CHAPTER 6

CAPITAL BUDGETING
Nguyen Thu Hang
 Capital Budget and Capital budgeting

• A capital budget lists the projects and

investments that a company plans to
undertake during the coming year.
• To determine this list, firms analyze alternative
projects and decide which ones to accept
through a process called capital budgeting.
 Outline
 Investment Decision Criteria
 Forecasting FCF
 Estimating incremental revenue, cost and earnings
 Forecasting FCF
 Some special projects
 Weighted Average Cost of Capital (WACC)
 Determining cost of capital
 Cost of equity
 Cost of debt
 Project based cost of capital
 Risk Analysis of Capital Investments
 Reading
CFA Corporate Finance, Level 2, Reading 23-
Capital Budgeting
Basic Principles of Capital Budgeting
Investment decision criteria
Cash flow projections
Project Analysis and evaluation
 Berk-DeMarzo, Ch8, 18
 The capital Budgeting process
 Generating Ideas: from anywhere, from the top or the
bottom of the organization, from an departments or
from outside  Most important.
 Analyzing individual proposals: gathering the
information to forecast cash flows for each projects and
then evaluating the projects profitability.
 Planning the capital Budget: fitting within the
company’s overall strategies
 Monitoring and Post-auditing: actual results are
compared to predicted results and any differences must
be explained
Ref: CFA L2, Corporate Finance, p. 6
I. Categories of Investment Projects
 Replacement projects.
 Expansion projects.
 New product/market development projects.
 Mandatory projects.
 Other projects (R&D,…).
Categories of Investment Projects

Projects may be
 Independent.
 Mutually Exclusive.
 Dependent.
 Basic Principles of capital budgeting
 Decisions are based on cash flows.
 Timing of cash flows is crucial.
Cash flows are based on opportunity costs
 Cash flows are analyzed on an after-tax basis
Financing costs are ignored

Ref: CFA L2, Corporate Finance, pp. 8-10

 Some detailed steps
 Forecasting FCFF (Forecasting earnings,
determining FCFF)
 Identifying cost of capital
Determining investment rules (NPV, IRR, PI,
PB)
Making decisions
 Some key concepts
• Sunk cost (chi phí chìm)
• Opportunity cost (chi phí cơ hội)
• Incremental cash flow (dòng tiền tăng thêm)
• Externality (ngoại tác), VD cannibalization
• Unlimited fund
• Capital rationing (giới hạn nguồn vốn)
Ref: CFA 2016, L2, Vol3, p.7
 Sunk cost
• A sunk cost is one that has already been
incurred. You cannot change a sunk cost.
Today’s decisions, on the other hand, should
be based on current and future cash flows and
should not be affected by prior, or sunk, costs.
• Ref: CFA. 2016 CFA Level II Volume 3 Corporate
Finance.
 Sunk Costs- Example
 Phương Xuân bought 1000 shares of VJC on Dec
2017 at P=VND 200,000.
 Today, P= VND 133,000. Should Phuong Xuan sell
the shares today?
 Opportunity cost
• An opportunity cost is what a resource is
worth in its next-best use.
• If a company uses some idle property, what
should it record as the investment outlay: the
purchase price several years ago, the current
market value, or nothing? If you replace an old
machine with a new one, what is the
opportunity cost? If you invest $10 million,
what is the opportunity cost?
 Incremental Cash flow
• An incremental cash flow is the cash flow that
is realized because of a decision: the cash flow
with a decision minus the cash flow without
that decision.
 Externality
• An externality is the effect of an investment on other
things besides the investment itself. Frequently, an
investment affects the cash flows of other parts of the
company, and these externalities can be positive or
negative. If possible, these should be part of the
investment decision.
• Sometimes externalities occur outside of the company.
An investment might benefit (or harm) other companies
or society at large, and yet the company is not
compensated for these benefits (or charged for the
costs).
• Ref: CFA. 2016 CFA Level II Volume 3 Corporate Finance
 Cannibalization
• Cannibalization is one externality.
Cannibalization occurs when an investment
takes customers and sales away from another
part of the company.
 Investment Decision Criteria
• Net Present Value (NPV) Investment rule
• Internal Rate of Return (IRR) Investment rule
• Profitability Index (PI)
• Payback rule (PB)
 I
NPV

