THE COST OF CAPITAL for evaluating the firm’s future investment

opportunities.
DEFINITION The cost of capital represents the
firm’s cost of financingand is the minimum rate of TERMS TO REMEMBER
return that a project must earn to increase firm
NET PROCEEDS: Funds that the firm receives from
value. (Gitman, 2018)
the sale
WHAT DOES THIS MEAN?
FLOTATION COSTS: Total costs of issuing and
 It's the cost of the next dollar of financing selling securities
necessary to finance a new investment
FLOTATION COST COMPONENTS UNDERWRITING:
opportunity
COSTS: Compensation earned by investment
 Investments with a rate of return above the
bankers for selling the security
cost of capital will increase the value of the
firm, and projects with a rate of return ADMINISTRATIVE COSTS: issuer expenses such as
below the cost of capital will decrease firm legal, accounting, and printing.
value.
COMPONENTS OF THE COST OF CAPITAL (PART 01)
BASIC CONCEPTS
 COST OF LONG-TERM DEBT
a. A firm’s cost of capital is estimated at a  COST OF LONG-TERM DEBT
given point in time and reflects the  COST OF COMMON EQUITY
expected average future cost of funds over  USING THE BOND YIELD+RISK PREMIUM
the long run. Although firms typically raise APPROACH AND CAPM
money in lumps, the cost of capital reflects
COST OF LONG-TERM DEBT
the entirety of the firm’s financing activities,
The financing cost associated with new funds
and they tend to toward some desired mix
raised through long-term borrowing. Typically, the
of financing.
funds are raised through the sale of corporate
b. We need to look at the overall cost of
bonds.
capital rather than just the cost of any
single source of financing to capture all the
relevant financing costs.
OUR GOALS

 There are four basic sources of long-term

capital for firms: long-term debt, preferred
stock, common stock, and retained earnings
(see right-hand side of balance sheet). Not
every firm will use all of these sources of
financing, but most firms will have some
mix of funds from these sources in their
capital structures.
 Although a firm’s existing mix of financing COST OF PREFERRED STOCKS
sources may reflect its target capital The ratio of the preferred stock dividend to the
structure, it is ultimately the marginal cost firm’s net proceeds from the sale of the preferred
of capital necessary to raise the next stock. The net proceeds represent the amount of
marginal dollar of financing that is relevant money to be received minus any flotation costs.

COST OF COMMON EQUITY
 Most important component of the Cost of
Capital
 Basic equity security of the firm
 Common stockholders have a residual claim
on the form
 Claim comes ONLY AFTER Bondholders and
Preferred Stockholders have been paid (in
this particular order)
 Because of this, it's the riskiest among the
sources of capital and has the highest cost.
 Estimating cost of equity is challenging
because it's the last in the pecking order!
 Common stock dividends are not fixed and,
in many cases, not paid at all, because if
there's no money left, then there's no
money left!
METHODS FOR ESTIMATING COST OF COMMON
EQUITY
1. Bond Yield + Risk Premium Approach
2. CAPM
3. Discounted Cash Flow (DCF):
Earnings/Dividend Growth
BOND YIELD + RISK PREMIUM APPROACH
THE CAPM METHOD
COST OF CAPITAL (PART 2) OF COMMON EQUITY
AND WACC
MAINCONCEPT
 COST OF COMMON EQUITY S #1-2)
YTM+RISK PREMIUM AND CAPM #3) DCF
APPROACH
 WEIGHTED AVERAGE COST OF CAPITAL
KEY INFO OVERVIEW OF PREVIOUS
COMPUTATIONS OF THE COST OF COMMON
EQUITY (Re)
 YTM + RISK PREMIUM APPROACH
Re = YTM + RISK PREMIUM
 CAPM SML/CAPM:
Re = Rf [E(Rm) - Rf]
 DISCOUNTED CASH FLOW (DCF) (DIVIDEND
DISCOUNT MODEL)
DDM/ DCF DIVIDEND DISCOUNT MODEL/
DISCOUNT CASH FLOW METHOD
 A quantitative method of valuing a
company ’ s stock price based on the
assumption that the current fair price of a
stock equals the sum of all of the company ’
s future dividends discounted back to their
present value.
 It only applies to companies that pay
dividends, and it also assumes that the
dividends will grow at a constant rate.
 The model does not account for investment
risk to the extent that CAPM does (since
CAPM requires beta)
 The Gordon Growth Model (GGM) is one of
the most commonly used variations of the
dividend discount model. The model is
called after American economist Myron J.
Gordon, who proposed the variation.
 Based on the assumption that the stream of
future dividends will grow at some constant
rate in the future for an infinite time.
 Helpful in assessing the value of stable
businesses with strong cash flow and steady
levels of dividend growth.
 Generally assumes that the company being
evaluated possesses a constant and stable
business model and that the growth of the
 company occurs at a constant rate over INVESTORS (BONDHOLDERS AND
time. STOCKHOLDERS)
PART A: COST OF RETAINED EARNINGS
 Cost of INTERNAL EQUITY.
 Because stockholders should get a return
on reinvested money, the company needs
to pay the stockholders for using the
retained earnings.
 There ' s no sale of the equity, so there ' s
no flotation costs involved. It' s simply
reinvesting the dividends that should have
been paid to equity holders.
 If the PREFERRED STOCK is part of the
company ' s CAPITAL STRUCTURE, we will
include it in the formula!

