Seminar 5

Investmen
t
Decisions I
• Cost of Capital

• Capital budgeting tools

(NPV, IRR, Payback)

1
What is
Capital
Budgeting?
• Analysis of potential projects,
e.g. investments in tangible and
intangible assets
• Long-term decisions involving
large expenditures
• Very important to firm’s future
• Therefore, companies need
procedures to analyse and select
its long-term investments

 Goal: Create value for

shareholders

2
Applications
An investment/project can range the spectrum from big to
small, money making to cost saving:
• Major strategic decisions to enter new areas of business or new
markets.
• Decisions on new ventures within existing businesses or markets.
• Acquisitions of other firms are projects as well.
• Decisions that may change the way existing ventures and projects
are run.
• Decisions on how best to deliver a service that is necessary for the
business to run smoothly.
Put in broader terms, every choice made by a firm can be
framed as an investment.

3
Steps to Capital Budgeting
1. Estimate CFs. Seminar 6

− Initial investments.
− Subsequent cash inflows/ outflows.
− Terminal cash flows.

2. Assess riskiness of CFs and determine the

appropriate risk-adjustedSeminar
cost5of capital for
discounting cash flows. Part 1

3. Apply Decision Rules: NPV, IRR, Payback, Seminar

PI. 5
Part 2
4
Weighted
Average Cost of
Capital (WACC)
From investor expected returns to company’s cost of capital

5
Intuition: Durian Pastry Business Venture
$1m needed for investment, expected to make $1.1m at the
end of one year 10% Return
 $400K borrowings from bank GOOD DEAL!

 $600K equity from your savings

What are the
alternatives?
$400K debt: bank looks at the riskiness of your business and
Opportunity cost of
charges you 5% interest equity capital
$600K equity:

 Invest in the stock market, which is equally risky as the durian pastry
business
 The stock market’s expected return is 15%
Intuition: Durian Pastry Business Venture
If youinvested in the durian cake business, at the end of one
year you expect to receive $1.1m from the business
 Pay $400K + Interest (5%*400K) = $420K to the bank
 Left with $1.1m - $420K = $680K Richer by $80K!

If you invested in the stock market, at the end ofRicher

the year,
by $90K and
 Expected to receive = $600K+15%*600K = $690K same risk levels

We need to compare the 10% return against the cost of

obtaining capital
 Cost of Capital = 5%*400K +15%*600K= $110K or 11%
 Lessons Learnt
Lesson 1: Cost of capital is the weighted average cost
of each type of financing.
• Expected returns of debtholders and equity holders become the
firm’s cost of capital.

Lesson 2: An investment must give a return that is at

least equal to the cost of capital.
• Cost of capital = hurdle rate
• Riskier projects have higher hurdle rates

Lesson 3: Equity holders bear the lost (enjoy the gains)

if project return is less (more) than cost of capital.
• Net Present Value (NPV) = Gain/Lost in present value terms
Introducing the weighted average
cost of capital (WACC)
Companies raise long-term capital with equity and debt
 Sometimes with preferred/ preference shares
 Focus on long-term capital as the capital is used to support long-
term investment projects

WACC is the weighted average cost of equity and cost of

debt and cost of preferred shares
Weighted average cost of capital =
Weight on debt*Cost of debt*(1-T) + Weight on equity*Cost of equity +
Weight on preferred shares*Cost of preferred shares

9
What are preferred shares?
Hybrid security, between stocks and bonds.

Like bonds, preferred stockholders receive a fixed dividend

that must be paid before dividends are paid to common
stockholders.
 Often stated as a percentage of the par value, e.g., 5% annual dividend
on par value of $10  $0.50 annual dividend

However, companies can omit preferred dividend payments

without fear of pushing the firm into bankruptcy.
Generally no voting rights.
Generally no expiration dates.
10
 Bank of America

Source
SGX

SET

11
Expected returns on preferred
shares
ABC has a preferred stock traded with a current price of
$48. If the preferred stock has a 5% annual dividend and
par value of $50, what is the expected return on the
preferred share?

12
 Costs
Weighted average cost of capital =
Weight on debt*Cost of debt*(1-T) + Weight on equity*Cost of equity
Weight on preferred shares*Cost of preferred shares

Debtholder’s expected Common shareholder’s Preferred shareholder’s

return expected return expected return
 Firm’s cost of debt  Firm’s cost of  Firm’s cost of
capital common equity capital preferred share capital

