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DEFINITION

1 The net present value of a

project is the expected cash flows

from the project discounted at the

rate of return IRR

2 The weighted average cost of

capital, WACC is a traditional

method of determining IRR for

capital budgeting projects

To Compute WACC

1 Compute the cost of individual

sources of capital, that is debt and

equity

2 Compute the weighted average of

these individual costs, with the weights

depending on the proportion of each

component ( in terms of market value)

in the firm’s capital structure

St. Nicholas University

Suppose that SNU is financed with two capital

components: Php400,000 in debt and Php600,000

in equity. Because SNU Incurs a cost in using this

capital, it is necessary to estimate the

“component costs of capital.”

Assume that the costs of debt and equity

are 8% and 165, respectively.

Capital Peso Component Weighted

omponent Amount Weight Cost Component

Cost

(1) (2) (3) (4) = (2) x (3)

-----------------------------------------------------------------------

ebt 400,000 0.40 0.08 0.032

quity 600,000 0.60 0.16 0.096

--------- ------ --------

1,000,000 1.00 WACC = 0.128

====================================

ecision Criterion: Accept projects with returns

greater than 12.8%

Cost of Equity

The cost of equity is equal to the return expected by

the stockholders. This is because an outflow from

the owners (cost) is an inflow (return) for the

stockholders.

Cost of Equity

E(Ř) = Rf + β[E(Řm) - Rf ]

Where

Rf is the risk-free rate

β measures the volatility of the stock’s returns relative to the market’s returns

Suppose that SNU has an equity beta of 1.25. Let us also assume that the

expected market return is 14% and the risk-free rate is 6%. The cost of

equity can be calculated by using the above equation:

= 0.16

So the stockholders for SNU stock 16% because this is

the return expect the cost of equity for SNU.

Cost of Debt

Suppose that the SNU issues a new series of coupon

bonds with a face value of Php1,000, a coupon rate of

10% annually (to be paid in equal semiannual installments),

and 20 years to maturity. The investment bank that

underwrites (sells) the issue guarantees to sell

the bonds at face value and charges a 5% underwriting fee.

The underwriting fee amounts to Php50 per bond,

so that the net proceeds to SNU are

Php950 per bond. SNU is subsequently obligated

to pay Php50 every six months for each bond

outstanding, plus Php1,000 per outstanding bond

to be paid on the maturity date.

If the IRR on the bond is X%, then X is the solution to the equation:

After this equation is solved, the yield of SNU bonds, its IRR,

is seen to be 10.60% compounded semiannually.

This is SNU pretax cost of debt.

tax deductible, debts provides a tax shield. All we need

to do to find SNU after-tax cost of debt is multiply the

pretax cost by 1 minus the tax rate. Suppose that SNU

is in the 24.5% marginal income tax bracket.

Because the pretax cost of the bond to SNU is 10.60%

the after-tax cost of capital for the bonds is

10.6^ x (1 – 0.245) = 8.00%

Criteria for Capital Budgeting

A criterion is needed as the basis for deciding whether

a particular project should be adopted.

The best criterion is one that is consistent with

the goal of financial management, -that is,

one that leads to investments that

increase the current shareholder’s wealth.

As found earlier, he best investment

is one that adequately compensates its

owner for the time of value of money and for risk.

Payback Period Criterion. The payback period for a project

measures the number of years required to recover the

initial investment.

Consider a project with an initial investment of

Php500,000 and expected cash inflows of Php100,000 per

year for ten years. The payback period for this project is

given by:

= [500,000/100,000]

= 5 years

Thus in five years the initial investment is recovered.

Even if cash flows are not uniform, the payback

period can be easily calculated by summing the

cash flows until the initial outlay is recovered.

Net Present Value Criterion. By focusing on all cash flows

generated by a project and then capitalizing them at a

market-determined discount rate, the net present value,

NPV method overcomes all the weaknesses of

the payback period method. Formally:

are determined by discounting the cash flows at a

market-determined opportunity cost of capital.

In calculating NPVs, it is

implicitly assumed that the intermediate cash flows

from a project are reinvested at

the opportunity cost of capital.

Internal Rate of Return Criterion The internal rate of return,

IRR is a discounted rate of return measure derived

directly from knowledge of a project’s cash flow pattern.

The IRR is the discount rate that makes the excess

market value, NPV, of a project Php0.00

makes the present value of an investment’s

cash inflows (PVINFLOWS ) equal to the present

value of its cash outflows (PV outflows ).

Stated algebraically, IRR is the discount rate that causes:

Profitability Index. Another discounted cash flow

criterion used to evaluate capital

budgeting projects is the profitability

index or benefit-cost-ratio. The profitability index,

PI is simply a different way of presenting

the same information that the NPV provides.

The NPV is the difference between the PVs

of the cash inflows and the cash outflows,

and the PI is the ratio of these two values:

and rejects projects if PI < 1.

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