issuing new preferred stock for the
Stars is 5.208%.
Raising Capital: Common Stock and
Retained Earnings
A firm can raise capital through two methods
with common stock:
1. The issue of new common stock
– primary offering (new shares sold)
– secondary offering (company ownership
sells off some of its shares)
2. Retained earnings: Earnings that would
otherwise be used to pay common
stockholder dividends
Calculating the Cost of Common
Stock
Three methods are used to determine the cost of
common stock:
1. Capital asset pricing model (CAPM)
• C = F + {(M - F) x B}
• C = expected cost of common stock
• F = expected rate of return from a risk-free
investment
• M = expected rate of return for the overall market
• B = the company’s beta coefficient
(continued)
Calculating the Cost of Common
Stock (continued)
2. Bond yield plus risk premium model
• The cost of common stock may be closely related to
the firm’s cost of debt.
• The cost of common stock will be several percentage
points higher than the firm’s cost of debt because of
the higher level of risk associated with stock.
• Thus, this method measures the cost of common
stock as the yield from the firm’s bonds plus some
risk premium (usually 3% to 5%).
(continued)
Calculating the Cost of Common
Stock (continued)
3. Dividend growth model (refer to equation 11.4
on p. 202 in the text)
• C=E/N+G
• C = required rate of return for stockholders (this
serves as a measure of the cost of common stock)
• E = annual dividend payment (for simplicity, we
assume that these payments are fixed at the same
level each year)
• N = current price per share of the stock
• G = annual growth rate of dividends
Trends in Stadium Financing
Some key points regarding sports stadiums follow:
• Because of changes in facility design, a stadium such as
FedEx Field in Washington, D.C., can produce
substantially more revenue for the franchise (e.g., more
luxury suites).
• Unlike other revenue sources, most stadium income is not
shared equally among all franchises.
– In the four major professional leagues, teams keep
100% of revenues from parking, concessions,
advertising, and stadium naming rights.
– New facilities are often built to maximize these revenue
sources.
Capital Budgeting Decisions
• Importance of time: The present value of a future stream
of income
• Net present value: Present value of future income versus
required investment
• Payback rule: How long it will take a business to get its
money back after investing in a capital project
• Discounted payback rule: Same as payback rule but
discounted for future cash flows based on the opportunity
cost of capital
• Internal rate of return: Initial cash investment compared
with the present value of cash returns from the next best
alternative
Errors in Measuring Cash Flow
• Measuring sunk costs
• Measuring opportunity costs
• Failing to analyze the impact of any funding
decision
• Failing to appreciate the impact of a capital
decision on net working capital
• Double counting interest payments
Questions for In-Class Discussion
1. Why is a business’ capital structure important?
2. Which funding option would be the most
economical to issue if you were trying to raise
$100 million?
3. What does flotation cost mean?
4. Why is the time value of money important?