1. The Cost of Capital
The Cost of Capital is the capital budgeting project’s required return.
It is the opportunity cost of investing those funds in the project.
It is the rate of return at which investors are willing to provide financing for the project today. It is based on current market conditions.
It reflects the risk of the project.
The Cost of Capital is NOT the historical cost of funds.

2. Corporate Valuation
The market value of the firm (or simply, firm value) can be viewed in two ways:
Firm value equals the sum of the market values of the claims on the firm’s assets.
Firm value equals the sum of the market values of its assets.
These two views are simply the balance-sheet accounting identity, but in current market values:
Assets = Liabs + O.E.

3. The Market Line for Capital Budgeting Projects
The Capital Asset Pricing Model (CAPM) can be used to obtain the cost of capital for a capital budgeting project.
rj = rf + bj(rm – rf)
where
rj = cost of capital for project j,
rf = riskless return
rm = required return on the market portfolio
bj = beta of project j

4. Using the Project Market Line
A capital budgeting project costs $2,300, and expects to return $410 per year in perpetuity. If rf = 7%, rm = 14%, and j = 1.3, what is the project’s NPV?
rj = rf + j(rm - rf) = (14 – 7) = 16.1%
NPV = 410/0.161 – 2,300 = $246.58

5. Leverage
According to the CAPM, the required return depends only on the non-diversifiable risk.
The non-diversifiable risk borne by shareholders can be split into two parts:
Operating (business) Risk
Financial Risk
Operating risk results in operating leverage.
Financial risk results in financial leverage.
Financial leverage is moving along the CML—lending or borrowing.

6. Operating Leverage
Operating leverage arises from the mix of fixed versus variable costs of production.
High fixed costs (and correspondingly lower variable costs per unit) results in high operating leverage.
The firm’s profits are more sensitive to changes in sales.
Conversely, low fixed costs (and correspondingly higher variable costs per unit) result in low operating leverage.

7. Variable Cost (per unit)
Operating Leverage
Jewel Plastics, Inc., plans to make plastic jewel cases for CD-ROM disks. Each packet of 10 cases can be sold for $5.00. Two alternative manufacturing technologies are available.
Plan A
Plan B
Annual Fixed Costs
60,000
$100,000
Variable Cost (per unit)
$2.00
$1.00
Ignoring taxes, compute the profits under each plan.

8. (Unit Sales) (Selling Price – Variable Costs) – Fixed Costs
Operating Leverage
Profit = Sales – Costs
(Unit Sales) (Selling Price – Variable Costs) – Fixed Costs
At a sales level of 50,000 units, the profits under plan A are:
50,000 ($5.00 – $2.00) – $60,000 = $90,000.
Under Plan B, profits at a sales level of 50,000 units are $100,000.

9. Financial Leverage
The presence of fixed costs associated with debt financing results in financial leverage.
As financial leverage increases, the variability of shareholder returns increases.
This increases shareholder’s risk.
We’ve seen financial leverage before, Borrowing to move up the CML.

10. The Weighted Average Cost of Capital
The Weighted Average Cost of Capital, WACC, is the weighted average rate of return required by the suppliers of capital for the firm’s investment project.
The suppliers of capital will demand a rate of return that compensates them for the proportional risk they bear by investing in the project.

11. Components of a Financing Package
Consider the case where a project will be financed with 40% debt and 60% equity.
Suppose the project requires an initial investment of $8,000 and has a NPV of $2,000.
The TOTAL value of the project is thus $10,000.
How much debt should the firm use?
(0.40) 10,000 = $4,000.

12. Components of a Financing Package
Since the project requires an initial investment of $8,000, the firm will raise the remaining $4,000 by selling stock.
Since the total value of the project is $10,000, the stock will be worth $6,000.
In perfect markets, ALL of the benefits from a project (the project’s NPV) goes to the shareholders.

