L3 - Capital Budgeting, Cost of Capital

Question 1

What is Internal and External Capital?

Answer 1

• Suppose you are the CFO of a large listed company an want to identify various sources of capital available to finance an investment (e.g., expanding existing operations or acquiring another firm). How can you raise capital?
• You can raise capital from internal or/and external sources of finance
• Internal capital
  
  • • Internal capital originates within the firm. It is cash flows from firms’ existing operations.
  • • Firms mainly rely on their internal capital to finance their investment projects
• External capital
• • External capital can be in two forms:
  
  • ▪ Equity (e.g., Facebook’s IPO in which it raised $16 billion)
    
    • Advantages
      
      • Dont have to pay interest on capital raised
      • Equity holders cannot force the company into bankrupts
    • Disadvantages
      
      • give up on ownership –> give up a proportion of the profit to owners of shares –> proportional to the shares they hold
  • ▪ Debt (Apple’s debt issue in which it raised $17 billion)
    
    • Advantages
      
      • Only pay interest on borrowed money not a proportion of the profit you made
    • Disadvantages
      
      • Pay interest on money borrowed
      • Contractable –> debt holders can force the business into bankruptcy

Question 2

What is the Cost of Equity Capital?

Answer 2

• the expected return for the shareholders (cost to the company)

Question 3

NPV calculation?

Answer 3

• IF perpetuity ==> C/r

Question 4

How can we estimate beta?

Answer 4

Question 5

How do we find the beta of levered firms?

Answer 5

Question 6

What are some characteristics of the betas of levered firms?

Answer 6

• beta_asset = (w_equity * β_equity) + (w_debt * β_{<span>debt</span>})
  
  • assume beta of debt is zero –> doesnt really follow the stock market does it

Question 7

How is the risk of firm different from the risk fo the project?

Answer 7

• In Blues plc example, we assumed that the risks (betas) of the new projects are equal to the firm’s existing risk.
• However, the risks of the projects can be different than the risk of the firm.
• In this case, for each project, an appropriate (comparable) risk should be used to find the discount rate of the each project.
• Therefore, use the beta of another company in an industry specific to the project (i.e., a surrogate company)

Question 8

What is WACC?

Answer 8

• So far we assumed that the projects A, B, C are financed with all equity. What if they are financed with both debt and equity?
• Assume Blues plc uses both equity and debt to finance its investments. The cost of equity is R_equity for its equity financing and cost of debt is R_debt for debt financing.
• Since the firm uses both equity and debt, the overall (average) cost will be weighted average cost of capital (WACC or R_WACC).
• We will use WACC as the discount rate#

Why do we multiple the tax rate with debt not equity aswell?

• Its a tax shield –> the more debt you have, the more interest payment you are required to pay debt holders thus it reduces taxable income

Question 9

Summary of how we perform an investment appraisal of levered firms?

Answer 9