PART B: COST OF NEW ORDINARY SHARES

 Cost of EXTERNAL EQUITY.
 This is the required rate of return of the
common stockholders.
 Since unlike retained earnings, these are
sold, it involves flotation costs.
 If not for the flotation costs, its value will be
the same as the cost of retained earnings!
(THE WACC) THE WEIGHTED AVERAGE COST OF
CAPITAL
WACC:
 The weighted cost of debt and equity used
to finance a firm ' s projects.
 IT SHOWS THE AVERAGE RATE OF RETURN
REQUIRED (NEEDED) BY THE FIRM'S
WHAT IF THE WEIGHTS ARE NOT GIVEN?
 LOOK AT THE CAPITAL STRUCTURE OF THE
FIRM
CAPITAL STRUCTURE
 The mix of debt and equity capital invested
in the firm.
 Summarized by the firm ' s Debt Ratio (Wd)
and Equity Ratio (We).
 Can be estimated using book values
(balance sheet values - HISTORICAL) and
market values (current value in the market -
PRESENT VALUE)
BOOK VALUE CAPITAL STRUCTURE
 Uses historical data from the balance sheet
 Includes RETAINED EARNINGS
 Short-term loans are included ONLY IF
THEY'RE RECURRING DEBT. If you don 't
include it, you ' re ignoring the interest-
bearing debt!

MARKET VALUE CAPITAL STRUCTURE
 Uses PRESENT VALUES of debt and equity
 Better to use than Book Value Capital
Structure since it' s more accurate, current,
and realistic
 Puts more emphasis on interest-bearing
debt and equity. Retained earnings is
usually excluded.
 If investing on this project will cost you less
than 5,489.59, go for it, because your NPV
will be positive.
 If investing on this project will cost you
more than 5,489.59, DO NOT get it because
your NPV will be negative.
CORPORATE VALUATION
The HORIZON VALUE is the projected cash flow of
the firm beyond the given year.
 If the company's debt is more than its PV
(Intrinsic value), it's going to be in trouble

WACC COMPUTATION
NOTE: The WACC is used as a HURDLE RATE to
assess whether or not a company produces value
for investors measured by the return on
investment of capital (ROIC). If a company's WACC
is greater than it's ROIC then the company is EQUITYVALUATION
generating a net negative return on capital and vice Equity value = Value of firm
versa!
THE VALUATION
The goal of the firm is to MAXIMIZE SHAREHOLDER
WEALTH BY MAXIMIZING THE VALUE OF THE FIRM!
 FCF = Free Cash Flow
 N = Investment Period
 r = Required Rate of Return (WACC)
 The firm ' s PV is infinite since it will
continuously apply itself into projects
 The project' s PV is N since it has an
economic life

