PART 3: CAPITAL BUDGETING
SUMMARY
■ All-equity companies can discount their
‘standard’ investment projects at the cost of
equity. Managers can estimate the cost of
equity using the CAPM.
■ The cost of equity is influenced by a
company’s cost structure (operating
leverage) as well as by its financial structure
(financial leverage).■ Companies with both debt and equity in
their capital structures can discount their
‘standard’ investments using the company-
wide weighted average cost of capital, or
WACC.
■ The WACC is the company-wide weighted
average of the cost of each source of
financing used by a company, where the
weights are equal to the proportion of the
market value represented by each source of
financing.
■ A company’s WACC and CAPM are
connected, in that the cost of equity and
debt (and any other financing source) are
driven by the betas of the company’s equity
and debt. Rather than calculate betas for
preferred shares and debt, we can estimate
their returns using dividend yield for
preferred shares and yield to maturity (YTM)
for debt.
■ The WACC can be calculated on both a
pre-tax and an after-tax basis. In manycountries interest payments to bondholders
are tax deductible, so we focus on the
after-tax WACC formula.
■ Several tools exist to assist managers in
understanding the sources of uncertainty in
a project’s cash flows. These tools include
breakeven analysis, sensitivity analysis,
scenario analysis, and decision trees. The
value of many investments includes not just
the NPV but also the investment’s option
value. As a static analytical tool, NPV analysis
often misses the value of management’s
ability to alter an investment in response to
environmental changes that may occur after
it is made.■ Types of real options include the option
to expand, the option to make follow-on
investments, the option to abandon, and
flexibility options related to production
inputs, outputs, and capacity.
■ An investment’s option value, unlike its NPV,
increases as risk increases.
■ For an investment to have a positive NPV,
it must have a competitive advantage –
something that distinguishes it from the
economic ideal of perfect competition.
■ Valuing an investment’s option value requires
strategic thinking. Articulating the strategy
may be as important as calculating the
project’s value.LO11.1LO11.2LO11.3LO11.4LO11.5LO11.611.1 E (ri) = rf + βi (E (rm) – rf )11.2 Operating leverage =∆
∆
EBIT
EBIT
sales
sales11.3 =
+
+
+
WACC
D
DEr
E
DE
der11.4 WACC when interest on debt is tax-deductible:= ()
+
−+
+
WACCD
DETrE
DE(^1) cd re
IMPORTANT EQUATIONS