PART 3: CAPITAL BUDGETING
Inserting the values from our example, we find that the WACC for Croc-in-a-Box is 13%:
=
+
×+
+
WACC ×=
$50
$50 $1009%
$100
$50 $10015% 13%
How can Croc-in-a-Box managers be sure that earning a 13% return on its investments will satisfy
the expectations of both bondholders and shareholders? Here’s a simple way to see the answer. Assume
the company invests in a project that does not alter the company’s overall risk and earns exactly 13%.
It therefore has a zero NPV if the company uses the WACC as its hurdle rate. Croc-in-a-Box has $150
million in assets. A project that offers a 13% return will generate $19.5 million in cash flow each year
(13% × $150 million). Suppose that the company distributes this cash flow to its investors. Will they
be satisfied? Table 11.3 illustrates that the cash flow the company generates is just enough to meet
the expectations of bondholders and shareholders. Bondholders receive $4.5 million, or exactly the 9%
return they expected when they purchased bonds. Shareholders receive $15 million, representing a 15%
return on their $100 million investment in the company’s shares.TABLE 11.3 CASH DISTRIBUTIONS TO CROC-IN-A-BOX INVESTORSTotal cash flow available to distribute (13% × $150 million) $19.5 million
Less: Interest owed on bonds (9% × $50 million) 4.5 million
Cash available to shareholders ($19.5 million – $4.5 million) $15.0 million
Rate of return earned by shareholders ($15 million ÷ $100 million) 15%The WACC has a large impact on the value of a company’s investments, and hence, on the value of the
company itself. Holding an investment’s cash flows constant, a lower WACC implies that the investment
has a higher value. Thus, policies that reduce the cost of capital in an economy encourage companies
to undertake new projects. The ‘Finance in practice’ box below explains that when countries open their
financial markets to foreign investors, the cost of capital falls and companies respond by investing more.CAN FOREIGN INVESTORS REDUCE THE COST OF CAPITAL?
What happens to the cost of capital when a
nation that has been closed to foreign financial
investment opens up to foreign investors? Finance
theory suggests that allowing foreign capital in
should reduce the cost of external financing for the
country’s publicly traded companies by increasing
the supply of potential lenders and equity investors.
Academic research strongly supports this idea.
A relatively recent study found that three
economically important things happen when
emerging economies open their share markets to
foreign investors. First, the aggregate dividend
yield on publicly traded shares falls by 240 basispoints (2.4%). This drop will lower the cost of
equity capital, re, and the WACC. The figure below
demonstrates how dividend yields change in the
five years before (–5 to –1) and five years after (+
1 to + 5) opening share markets, which occurs in
year 0 in the figure. Second, the nation’s overall
stock of capital increases by an average of 1.1
percentage point per year, meaning that companies
invest more in productive assets. Third, the growth
rate of output per worker rises by 2.3 percentage
points per year. Together these three outcomes
make a clear policy statement: let foreign financial
investment in!
> >finance in practice