PROJECT VALUATION
C A P I T A L B U D G E T I N G (Part 1)
Strategic Asset Allocation
 A portfolio strategy wherein the investor sets
target allocations for various asset classes and
rebalances the portfolio periodically.
 Target allocations depend on several factors:
the investor’s risk tolerance, time horizon, and
investment objectives. Also, the allocations may
change over time as the parameters change
BUT IT'S NOT THAT SIMPLE...
 Process is usually more involved than just
deciding whether to buy a particular fixed asset.
Business establishments face broader issues
like, whether they should launch a new product
or enter a new market
 Decisions such as those influence the nature of
a firm’s operations and products for years to
come primarily because investments in fixed
assets are generally long-lived and not easily
reversed once they are made.
ESSENTIAL QUESTIONS
One fundamental decision a business must make
concerns its product line of the business enterprise. It
will require answers that will involve commitment of its
scarce and valuable capital to certain type of assets
 What services will the firm offer or what will it
sell?
 What new products will it introduce?
 In what markets will it compete?
REGARDING PROJECTS
A firm contemplating a major capital expenditure
program should arrange its financing several years in
advance to be sure the funds required are available.
Before a firm can spend a large amount of money, it
must have the funds. Huge amounts are not freely
available
CAPITAL BUDGETING
A decision-making process where a company plans and
determines any long term capital expenditure (Capex)
whose returns in terms of cash flows are expected to be
received beyond a year.
THE CAPITAL BUDGETING PROCESS
 Generating Project Proposals
 Collecting Relevant Information About
Opportunities Estimating Cash Flows
 Evaluating Project Proposals
 Selecting Projects
 Implementing and Renewing Projects
Advantages of Capital Budgeting
 Helps in making decisions in the investment’s
opportunities
 Promotes understanding of risks and its effects
on the business
 Abstain from Over or Under Investment
TYPE OF CAPITAL BUDGETING DECISIONS
 Replacement Decisions to continuous current
operations.
 Replacement to effort cost reduction
 Expansion into new products or markets
 Expansion of existing products or markets
Equipment selection decisions
 Safety and / or environmental projects
 Merger Other Projects
CATEGORIES OF INVESTMENT DECISIONS
I. Independent capital investment These relate to
whether a proposed project is acceptable
II. Mutually exclusive capital investment selecting
from among several acceptable alternatives. For
the project to be acceptable, it must pass the
criteria of acceptability of the company and be
better than the others.
ESTIMATING CASH FLOWS
CASH FLOWS OF A PROJECT FALLS INTO THESE
CATOEGORIES:
 Net Initial investment
 Net operating Cash Flows or Returns
 Net Terminal Cash flow
EVALUATING PROJECT PROPOSALS
Capital investment are evaluated under certainty or
risk.
 Under Certainty, the exact values associated
with the investment, such as the cash flows and
the required rate of return, are known in
advance.
 Under Risk , variables are required for
evaluating investment proposals are not certain
and involve a margin of error
SELECTING PROJECTS
The firm should invest in new projects up to the point
where the rate of return from the last project is equal to
the firm’s marginal cost of capital
Many factors, quantitative as well as qualitative, should
be given consideration before the final decision is made
as to the selection of a particular investment.
The final selection of projects depends on three major
factors:
 Project type
 Availability of funds
 Decision criteria
IMPLEMENTING AND REVIEWING PROJECTS
 The decision to accept or reject a proposed
project must be communicated to its originator
and to others in the firm.
 Acceptable projects must then be implemented
in a timely and efficient manner,
 The implementation stage involves developing
formal procedures for authorizing the
expenditures of funds for capital projects
 The review stage involves analyzing projects
that have been adopted in order to determine if
they should be continued, modified, or
terminated..
POST-AUDIT
After a project is completed, a post-audit is conducted
in which comparisons are made between earlier
estimates and actual data.
IMPROVE FORECASTS
When decision makers are forced to compare their
projections with actual outcomes there is a tendency
for estimates to improve
IMPROVE OPERATIONS
Businesses are run by people, and people can perform
at higher or lower levels of efficiency
CAPITAL BUDGETING (Part 2)
Summary of the Investment Decision Process
 Determine the initial cost of the project
 Estimate expected cash flows over the life of
the project
 Estimate the cost of capital appropriate for the
project
 Determine if the project should be accepted
using one or more investment decision rules
PAYBACK:
Number of years it takes to recover the cost of a
project from the project's expected cash flows
 Decision Rule: Accept project if PB < N*
N* = Maximum cost-recovery time established by
the firm
 For mutually exclusive projects, choose the
project with the shorter payback in so far as
that project's PB <N*