IRR

PI
Example
• Researchers at Fredrick’s Feed and Farm have made a
breakthrough. They believe that they can produce a new,
environmentally friendly fertilizer at a substantial cost
savings over the company’s existing line of fertilizer. The
fertilizer will require a new plant that can be built
immediately at a cost of $250 million.
• Financial managers estimate that the benefits of the new
fertilizer will be $35 million per year, starting at the end of
the first year and last in forever, as shown by the following
timeline:
 NPV Investment Rule
• Take the alternative with the highest NPV.
• A stand-alone project: Accept the project if its
NPV is positive.
The NPV Profile
 IRR Investment Rule
• Take any investment opportunity where the
IRR exceeds the opportunity cost of capital.
• The internal rate of return investment rule is
applied to single, standalone projects within
the firm, when all of the project’s negative
cash flows precede its positive cash flows.
 Pitfall 1: Delayed Investments
• John Star, the founder of SuperTech, the most successful
company in the last 20 years, has just retired as CEO. A
major publisher has offered to pay Star $1 million upfront if
he agrees to write a book about his experiences. He
estimates that it will take him three years to write the book.
The time that he spends writing will cause him to forgo
alternative sources of income amounting to $500,000 per
year. Considering the risk of his alternative income sources
and available investment opportunities, Star estimates his
opportunity cost of capital to be 10%.
 Pitfall 1: Delayed Investments

• IRR=23.38%. Cost of capital= 10%

According to the IRR rule, Star should sign the
deal.
• Cost of capital =10%  NPV=-$243,426. 
According to the NPV rule, Star should not
sign the deal.
• The IRR rule and the NPV rule will give exactly
opposite recommendations.
Pitfall 1: Delayed Investments
Pitfall 2: Multiple IRRs
• Star has informed the publisher that it needs to sweeten the
deal before he will accept it. In response, the publisher
offers to give him a royalty payment when the book is
published in exchange for taking a smaller upfront
payment. Specifically, Star will receive $1 million when the
book is published and sold four years from now, together
with an upfront payment of $550,000. Should he accept or
reject the new offer?
Pitfall 2: Multiple IRRs

• IRR= 7.164% and 33.673%

• There is more than one IRR, we cannot apply the IRR
rule.
• When multiple IRRs exist, the only choice is to rely on
the NPV rule.
Pitfall 2: Multiple IRRs

