top answer: FIN 425 – Course Project CougCoffee Inc. DCF Project and Company Analysis Instructions:
FIN 425 – Course Project
CougCoffee Inc.
DCF Project and Company Analysis
Instructions:
Your final report should include a complete set of tables, numerical and written answers to each
part of the assigned questions. Show your computation steps. Your written report for this project
should not exceed 8 pages. There is no minimum page requirement as long as you answer all
questions properly.
If necessary, you can choose to provide additional evidence such as supporting excel calculations,
regressions or data. However, additional evidence is not required and the project report itself
should be self-explanatory.
Additional Requirements
In conducting the analysis and preparing your report, you may use any sources you find helpful:
textbook, public documents, data from various websites, etc. However, the work you submit must
be your own in the sense that it represents your own synthesis and analysis of information
gathered from multiple sources and is written in your own words. Be sure to carefully document
all your sources, calculations, and assumptions.
Moreover, you should perform your own data analysis and estimations, rather than copying
from other available analyst’s report (such as beta, alpha, cost of capital, etc.).
Failure to follow any of the above requirements can result in serious consequence. It can lead
to a failure of this project and this course.
Additional important project Policies and Template will be posted on canvas. It is your
responsibility to read and comply with these policies.
CougCoffee is an American coffee product retailer and manufacturer located in Pullman, WA. The
company president is Jack Ryan, who inherited the company. When the company was founded
over 50 years ago, it originally imported coffee beans from Mexico. The company focused on
roasting and retailing coffee beans to more than 30 states in the US. Over the years, the company
still maintains its original coffee beans retail business, accounting for about 50 percent of its total
revenue. Faced with stiff competition, the company also expanded into the business of
manufacturing coffee machines. You, as a Carson College business majored, are hired by the
company’s finance department to evaluate a new project for the company.
As of now, CougCoffee’s only coffee maker is named the QuickCofee (QC), and sales have been
excellent. CougCoffee’s main competitor in the coffee maker market is Stanley Black & Decker,
Inc. (SWK). CougCoffee’s QC is similar to the SWK’s Black & Decker but easier to use. However,
CougCoffee wants to introduce a new version of the coffee maker, the CoffeeMaster (CM), into
their lineup. CougCoffee spent $300,000 to develop the new CM, which can adjust brew
temperature according to different types of coffee beans and brews directly into the included 18-
ounce thermal mug or into any mug or cup of your choice. The company has spent a further
$50,000 on a marketing study to determine the new coffee makers expected sales figures.
CougCoffee can manufacture the new coffee maker for $55 per machine in variable costs. Fixed
costs for the operation are estimated to run $1,500,000 per year. The estimated sales volumes (in
units) are 140,000, 160,000, and 100,000 coffee makers per year for the next three years,
respectively. The unit price of the new coffee maker will be $95. The necessary equipment can be
purchased for $3,000,000 and will be depreciated on a five-year MACRS schedule. It is believed
the value of the equipment in three years will be $1,500,000.
As previously stated, CougCoffee currently manufactures the QC. Production of the existing
product is expecting to be terminated in two years. If CougCoffee does not introduce the new CM
product, sales of the existing product will be 100,000 and 90,000 units per year for the next two
years, respectively. The price of the existing coffee maker, QC is $75 per coffee maker, with
variable costs of $45 each and fixed costs of $900,000 per year. If CougCoffee does introduce the
new coffee maker, sales of the existing one will fall by 50,000 (units) coffee makers per year, and
the price of the existing coffee maker will have to be lowered to $40 per coffee maker.
Net working capital for the new project will be 20 percent of sales and will occur with the timing
of the cash flows for the year; for example, there is no initial outlay for NWC, but changes in NWC
will first occur in Year 1 with the first year’s sales. CougCoffee has a 20 percent corporate tax rate.
The company has a target debt to equity ratio of 0.5 and is currently A rated (according to S&P
500 ratings). The overall cost of capital of CougCoffee is 14 percent.
The finance department of the company has asked you to prepare a report to Jack, the company’s
CEO, and the report should answer the following questions.
QUESTIONS
1. Can you prepare the income statement and the total cash flow (CFFA) table for this new
project?
2. Please use these tables to help explain to Jack the relevant and irrelevant cash flows of this
project?
3. The company’s CEO, Jack, wants to understand the risk of the coffee maker industry better.
Since CougCoffee’s main competitor, Stanley Black & Decker Inc (SWK), is a leading
company in this industry, Jack asks you to perform the following analysis on SWK.
a. Using the past N years of data (ending in December 2021), estimate your own beta
and alpha of SWK based on a regression analysis. Document the data sources used.
Also, explain how long a time period (from which year to which year) that you
decide to use to perform your estimation, and explain why?
b. Provide your beta and alpha estimates, as well as the statistical significance (e.g., t
ratio, p-value). Comment briefly.
c. Plot the security characteristic line for this company, and clearly show alpha and
beta on the diagram. Is the company correctly priced, overpriced, or underpriced?
d. From the above analysis, can you explain to Jack the risk characteristics of SWK
and the coffee maker industry using the beta you estimated? Do you think your
estimated beta makes sense given the nature of the company and the industry?
4. Given your understanding of CougCoffee and your analyses so far, can you help Jack to make
the project decision regarding the company’s new product CM? That is, please compute the
NPV and IRR of CougCoffee’s new project? Please show your computation steps clearly
(show your inputs if using financial calculator or excel sheet).
Should Jack take the new project? Why or why not (Please explain using the NPV and IRR
rules separately)?
CHAPTER 10
MAKING CAPITAL INVESTMENT DECISIONS
– DCF (Discounted CF Analysis)
Jeep is reviving a classic. See the
new Grand Wagoneer
What went into Jeep’s decision to launch its new
Grand Wagoneer ?
https://www.cnn.com/2021/03/11/success/jeep-grand-
wagoneer-reveal/index.html
Here’s what it’s like to drive a new
$100,000 Jeep
(CNN) Cruising up a highway heading north out of New York City, the bright
white Jeep Grand Wagoneer I was driving got the sort of attention usually
given to Lamborghinis and Ferraris. Other vehicles maneuvered to get a better
look and smartphones were held out through car windows for a shot. I was
driving the luxuriously equipped Grand Wagoneer, with a total price of more
than $100,000, toward an off-road course on private land.
The new Jeep Grand Wagoneer offers a level of luxury not seen in a Jeep
before.
Here’s what it’s like to drive a new
$100,000 Jeep
Features and Competitors:
•As the heir to an iconic American luxury SUV, the new model – 2022 Grand Wagoneer
– has a reputation to live up to. It’s available with a 6.4-liter V8 and an eight-speed
automatic transmission. The V8 is rated at 471 hp and lets the body-on-frame SUV go
0-60 mph in 6 seconds. But, while the Grand Wagoneer doesn’t offer hybrid options
like the Range Rover, it does offer standard 4WD with a two-speed transfer case. And
with the integrated tow hitch, it can tow up to 9850 pounds. In Rock Mode, the SUV
has 10.1” of ground clearance and can wade into water 24” deep. Plus, like the Range
Rover, it has independent front and rear suspension.