Use marginal cost of raising capital today instead of

historical cost
• The cost of capital is used primarily to make decisions that involve
raising new capital so we should focus on today’s marginal cost.
• The historical cost of existing financing on the firm’s books is
irrelevant
13
Practical notes on how to obtain
costs
 Cost of common equity: CAPM
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 =𝑟 𝑓 +¿
Which source of capital
 Cost of debt
has the highest cost?
 Risk-free rate + Default risk premium
 Interest rates on new bank borrowings
 YTM on existing long-term debt
Do not use cost of borrowing short-term just because it is lower! This is
because we are evaluating long-term projects, we should use the cost of
borrowing long-term today.
Do not use the coupon rates on existing debt. They are historical costs and
should not be used 𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠h𝑎𝑟𝑒𝑠=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒
 Cost of preferred shares: 14
After-tax capital cost
Weighted average cost of capital =
Weight on debt*Cost of debt*(1-T) + Weight on equity*Cost of equity +
Weight on preferred shares*Cost of preferred shares

Shareholders focus on after-tax CFs. Therefore, we should focus

on after-tax capital costs.

Only cost of debt needs adjustment, because interest is tax

deductible.
 Interest are paid being taxes are calculated  Because you pay interest, you
pay less taxes

Costs of equity and preferred shares do not need adjustment

because dividends are paid after taxes

Tax rate: Often assumed to be the 15

statutory tax rates
 Weighted average cost of capital =
Weight on debt*Cost of debt*(1-T) + Weight on equity*Cost of equity + Weight on preferred
shares*Cost of preferred shares

Weights Capital Structure

Preferred shares
Capital structure: Mix of debt vs 10% Debt
20%
equity vs preferred shares used
to finance the firm’s assets (Go
to MSFT on CapitalIQ Pro) Equity
70%

2 Key Concepts:

 Weights should be based on target Target capital structure: Desired mix of equity,
capital structure rather than the debt and preferred shares financing that firms
actual financing of projects attempt to maintain in the long run

 Weights should be market value- Book values: Historical value of debt, equity, and
preferred shares in the financial statements
based and not book value-based Market values: Value of debt, equity and
preferred shares as determined by the markets
16
 In-class group
assignment: What
weights to use?
You are the CFO of EpicWorld Inc, a
theme park operator looking to invest in
a new theme park in Japan and this
theme park will be 100% financed by
debt. The bank is willing to lend you at a
9% interest rate. The investment is
expected to give a return of 11%.

The CEO says: “Since the expected return

is higher than the cost of debt used to
finance the investment, the project
should be a go!”

Do you agree with your CEO? Explain

your answer.
Deiiverables: 1 slide
17
Weights - Market vs book
value
The cost of capital must be based on what investors are actually willing
to pay for the company’s outstanding securities, i.e., market values.

Market Value of Equity - Market price per share multiplied

by the number of outstanding shares.
Market Value of Preferred Shares - Market price per share
multiplied by the number of outstanding shares.
Market Value of Debt

 Publicly Traded Bonds - PV of all coupons and par value discounted at

the current YTM.
 Bank Debt - May use the book value to proxy for market value if
interest rates do not change much
  May be difficult to find the market value of all debts, some people
use the book value of debt to proxy for market value (works only if
interest rates or company financial health do not change much) 18
Example – EpicWorld Inc
The following table gives the balance sheet of EpicWorld. The preferred
stock currently sells for $15 per share and pays a dividend of $2 a share.
There are 100,000 preferred stock outstanding. The common stock sells
for $20 per share and has a beta of 0.8. There are 1 million shares
outstanding. The company has a single tranche of bond with 8% annual
coupon, 10 years left to$millions
Assets maturity, and Equity
currently
and selling$millions
with YTM of 9%.
Liabilities
Fixed Assets $21 Debt $10
Current Assets $9 Equity $18
Preferred stock $2

A) What are the weights used in the calculation of the company’s

WACC?
B) The market risk premium is 10%, the risk-free rate is 6% and the
firm’s tax rate is 27%. What is the company’s WACC?
19
EpicWorld - Calculating
weights
We assume that the current capital structure is its target
capital structure
MV of equity = $20*1m = 20million

MV of P.S. = $15*0.1m = 1.5m

MV of debt: Rate = 0.09, NPER = 10, PMT = 0.08*10, FV =

10  MV of debt = 9.358m
 Total capital = 30.858m

 Weight on equity = 20/30.858 = 64.81%

 Weight on preferred stock = 1.5/30.858 = 4.86%
 Weight on debt = 9.358/30.858 = 30.33%

20
EpicWorld WACC
Cost of equity = 6%+0.8*10% = 14%

Cost of P.S. = 2/15 = 13.33%

Cost of debt = 9% (YTM, Not coupon rate of 8%!)

WACC

= 64.81%*14% + 4.86%*13.33% + 30.33%*9%*(1-0.27)

= 11.71%

21
EpicWorld’s new investments
You have now calculated the WACC for EpicWorld, a theme
park operator. What can you use this WACC for?