• IRR= 7.164% and 33.673%

• There is more than one IRR, we cannot apply the IRR
rule.
• When multiple IRRs exist, the only choice is to rely on
the NPV rule.
Pitfall 3: Nonexistent IRR
• After protracted negotiations, Star is able to
get the publisher to increase his initial
payment to $750,000, in addition to his $1
million royalty payment when the book is
published in four years.
 No IRR exists; that is, there is no discount rate
that makes the NPV equal to zero The IRR
rule provides no guidance whatsoever.
Pitfall 3: Nonexistent IRR
Example
Problem
The payback rule
• The payback investment rule states that you
should only accept a project if its cash flows
pay back its initial investment within a
prespecified period.
• Payback period: the amount of time it takes to
pay back the initial investment,
• Accept the project if the payback period is
less than a prespecified length of time—
usually a few years. Otherwise, reject the
project.
 Example
• Assume Fredrick’s requires all projects to have
a payback period of five years or less. Would
the firm undertake the fertilizer project under
this rule?
• It will not be until year 8 that the initial
investment will be paid back ($35 * 8 = $280
million).
• Because the payback period for this project
exceeds five years, Fredrick’s will reject the
project.
III. CÁC Example
The payback rule
Required rate of return= 12%.
0 1 2 3 4 5
-500 200 200 200 250 250
 Payback period?
 Discounted payback period?
 Payback Rule
• The payback rule is not as reliable as the NPV
rule because:
 It ignores the project’s cost of capital and the
time value of money.
It ignores cash flows after the payback period.
 It relies on an ad hoc decision criterion (what is
the right number of years to require for the
payback period?)
• This rule is typically used for small investment
decisions.
NPV Rule and Mutually Exclusive
Investments
NPV Rule and Mutually Exclusive Investments
• When projects are mutually exclusive, we
need to determine which projects have a
positive NPV and then rank the projects to
identify the best one.
• Pick the project with the highest NPV. Because
the NPV expresses the value of the project in
terms of cash today, picking the project with
the highest NPV leads to the greatest increase
in wealth.
 IRR and Mutually Exclusive Investments
• Picking one project over another simply
because it has a larger IRR can lead to
mistakes.
• When projects differ in their scale of
investment, the timing of their cash flows, or
their riskiness, then their IRRs cannot be
meaningfully compared.
 Differences in Scale
• Would you prefer a 500% return on $1, or a 20%
return on $1 million?
• A shortcoming of IRR: Because it is a return, you
cannot tell how much value will actually be created
without knowing the scale of the investment.
• IRR(Book Store)=24%, IRR(Coffee shop)=23%, Cost
of capital=8%
• NPV(Book Store)=$960,000; NPV(Coffee shop)=
$1,200,000
 Differences in Timing
• Even when projects have the same scale, the
IRR may lead you to rank them incorrectly due
to differences in the timing of the cash flows:
• Example:

• IRR(Music Store)= 26%, NPV(Music

Store)=$900,000
 Differences in Risk
• To know whether the IRR of a project is
attractive, we must compare it to the project’s
cost of capital, which is determined by the
project’s risk.
• An IRR that is attractive for a safe project need
not be attractive for a risky project
• IRR(Electronics Store)= 28%, Cost of
capital=11%.
The Incremental IRR
• The incremental IRR tells us the discount rate
at which it becomes profitable to switch from
one project to the other.
• Rather than compare the projects directly, we
can evaluate the decision to switch from one
to the other using the IRR rule.
Example
 Example
• The incremental IRR of switching from the
minor overhaul to the major overhaul.
Example
 Shortcomings of incremental IRR
• Even if the negative cash flows precede the positive ones
for the individual projects, it need not be true for the
incremental cash flows. If not, the incremental IRR is
difficult to interpret, and may not exist or may not be
unique.
• The incremental IRR can indicate whether it is profitable to
switch from one project to another, but it does not indicate
whether either project has a positive NPV on its own.
• When the individual projects have different costs of
capital, it is not obvious what cost of capital the
incremental IRR should be compared to. In this case only
the NPV rule, which allows each project to be discounted
at its own cost of capital, will give a reliable answer.
 Capital rationing
• Your company has a fixed of $1000 and has
opportunity to invest in four projects:
 Capital rationing
• Your company has a fixed of $1000 and has
opportunity to invest in four projects:
Mutually exclusive projects with unequal
lives
Mutually exclusive projects wit unequal
lives
 Capital Budgeting
Forecasting Earnings
-Revenue and cost estimates
-Incremental Earnings Forecast
-Interest expenses
-Some issues
FCF and NPV
Example
• Let’s consider a hypothetical capital budgeting decision
faced by managers of the Linksys division of Cisco
Systems, a maker of consumer networking hardware.
Linksys is considering the development of a wireless home
networking appliance, called HomeNet, that will provide
both the hardware and the software necessary to run an
entire home from any Internet connection. In addition to
connecting PCs and printers, HomeNet will control new
Internet-capable stereos, digital video recorders, heating
and air-conditioning units, major appliances, telephone
and security systems, office equipment, and so on. Linksys
has already conducted an intensive, $300,000 feasibility
study to assess the attractiveness of the new product.
 Example-Revenue and cost estimates
• HomeNet’s target market is upscale residential “smart”
homes and home offices. Based on extensive marketing
surveys, the sales forecast for HomeNet is 100,000 units per
year. Given the pace of technological change, Linksys expects
the product will have a four-year life. It will be sold through
high-end electronics stores for a retail price of $375, with an
expected wholesale price of $260.
• Developing the new hardware will be relatively inexpensive,
as existing technologies can be simply repackaged in a newly
designed, home-friendly box. Industrial design teams will
make the box and its packaging aesthetically pleasing to the
residential market. Linksys expects total engineering and
design costs to amount to $5 million. Once the design is
finalized, actual production will be outsourced at a cost
(including packaging) of $110 per unit.
 Example-Revenue and cost estimates
• In addition to the hardware requirements, Linksys must build a
new software application to allow virtual control of the home
from the Web. This software development project requires
coordination with each of the Web appliance manufacturers
and is expected to take a dedicated team of 50 software
engineers a full year to complete. The cost of a software
engineer (including benefits and related costs) is $200,000 per
year. To verify the compatibility of new consumer Internet-
ready appliances with the HomeNet system as they become
available, Linksys must also install new equipment that will
require an upfront investment of $7.5 million.
• The software and hardware design will be completed, and the
new equipment will be operational, at the end of one year. At
that time, HomeNet will be ready to ship. Linksys expects to
spend $2.8 million per year on marketing and support for this
product.
Incremental Earnings Forecast
 Capital Expenditures and Depreciation
• While investments in plant, property, and
equipment are a cash expense, they are not
directly listed as expenses when calculating
earnings. Instead, the firm deducts a fraction
of the cost of these items each year as
depreciation.
 Interest Expenses
• When evaluating a capital budgeting decision,
we generally do not include interest expenses.
• Any incremental interest expenses will be
related to the firm’s decision regarding how to
finance the project. Here we wish to evaluate
the project on its own, separate from the
financing decision.
 Taxes
• The correct tax rate to use is the firm’s marginal
corporate tax rate, which is the tax rate it will
pay on an incremental dollar of pre-tax income.

