This document discusses various aspects of capital budgeting and project financing, including: 1) Types of equity financing like retained earnings and issuing new stock or bonds. 2) Methods of debt financing such as bonds and term loans. 3) How to calculate the weighted average cost of capital (WACC) using the costs of equity and debt. 4) Examples are provided to demonstrate calculating the costs of different sources of financing like equity, debt, and the overall WACC.

1. Capital Budgeting Decisions Project Financing Chapter 16

6. Example 16.2: Debt Financing: $10mm Bond Financing: Flotation cost: 1.8% 5 year bond; face value: $1000; sale price: $985 annual interest: 12% Worth of bonds sold: $10,000,000/(1-0.018) = $10.1833mm Floatation cost: $183,300 Number of bonds sold: $10,183,300/$985 =10,338.38 Annual interest paid: $10,338,380 x 0.12 = $1,240,606 Full principal due on maturity Term Loan: 11% bank loan for 5 years Annual payments: $10mm(A/P,11%,5) = $2,705,703

9. Example 16.3 Project : $10mm Life = 5 years Land = $1mm Building = $3mm (39 years MACRS) Equipment = $6mm (7 years MACRS) Salvage: Land=$1.5mm Building=$2mm Equip: $3mm Capital Structure (debt ratio) = 0.5 Bonds: $5mm Stocks: $5mm (dividend = $2/share) Flotation cost: bonds=3.2% stock = 8.1% Bonds: 5 year, 12%, $1000 par, sold at 1.5% discount

10. Unit production cost = $50.31 Unit price = $250 Demand = 20,000 O&M cost per year = $600,000 Working capital = $500,000 fully recovered at the end Marginal tax rate = 40% MARR = 20% (ignore inflation) Assume stock bought back at end of year 5 for $5,440,708 After-tax cash flows of the project with financing? Rate of Return of the project? # of shares to net $5mm = 5,000,000/0.919 (28) = 194,311 Worth of Bonds = 5,000,000/(0.968)(.985) = $5,243,948

11. Revenue = $250 x 20,000 = $5mm /yr COGS = $50.31 x 20,000 = $1,006,200 /yr Bond interest = $5,243,948 x 0.12 = $629,274 /yr Cash dividend = 194,311 shares x $2 = $388,622 /yr Property Salvage Book Gain/Loss Gain Value Value Tax Land $1,500,000 $1,000,000 $500,000 $200,000 Building 2,000,000 2,621,795 (621,795) (248,718) Equipment 2,500,000 1,606,500 893,500 357,400 Total $308,682

13. PW @ 20% = 2,707,530

14. What is the cost of the capital for this financing? For equity financing: Cost of capital = Firm’s required return on equity Assume $100 = Initial stock price Use in WACC (Weighted Average Cost of Capital) When buying equity capital investors look for sum of dividend income and share appreciation. Assume investors expect to receive $5 dividend at end of first year, that dividends will grow at an annual rate of 10% and that investors expect stock price at end of Year 3 of $120.

15. Cost of Retained Earnings (Gordon Model) By using k r as the discount rate, NPV will be positive if IRR> k r Use k r as the cost of equity in WACC D 0 = the first year dividend P 0 = current market price g = growth rate of dividend

16. Cost of New Common Stock Cost of Preferred Stock D * = the fixed annual dividend P * = the issuing price Weighted average cost of equity a = fraction of total equity financed by retained earnings b = …financed from issuing new stock c = …financed from issuing preferred stock f c = flotation cost

17. Example 13.4 Project Cost = $10mm Debt Ratio = 0.4 thus, $6mm must be raised from equity sources

18. COMMON STOCK Current stock price = $40 Annual cash dividend = $5 Dividend growth rate = 8% Floatation cost = 12.4% PREFERRED STOCK Par value = $100 Dividend = 9% Market sale price = $95 Floatation cost = 6% What is the cost of equity to finance the project? Cost of retained earnings: Cost of new common stock: Cost of preferred stock: Cost of equity:

19. Cost of Debt Term loans and bonds Interest payment on both are tax deductible After tax cost of debt: d=fraction of the term loan over total debt k s =before tax interest on the term loan t m =marginal tax rate k b =before tax interest rate on the bond

20. Example 13.5 Determining the cost of debt Finance $4 million through term loan and 20-year bonds $1000 par value bonds with net value of $940 with annual interest payments Marginal tax rate = 38%

21. Because of the flotation cost, the specific interest rate for the bond will be higher than the nominal interest rate Solving, k d = 10.74% The after-tax cost of debt is the interest rate times (1 -t m ) Government subsidizes the debt through tax deduction i d = (0.25)(0.12)(1 - 0.38) + (0.75)(0.1074)(1 - 0.38) = 6.85%

22. Tax adjusted weighted-average cost of capital C d = Total debt capital C e = Total equity capital V = C d + C e i e = Average equity cost of capital i d = After tax average borrowing interest rate from all sources The cost of equity is already expressed in terms of after-tax cost, because dividends are made after payment of income taxes.

23. Marginal Cost of Capital The cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised. Example 13.6 Capital structure: 40% debt 60% equity Tax rate = 38% What is the cost of raising additional $10 million? C d = $4 million C e = $6 million V = $10 million i d = 6.85% i e = 19.96% Marginal cost of capital the company would expect to pay to raise $10 million and maintain identical capital structure k = (0.0685)(4) + (0.1996)(6) 10 10 = 14.72%

24. Minimum Attractive Rate of Return !! When cash flow computations reflect interest, taxes, and debt repayment, we have Net Equity Flow To maximize the wealth of stockholders, focus on the equity cash flow and use the cost of equity as the appropriate discount rate Hence, MARR represents the cost of equity, i e in this situation

25. However! Most companies use Unlevered Analysis! When cash flow computations exclude interest and debt then calculation should be made on unlevered basis (exclusive of financing). In this case, the overall cost of capital for the firm should be used as the discount rate or MARR = i k . Either method is acceptable if used correctly.