Suppose EpicWorld is thinking of entering the movie

industry and is now evaluating whether to invest in
producing and distributing a new movie. The CEO suggests
using the current WACC of the company as the hurdle rate
to evaluate the movie project because this is how much
the company can raise capital at. However, the CFO argues
that movie making is much riskier than theme parks. And
the CFO has calculated that movie studios have a WACC of
15%. Who do you think is correct? Why?
22
Project Risk and WACC
The W ACC is an appropriate discount rate only for a
project that is a carbon copy of the firm's existing business.

The hurdle rate has to be adjusted for the risk of the

project. Riskier projects should have higher hurdle rates
 Subjective adjustments
 Look to WACC of peers with similar projects

23
Application: Cost of Capital
for MSFT
 What sources of long-term capital does the company have?
 In CapitalIQ Pro, search for MSFT. In left hand column  Financials  Templated  Capital
Structure Summary
 What is the book value of equity and book value of debt for MSFT?

 What is the market value of equity?

 In CapitalIQ Pro, go to Corporate Profile  Market Data  Market Cap.

 Calculate the weights used in the WACC calculation for MSFT.

 For simplicity, assume that the market value of debt = book value of debt. Note that this may not
be valid as interest rates have risen by a lot in recent years, the market value of debt is likely
lower than book value
 What is the cost of equity for MSFT?
 Find MSFT’s beta on CapitalIQ Pro: Corporate Profile  Market Data  Beta 3Y
 Find 10-year risk-free rate in USD: Click on Markets tab  Rates and Yields  Yield Curve  Find
what is the current yield on 10-year US treasury.
 Assume market risk premium for U.S. = 3.54% (Refinitiv)

 What is the cost of debt for MSFT?

 YTM on existing debt: On left hand column, go to Corporate Issuance  Securities Summary 
Debt Capital Structure. Choose a bond that is “Senior Unsecured”, then choose the bond with
about 10 years left to maturity, denominated in USD and without any features.
 Note that you can also use risk-free rate + default risk premium as learnt in Seminar 4

 What 24
is MSFT’s WACC? Assume tax rate = 25%
Key takeaways
Weighted average cost of capital (WACC)

 Used as a hurdle rate when evaluating projects

 Company-wide WACC reflects risk of firm’s existing assets. Important to
adjust the company-wide WACC to reflect project-specific risk

Weighted average cost of capital =

Weight on debt*Cost of debt*(1-T) + Weight on equity*Cost of equity +
Weight on preferred shares*Cost of preferred shares

4 key concepts:

 Use marginal costs and not historical costs

 Only cost of debt needs tax adjustments
 Use market value weights and not book value weights
 Use target capital structure weights
25
Decision
Rules
- Payback, NPV, IRR

26
Steps to Capital Budgeting
1. Estimate CFs.
− Initial investments.
− Subsequent cash inflows/ outflows.
− Terminal cash flows.

2. Assess riskiness of CFs and determine the

appropriate risk-adjusted cost of capital for
discounting cash flows.

3. Apply Decision Rules: Payback, NPV, IRR.

27
27
Classification of Projects
Goal of capital budgeting: Create the most value for
shareholders.
Value is created when benefits of decision exceed costs.

1. Independent projects: Choose to accept or reject a

single project
 Accept the project if benefits exceed costs
2. Mutually exclusive projects: Choose between two
projects
 Accept the project with higher value given that
benefits exceed costs

28
Decision Rules
 Payback Period
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
* Refer to “MBA_S05_CapitalBudgeting.xlsx” for the excel
calculations in this set of slides.

29
30
 Should we invest in the cooling
system(s)?
Here are the systems’ expected after-tax cash flows:

0 1 2 3 4 5

ST Cool -12m 4m 4m 3m 2.5m 2.5m

TT Cool -12m 6m 4m 2.5m 1m 1m
Cost of capital = 10%
Single project: If only ST Cool is available, should we invest in ST
cool?
Mutually exclusive projects: Which cooling machine should we buy?

How should we conduct the analysis to create the most value for
shareholders? 31
Payback period
The number of years required to recover a project’s cost,
or “How long does it take to get our money back?”

Payback Rule:

• Accept a project if its

Single project payback period is less than
an arbitrary cutoff period

• Accept the project with

Choosing shorter payback
between projects
32
 Application of payback to cooling system
investment
Here are the cooling systems’ expected after-tax cash flows:

0 1 2 3 4 5

ST Cool -12m 4m 4m 3m 2.5m 2.5m

TT Cool -12m 6m 4m 2.5m 1m 1m

Cost of capital = 10%

Should we
Payback period for ST Cool = =3.4 years invest in ST
Cool?
Payback period for TT Cool

33
 Weaknesses and Strengths of
Payback Method
Strengths

 Easy to calculate and understand.

 Provides an indication of a project’s risk and liquidity.