• HomeNet will reduce Cisco’s taxable income in

year 0 by $15 million. As long as Cisco earns
taxable income elsewhere in year 0 against which
it can offset HomeNet’s losses, Cisco will owe $15
million * 40% = $6 million less in taxes in year 0.
The firm should credit this tax savings to the
HomeNet project.
Unlevered Net Income Calculation
• Unlevered net income= net operating profit
after tax (NOPAT).
 Opportunity Costs
• Suppose HomeNet’s new lab will be housed in
warehouse space that the company would
have otherwise rented out for $200,000 per
year during years 1–4. How does this
opportunity cost affect HomeNet’s
incremental earnings?
Project externalities
• Example: Suppose that approximately 25% of
HomeNet’s sales come from customers who
would have purchased an existing Linksys
wireless router if HomeNet were not available.
• For the cannibalization, suppose that the
existing router wholesales for $100 so the
expected loss in sales is $25% * 100,000 units
* $100/unit = $2.5 million
• Suppose the cost of the existing router is $60
per unit.
Incremental Earnings Forecast
 Determining Free Cash Flow and NPV
• Earnings are an accounting measure of the firm’s
performance. They do not represent real profits:
The firm cannot use its earnings to buy goods, pay
employees, fund new investments, or pay
dividends to shareholders.
• To evaluate a capital budgeting decision, we must
determine its consequences for the firm’s
available cash. The incremental effect of a project
on the firm’s available cash is the project’s free
cash flow.
 Depreciation
• Depreciation is not a cash.
 The effects of different depreciation
methods on the FCF are through the
deferral of tax expenses.
 At terminal year, salvage value of fixed
assets and its effect on taxes must be
included in the calculation of cash flows.
 Net Working Capital (NWC)

