Sources of capital Two basic sources stocks (equity both common
and preferred) and debt (loans or bonds) Capital buys assets to
produce revenue and profits to pay back your investors
Slide 4
WACC (Weighted Average Cost of Capital) Each component of
capital (debt, preferred, equity) has an individual cost. In order
to have a measure to gauge the acceptability of investments most
companies calculate a weighted average of the three components of
capital. The weighted average cost of capital is simply breaking
down the components of your capital structure.
Slide 5
WACC (Weighted Average Cost of Capital) D x Rd (1-t) + E x Re
+P x Rp V V V Where: V = the total of Debt + Equity + Preferred or
the value of the firm D is the market value of the firms debt E is
the market value of the firms equity P is the market value of the
firms preferred Rd (1-t) is the after tax cost of debt Re is the
cost of equity Rp is the cost of preferred
Slide 6
WACC (Weighted Average Cost of Capital) This formula and its
calculation look complicated but it is really very simple. Lets
look at an example. Assume: The firm has a capital structure
consisting of $ 1,000,000 in debt and $1,000,000 in equity or 50%
debt and 50% equity. Assume also that the cost of debt is 10% and
the firms tax rate is 40%. Assume also that the cost of equity as
determined by the capital asset pricing model is 12% The weighted
average cost of capital is calculated as follows: V = $1,000,000
debt + $1,000,000 equity = $2,000,000 D = 1,000,000/2,000,000 =.50
V E = 1,000,000/2,000,000 =.50 V After tax cost of debt +.10
(1-.40) =.06 or 6% Weighted average cost of capital: 6% x.50 + 12%
x.50 = 3% + 6% = 9%
Slide 7
WACC (Weighted Average Cost of Capital) Note two things that
happen when debt is included in the cost of capital calculation.
First because interest payments on debt are tax deductible the
actual cost of debt is lower than the stated coupon. Secondly, the
inclusion of debt in the capital structure will lower the overall
cost of capital. Because of these advantages many companies will
include debt in their capital structure a strategy known as
financial leverage.
Slide 8
Net Present Value The Basic Idea Net present value the
difference between the market value of an investment and its cost.
Estimating cost is usually straightforward; however, finding the
market value of assets can be tricky. The principle is to find the
market price of comparables. Discounted cash flow (DCF) valuation
finding the market value of assets or their benefits by taking the
present value of future cash flows, i.e., by estimating what the
future cash flows would trade for in todays dollars.
Slide 9
Net Present Value (NPV) NPV = Sum of the present value of
future cash flows - initial outlay T0 T1 T2 T3 T4 T5 (1,200,000)
+300,000 + 300,000 + 300,000 +300,000 +500,000 1.10 (1.10) ^2
(1.10) ^3 (1.10^4) (1.10) ^5 Discounting: (1,200,000) + 272,727
+247,933 + 225,394 +204,904 +310,461 Next we want to determine the
Net Present Value or NPV of the investment. We do this by
subtracting the initial outlay from the sum of the present value of
the cash flows. NPV = 1,261,419 - 1,200,000 NPV = $61,419
Slide 10
Net Present Value (NPV) As you can see the difference between
the sum of the present value of the future cash flows ($1,261,419)
and the initial investment ($1,200,000) is positive. The difference
between the initial outlay and the sum of the cash flows is called
the Net Present Value or NPV. Projects that have a positive net
present value add economic value to the firm and should be
accepted. Projects with negative net present values should be
rejected. With this information we can state our first decision
rule: If the Net Present Value (NPV) is positive the company should
accept the project.
Slide 11
The Payback Rule Defining the Rule Payback period length of
time until the accumulated cash flows equal or exceed the original
investment. Payback period rule investment is acceptable if its
calculated payback is less than some specified number of years.
Summary of the Rule Advantages: Easy to understand Adjusts for
uncertainty of later cash flows Biased towards liquidity
Disadvantages: Ignores the time value of money Requires an
arbitrary cutoff point Ignores cash flows beyond the cutoff date
Biased against long-term projects
Slide 12
The Internal Rate of Return Problems with the IRR
Non-conventional cash flows the sign of the cash flows changes more
than once or the cash inflow comes first and outflows come later.
If the cash flows are of loan type, meaning money is received at
the beginning and paid out over the life of the project, then the
IRR is really a borrowing rate and lower is better. If cash flows
change sign more than once, then you will have multiple internal
rates of return. This is problematic for the IRR rule; however, the
NPV rule still works fine. Mutually exclusive investment decisions
taking one project means another cannot be taken
Slide 13
The Internal Rate of Return Redeeming Qualities of the IRR
People seem to prefer talking about rates of return to dollars of
value NPV requires a market discount rate, IRR relies only on the
project cash flows, although you do need an estimate of a required
return to make the final decision
Slide 14
The Internal Rate of Return Internal rate of return (IRR) the
rate that makes the present value of the future cash flows equal to
the initial cost or investment. In other words, the discount rate
that gives a project a $0 NPV. IRR decision rule the investment is
acceptable if its IRR exceeds the required return. NPV and IRR
comparison: If a projects cash flows are conventional (costs are
paid early and benefits are received over the life), and if the
project is independent, then NPV and IRR will give the same accept
or reject signal.