•If it were a contest, the Grand Wagoneer makes a strong play for leader in total
touchscreen area inside an SUV. There was even a screen just for the front passenger,
one each for rear passengers and one in the center between the second row passengers.
•The Jeep Grand Wagoneer has a surprising level of technology throughout. It’s
available with driving assistance technologies that help it hold its lane on the highway
and maintain a set speed in traffic without driving into vehicles ahead of it.
Here’s what it’s like to drive a new
$100,000 Jeep
Features and Competitors:
•Still, the best things about both the Wagoneer and Grand Wagoneer are built into their
bones. These are, fundamentally, excellent big SUVs that are comfortable, practical and
capable. The more expensive Grand Wagoneer is in a price range with the most opulent
European SUVs, like the BMW X7 and Mercedes-Benz GLS. While they do provide a
more luxurious experience for those who want to ride like royalty, the European SUVs
might not be so good at crawling over rock beds. The Grand Wagoneer and Wagoneer
are clear contenders for king of the mountain among big SUVs.
Pricing
The Grand Wagoneer has a starting price near $90,000, a sizable jump up from
the $60,000 for the two-wheel drive base version of the Wagoneer. The lowest-
price version won’t be available until later, though. The Wagoneer that’s
currently on the market costs nearly $70,000.
Do you think $70,000 starting
price is reasonable?
Any theoretical foundation?
How exactly to set a
competitive price on a new
product?
Here’s what it’s like to drive a new
$100,000 Jeep
What went into Jeep’s decision to launch its new
Grand Wagoneer ?
How would you go about making such a project
decision?
https://www.cnn.com/2021/08/31/success/jeep-grand-
wagoneer-review/
❑ Decision Rules (Ch 9)
❑ Cash flows (Ch10)
❑ Discount rates/Cost of
Capital (Ch14)
Chapter10 Outline
– 2nd Chapter under Capital budgeting
Incremental Cash Flows
Financial Statements and Project Cash Flows
Alternative Definitions of Operating Cash Flow
Some Special Cases of Discounted Cash Flow
(DCF) Analysis
10-7
Relevant Cash Flows
❑ The first and most important step for capital
budgeting decision – is to decide which cash flows
are relevant.
❑ Should be straightforward to determine – But in a
few situations it is easy to make mistakes
10-8
Any and all changes in the firm’s future cash
flows that are a direct consequence of taking the
project ‒ The incremental cash flows
Example
Suppose Hill’s Pet Nutrition Company hires a financial
marketing company to help evaluate whether a line of
new dog treat should be launched. When the consultant
turns in the report, Hill’s pet objects to the analysis
because the consultant did not include the hefty
consulting fee as a cost of the dog treat project.
Should the consulting fee be included in the cost of the
dog treat project?
Sunk Cost
❑ Consulting fee must be paid whether or not the new dog treat
line will be launched. So the consulting fee is a Sunk Cost.
❑ Sunk cost is NOT a relevant cash flow – Not a direct
consequence to accepting the project.
❑ The point is: we should always be careful to exclude sunk
costs (e.g. consulting fee) from our analysis.
10-10
Sunk cost is a cost we have already paid, or
already incurred the liability to pay.
No, exclude consulting fee
Example
A company is thinking of converting an old rustic factory
building (and the associated land) into an upscale office
building. The company bought the old building years
ago for $500,000. If they undertake this project, there
will be no direct cash outflow associated with buying the
old building because they already own it.
For purposes of evaluating the office building project,
should they treat the old building as “free”?
Opportunity Cost
The old factory building is a valuable resource.
Using it for the project has an opportunity cost:
They give up the valuable opportunity of selling it (to build an
office building).
Should they treat the old building as “free”?
The answer is NO!
What is the direct
consequence?
Take the project Use the old factory
building/land
Not take the project Sell it !
No, they should NOT treat the old building as free!
Opportunity Cost
How much should we charge (the office project) for the
use of the old building?
Should we use $500,000, given we paid that much years ago?
No. The fact that we paid $500,000 some years ago is
irrelevant.
Should charge the amount we give up – the opportunity cost
That is what the factory would sell for today – Market value.
The point: Need to pay attention to opportunity costs!
Side effects
❑ It is common for a project to have side, or spillover effects, both
good and bad → the cash flows should be adjusted to reflect these
side effects
❑ Negative impact (Erosion)
➢ Introducing of a new product may have a negative impact on the
cash flows of an existing product.
E.g. Opening an in Pullman ??
❑ Positive impact
➢ HP sells far more printers now than in the 1990s, but the price is
only 1/5 – they sell more cartridges and special papers
will drain customers
from Moscow Applebees.
Common Types of Cash Flows
Other incremental cash flows:
❑ Changes in net working capital
▪ Most projects will require an increase in NWC initially as we build
inventory and receivables. Then, we recover NWC at the end of the
project.
❑ Financing costs – In analyzing a project, we will not include
financing costs such as interest paid, dividends repaid.
▪ Financing cost is included in the required return (cost of capital) –
avoid double counting
▪ finance the entire portfolio of projects at one time, not a single one
at a time.
❑ Taxes – we need to consider cash flows on an after-tax basis.
10-15
Question 3
Suppose that Ford is considering a project to make a
new brand of gas-saving car. In that project, the sales
of the new brand will decrease the sales of existing
brands of cars. This decrease in the sales of existing
brands of cars is an example of:
a. fixed cost
b. sunk cost
c. opportunity cost
d. erosion
Note:
Erosion = negative side effect
Question 4
Which one of the following should NOT be included in the analysis
of a new product?
A. Increase in accounts payable for new product inventory
purchases.
B. Reduction in sales for a current product once the new product
is introduced.
C. Market value of a machine owned by the firm which will be
used to produce the new product.
D. Money already spent for research and development of the
new product.
B – Neg. Side effect: Erosion
C – Opportunity cost
D – Sunk cost
A – changes in NWC
Pro Forma (projected) Statements and Cash
Flow
Capital budgeting relies heavily on pro forma, or
projected, accounting statements, particularly income
statements
Computing cash flows – refresher
▪ Operating Cash Flow (OCF) = EBIT + depreciation – taxes
▪ Cash Flow From Assets (CFFA) =
OCF – net capital spending (NCS) – changes in NWC
10-18
Example – the Project
Suppose we can sell 50,000 cans of shark attractant per year at a price
of $4 per can. It costs us about $2.50 per can to produce, and a new
product like this typically has only a three-year life. We require a 20
percent return on new products.
Fixed costs for the project, including rent on the production facility,
which will run $12,000 per year.
Further, we will need to invest a total of $90,000 in manufacturing
equipment. Assume that this $90,000 will be 100 percent depreciated
over the three year (straight-line). Furthermore, the equipment will be
essentially worthless on a market value basis at the end.
Finally, the project will require an initial $20,000 investment in net
working capital, and the tax rate is 34 percent.
Should we accept the project?
Table 10.1 Pro Forma Income Statement
Sales (50,000 units at
$4.00/unit)
$200,000
Variable Costs ($2.50/unit) 125,000
Gross profit
Fixed costs
Depreciation ($90,000 / 3)
EBIT
Taxes (34%)
Net Income
10-20
Key Information:
•rent on facility,
$12,000 per year.