• Any increases in net working capital represent

an investment that reduces the cash available
to the firm and so reduces free cash flow.
 Required working capital increases when firms
proceed additional projects.
 When projects end, working capital is
recovered.
 Net Working Capital (NWC)- Example
• Suppose that HomeNet will have no
incremental cash or inventory requirements
(products will be shipped directly from the
contract manufacturer to customers).
However, receivables related to HomeNet are
expected to account for 15% of annual sales,
and payables are expected to be 15% of the
annual cost of goods sold (COGS).
Net Working Capital (NWC)- Example
Free Cash Flow
Calculating Free Cash Flow Directly
 Calculating the NPV
• To compute HomeNet’s NPV, we must discount
its free cash flow at the appropriate cost of
capital. The cost of capital for a project is the
expected return that investors could earn on
their best alternative investment with similar
risk and maturity.
• Assume that Cisco’s managers believe that the
HomeNet project will have similar risk to other
projects within Cisco’s Linksys division, and that
the appropriate cost of capital for these projects
is 12%.
Calculating the NPV
 Liquidation or Salvage Value
• Assets that are no longer needed often have a resale
value or some salvage value if the parts are sold for
scrap. Some assets may have a negative liquidation
value. For example, it may cost money to remove and
dispose of the used equipment.
Gain on Sale = Sale Price - Book Value
Book Value = Purchase Price – Accumulated Depreciation
• Adjust the project’s free cash flow to account for the
after-tax cash flow:
• would result from an asset sale
 Example
Suppose that in addition to the $7.5 million in
new equipment required for HomeNet, some
equipment will be transferred to the lab from
another Linksys facility. This equipment has a
resale value of $2 million and a book value of $1
million. If the equipment is kept rather than sold,
its remaining book value can be depreciated next
year. When the lab is shut down in year 5, the
equipment will have a salvage value of $800,000.
What adjustments must we make to HomeNet’s
free cash flow in this case?
Example
Calculating Free Cash Flow Directly (1)
• Free Cash Flow
        Unlevered
   Net Income
       
Free Cash Flow  (Revenues  Costs  Depreciation)  (1  c )
 Depreciation  CapEx  NWC

Free Cash Flow  (Revenues  Costs)  (1  c )  CapEx  NWC

 c  Depreciation

– The term tc × Depreciation is called the

depreciation tax shield.
Calculating Free Cash Flow Directly (2)
Cash flow collected by year
Outlay = FCInv + NWCInv  Initial Outlay in year
0

CF=(S-C-D) (1-T) + D  Annual after-tax operating

cash flow

TNOCF= SalT+ NWCInv- T(SalT-BT)

