Capital Budgeting in Business: Strategies and Calculations
E N D
Presentation Transcript
chapter11 Capital Budgeting Lonni Steven Wilson, Medaille College
Key Chapter Objectives • Define capital budgeting. • Understand the process of calculating the cost of capital. • Understand how to make capital decisions. • Describe cash flow and how it works.
Key Terms capital—The long-term funding that is necessary for the acquisition of fixed assets (Brigham & Ehrhardt, 2005). capital budgeting—The process of making investments toward fixed assets, both tangible and intangible. capital spending—Net spending on fixed assets. net spending—The total money a business uses to acquire real assets, less the sale of previously owned real assets (Brigham & Ehrhardt, 2005).
Goals of Capital Budgeting • To select investment opportunities that are worth more than they cost • To invest in those projects that provide the greatest return on investment (ROI) The second point may not always be true, as in not-for-profit organizations.
Capital Components Sport businesses can use four traditional methods of funding capital growth: • Debt (bonds and long-term loans) • Preferred stock • Common stock • Retained earnings
Raising Capital: Debt Cost of debt • Cost of debt is the interest that is paid in addition to the principal that is borrowed. • Debt is important because many smaller businesses raise most of their capital through this capital component, usually in the form of bank loans (Brigham & Ehrhardt, 2005). From a case study in the text • If the Smiths borrow $200,000 at an interest rate of 8%, the cost of debt is, excluding taxes, also 8%. • Because of tax savings, the cost of debt in this scenario could be reduced from $16,000 (8%) to $9,600.
Calculating the Cost of Debt • D = R - (R x T) D = cost of debt R = interest rate paid to debt holder T = marginal tax rate on interest payments • Can also be written D = R x (1 - T) • Assume that SMC borrows $1,000,000 at an interest rate of 6% and has a marginal tax rate of 40%. Their actual cost of debt is 3.6%: D = 6% x (1 - 0.4) D = 3.6%
Raising Capital: The Issuance of Equity Capital can also be acquired through selling ownership in the business, also known as the issuance of equity. There are two classifications of equity: • Preferred stock • Common stock
Calculating the Cost of Preferred Stock • S = v / P S = cost of preferred stock v = preferred stock dividend P = net issue price (continued)
Calculating the Cost of Preferred Stock (continued) • Assume that the Stars want to issue $20 million of new preferred stock. The new preferred stock will have a $100 par value and pay an annual dividend of $5 per share, and the flotation cost will be 4%. The cost of preferred stock is then calculated as follows: • Refer to equation 11.3 on p. 199 of the text • The cost of issuing new preferred stock for the Stars is 5.208%.
Raising Capital: Common Stock and Retained Earnings A firm can raise capital through two methods with common stock: • The issue of new common stock • primary offering (new shares sold) • secondary offering (company ownership sells off some of its shares) • Retained earnings: Earnings that would otherwise be used to pay common stockholder dividends
Calculating the Cost of Common Stock Three methods are used to determine the cost of common stock: • Capital asset pricing model (CAPM) • C = F + {(M - F) x B} • C = expected cost of common stock • F = expected rate of return from a risk-free investment • M = expected rate of return for the overall market • B = the company’s beta coefficient (continued)
Calculating the Cost of Common Stock (continued) 2. Bond yield plus risk premium model • The cost of common stock may be closely related to the firm’s cost of debt. • The cost of common stock will be several percentage points higher than the firm’s cost of debt because of the higher level of risk associated with stock. • Thus, this method measures the cost of common stock as the yield from the firm’s bonds plus some risk premium (usually 3% to 5%). (continued)
Calculating the Cost of Common Stock (continued) 3. Dividend growth model (refer to equation 11.4 on p. 202 in the text) • C = E / N + G • C = required rate of return for stockholders (this serves as a measure of the cost of common stock) • E = annual dividend payment (for simplicity, we assume that these payments are fixed at the same level each year) • N = current price per share of the stock • G = annual growth rate of dividends
Trends in Stadium Financing Some key points regarding sports stadiums follow: • Because of changes in facility design, a stadium such as FedEx Field in Washington, D.C., can produce substantially more revenue for the franchise (e.g., more luxury suites). • Unlike other revenue sources, most stadium income is not shared equally among all franchises. • In the four major professional leagues, teams keep 100% of revenues from parking, concessions, advertising, and stadium naming rights. • New facilities are often built to maximize these revenue sources.
Capital Budgeting Decisions • Importance of time: The present value of a future stream of income • Net present value: Present value of future income versus required investment • Payback rule: How long it will take a business to get its money back after investing in a capital project • Discounted payback rule: Same as payback rule but discounted for future cash flows based on the opportunity cost of capital • Internal rate of return: Initial cash investment compared with the present value of cash returns from the next best alternative
Errors in Measuring Cash Flow • Measuring sunk costs • Measuring opportunity costs • Failing to analyze the impact of any funding decision • Failing to appreciate the impact of a capital decision on net working capital • Double counting interest payments
Questions for In-Class Discussion • Why is a business’ capital structure important? • Which funding option would be the most economical to issue if you were trying to raise $100 million? • What does flotation cost mean? • Why is the time value of money important?