•Invest $90,000 in
equipment
$75,000
12,000
30,000
$ 33,000
11,220
$ 21,780
OCF = EBIT + depreciation – taxes
Projected Operating Cash Flow
Operating Cash Flow (OCF) = EBIT + depreciation – taxes
Table 10.5 Projected Total Cash Flows
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in
NWC
-$20,000 20,000
NCS -$90,000 0
CFFA -$110,000 $51,780 $51,780 $71,780
10-22
▪ OCF each year = $51,780 ;
▪ Further, we will need to invest a total of $90,000 in manufacturing equipment. the
equipment will be essentially worthless on a market value basis at the end.
▪ Finally, the project will require an initial $20,000 investment in net working capital
Making The Decision
❑ Now that we have the cash flows, required return=20%, we
can apply the techniques that we learned in Chapter 9
❑ Compute NPV &IRR
▪ CF0 = -110,000;
▪ C01 = 51,780; F01 = 2;
▪ C02 = 71,780; F02 = 1;
▪ NPV: I = 20;
▪ CPT NPV = 10,648
▪ CPT IRR = 25.8%
❑ Should we accept or reject the project?
▪ The project creates over $10,000 and should be accepted.
▪ Also, we find that the IRR = 25.8 % > 20%
10-23
0 1 2 3
CFFA -$110,000 $51,780 $51,780 $71,780
Things that affect CFs:
10-24
Things that affect CFs:
❑ Depreciation
❑ Salvage Value
– market value of initial investments (e.g.
equipment) at the end of project
Things that affect CFs: Depreciation
Depreciation itself is a non-cash expense;
▪ it is only relevant because it affects taxes
Depreciation tax shield = D × T
▪ D = depreciation expense
▪ T = marginal tax rate
10-25
OCF = EBIT + depreciation – taxes
Taxes are determined by:
▪ EBIT = S – C – D
▪ the higher D, the lower the taxable income
Computing Depreciation
Straight-line depreciation
➢ Dep. amount is the same each year during the life time of the asset
D = (Initial cost – salvage) / number of years
Salvage – market value of initial investments at the end of project
➢ If the requirement is “straight-line depreciation to 0”, then:
D = (Initial cost – 0) / number of years
➢ Very few assets are depreciated straight-line for tax purposes
Modified Accelerated Cost Recovery System (MACRS)
➢ every asset is assigned to a particular class
D = initial cost x % given in table
➢ The expected salvage value are NOT explicitly considered in the
calculation of depreciation
10-26
MACRS
Class Examples
Three-year Equipment used in research
Five-year Autos, computers
Seven-year Most industrial equipments
TABLE 10.6
Modified ACRS Property Classes
❑ under MACRS, every asset is assigned to a
particular class
You can find the full list in IRS Pub 946.
MACRS
Property Class
Year Three-Year Five-Year Seven-Year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
TABLE 10.7 Modified ACRS Depreciation Allowances
▪ depreciation % are much higher in early years than in later years
o asset is most heavily used when it is new, functional
o Why might firms prefer an accelerated depreciation method (MACRS)?
lower taxes in early years, defer taxes to later periods
❑ After-tax Salvage Value
❑ Sell the equipment at the end, and pay tax
▪ After-tax salvage value affect firms’ cash flows at the end
of project life
❑ After-tax salvage = salvage – T*(salvage – book value)
▪ BV = initial cost – accumulated depreciation
▪ If the salvage value is different from the BV of the asset,
then there is a tax effect
10-29
Things that affect CFs: After-Tax Salvage
Example: Depreciation affets After-tax Salvage
❑ You purchase equipment for $100,000, and it costs $10,000
to have it delivered and installed.
❑ Based on past information, you believe that you can sell the
equipment for $17,000 when you are done with it in 6 years.
❑ The company’s marginal tax rate is 40%.
❑ What is the depreciation expense each year and what is the
after-tax salvage in year 6 for each of the following
situations?
▪ Straight-line depreciation to salvage value
▪ MACRs depreciation
10-30
Case 1: Straight-line to Salvage
D = (Initial cost – salvage) / number of years
❑ D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years
❑ BV in year 6 = 110,000 – 6*(15,500) = 17,000
❑ After-tax salvage = salvage – T*(salvage – book value)
=17,000 – .4 * (17,000 – 17,000)
= 17,000
10-31
Key information:
You purchase equipment for $100,000, and it costs $10,000 to have it delivered and
installed.
you can sell the equipment for $17,000 when you are done with it in 6 years.
Tax rate is 40%.
Before-tax salvage value
Case2: Three-year MACRS
Yr MACRS
percent
D =
initial cost x % dep.
1 .3333 .3333(110,000)
= 36,663
2 .4445 .4445(110,000)
= 48,895
3 .1481 .1481(110,000)
= 16,291
4 .0741 .0741(110,000)
= 8,151
5 0
6 0
BV in year 6 =
110,000 – 36,663 –
48,895 – 16,291 – 8,151
= 0
After-tax salvage
= 17,000 – .40 * (17,000 – 0) = $10,200
Will the effect always be negative?
10-32
No, salvage < BV, positive
Chapter Outline
Incremental Cash Flows
Financial Statements and Project Cash Flows
Alternative Definitions of Operating Cash Flow
Some Special Cases of Discounted Cash Flow (DCF)
Analysis
10-33
Other Methods for Computing OCF
Top-Down Approach
▪ OCF = Sales – Costs – Taxes
▪ Don’t subtract non-cash deductions
Bottom-Up Approach
▪ OCF = NI + depreciation
Tax Shield Approach
▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T
10-34
Traditional Approach:
OCF = EBIT +Depreciation – Taxes
Tax shield
Other Methods for Computing OCF
Top-Down Approach
▪ Start from traditional:
▪ OCF = EBIT + Dep. – Taxes
Since EBIT=Sales – Costs – Dep., if add back Depreciation:
▪ Top-down: OCF = Sales – Costs – Taxes
Examples
▪ Traditional approach
▪ OCF = EBIT + D – T
▪ EBIT = S – C – D
= $1,500 -700 -600 = $200
▪ Taxes = EBIT x T =$200 x 0.34 = $68
▪ OCF = $200 + 600 – 68 = $732
10-35
Top-down Approach
OCF = Sales – Costs – Taxes
= 1,500 – 700 – 68
= $732
Sales = $1,500
Costs=$700
Depreciation =$600
T=34%
Other Methods for Computing OCF
❑ Bottom-Up Approach
▪ OCF = NI + depreciation
▪ The bottom-up approach – start with the accountant’s bottom
line (net income) and add back any noncash deductions such
as depreciation
❑ Example
10-36
.
▪ EBIT= S – C – D
=1500 – 700 – 600 = $200
▪ Taxes=200 x 0.34 = $68
▪ NI = EBIT – Taxes = $200 – 68 =$132
▪ OCF = NI + Dep. = $132 + 600 = $732
Sales = $1,500
Costs=$700
Depreciation =$600
T=34%
▪ NI = Total sales x Profit margin
o profit margin = NI/ Total sales
▪ Profit margin=8.8%,
NI = $1500 x 8.8% = $132
Other Methods for Computing OCF
❑ Tax Shield Approach
❑ OCF = after-tax profit + Dep. Tax shield
= (Sales – Costs)(1 – T) + Depreciation*T
❑ Do we get the same answer?