(terminal year incremental after-tax non operating
CF):
Example:
• Investment outlays (year 0) : $200,000 for fixed capital
items ($25,000 for nondepreciable land and $175,000
for equipment that will be depreciated straight-line to
zero over five years)
• Working capital: $50,000 of current assets; $20,000 in
current liabilities (year 0- year 4)
• Year 1-5: sales will be $220,000 and cash operating
expenses will be $90,000.
• Income taxes: 40 percent
• Year 5: sell off the fixed capital assets (including the
land) for $50,000. NWC is recovered.
• Cost of capital: 10%
 Choosing Among Alternatives
• Compare mutually exclusive alternatives, each of
which has consequences for the firm’s cash flows.
• Compute the free cash flow associated with each
alternative and then choosing the alternative
with the highest NPV.
• When comparing alternatives, we need to
compare only those cash flows that differ
between them. We can ignore any cash flows
that are the same under either scenario.
 Example
• Suppose Cisco is considering an alternative manufacturing
plan for the HomeNet product. The current plan is to fully
outsource production at a cost of $110 per unit.
• Alternatively, Cisco could assemble the product in-house
at a cost of $95 per unit. However, this will require $5
million in upfront operating expenses to reorganize the
assembly facility, and starting in year 1 Cisco will need to
maintain inventory equal to one month’s production.
• (Receivables related to HomeNet are expected to account
for 15% of annual sales, and payables are expected to be
15% of the annual cost of goods sold (COGS)). Cost of
capital:12%
Example
 Choosing Among Alternatives (cont'd)
• Evaluating Manufacturing Alternatives
– Outsource
• Cost per unit = $110
• Investment in A/P = 15% of COGS
– COGS = 100,000 units × $110 = $11 million
– Investment in A/P = 15% × $11 million = $1.65 million
» ΔNWC = –$1.65 million in Year 1 and will increase by $1.65 million in
Year 5
» NWC falls since this A/P is financed by suppliers
 Choosing Among Alternatives (cont'd)
• Evaluating Manufacturing Alternatives
– In-House
• Cost per unit = $95
• Up-front cost of $5,000,000
• Investment in A/P = 15% of COGS
– COGS = 100,000 units × $95 = $9.5 million
– Investment in A/P = 15% × $9.5 million = $1.425 million
– Investment in Inventory = $9.5 million / 12 = $0.792 million
– ΔNWC in Year 1 = $0.792 million – $1.425 million =
–$0.633 million
» NWC will fall by $0.633 million in Year 1 and increase by $0.633 million
in Year 5
 Choosing Among Alternatives (cont'd)
• Evaluating Manufacturing Alternatives
Table 8.6 Spreadsheet NPV Cost of Outsourced Versus In-House Assembly of
HomeNet
 Choosing Among Alternatives (cont'd)
• Comparing Free Cash Flows Cisco’s
Alternatives
– Outsourcing is the less expensive alternative.
• Galt Motors currently produces 500,000 electric motors a year and expects output
levels to remain steady for 10 years in the future. It buys armatures from an outside
supplier at a price of $2.50 each. The plant manager believes that it would be
cheaper to make these armatures rather than buy them. Direct in-house production
costs are estimated to be only $1.80 per armature. The necessary machinery would
cost $700,000 and would be obsolete in 10 years. This investment would be
depreciated to zero for tax purposes using a 10-year straight line depreciation. The
plant manager estimates that the operation would require additional working capital
of $40,000 but argues that this sum can be recoverable at the end of the tenth year.
The expected proceeds from scrapping the machinery after 10 years are estimated
to be $10,000. Galt Motors pays tax at a rate of 35% and has an opportunity cost of
capital of 14%. What decision should Galt Motors take regarding manufacturing
the armatures in house?
 Cash flows for a replacement project
• We are considering the replacement of old
equipment project with new equipment that
has more capacity and is less costly to
operate. The characteristics the old and the
new equipment are given below:
 Cash flows for a replacement project:
• One year ago, your company purchased a machine used in
manufacturing for $110,000.
• You have learned that a new machine is available that offers many
advantages; you can purchase it for $150,000 today. It will be
depreciated on a straight-line basis over 10 years, after which it has
no salvage value. You expect that the new machine will produce
EBITDA (earning before interest, taxes, depreciation, and
amortization) of $40,000 per year for the next 10 years. The current
machine is expected to produce EBITDA of $20,000 per year. The
current machine is being depreciated on a straight-line basis over a
useful life of 11 years, after which it will have no salvage value, so
depreciation expense for the current machine is $10,000 per year. All
other expenses of the two machines are identical. The market value
today of the current machine is $50,000. Your company’s tax rate is
45%, and the opportunity cost of capital for this type of equipment is
10%. Is it profitable to replace the year-old machine?
Cash flows for a replacement project
 Cash flows for a replacement project
• If the new equipment replaces the old
equipment, an additional investment of
$80,000 on net working capital will be
required. The tax rate is 30 percent, and the
required rate of return is 8 percent. Is it
profitable to replace the year-old machine?
 Cash flows for a replacement project

Outlay = FCInv + NWCInv- Sal0 + T(Sal0-B0)

CF=(S-C-D) (1-T) + D

TNOCF= SalT+ NWCInv- T(SalT-BT)

