Cost of Capital Evaluating Cash Flows
Payback, discounted payback NPV IRR, MIRR
The Cost of Capital
• Cost of Capital Components
– Debt – Common Equity
Should we focus on historical (embedded) costs or new (marginal) costs?
The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.
What types of long-term capital do organizations use?
nLong-term debt nEquity
Weighted Average Cost of Capital is the weighted Average of the Marginal Costs of the Capital Components employed to acquire a long term asset (make a new real investment in things like Plant and Equipment, R&D, Human Capital, a new Product, a new Process, or a new Marketing Channel
Sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.
WACC Estimates for Some Large U. S. Corporations
Company WACC Intel (INTC) 16.0 Dell Computer (DELL) 12.5 BellSouth (BLS) 10.3 Wal-Mart (WMT) 8.8 Walt Disney (DIS) 8.7 Coca-Cola (KO) 6.9 H.J. Heinz (HNZ) 6.5 Georgia-Pacific (GP) 5.9 wd 2.0% 9.1% 39.8% 33.3% 35.5% 33.8% 74.9% 69.9%
What factors influence a company’s WACC?
• Market conditions, especially interest rates and tax rates. • The organization’s capital structure and dividend policy. • The organization’s investment policy. organizations with riskier projects generally have a higher WACC.
Should the company use the composite WACC as the hurdle rate for each of its divisions? • NO! The composite WACC reflects the risk of an average project undertaken by the organization. • Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.
Four Mistakes to Avoid
1. When estimating the cost of debt, don’t use the coupon rate on existing debt. Use the current interest rate on new debt. 2. When estimating the risk premium for the CAPM approach, don’t subtract the current long-term Tbond rate from the historical average return on common stocks. (More ...)
For example, if the historical rM has been about 12.2% and inflation drives the current rRF up to 10%, the current market risk premium is not 12.2% - 10% = 2.2%!
3. Don’t use book weights to estimate the weights for the capital structure. Use the target capital structure to determine the weights. If you don’t know the target weights, then use the current market value of equity, and never the book value of equity. If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt. (More...)
4. Always remember that capital
components are sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC.
Evaluating Cash Flows
• Overview and “vocabulary” • Methods
– Payback, discounted payback – NPV – IRR, MIRR
• Economic life
What is capital budgeting?
• Analysis of potential projects. • Long-term decisions; involve large expenditures. • Very important to organization’s future.
Steps in Capital Budgeting
• Estimate cash flows (inflows & outflows). • Assess risk of cash flows. • Determine r = WACC for project. • Evaluate cash flows.
What is the difference between independent and mutually exclusive projects? Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one would be adversely affected by the acceptance of the other.
What is the payback period?
The number of years required...