▪ OCF = ($1,500 – $ 700) x.66 + 600 x 0.34
= $528 + $204 = $732
❑ All 4 methods give us the same OCF.
▪ If we know NI, bottom up is more efficient,
▪ Otherwise we should use top down, or tax shield
approach.
10-37
Sales = $1,500
Costs=$700
Depreciation =$600
T=34%
OCF=$732
Question 6:
The Beach House has sales of $784,000 and a profit margin of
11 percent. The annual depreciation expense is $14,000. What is
the amount of the operating cash flow?
A. $68,760
B. $72,240
C. $86,240
D. $100,240
E. $101,760
Answer – D
▪NI = Total sales x Profit margin
= $784,000 0.11=$86,240
▪Bottom up:
OCF = NI + D
=$86,240 + $14,000
= $100,240
Question 5:
Lily’s Fashions is considering a project that will require $28,000
in net working capital and $87,000 in initial investment in fixed
assets. The project is expected to produce annual sales of
$75,000 with associated costs of $57,000. The project has a 5-
year life. The company uses straight-line depreciation to a zero
book value over the life of the project. Salvage value is zero. The
tax rate is 30 percent. Using tax shield approach, what is the
operating cash flow for this project?
A. -$1,520
B. -$580
C. $420
D. $15,680
E. $17,820
Answer: E
OCF = (Sales – Costs)(1 – T) +Depreciation*T
Depreciation Tax shield = ($87,000/5)*0.30 =$5,220
OCF = ($75,000 – $57,000)(1 – 0.30) + $5,220
= $17,820
Practicing Question 10
You have the following information:
A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year.
Salvage value will be $200,000 at that time.
The project requires $150,000 in additional inventory and will increase
accounts payable by $50,000.
It will generate $207,160 operating cash flows (OCF) each year. The tax rate
is 40%.
What is the incremental cash flow in years 0 and year 6 respectively?
10-40
Year 0 Years1 – 5 Year 6
OCF $207,160 $207,160
Change in NWC -$100,000 +$100,000
NCS
CFFA
❑Changes in NWC = 150,000 – 50,000 = 100,000
Practicing Question 10
You have the following information:
A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year.
Salvage value will be $200,000 at that time.
The project requires $150,000 in additional inventory and will increase
accounts payable by $50,000.
It will generate $207,160 operating cash flows (OCF) each year. The tax rate
is 40%.
What is the incremental cash flow in years 0 and year 6 respectively?
10-41
Year 0 Years1 – 5 Year 6
OCF $207,160 $207,160
Change in NWC -$100,000 +$100,000
NCS -$1,000,000 +$120,000
CFFA
❑After-tax salvage = salvage – (salvage – BV)*T
= 200,000 – (200,000 – 0) * 40% = 120,000
Practicing Question 10
You have the following information:
A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year.
Salvage value will be $200,000 at that time.
The project requires $150,000 in additional inventory and will increase
accounts payable by $50,000.
It will generate $207,160 operating cash flows (OCF) each year. The tax rate
is 40%.
What is the incremental cash flow in years 0 and year 6 respectively?
10-42
Year 0 Years1 – 5 Year 6
OCF $207,160 $207,160
Change in NWC -$100,000 +$100,000
NCS -$1,000,000 +$120,000
CFFA -$1,100,000 $207,160 $427,160
Full-fledged DCF Analysis
10-43
❑ Relevant Cash Flows.
❑ Use financial statements and CF table
▪ Compute OCF and CFFAs
❑ Using decision rules (NPV, IRR) to make the
decision.
Some Special Cases
10-44
1. Investments that are primarily aimed at
improving efficiency and thereby cutting costs.
2. When a firm is involved in submitting
competitive bids.
Case1 – EVALUATING COST-CUTTING
PROPOSALS
Suppose we are considering automating some part of an
existing production process.
The necessary equipment costs $80,000 to buy and install.
The automation will save $22,000 per year (before taxes)
by reducing labor and material costs.
For simplicity, assume that the equipment has a five-year
life and is depreciated to 0 on a straight-line basis over that
period. It will actually be worth $20,000 in five years.
The tax rate is 34 percent, and the discount rate is 10
percent. Should we automate?
Case1 – EVALUATING COST-CUTTING
PROPOSALS
The first step – identify the relevant cash flows (OCF & CFFA)
OCF = EBIT + D – Taxes
❑ EBIT = S – C – D
▪ Do we have sales and costs?
the project’s operating income (gross profit) is NOT in terms of (S
– C), BUT in terms of:
Cost saving = $22,000 each year
▪ D = $80,000/5 = $16,000 per year.
▪ So, EBIT = $22,000 − $16,000 = $6,000.
❑ Taxes = $6,000 × .34 = $2,040.
Basic information
automation will save $22,000 per year (before taxes) by reducing labor and
material costs.
The initial investment in equipment costs $80,000. The equipment has a 5-year
life and is depreciated to 0 on a straight-line basis.
EBIT = Cost saving – D
Case1 – EVALUATING COST-CUTTING
PROPOSALS
Net Capital Spending (NCS):
▪ Initially outflow: – $80,000
▪ After-tax salvage value = $20,000 – $0.34 *($20,000 – 0)
= $13,200
The necessary equipment costs $80,000
the equipment has a 5-year life and is depreciated to 0 on a straight-line
basis over that period. It will actually be worth $20,000 in five years.
❑ At 10 percent, it’s straightforward to verify: NPV = $3,860 > 0
❑ So we should go ahead and automate.
Question 2
The operating cash flow of a cost cutting project:
A. is equal to the depreciation tax shield.
B. is equal to zero because there is no incremental
sales.
C. can only be analyzed by projecting the sales and
costs for a firm’s entire operations.
D. can be positive even though there are no sales.
Answer: D
Normal project: OCF = Aftertax Profit + D*T
Cost cutting: OCF = Aftertax cost saving +D*T
Case 2 – Setting Competitive Bid or
Price
Special Cases
10-49
Case2 – Setting the Bid Price
❑ Imagine we are in the business of buying stripped-down truck
platforms and then modifying them to customer specifications
for resale. A local distributor has requested bids for 5 specially
modified trucks each year for the next 4 years, for a total of 20
trucks in all.
❑ We need to decide what price per truck to bid.
❑ The goal of our analysis is to determine the lowest price we
can profitably charge.
➢ This price should be low enough to maximize our chances of getting
the contract
➢ while guarding against the winner’s curse (that is, too cheap, we will
not earn the required return).
Case2 – Setting the Bid Price
Suppose we can buy the truck platforms for $10,000 each. The
facilities can be leased for $24,000 per year. The labor and
material costs work out to be about $4,000 per truck.
▪ Total cost per year (of 5 trucks) = $24,000 + 5 × (10,000 + 4,000) =
$94,000.
We will need to invest $60,000 in new equipment. This
equipment will be depreciated straight-line to a 0 over the 4
years. It will be worth about $5,000 at the end of that time.