Decision Rule
Independent Projects: Accept projects with PB<N*
Mutually Exclusive: Choose the project with the
shorter PB in so far as that project's PB < N*
DISADVANTAGES:
 DISREGARDS CASH FLOWS AFTER PAYBACK
PERIOD
 IGNORES THE TIME VALUE OF MONEY
NET PRESENT VALUE
NPV is the PV of ALL CASH FLOWS, including the
initial project cost
 Decision rule: Accept project if NPV is
positive
 If the two projects are independent, accept
both because both projects have positive
NPV
 If the two projects are mutually exclusive
(meaning we have to choose only one), we
should accept Project B because its NPV is
greater
PROFITABILITY INDEX
Profitability Index is a capital budgeting tool used
to rank projects based on their profitability. It is
calculated by dividing the present value of all cash
inflows by the initial investment. Projects with
higher profitability index are better.
While the net present value gives us the absolute
value that a project adds, it is wrong to compare
the net present values of different investments
directly.
FOR DECISION-MAKING
How to Interpret the Profitability Index?
 If the index is more than 1, then the
investment is worthy because then you may
earn back more than you invest in. So if you
find any investment whose Pl is more than
1, go ahead and invest in it.
 If the index is less than 1, then it's better to
step back and look for other opportunities.
Because when Pl is less than 1, that means
you would not get back the money you
would invest. Why bother to invest at all?
 If the index is equal to 1, then it's an
indifferent or neutral project. You shouldn't
invest in the project until and unless you
consider it better than other projects
available during the period. If you find that
the PI of all other projects to be negative,
then consider investing in this project
ECONOMIC VALUE ADDED
Economic Value Added (EVA) or Economic Profit is
a measure based on the Residual Income technique
that serves as an indicator of the profitability of
projects undertaken. Its underlying premise
consists of the idea that real profitability occurs
when additional wealth is created for shareholders
and that projects should create returns above their
cost of capital.
STEPS: IF NOPAT IS NOT GIVEN
 FIND NOPAT FIND
 WACC
 SUBSTITUTE VARIABLES IN THE FORMULA
FIND NOPAT
Formula 1
Formula 2
FIND EVA
WHAT DOES IT MEAN?
 EVA compares the rate of return on invested
capital with the opportunity cost of investing
elsewhere. This is important for businesses to
keep track of, particularly those businesses that
are capital intensive.
 When calculating economic value added, a
positive outcome means that the company is
creating value with its capital investments.
 Conversely, a negative outcome would mean
that the company is destroying value with its
capital investments and the capital would be
better spent elsewhere.
CAPITAL BUDGETING (Part 3)
The Internal Rate or Return
The IRR
 IRR is the rate of return on a project
 It is calculated as the rate that sets the NPV to
zero
FORMULA:
COMPUTATION: IRR
Manually irr is solve by trial-and-error until you find the
rate that sets the NPV to 0. That rate is the IRR.
TRIAL AND ERROR APPROACH
 Estimate an Interest rate (IRR)
 Get the PV of each cash flow using the IRR
 GET THE NPV.
o IF THE NPV IS 0, THAT INTEREST RATE IS
YOUR IRR
o IF THE NPV IS NOT 0, DO THE SAME
PROCESS AGAIN FOR THE SECOND TIME
 IF AFTER THE SECOND TRY GETTING A 0 NPV,
FAILS:
o SUBTRACT THE LOWER NPV FROM THE
HIGHER NPV.
o DIVIDE THE FIGURE BY THE DIFFERENCE
BETWEEN THE TWO INTEREST RATES.
THIS WILL GIVE YOU THE VALUE WHICH
REPRESENTS HOW MUCH THE NPV
RISES AND FALLS WITH ONE PERCENT
INCREASE OR DECREASE IN INTEREST
RATE.
o DIVIDE HIGHER NPV BY THE RESULT OF
THE STEP ABOVE. THIS WILL GIVE YOU
 THE PERCENTAGE POINTS BETWEEN
THE TWO INTEREST RATES YOU
SELECTED EARLIER.
o ADD LOWER INTEREST RATE TO THE
RESULT OF THE STEP ABOVE.
o NOW YOU HAVE YOUR IRR, OR AT
LEAST, VERY CLOSE TO IT
IRR DECISION-MAKING
If the two projects are independent, accept both
because both projects' IRR > r

If the two projects are mutually exclusive (meaning

we have to choose only one), we should choose
Project A because its IRR is greater

CONFLICTING
 If projects are independent, NPV and IRR
lead to the same
 THIS IS BECAUSE FOR INDEPENDENT
PROJECTS, IF YOUR IRR IS ABOVE THE COST
OF CAPITAL, YOU CAN GET BOTH THE
PROJECTS
 But if projects are mutually exclusive, the
potential for conflict exists,
THE CROSSOVERRATE VS THE COST OF CAPITAL
If the cost of capital is greater than the crossover rate
there wouldn’t have been a conflict, below it theres a
conflict, above it theres a conflict.
Which Project Should I Choose when Conflict Exists
between NPV and IRR?
 Condition for conflict exists when the size of
one project's CFs are much larger in the early
years than the other project's CFs
 When a conflict exists between NPV and IRR,
we should decide based on NPV because NPV
selects the project with the greater value
 NPV should be used to choose between
mutually exclusive projects when in doubt
because it ensures value is maximized
 Moreover, NPV assumes cash flows are
reinvested at cost of capital, r
 While IRR assumes the reinvestment rate is IRR
 Reinvesting at r is more realistic, so NPV
method is more reliable