(terminal year incremental after-tax non
operating CF):
 Problem 1
• FITCO is considering the purchase of new equipment.
The equipment costs $350,000, and an additional
$110,000 is needed to install it. The equipment will
be depreciated straight-line to zero over a five-year
life. The equipment will generate additional annual
revenues of $265,000, and it will have annual cash
operating expenses of $83,000. The equipment will
be sold for $85,000 after five years. An inventory
investment of $73,000 is required during the life of
the investment. FITCO is in the 40 percent tax bracket
and its cost of capital is 10 percent. What is the
project NPV?
 Weighted Average Cost of Capital
• Cost of equity- rE
• Cost of debt – rD
• Unlevered cost of capital- rU
• Weighted Average cost of capital- rWACC
• Based on the firm’s cost of equity and debt
• Based on comparable firms
 Reading
Berk, Ch12, Estimating cost of capital
12.1. Equity Cost of Capital
12.3. Beta estimation
12.4. Debt cost of capital
12.5. A project’s cost of capital
12.6
Financing and Weighted Average cost of capital
 Weighted Average Cost of Capital
• If a firm is financed with both equity and debt, then the
risk of its underlying assets will match the risk of a
portfolio of its equity and debt.
• The appropriate cost of capital for the firm’s assets is the
weighted average of the firm’s equity and debt cost of
capital  Unlevered cost of capital, or pretax WACC.
Interest Tax Shield
 Interest Tax Shield

Additional income = 150 = Interest payment *

Corporate Tax Rate  Interest Tax Shield
 Interest Tax Shield
• Tax: 35%, debt: $100.000, interest rate=10%

• Effective cost of the debt= $6,500/$100,000 = 6.50% =

Interest Rate * (1- Tax)
 Weighted Average Cost of Capital
• With tax:
 Weighted Average Cost of Capital
 Cost of equity: historical stock returns, CAPM, DDM,
Cost of debt plus risk premium,…
 Cost debt: some firms (large proportion) do not
estimate cost of equity and use cost of debt to
discount cash flows
 The Equity Cost of Capital
• The Capital Asset Pricing Model (CAPM) is a
practical way to estimate.
• The cost of capital of any investment
opportunity equals the expected return of
available investments with the same beta.
• The estimate is provided by the Security
Market Line equation:
ri =rf + i  (E[RMkt ]-rf )
Risk Premium for Security i
 Example
• Suppose you estimate that eBay’s stock has a
volatility of 30% and a beta of 1.45. A similar
process for UPS yields a volatility of 35% and a
beta of 0.79. Which stock carries more total risk?
• Which has more market risk? If the risk-free
interest rate is 3% and you estimate the market’s
expected return to be 8%, calculate the equity
cost of capital for eBay and UPS.
• Which company has a higher cost of equity
capital?
Beta estimation
 Debt Cost of Capital
• Debt Betas
– Alternatively, we can estimate the debt cost of
capital using the CAPM.
– Debt betas are difficult to estimate because
corporate bonds are traded infrequently.
– Chapter 21 shows a method for estimating debt
betas.
– One approximation is to use estimates of betas of
bond indices by rating category.
Table 12.3 Average Debt Betas by Rating
and Maturity
 Project-Based Costs of Capital
• In the real world, a specific project may have
different market risk than the average project
for the firm.
• Suppose Avco launches a new plastics
manufacturing division that faces different
market risks than its main packaging business.
– The unlevered cost of capital for the plastics division
can be estimated by looking at other single-division
plastics firms that have similar business risks.
 Estimating the Unlevered Cost
of Capital
• Assume two firms are comparable to the
plastics division and have the following
characteristics:
 Estimating the Unlevered Cost
of Capital (cont'd)
• Assuming that both firms maintain a target
leverage ratio, the unlevered cost of capital for
each competitor can be estimated by
calculating their pretax WACC.
Competitor 1: rU  0.60  12.0%  0.40  6.0%  9.6%
Competitor 2: rU  0.75  10.7%  0.25  5.5%  9.4%
 We estimate an unlevered cost of capital for
the plastics division is approximately 9.5%.
 Project Leverage
and the Equity Cost of Capital
• A project’s equity cost of capital may differ
from the firm’s equity cost of capital if the
project uses a target leverage ratio that is
different than the firm’s. The project’s equity
cost of capital can be calculated as:
D
rE  rU  (rU  rD )
E
 Project Leverage and the Equity Cost of
Capital (cont'd)
• Now assume that Avco plans to maintain an
equal mix of debt and equity financing as it
expands into plastics manufacturing, and it
expects its borrowing cost to be 6%.
– Given the unlevered cost of capital estimate of
9.5%, the plastics division’s equity cost of capital is
estimated to be:
0.50
rE  9.5%  (9.5%  6%)  13.0%
0.50
 Project Leverage and the Equity Cost of
Capital (cont'd)
• The division’s WACC can now be estimated to
be:
rWACC  0.50  13.0%  0.50  6.0%  (1  0.40)  8.3%