We will also need to invest $40,000 in raw materials inventory
and other working capital items. The relevant tax rate is 39%.
What price per truck should we bid if we require a 20% return
on our investment?
Case2 – Setting the Bid Price
First, the basic intuition:
❑ By logic, what is the lowest possible price we can profitably
charge (at 20%)?
▪ When NPV=0 (at discount rate =20%): → earn exactly
20% !
▪ Set that price (NPV=0) as the optimal bidding price – no
more, no less!
❑ Conclusion: Optimal price (P*) is price at NPV=0
❑ we first determine the CF (or OCF) that the NPV = 0. Then
we can back out the P* from OCF.
That is: the price that maximize our chance of getting the
contract, and also make sure we earn our required return (20%)
Case2 – Setting the Bid Price
Steps to determine Optimal price (P*)
First, Set up Cash Flow Table
Second, solve for OCF* that will make NPV=0 (at
our required return)
Third, backout the Optimal price from OCF*
◼Use OCF formula to back out P*
Case2 – Setting the Bid Price
We can’t determine the OCF just yet because we don’t know
the sales price.
Net Capital spending (NCS):
▪ – $60,000 today for new equipment.
▪ The after-tax salvage =$5,000 – (5,000-0) × .39 = $3,050.
Change in NWC:
▪ invest – $40,000 today in working capital. We will get this back in
four years.
We will need to invest $60,000 in new equipment,
depreciated straight-line to a 0 over the 4 years. Salvage = $5,000 at the end
of that time.
Need to invest $40,000 in raw materials inventory and other WC items
Case2 – Setting the Bid Price
We can’t determine the OCF just yet because we don’t know the
sales price. Thus, here is what our CF table looks like so far:
Net Capital spending (NCS):
▪ – $60,000 today for new equipment.
▪ The after-tax salvage =$5,000 – (5,000-0) × .39 = $3,050.
Change in NWC:
▪ invest +$40,000 today in working capital. We will get this back in
four years.
We will need to invest $60,000 in new equipment,
depreciated straight-line to a 0 over the 4 years. Salvage = $5,000. Need to invest
$40,000 in NWC
Case2 – Setting the Bid Price
❑ Therefore we first need to determine the annual OCF for the
NPV = 0.
– $100,000
+ 43,050/1.24= – $79,239
Case2 – Setting the Bid Price
Now, the OCF is now an annuity amount.
Determine OCF* that makes NPV=0:
▪ PV of OCF = OCF * PVIFA
▪ PV of OCF = OCF * 2.5887 = $79,239
▪ OCF = $79,239/2.5887 = $30,609
Are we finished?
No! need optimal sales price results in an OCF* = $30,609.
The present value interest factor of
annuity (PVIFA) – refresher
PVIFA (r, n) = [1-1/(1+r)n]/r
PVIFA (20%, 4)
= [1-1/(1.20)4]/0.20= 2.5887
This is the OCF* that makes NPV=0
Case2 – Setting the Bid Price
Use OCF formula to back out price
❑ Tax Shield Approach
▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T
▪ $30,609 = (Sales – $94,000) *0.61 +$15,000*0.39
▪ Sales = $134,589
❑ the contract calls for 5 trucks per year
Sale Price = $134,589/5 = $26,918.
Bid about $27,000 per truck.
OCF = $30,609
Costs = $94,000
D= $15,000
T=0.39
CHAPTER 14
COST OF CAPITAL
Chapter 11
– PROJECT ANALYSIS AND
EVALUATION
Lecture slides posted on blackboard
For your own reading, will not be on the
exam
11-2
Chapter 14 – Cost of Capital
The Cost of Capital – Equity, Debt, and Preferred
(Quick Review of DGM & CAPM)
The Weighted Average Cost of Capital (WACC)
Project Costs of Capital
Flotation Costs and the WACC
14-3
– last piece to complete capital budgeting analysis
Cost of Capital
14-4
Banker: The
required return
must be…
CFO: Wow,
that’s my cost!
Cost of Capital
14-5
required return
(for investors)
Cost of capital
(to the firm)
required return = discount rate = cost of capital
more or less interchangeably
=
Cost of Capital
How do we determine the cost of capital/required return?
14-6
required return = discount rate = cost of capital
more or less interchangeably
Key principle – the return required on some
asset/project depends on the risk of the asset
Key principle – The cost of capital depends primarily on
the use of the funds, not the source of the funds.
14-7
Moscow
❑The cost of capital depends primarily on the
use of the funds (risk), not the source.
Travel agency
Pullman
Higher risk, higher
cost of capital
Importance of cost of capital
❑ Why is it important to determine Cost of Capital ?
Required return = discount rate = cost of capital
❑ How to determine a firm’s overall cost of capital?
– depends on the return required on the firm’s overall assets
14-8
Cost of Equity
Cost of Debt
Capital budgeting decisions (DCF analyses):
We need to know the required return (discount rate) for an
investment before we can compute the NPV and make a decision
about whether or not to take the investment
Corporate policy decisions:
the optimal capital structure (D/E) – minimizes the cost of capital
Cost of Equity
The cost of equity (RE)
– the return required by equity investors, given the
risk of (the cash flows from) the firm
There are two major methods for determining the
cost of equity
▪ Dividend growth model (DGM)
▪ CAPM (or SML)
14-9
Covered in FIN325
A quick review here
Chapter 13
The Dividend Growth Model Approach – Quick
Review
Start with the dividend growth model (DGM)
(with constant growth)
14-10
D1 = D0(1+g)
RE = dividend yield (D1 / P0) + capital gains yield (g)
Rearrange, solve for RE
Example: Dividend Growth Model
Example – Suppose that your company is expected
to pay a dividend of $1.50 per share next year.
There has been a steady growth in dividends of
5.1% per year and the market expects that to
continue.
The current price is $25. What is the cost of
equity?
14-11
The Dividend Growth Model Approach
The dividend growth model (DGM) formula
14-12
D1 = D0(1+g)
❑ To use DGM, we need 3 pieces of information: D0 , P0 , and g.
❑ Which one is most difficult to get?
▪ the expected g for dividends, must be estimated.
❑ To estimate g:
▪ Use analysts’ forecasts of future growth rates -available
from a variety of sources, e.g. at yahoo.com, or zacks.com.
▪ Use historical growth rates
Advantages and Disadvantages of Dividend
Growth Model
Advantages and disadvantages of DGM:
Advantage – easy to understand and use
Disadvantages ?
▪ Only applicable to companies currently paying
dividends
▪ Not applicable if dividends aren’t growing at a
reasonably constant rate
▪ Extremely sensitive to the estimated g —
an overestimation of g by 1% → an overestimation of RE by 1%
▪ Does not explicitly consider risk
14-13
Chapter 14 – Cost of Capital
The Cost of Capital – Equity
(Quick Review of DGM & CAPM)
14-14
The CAPM (or SML) Approach
14-15
What is risk premium?
Risk premium = Expected return – risk-free rate
E(RE) – Rf = E (E(RM) – Rf)
CAPM (or SML) Approach: Link Expected Return to Risk
The risk premium on individual assets depends on:
▪ risk premium on the market portfolio (M)
▪ risk – the beta coefficient with respect to M
Nobel Prize
Wining Theory
E(RE) = Rf + E (E(RM) – Rf)
Expected Return and Risk
According to CAPM, what type risk should matter for E(R)?
