Module 5 summary

Capital budgeting evaluation criteria and cost of capital

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.

Explain why net present value (NPV) is the preferred capital budgeting criterion, and illustrate how it is implemented.

Describe the appropriate discount rate to apply in capital budgeting.

Estimate a project’s beta, calculate a risk-adjusted discount rate using CAPM, and explain the difficulties in using the CAPM in capital budgeting.

Calculate a project’s internal rate of return, payback period, and profitability index, and explain the relationship between NPV and these capital budgeting criteria.

Describe the selection process for projects when there are capital rationing restrictions.

Explain the cost of capital.

Describe how the cost of capital is used.

Calculate the component costs of capital for debt, preferred shares, and common shares.

Calculate the component weights to determine the cost of capital.

Calculate the weighted average cost of capital (WACC).

Describe how to determine beta for different project classes.