• An alternative method for calculating the

division’s WACC is: rWACC=ru-d*tax*rD

rwacc  9.5%  0.50  0.40  6%  8.3%

Textbook Example 18.5
 Problem
• Consider a firm with a debt-to-value ratio of
25%, a debt cost of capital of 6.67%, an equity
cost of capital of 12%, and a tax rate of 40%.
Suppose the firm increases its debt-to-value
ratio to 50%. What is the WACC?
Three common methods of capital budgeting
 Weighted Average Cost of Capital (WACC).
 Adjusted Present Value (APV)
 Flow-to-Equity
 The examples in this chapter are based on the
following assumptions:
a) The project has average risk.
b) The firm’s D/E ratio remains constant.
c) Corporate taxes are the only imperfections.
 IWACC Method
 Estimate project’s free cash flows.
 Calculate WACC.
 Accept/Reject the project based on NPV.
 Is sometimes called FCF (Free-cash-flow) method.
 Example
• Avco engineers expect the technology used in these
products to become obsolete after four years. During
the next four years, however, the marketing group
expects annual sales of $60 million per year for this
product line. Manufacturing costs and operating
expenses are expected to be $25 million and $9 million,
respectively, per year. Developing the product will
require upfront R&D and marketing expenses of $6.67
million, together with a $24 million investment in
equipment. The equipment will be obsolete in four
years and will be depreciated via the straight-line
method over that period. Avco bills the majority of its
customers in advance, and it expects no net working
capital requirements for the project. Avco pays a
corporate tax rate of 40%.
 Example-new
• Avco engineers expect the technology used in these
products to become obsolete after four years. During
the next four years, however, the marketing group
expects annual sales of $60 million per year for this
product line. Gross profit margin is 60% and operating
expenses are expected to be $7 million, respectively,
per year. Developing the product will require upfront
R&D and marketing expenses of $6.67 million,
together with a $24 million investment in equipment.
The equipment will be obsolete in five years and will
be depreciated via the straight-line method over that
period. Receivables: 30 days, payables 20 days,
inventory days. Savage value at year 4 will be 7 mil.
Avco pays a corporate tax rate of 40%.
Example
Example
 WACC
• Avco intends to maintain a similar (net) debt-equity ratio for
the foreseeable future, including any financing related to the
RFX project. Thus, Avco’s WACC is

E D 300 300
rwacc  rE  rD (1   c )  (10%)  (6%)(1  0.40)
E  D E  D 600 600
 6.8%
• Note that net debt = D=320-20=$300 million.
 Using the WACC
to Value a Project (cont'd)
• The value of the project, including the tax
shield from debt, is calculated as the present
value of its future free cash flows.
18 18 18 18
V0
L
  2
 3
 4
 $61.25 million
1.068 1.068 1.068 1.068

• The NPV of the project is $33.25 million

– $61.25 million – $28 million = $33.25 million
 Summary of the WACC Method
1. Determine the free cash flow of the
investment.
2. Compute the weighted average cost of
capital.
3. Compute the value of the investment,
including the tax benefit of leverage, by
discounting the free cash flow of the
investment using the WACC.
• END OF CHAPTER 4