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Chapter 11 - Capital Budgeting and Risk Analysis

Chapter 12 - Cost of Capital

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Tujuan Pembelajaran 1

Mahasiswa mampu untuk:Menjelaskan pengukuran risiko yang tepat untuk tujuan penganggara modal

Menetapkan akseptabilitas dari suatu proyek baru dengan menggunakan baik metode certainty equivalent maupun metode risk-adjusted discount risk

Menjelaskan penggunaan simulasi dan pohon probabilitas untuk mengimitasi kinerja proyek yang sedang dievaluasi

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Pokok Bahasan 1

Risiko dan keputusan investasi

Metode-metode untuk memasukkan risiko ke dalam penganggaran modal

Pendekatan lain untuk mengevaluasi risiko dalam penganggaran modal

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Tujuan Pembelajaran 2

Mahasiswa mampu untuk: Menjelaskan konsep yang mendasari biaya modal perusahaan dan tujuan perhitungannya

Menghitung biaya modal setelah pajak untuk hutang, saham preferen dan saham biasa, serta biaya modal rata-rata tertimbang suatu perusahaan

Menjelaskan prosedur untuk menaksir biaya modal pada perusahaan yang memiliki banyak divisi

Menggunakan biaya modal untuk mengevaluasi investasi baru

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Pokok Bahasan 2

Biaya Modal: Definisi dan Konsep kunci

Menghitung biaya modal individual

Biaya modal rata-rata tertimbang

Menghitung Biaya Modal Divisi: Kasus Pepsico, Inc.

Menggunakan cost of capital perusahaan untuk mengevaluasi investasi baru

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Three Measures of a Project’s Risk

Project Standing Alone Risk

Risk diversified away

within firm as thisproject is combined

with firm’s otherprojects and assets.

Risk diversified away

by shareholders as securities are combined

to form diversifiedportfolio.

Project’sContribution-to-Firm Risk

Systematic Risk

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Incorporating Risk into Capital Budgeting

Two Methods:

Certainty Equivalent Approach

Risk-Adjusted Discount Rate

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How can we adjust this model to take risk into account?

Adjust the After-tax Cash Flows (ACFs), or

Adjust the discount rate (k).

NPV = - IO FCFt

(1 + k) t

n

t=1S

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Certainty Equivalent Approach

Adjusts the risky after-tax cash flows to certain cash flows.

The idea:

Risky Certainty Certain

Cash X Equivalent = Cash

Flow Factor (a) Flow

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Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash

Flow Factor (a) Flow

Risky “safe”

$1000 .95 $950

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The greater the risk associated with a particular cash flow, the smaller the CE factor.

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Certainty Equivalent Method

tNPV = - IO t ACFt

(1 + krf)

n

t=1S

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Certainty Equivalent Approach

Steps:

1) Adjust all after-tax cash flows by certainty equivalent factors to get certain cash flows.

2) Discount the certain cash flows by the risk-free rate of interest.

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Incorporating Risk into Capital Budgeting

Risk-Adjusted Discount Rate

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How can we adjust this model to take risk into account?

Adjust the discount rate (k).

NPV = - IO ACFt

(1 + k) t

n

t=1S

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Risk-Adjusted Discount Rate

Simply adjust the discount rate (k) to reflect higher risk.

Riskier projects will use higher risk-adjusted discount rates.

Calculate NPV using the new risk-adjusted discount rate.

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Risk-Adjusted Discount Rate

NPV = - IO FCFt

(1 + k*)t

n

t=1S

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Risk-Adjusted Discount Rates

How do we determine the appropriate risk-adjusted discount rate (k*) to use?

Many firms set up risk classes to categorize different types of projects.

