In this module, you study capital budgeting decision criteria. The module begins by explaining the discount rate to apply to an investment project. Capital budgeting and risk are explored. You look at using the CAPM model to create a risk-adjusted discount rate (RADR) for capital budgeting. You also explore RADRs by project. The relationship between NPV and other frequently-employed capital budgeting criteria is explained. You calculate the internal rate of return of an investment. You also learn how to select projects when there is a constraint on the amount of capital the firm can spend on new projects (capital rationing).

In the second part of the module, you study how a company determines its cost of capital. This includes calculating the component weights and component costs for debt, preferred shares, and common shares. The weighted average cost of capital (WACC) is explained. Finally, you learn how to allocate projects to risk classes.

- NPV meets two critical requirements for capital budgeting:
- It accounts for the time value of money.

- It considers all relevant cash flows.

- NPV measures the increase in value to the firm.

- The NPV rule accepts all investment projects that have a positive net present value, subject to capital rationing constraints.

- The NPV calculation incorporates all relevant cash flows, including:
- cash outlays to acquire capital assets, discounted to the present

- present value of tax shield (PVTS) on capital outlays
- salvage values, discounted to the present
- capital gains tax on land disposed of, if applicable, discounted to the present
- the PVTS lost on other assets disposed of at the end of the project
- after-tax net cash inflows (that is, increased revenues or decreased expenses), discounted to the present

- A project’s risk is defined as the possibility that the actual cash flows will not be the same as the expected cash flows.

- Engaging in many projects can diversify risk.

- A firm should take into account a project’s risk with respect to the entire portfolio of projects.

- The discount rate for projects in the same risk class as the firm is the firm’s weighted-average cost of capital (WACC).

- The discount rate for projects in a different risk class than the firm is the risk-adjusted discount rate (RADR). This rate can be derived using the capital asset pricing model (CAPM).

- Cash flows in capital budgeting are risky.

- If a firm diversifies its portfolio of projects, then systematic risk is the only risk that needs to be assessed.

- RADR = RF + (ER
_{M}– RF) × (beta)

- This rate should be used for calculating the NPV of projects.

- Difficulties involved in using the CAPM for capital budgeting:
- Incomplete or unreliable data
- Difficulty in estimating periodic returns
- Lack of historical data
- Unpredictable outcomes
- CAPM is a single-period tool and not suitable for multi-period analysis
- Historical data may not predict future risk

- The internal rate of return (IRR) calculates the break-even rate of return on the project such that the NPV is equal to zero.

- IRR is the interest rate at which the net present value of the cash flows equals zero.

- In equation form, IRR is the rate at which

where C is the cost of the project

t is the time frame

r is the interest rate (IRR)

- Two problems with using IRR are
- multiple IRRs

- crossing NPV profiles

- The payback period (PBP) measures the length of time that is required for expected after-tax cash inflows to recover the initial cost of the project.

- The disadvantages of PBP are:

- It does not consider the time value of money (present value).
- It ignores all cash flows beyond the payback period.

- The profitability index (PI) is the present value of future cash flows divided by the initial investment in the project. The project is acceptable if the PI is greater than 1.

- The disadvantage of PI is that it provides no help in selecting projects under capital rationing conditions.

- Capital rationing exists when the firm has generated more positive NPV projects than it can adopt due to a shortage of funds.

- Ideally, under capital rationing, the firm should either attempt to sell its project idea or form a joint venture in order to derive some benefits.

- If it still has more positive NPV projects than it can fund, then it should use the brute force method up to the capital spending ceiling, accepting the combination of projects that yields the highest combined NPV.

- A firm’s cost of capital is what is has to pay investors to induce them to contribute funds to the firm; it is an opportunity cost.

- Cost of capital reflects current market costs and values.

- It is defined as the net cash flow to the firm after corporate taxes.

- The cost of capital has three main uses:
- as the hurdle rate against which to compare projects’ internal rates of return
- as the choice of optimum capital structure that minimizes WACC
- as the method for setting prices in regulated industries such as hydro, where a fair return is deemed to be the monopoly’s WACC

- Cost of issuing new long-term debt:

- The after-tax cost of debt, k
_{i}, solves the following expression

where

NP = the net proceeds to the firm from the bond issue after considering flotation costs T = the firm's tax rate I = the interest or coupon payments F = face value or par value of the bond

- The cost of issuing new preferred shares, k
_{p}:

- The required return on preferred shares is k
_{p}= D_{p}÷ P_{p}

- The component cost of preferred shares is then k
_{p}= D_{p}÷ NP

- Cost of using internally generated common equity, k
_{e}:

- Several different models are available to estimate k
_{e}: the CAPM, the dividend growth model, and the earnings yield model. - Flotation costs can be ignored if all the equity financing can be satisfied from retained earnings, thus making k
_{e}= the required return by common shareholders.

- The following models are used to estimate k
_{e}:

- CAPM Model

- Dividend growth model

- Earnings yield model (inverse of the P/E ratio)

- When the firm is forced to issue new common shares, then flotation costs must be considered.

- Using the above models, k
_{ne}is estimated as:

- CAPM Model

- Dividend growth model

- Earnings yield model (inverse of the P/E ratio)

- The appropriate weights are the current mix of sources of funds at current market values.

- The optimal component mix is the one that minimizes the WACC.

- The cost of capital is the after-tax cost, in terms of required payments to investors, of raising new funds.

- The cost of capital is an opportunity cost or a hurdle rate that the return on new investment projects must exceed for them to be adopted.

- The cost of capital is calculated by:
- identifying the sources of funds, such as bonds, preferred stock, and common stock

- determining the after-tax cost of each component
- calculating the market weights for each component
- calculating WACC by multiplying each component cost by its market weight
- totalling these weighted costs to calculate WACC

- Use the conceptual approach to calculate the cost of debt (k
_{i}) when NP, I, T, and F are given or determinable.

- Projects that are in the same risk class as the firm can use the firm’s beta to estimate the RADR, or use the firm’s weighted average cost of capital (WACC) for the RADR.

- Projects that are riskier than the firm should use a beta that is higher than the firm’s beta, in which case RADR > WACC.

- Projects that are lower risk than the firm should use a beta that is lower than the beta of the firm, with RADR < WACC.