Still remember Systematic vs. Unsystematic risk?
❑ Systematic risk – inflation, recession, interest rate
❑ Unsystematic risk – lighting strike, CEO heart attack, unexpected big order
Systematic !
Unsystematic risk
can be diversified
away, not priced
Recession Lighting strike
Expected Return and Risk
❑According to CAPM, only Systematic risk matters in
determining E(R), unsystematic risk can be diversified away,
you will not be paid if you hold it.
❑How to measure systematic risk? – by Beta:
i =[COV(ri,rM)] / σ
2
M
measures: How individual security is correlated with market
portfolio.
❑An individual security’s total risk (2i) can be partitioned into
systematic and unsystematic risk:
What is the beta of the market? M = ?
2i = sys. risk + unsys. risk
= i
2 M
2 + 2(ei)
M = 1
Expected Return and Risk (Basic Logic)
In equilibrium, return-to-risk ratio should be the same for all
assets.
The ratio of risk premium to beta should be the same for any
two securities, and to that of the market portfolio:
M
fM
i
fi
rrErrE
−
=
− )()(
CAPM
j
j
i
i
risk
Return
risk
Return
=
Systematic
risk ()
Risk
premium
M = 1
Professor William Sharpe, Stanford
University, won the Nobel Prize in 1990
Sample Calculations for SML
βx = 1.25
E(rx) =3% + 1.25 (8%) = 13%
βy = .6
E(ry) =3% + 0.6 (8%) = 7.8%
Equation of the CAPM
E(ri) = rf + βi[E(rM) – rf]
If β = 1?
If β = 0?
Can we plot the return-risk
relation of these stocks?
E(rm) – rf = 8% – Market risk premium – Return per unit of sys. risk
rf = 3% – Risk-free rate
E(rm) – rf = 8% – Market risk premium (Return per unit of sys. Risk)
E(rm) = 11% – Market return
rf = 3% – Risk-free rate
E(r)
SML
ß
ßM
1.0
RM=11%
3%
Rx=13%
ßx
1.25
Ry=7.8%
ßy
.6
8%
Graph of Sample Calculations
7-20
▪ =0 , ERriskfree=3%
▪ =0.6 , ER=7.8%
▪ =1, ERMkt=11%
▪ =1.25, ER=13%
Market risk premium
Equation of the CAPM
E(ri) = rf + bi [E(rM) – rf]
If all securities are correctly
priced (CAPM), they should plot
on SML.
Question 1
Southern Home Cookin’ just paid its annual dividend
of $0.65 a share. The stock has a market price of $13
and a beta of 1.2. The return on the U.S. Treasury bill
is 2.5 percent and the market return is 10.5 percent.
What is the cost of equity?
A. 9.60 percent
B. 12.10 percent
C. 12.60 percent
D. 15.10 percent
Answer: B – Not D
Re = 2.5% + 1.2 (10.5% – 2.5%)
= 12.10 percent
Wrong answer:
Re = 2.5% + 1.2 10.5%
= 2.5% + 12.60% =15.10 percent
Equation of the CAPM
E(ri) = rf + bi [E(rM) – rf]
The CAPM or SML Approach – A quick review
14-22
CAPM (or SML) Approach:
The risk premium on individual assets depends on:
▪ risk premium of market
▪ sys. risk (β)
Higher beta, higher return
High beta stock? Low beta stock?
E(r)
SML
ß
ERLVS
ßLVS
2.0
ERMCD
ßMCD
.38
Graph of Sample Calculations
7-23
Using past 10
years data:
E(R)LVS=28%
E(R)MCD=12%
= +2% Positive is good, Plot above SML
+ gives the buyer a positive abnormal return
E(rE(r))
15%15%
SMLSML
ßß
1.01.0
RRmm=11%=11%
rrff=3%=3%
1.251.25
Disequilibrium Example
Suppose a security Q with β Q of ____ is
offering an expected return of ____
According to the SML, the E(r) should be
___?__
1.25
15%
Underpriced: too cheap – offers too high of a return for its level of risk
The difference between the actual return and the return required for the risk
level as measured by the CAPM is called the stock’s alpha. What is the α in
this case?
E(r) = rf + β Q [E(rM) – rf]
=
Is the security under or overpriced?
13%
7-24
Q
3% + 1.25 (8%) = 13%
Mispricing
More on alpha and beta
E(rM) = 14%
βS = 1.5
rf = 5%
Required return(s) = rf + β S [E(rM) – rf]
=
If you believe the stock will actually provide a return of ____,
what is the implied alpha? Is the stock overpriced or
underpriced?
=
5 + 1.5 [14 – 5] = 18.5%
17%
17% – 18.5% = – 1.5%, the stock is overpriced (too expensive)
A stock with a negative alpha plots below the SML & gives
the buyer a negative abnormal return
Measuring Beta
Concept:
Method
We need to estimate the relationship between the
security and the “Market” portfolio.
▪ using historical data of excess returns of the
security and the Market portfolio
▪ Use regression analysis to calculate the Security
Characteristic Line (SCL) and estimate beta
How to measure beta?
Security Characteristic Line (SCL)
Excess Returns (i)
.
.
.
..
.
. .
. ..
. .
.
. .
. .
.
.
.
.
. .
. .
.
. .
.
. .
. .
.
. .
.
. .
.
. … .
. .. .
Excess returns
on market (M)
Ri = i + ßiRM + ei
Slope =
– abnormal return
What should be?
SCL
Dispersion of the points
around the line measures
__________________.Unsys. risk (e)
7-27
SCL equation:
E(ri) – rf = i + βi[E(rM) – rf]
Advantages and Disadvantages of
CAPM
Advantages
▪ Explicitly adjusts for systematic risk
▪ Applicable to all companies, even companies that do not pay
dividends! – as long as we can estimate beta.
Disadvantages
▪ Have to estimate beta, which also varies over time
▪ Have to estimate the expected market risk premium, which
does vary over time
▪ We are using the past to predict the future, which is not
always reliable
14-28
Advantages and Disadvantages of CAPM
Takeaways or what to do – When estimate Beta?
❑ Looking at analyst forecasts may NOT be reliable
▪ especially if you have the skill to estimate beta yourself
❑ If you notice that there are business strategy changes
▪ you probably want to use the most recent data to estimate
beta
❑ On the other hand, if the company has been stable
▪ you should use as long a time period as possible.
▪ Because, statistically, the more the observations, the more
accurate the estimation
Chapter Outline
The Cost of Capital
The Weighted Average Cost of Capital (WACC)
▪ The Cost of Equity
▪ The Costs of Debt and Preferred Stock
Divisional and Project Costs of Capital
Flotation Costs and the WACC
14-30
Cost of Debt – Chap 7
❑The cost of debt – required return (YTM) on a
company’s debt.
❑How to estimate Cost of Debt for a company?
▪ Computing the YTM on the existing debt
▪ Use current YTM based on the credit rating
❖If the firm is rated as BBB, we can find YTM (or the
interest rate) on newly issued BBB bonds.