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Risk Classes

Risk RADR

Class (k*) Project Type

1 12% Replace equipment,

Expand current business

2 14% Related new products

3 16% Unrelated new products

4 24% Research & Development

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Summary: Risk and Capital Budgeting

You can adjust your capital budgeting methods for projects having different levels of risk by:

Adjusting the discount rate used (risk-adjusted discount rate method),

Measuring the project’s systematic risk,

Analyzing computer simulation methods,

Performing scenario analysis, and

Performing sensitivity analysis.

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Chapter 12 - Cost of Capital

Ó 2005, Pearson Prentice Hall

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Basic Skills: (Time value of money, Financial Statements)

Investments: (Stocks, Bonds, Risk and Return)

Corporate Finance: (The Investment Decision - Capital Budgeting)

Where we’ve been...

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Assets Liabilities & Equity

Current Assets Current Liabilities

Fixed Assets Long-term Debt

Preferred Stock

Common Equity

The investment decision

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Corporate Finance: (The Financing Decision)

Cost of capital

Leverage

Capital Structure

Dividends

Where we’re going...

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Assets Liabilities & Equity

Current Assets Current Liabilities

Fixed Assets Long-term Debt

Preferred Stock

Common Equity

The financing decision

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Assets Liabilities & Equity

Current assets Current Liabilities

Long-term Debt

Preferred Stock

Common Equity

}

Capital Structure

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Ch. 12 - Cost of Capital

For Investors, the rate of return on a security is a benefit of investing.

For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm.

In other words, the cost of raising funds is the firm’s cost of capital.

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How can the firm raise capital?

Bonds

Preferred Stock

Common Stock

Each of these offers a rate of return to investors.

This return is a cost to the firm.

“Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources.

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Cost of Debt

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Cost of Debt

For the issuing firm, the cost of debt is:

the rate of return required by investors,

adjusted for flotation costs (any costs associated with issuing new bonds), and

adjusted for taxes.

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Example: Tax effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

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Example: Tax effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

Now, suppose the firm pays $50,000 in dividends to the stockholders.

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Example: Tax effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

- dividends (50,000) 0

Retained earnings 214,000 231,000

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After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

-= 1

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Example: Cost of Debt

Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond.

What is the pre-tax and after-tax cost of debt for Prescott Corporation?

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Pre-tax cost of debt: (using TVM)

P/Y = 2 N = 40

PMT = -50

FV = -1000 So, a 10% bond

PV = 950 costs the firm

solve: I = 10.61% = kd only 7% (with

After-tax cost of debt: flotation costs)

Kd = kd (1 - T) since the interest

Kd = .1061 (1 - .34) is tax deductible.

Kd = .07 = 7%

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Cost of Preferred Stock

Finding the cost of preferred stock is similar to finding the rate of return (from Chapter 8), except that we have to consider the flotation costs associated with issuing preferred stock.

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Cost of Preferred Stock

Recall:

kp = =

From the firm’s point of view:

kp = =

NPo = price - flotation costs!

DPo

Dividend Price

DividendNet Price

DNPo

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Example: Cost of Preferred

If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?

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Cost of Preferred Stock

kp = =

= = 10.81%

DividendNet Price

DNPo

8.0074.00

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Cost of Common Stock

There are two sources of Common Equity:

1) Internal common equity (retained earnings).

2) External common equity (new common stock issue).

Do these two sources have the same cost?

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Cost of Internal Equity

Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return.

Why?

If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.

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Cost of Internal Equity

1) Dividend Growth Model

kc = + g

2) Capital Asset Pricing Model (CAPM)

kj = krf + j (km - krf )

D1

Po

b

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Dividend Growth Model

knc = + g

Cost of External Equity

D1

NPo

Net proceeds to the firmafter flotation costs!

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Weighted Cost of Capital

The weighted cost of capital is just the weighted average cost of all of the financing sources.

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Weighted Cost of Capital

Capital

Source Cost Structure

debt 6% 20%

preferred 10% 10%

common 16% 70%

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Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16%)

= 13.4%

Weighted Cost of Capital(20% debt, 10% preferred, 70% common)

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