Weaknesses Benchmark set subjectively by management

based on factors such as project’s perceived risk,
 Arbitrary benchmark. and also based on past projects’ payback period.

 Ignores the time value of money.

 Ignores CFs occurring after the payback period.
0 1 2 3 4 5

Proj ST -12m 4m 4m 3m 2.5m 10m

Proj TT -12m 6m 4m 2.5m 1m 1m 34
 Value of any asset =
Present value of all its
Net Present Valuefuture cash flows
NPV = PV of future cash flows minus initial investments

 Benefits minus costs = “Added value” of project after accounting

for time value of money and cost
NPV =-Initial Investments +

NPV rule

• Accept a project if its

Single project
NPV > 0

Choosing • Accept the project

between projects with higher NPV 35
 Application of NPV to cooling
system investment
Here are the cooling systems’ expected after-tax cash flows:

0 1 2 3 4 5

ST Cool -12m 4m 4m 3m 2.5m 2.5m

TT Cool -12m 6m 4m 2.5m 1m 1m
Value of project
Should we
= PV of future cash flows
Cost of capital = 10% invest in ST
Cool?
NPV for ST Cool=

NPV for TT Cool=

36
NPV and Impact on Shareholder
Wealth
NPV =-Initial Investments +

Added value of project

 NPV indicates how much shareholders’ wealth will increase if

project is taken up.
 Accepting ST Cool will increase shareholder wealth by $456,000

 If company has 1m shares outstanding, theoretically, share price

should increase by $0.456 upon acceptance of ST Cool
 Choosing project with higher NPV  Higher increase in
shareholders’ wealth

37
Internal Rate of Return (IRR)
IRR is the discount rate where NPV = 0.

 Expected annual rate of return on the project.

0 =-Initial Investments +

IRR Rule Recall intuition from

durian pastry venture?
• Accept a project if its IRR > cost
Single project of capital (hurdle rate)

• Accept the project with higher

Choosing IRR, provided project IRR > cost
between projects of capital
38
 Application of IRR to cooling
system investment
Here are the cooling systems’ expected after-tax cash flows:

0 1 2 3 4 5

ST Cool -12m 4m 4m 3m 2.5m 2.5m

TT Cool -12m 6m 4m 2.5m 1m 1m

Cost of capital = 10%

ST:
Should we invest in ST Cool?
 IRR = 11.6%
TT:
39
NPV vs IRR: Single project
NPV Profile (ST Cool)
5.0000
NPV is always positive when IRR > cost of capital
4.0000  IRR and NPV gives the same accept/reject
decision for single project
3.0000

2.0000

1.0000
IRR = 11.6%
NPV

0.0000
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25%

Cost of capital
-1.0000

-2.0000

-3.0000

-4.0000

40
NPV vs. IRR for Mutually
Exclusive Projects:
Complication 1 – CF Timing
Project A

Cash Flow $ 5,000,000 $ 4,000,000 $ 3,200,000 $ 3,000,000

Investment $ 10,000,000

Cost of NPV = $1,191,712

IRR=21.41%
capital =
15% Project B

Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000

Investment $ 10,000,000
NPV = $1,358,664
IRR=20.88%

41
NPV vs. IRR for Mutually Exclusive
Projects: Complication 1 – CF Timing
There is a difference in the reinvestment rate assumption
between NPV and IRR
 The NPV rule assumes that intermediate cash flows on the project
get reinvested at the hurdle rate.
 The IRR rule assumes that intermediate cash flows on the project get
reinvested at the IRR. Implicit is the assumption that the firm has an
infinite stream of projects yielding similar IRRs.
Conclusion: When the IRR is high (the project is creating
significant surplus value) and the project life is long, the
IRR will overstate the true return on the project.

42
In-class group assignment
NPV vs. IRR for Mutually Exclusive
Projects: Complication 2 – Project Scale
Project A

Cash Flow $ 350,000 $ 450,000 $ 600,000 $ 750,000

Investment $ 1,000,000

Cost of
capital =
15% Project B

Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000

Investment $ 10,000,000

Calculate the NPV and IRR of Project A and B. Which project would you pick and
why? You can only pick one project. What are some of your considerations?
43
What do companies use?

Source: Graham (2022) 44

Key Takeaways
Payback period: Number of years to breakeven

NPV: Increase in shareholder’s wealth if project is taken

NPV =-Initial Investments +

IRR: Annualized rate of return on project

0 =-Initial Investments +

When choosing independent projects, NPV and IRR always

give the same accept/reject decision
When choosing between mutually exclusive projects, NPV
and IRR may differ due to 1) differences in CF timing, and
2) project scale
45
Next steps
Hand in in-class group assignment

Work on problem set

Next week, we will learn how to estimate project cash

flows

46