Capital Budgeting and Cost of Capital Quiz

Capital Budgeting and Cost of Capital

• Single hurdle rate can lead riskier divisions to receive more funds, possibly funding unprofitable projects.
• The cost of capital is typically difficult to estimate for divisions due to a lack of traded securities; alternatives include using pure play proxies or subjective adjustments.
• The discount rate for projects should be lower than the rate derived from the Security Market Line (SML).
• The firm's weighted average cost of capital (WACC) serves as the appropriate discount rate for projects.

Understanding Beta

• Beta indicates a security's return sensitivity relative to market movements, influenced by revenue cyclicality, operating leverage, and financial leverage.
• Companies with revenues that respond strongly to economic changes tend to have higher betas.
• High operating leverage results in greater fluctuations in Earnings Before Interest and Taxes (EBIT) relative to sales, hence increasing beta.
• Financial leverage, through fixed interest payments, further magnifies revenue cyclicality, affecting the stock returns' responsiveness to market movements.

Key Cost of Capital Concepts

• Overall capital cost is determined by the risk of the project rather than financing sources.
• Tax implications make interest expenses deductible, typically assessed at the firm's after-tax cost of debt.
• New project's risk is often assumed to align with the company's overall risk, which can be misleading if the project has unique risks.
• The SML model requires estimating the risk-free rate, expected market return, and beta, often relying on historical data.

WACC Calculation

• Example WACC calculation illustrates outcomes based on the proportionate weight of equity and debt in a capital structure.
• WACC is computed through specific formulas considering the firm’s equity and debt costs, leading to precise financial decision-making.

Cash Flow Analysis

• EBIT growth projected at 10% annually for five years impacts cash flow and overall financial health.
• Key elements impacting cash flows include tax liabilities, depreciation, and adjustments for net working capital and capital expenditures.
• Terminal value can be calculated for year 5 cash flows, providing long-term cash flow projections post-initial analysis.

Financing and Flotation Costs

• Flotation costs vary depending on financing strategies (externally raised vs. internally generated equity).
• Accurate initiation of cash flow projections incorporates flotation costs to ensure financial planning reflects real costs.
• Variations in flotation costs affect how much capital must be raised to cover project expenses due to different sources of equity financing.

Relevant vs. Irrelevant Costs

• Historical costs (e.g., land purchase) are deemed irrelevant when assessing the current project; only opportunity costs provide real financial considerations.
• Calculating market value capitalizations ensures precise understanding of the firm's financial structure, facilitating informed investment decisions.

Capital Structure Weights

• Understanding the weights of debt, equity, and preferred shares in the capital structure is crucial for calculating the overall cost of capital accurately.
• The method of calculating weights emphasizes the proportion of each financing source relative to the company’s total market value.

Summary of Key Financial Metrics

• Present value calculations and NPV assessments highlight the importance of future cash flows relative to current investment choices.
• The depth of financial analysis encourages accurate predictions of profitability and project viability in corporate finance.