BA 280.2_Cost of Capital

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  10/09/20191 Cost of Capital Review: Capital Budgeting ãInvest on a project Initial Outlay ãInc Revenue ãInc Expenses  Annual Cash Flows ãAll cash flows discounted using the hurdle rate Net Present Value of the Project  10/09/20192 Linking Investment and Financing ãFind good projects ãEvaluate them by doing capital budgetingãOUTPUT: IRR Where to invest? ãWill I fund them on my own? (EQUITY)ãWill I borrow from someone else? (DEBT)ãOUTPUT: Capital Structure How to fund them? ãIs the project worth it, given the sources of funding?ãOUTPUT: GO/NO GO DECISIONãCOMPARE: IRR vs HURDLE RATE? ãWHAT IS THE HURDLE RATE? Will the project be viable, given funding source? Cost of Capital ãIt is the opportunity cost of capital  –the required return investors expect to earn if they invest in assets, securities, projects of similar risk –In capital budgeting, the cost of capital is used as the discount rate in getting the present values of cash flows –In asset valuation, it is the discount rate used in getting the present values of cash flows related to equity and debt securities  10/09/20193 The Cost of Capital ãRate of return required by investors and financiers of a business.  –Investors who gave equity  –Creditors who gave loans ãDiscount rate or hurdle rate in capital budgeting (the corporate investment decision)ãA key criterion in capital structure (the financing decision) Risk-Return Trade-Off  ãInvestors won’t take on additional risk unless compensated by an additional return  10/09/20194 Determinants of Cost of Capital ãEconomic conditionsãNature of the BusinessãCompany’s Operating StrategyãFinancing Strategy  –Source of capital –Amount Discount Rate ãRequired Rate of Return  –Time value of money –Expected Rate of Inflation –Risk Involved
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