Chapter 2: Introduction to Cost of Capital

Applications: Valuation and Project Selection

 Introduction
 Net Cash Flow Is the Preferred Economic Income Measure
 Cost of Capital Is the Proper Discount Rate
 Present Value Formula
 Example: Valuing a Bond
 Applications to Businesses, Business Interests, and Capital
Budgeting Projects
 Applications in Ratemaking
 Summary

Cost of Capital: Applications and Examples 5 th ed. Chapter 2 - 1

 Introduction

 The basic steps in valuation and investment selection are:

1. Estimation of economic income
2. Estimation of the cost of capital
3. Use of the cost of capital to calculate present values
 These steps are applicable to both the discounted cash flow
(DCF) method and the single-period capitalization method.

Cost of Capital: Applications and Examples 5 th ed. Chapter 2 - 2

 Net Cash Flow Is the Preferred Economic
Income Measure

We usually assume that the measure of economic income to

which the cost of capital will be applied is net cash flow (sometimes
called free cash flow). Net cash flow represents discretionary cash
available to be paid out to stakeholders (providers of capital) of an
entity (e.g., interest, debt payments, dividends, withdrawals)
without jeopardizing the projected ongoing operations of the entity.

Cost of Capital: Applications and Examples 5 th ed. Chapter 2 - 3

 Cost of Capital Is the Proper Discount Rate

In this context, let us keep in mind the critical characteristics of a

discount rate:
 Definition: A discount rate is a yield rate used to convert
anticipated future economic income (payments or receipts)
into present value (i.e., a cash value as of a specified
valuation date).
 A discount rate represents the total expected rate of return
that the investor requires on the amount invested.

Cost of Capital: Applications and Examples 5 th ed. Chapter 2 - 4

 Present Value Formula

 The numerator. The expected amount of economic income (e.g.,

the net cash flow) to be received from the investment in each
future period over the life of the investment.
 The denominator. A function of the discount rate, which is the
cost of capital, which in turn is the required rate of return. This
function is usually written as (1 + k)n.

Cost of Capital: Applications and Examples 5 th ed. Chapter 2 - 5

 Present Value Formula (cont.)

Cost of Capital: Applications and Examples 5 th ed. Chapter 2 - 6