14-31
Cost of Preferred Stock
Reminders
▪ Preferred stock generally pays a constant dividend each
period forever
Preferred stock is a perpetuity:
RP = D / P0
14-32
• perpetuity formula: P0= D / RP ,
• rearrange and solve for RP
If a company has preferred stock with an
annual dividend of $3. Current price is
$25, then cost of preferred stock is:
RP = 3 / 25 = 12%
The Weighted Average Cost of Capital
14-33
Cost of
equity
Cost of
debt
Weighted Ave.
Cost of Capital
(WACC)
The weights are determined by
market value of each asset
Capital Structure Weights
Notations
▪ E = market value of equity
= # of outstanding shares x price per share
▪ D = market value of debt
= # of outstanding bonds x bond price
▪ V = market value of the firm
= D + E
Weights (capital structure weights)
▪ wE = E/V = percent financed with equity
▪ wD = D/V = percent financed with debt
14-34
Taxes and the WACC
Effect of taxes
❑ Interest expense (on bonds) reduces firms’ tax liability, therefore
reduces the cost of debt
After-tax cost of debt = RD(1-TC)
❑ Dividends (on stocks) are not tax deductible, so there is no tax
impact on the cost of equity
Therefore:
WACC = wE RE + wD RD (1-TC)
14-35
Extended Example: WACC
Equity Information
▪ 50 million shares
▪ $80 per share
▪ Beta = 1.15
▪ Market risk
premium = 9%
▪ Risk-free rate = 5%
Debt Information
▪ $1 billion in
outstanding debt
(face value)
▪ Current price = 1,100
▪ Coupon rate = 9%,
semiannual coupons
▪ 15 years to maturity
Tax rate = 40%
14-36
Extended Example: WACC
What is the cost of equity?
▪ RE = 5 + 1.15(9) = 15.35%
What is the cost of debt?
▪ N = 30; PV = -1,100; PMT = 45;
FV = 1,000;
▪ CPT I/Y = 3.9268
▪ RD = 3.927(2) = 7.854%
What is the after-tax cost of debt?
▪ RD(1-TC) = 7.854(1-40%) = 4.712%
14-37
Equity Information
50 million shares
$80 per share
Beta = 1.15
Market risk premium = 9%
Risk-free rate = 5%
Debt Information
$1 billion in outstanding debt
Current price = 1100
Coupon rate = 9%, semiannual;
15 years to maturity
Tax rate = 40%
Extended Example: WACC
What are the capital structure weights?
▪ E = 50 million ($80) = $4 billion
▪ # of outstanding bonds
=$ 1billion FV/$1,000 =1 mil units of bonds
▪ D = 1 mil x ($1,100) = $1.1 billion
▪ V = 4 billion + 1.1billion = $ 5.1 billion
▪ wE = E/V = 4 / 5.1 = 78.43%
▪ wD = D/V = 1.1 / 5.1 = 21.57%
What is the WACC?
▪ WACC = .7843 x (15.35%) + .2157 x (4.712%) = 13.06%
14-38
Equity Information
50 million shares
$80 per share
Debt Information
$1 billion in outstanding debt
(FV)
Current price = $1100
RE = 15.35%; RD(1-TC) = 4.712%
Practice Question 8
Kelso’s has a debt-equity ratio of 0.55. The firm does not issue
preferred stock. The cost of equity is 14.5 percent and the cost of
debt is 8% and tax rate is 40%. What is the weighted average
cost of capital?
A. 10.46 percent
B. 10.67 percent
C. 11.06 percent
D. 11.38 percent
E. 12.19 percent
Answer – C
D/E=0.55; D=0.55; E=1; V=0.55+1=1.55
E/V =1 / 1.55 =64.52%;
D/V = 0.55 /1.55 =35.48%
WACC= (64.52%) (14.5%) + (35.48%) x 8% x (1-0.4)
= 11.06%
❑ How to estimate WACC
❑ First, Cost of Equity
❑ Go to Yahoo! Finance
to get information on Eastman Chemical (EMN)
◼ Under Profile and Key Statistics, you can find:
▪ # of shares outstanding; Price; Beta
◼ Under analysts estimates:
▪ estimates of earnings growth (g)
◼ The Bonds section : T-bill rate
❑ Use CAPM and DGM to estimate the cost of equity
14-40
Eastman Chemical (EMN)–
is an American Fortune 500 company, it
is a global chemical company with
Market cap about 13 billion
A Real Example
– WACC
Eastman Chemical (EMN) – Cost of Equity
Yahoo.finance
Summary of EMN
Price=85
Beta=1.24
D1=2.04
Find other information
under: statistics and
analysis (such as g,
D/E)
85
1.24
2.04 Forward dividend
EMN
2018-9-14
Estimate beta yourself
Eastman Chemical (EMN) – Cost of Equity
Growth
Estimates
EMN Industry Sector S&P 500
Current Qtr. 13.70% N/A N/A 0.34
Next Qtr. 12.10% N/A N/A 0.40
Current Year 10.90% N/A N/A 0.17
Next Year 8.80% N/A N/A 0.12
Next 5 Years
(per annum)
8.00% N/A N/A 0.12
Past 5 Years
(per annum)
4.06% N/A N/A N/A
g=8%
Eastman Chemical (EMN) – Cost of Equity
140 D/E=140%
(mrq-most recent Q)
Eastman Chemical – Cost of Equity
Use CAPM and DGM to estimate the cost of equity
(1) Use DGM:
RE= D1 / P0 + g
= 2.04/85 + 8%= 2.4%+ 8% =10.4%
(2) Use CAPM:
RE=riskfree +Beta*(RM – riskfree)
RE=1%+1.24* (14% – 1%)=17.12%
14-44
Price = $85
Beta = 1.24
g = 8%
D1= $2.04
Last 3 years, average market return was about 14% (market index, e.g.
S&P500), Risk-free rate 1% (3-month T bill)
Average these two = 13. 76%
Eastman Chemical (EMN) – Cost of Debt
14-45
Various websites for bond information:
▪ Government website: FINRA, or morningstar.com
▪ Bloomberg terminal
Enter “EMN” to find bond information
▪ Note that you may not be able to find information on all bond issues due to
the illiquidity of the bond market
7 bond issues currently outstanding
Do a weighted average YTM of all EMN bonds
Cost of debt = 3.29 %
Eastman Chemical (EMN) – WACC
Find the weighted average cost of the debt (WACC)
▪ Use market values if you were able to get the information
▪ Use the book values (only) if market information was not available
▪ They are often very close
Compute Eastman’s WACC (Assuming a tax rate of 35%)
14-46
WACC = 13.76% * 0.42 + 3.29% * (1-T) *0.58 = 7.02 %
Type Percentage
D/E ratio 140%
Debt 58%
Equity 42%
D/E = 140%
D=140; E=100
V= D + E =240
D/V=140/240 = 58%
E/V=100/240 = 42%
Cost of Equity= 13.76%; Cost of Debt = 3.29%; T=35%
find WACC
with just a
Name!
Chapter Outline
The Cost of Capital
The Weighted Average Cost of Capital (WACC)
Flotation Costs and the WACC
Divisional and Project Costs of Capital
14-47
Flotation Costs and WACC
If a company accepts a new project, it may be required to
issue, or float, new bonds and stocks. This means that the
firm will incur some costs, which we call flotation costs.
Flotation costs is NOT included in WACC (i.e. discount rate)
– included directly in the Initial Cost of a project.
Basic Approach
▪ Compute the weighted average flotation cost, use it to
adjust the overall initial cost properly
14-48
Example: Flotation costs
The Marcus company uses both debt and equity. The
firm’s target capital structure is 60 percent equity, 40
percent debt. The flotation costs associated with equity
are 10 percent and with debt are 5 percent.
The firm is contemplating a large-scale, $100 million
expansion of its existing operations, which will be
financed by issuing both debt and equity.
When flotation costs are considered, what is the cost of
the expansion?
Example: Flotation costs
First, the weighted average flotation cost, fA
fA= E/V * fE + D/V *fD
= 60% x 0.1 + 40% x 0.05 = 8%
Important principal –
▪ Although we may not know how much equity/debt the firm issued to get the
$100 mil.
▪ We should always use the target capital structure weights because the firm
will issue securities in target weights over the long term
▪ Target capital structure is 60% equity, 40% debt.
▪ The flotation costs of equity are10% and of debt are 5%.
▪ New project costs $100 million and will be financed by issuing both debt
and equity.
When flotation costs are considered, what is the cost of the expansion?
E=60%
D=40%
Example: Flotation costs
The weighted average flotation cost, fA
Incorporate flotation cost in the initial cost:
Amount raised excluding flotation costs = amount needed for the project
Amount raised x (1-8%) = 100 million
Total Amount raised = $100 million/(1 − 8%)
= $108.7 million.
fA= 8%
▪ Target capital structure is 60% equity, 40% debt.
▪ The flotation costs of equity are10% and of debt are 5%.
▪ New project costs $100 million and will be financed by issuing both debt
and equity.
When flotation costs are considered, what is the cost of the expansion?
Total amount raised including flotation
costs = the true cost of the project
FLOTATION COSTS AND NPV
Suppose the Tripleday Printing Company is currently at its target
debt−equity ratio of 100 %. It is considering building a new
$500,000 printing plant in Kansas. This new plant is expected to
generate aftertax cash flows of $73,150 per year forever. The tax
rate is 34 %. There are two financing options:
A $500,000 new issue of common stock: The issuance costs is 10
% of the amount raised. The required return on equity is 20 %.
A $500,000 issue of 30-year bonds: The issuance costs is 2 % of
the proceeds. The company can raise new debt at 10 %.
What is the NPV of the new printing plant?
FLOTATION COSTS AND NPV
What is the NPV of the new printing plant?
❑The company’s cost of capital:
WACC =50% x 20 + 50% x 10 x (1-0.34)
= 13.3%
❑ OCF= $73,150 per year forever:
PV of perpetuity = OCF / WACC
= $73,150/0.133=$550,000
❑If we ignore flotation costs, the project can
generate:
NPV=$550,000 – 500,000 = $50,000
❑ common stock: require
return = 20 %
❑ bonds: required return
= 10 %
❑ Tax rate = 34%
❑ D/E=1
❑ Initial cost = 500,000
FLOTATION COSTS AND NPV
What is the NPV of the new printing plant,
considering flotation costs?
Compute weighted average flotation cost:
The true cost (amount raised) including
flotation costs:
Amount raised (1-f)= $500,000
Amount raised = $500,000/(1 − fA)
= $500,000/.94 = $531,915.
With flotation costs, the project can generate:
NPV=$550,000 – 531,915 = $18,085
Without flotation costs,
NPV= $50,000
❑ common stock: The
issuance costs= 10 %
❑ bonds: The issuance
costs = 2 %
❑ D/E=1
❑ Initial cost = 500,000
❑ PV of CFs
=$73,150/0.133
=$550,000
%6%250.0%1050.0
)/()/(
=+=
+=
DEA
fVDfVEf
Divisional and Project Costs of Capital
We use WACC to value the entire firm
For an individual project, can we use
WACC of the firm?
▪ Yes, if it has the same risk as the firm’s
current operations
▪ If a project does NOT have the same risk as
the firm ➔ need to determine the
appropriate discount rate for that project
Same is true for different divisions –
company has more than one line of
business.
14-55
Entire Firm
WACC
(discount rate)
Division
(project)
Division
(project)
Cost of
capital
Cost of
capital
14-56
Moscow Travel agency
Smart Cougs !
Offers R=16%
βB=1.2
E(R)= 7% +1.2×8% = 16.6%
Offers R=14%
βA=0.6
E(R)= 7% +0.6×8% =11.8%
Rf = 7%
RM – Rf=8%
• 14% >11.8%, positive α, Accept! • 16% < 16.6%, negative α, Reject!
Pullman Ice Cream & Deli
14-57
Moscow Travel agency
Smart Cougs !
Offers R=16%
negative α & NPV
Offers R=14%
Positive α &NPV
❑Wrong decision!
Using WACC for all projects without
considering risk:
Accept risky projects
Reject less risky but profitable projects
❑if the company does this on a
consistent basis
The firm will become riskier.
The overall WACC will increase!Cutoff
=15%
Pullman Ice Cream & DeliWACC=15%
Solutions? – The Pure Play Approach
Pure Play Approach
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From this example, we learn:
❑ Estimate cost of capital for individual project (based on
risk) is important!
❑ However, in this example, Beta is given:
▪ ICE Cream Beta =0.6; Travel agency Beta = 1.2
❑ But, how do we get these?
▪ The company has not started the projects yet? – No
data/information
Solutions? – The Pure Play Approach
Find pure play companies
– companies that specialize in the product or service that we are
considering
Use beta & CAPM to find the appropriate required rate of
return for each pure play company
◼ use for the project we’re considering
◼ Assumption – the project has the same risk as the pure play
company
Disadvantage – Often difficult to find pure play companies
◼ need to find companies that focus as exclusively as possible on
the type of project in which we are interested.
14-59
Solutions? – Subjective Approach
Subjective approach:
Consider the project’s risk relative to the firm
overall risk
◼ If the project risk > the firm, use a discount rate
greater than the WACC
◼ If the project risk < the firm, use a discount rate
less than the WACC
14-60
Example – Subjective Approach
Category Examples
Adjustment
Factor
Discount Rate
High risk New products +6% 20%
Moderate risk
Expansion of existing
lines, cost savings
+0 14%
Low risk
Replacement of existing
equipment
−4% 10%
WACC of the firm = 14%
Which one to choose if using WACC=14%?
Which one to choose if putting them into
proper risk categories?
B
A
A =12%
B =16%
Correct decision!
Example – Subjective Approach
Category Examples
Adjustment
Factor
Discount Rate
High risk New products +6% 20%
Moderate risk
Expansion of existing
lines, cost savings
+0 14%
Low risk
Replacement of existing
equipment
−4% 10%
WACC of the firm = 14%
Summary:
❑Not as precise as CAPM – do not compute the exact E(R)
❑But the error rate should be lower than not considering subjective
approach at all – especially useful when it’s hard to find pure play
companies