13. WACC Calculation
Let L = the ratio of debt financing to total financing,
re = required return for equity,
rd = required return on debt, and
T = marginal corporate tax rate on income from the project.
Then,

14. WACC Calculation
Compute the WACC for the Nikko Co. given the following information:
Nikko has 9 million common shares outstanding priced at $13.00 each. Next year’s dividend on these shares is expected to be $1.33, and will grow at 5% per year forever. Nikko has 60,000 bonds outstanding, each with a coupon rate of 11% and are priced at $1,050 each to yield 10% to bondholders. Nikko’s marginal corporate income tax rate is 34%.

15. WACC Calculation Market value of Nikko’s equity =
9 million × $13.00 per share = $117 million.
Market value of Nikko’s debt =
60,000 × $1,050 per bond = $63 million.
Total market value of Nikko =
$117 million + $63 million = $180 million.
Proportion of debt financing used by Nikko =
L = $63 M / $180
L = 35%

16. WACC Calculation
To compute the rate of return required by Nikko’s stockholders, we use the constant growth model of stock valuation. r D P g e = + 1 33 00 05 15
25% $1 .
$13

17. WACC Calculation
Because we are interested in measuring the firm’s current cost of capital, we use the bond yield currently demanded by the bondholders.
Thus, rd = 10%.
Also, the tax rate, T, is 34%.

18. WACC Calculation

19. Perfect Market View of Capital Structure
$2,000 Equity
$1,000
Equity
$1,000
Debt
Unleveraged Firm
Leveraged Firm
VU = $2,000
VL = $2,000

20. Shareholder’s Required Return in Perfect Markets
At 10%, MFI’s annual interest expense is $100.
The annual expected cash flow to its shareholders is $300 – $100 or $200.
Since the equity is worth $1,000, the rate of return required by the shareholders is 20%:
$1,000 = $200/0.20
With leverage, equity is riskier and the shareholder’s required rate of return increases.

21. Leverage Ratio The leverage ratio, (L) is: value firm total debt of ue
Market val = L = $1 , $2 .
000 50
50% or

22. WACC and Capital Structure in Perfect Markets
The weighted average cost of capital is 15%:
WACC = (1 – L)re + L rd
= (1 – 0.5)×(0.20) + 0.5×0.10
=15%

23. Dividend Policy in Practice
Preference for paying common dividends
Smaller and younger firms
Mature firms
Stability of Dividends
Dividends are more stable from year to year than are earnings.
They follow the trend in cash flow more closely.

24. Dividend Policy in Practice
Regular decisions
Review dividend policy at least annually, and at about the same time each year.
Regular payments
Quarterly payments most common.
Annual, semi-annual, and monthly payments are less common.

25. Dividend Policy in Practice
Reluctance to cut dividends
Dividend cut is interpreted as a negative signal.
Extra or special dividends
Paid during periods of temporarily high earnings.
Generally occur at the end of the fiscal year.

26. Industry Differences in Dividend Policy
Investment opportunities are comparable within an industry, but vary across industries.
Firm-specific information must be taken into account.

27. Dividend Payment Mechanics
Dividends are declared by the board of directors:
amount of dividend
record date
payment date
The ex-dividend date is two business days prior to the record date.

28. Dividend Payment Mechanics
On Tuesday, October 15, 2002, General Supply Co. announced a dividend of $0.36 per share payable to shareholders of record as of Thursday, November 7, The dividend would be paid on Monday, December 9, 2002.
What is the ex-dividend day?
What happens to the stock price on this day?

29. Dividend Payment Mechanics
The ex-dividend day is 2 business days prior to the ex-dividend day.
Tuesday, November 5, 2002.
Suppose General Supply’s stock closed at $20 on Monday, November 4, 2002.
The stock would open ex-dividend on Tuesday, November 5, 2002 at about $19.64 = $20 – $0.36

30. Dividend Payment Mechanics
Declaration Date
Ex-Dividend Date
Record Date
Payment Date
December 9, 2002
November 5, 2002
October 15, 2002
November 7, 2002 …

31. Dividend Policy Guidelines
Project future residual funds.
Earnings and cash flow projections for the next few years.
Include depreciation generated funds.
Deduct capital expenditures.
Determine an appropriate target payout ratio.
Range of payout ratios.
Set the quarterly dividend.
Evaluate alternative dividend policies.

32. Stock Dividends
A stock dividend proportionately increases the number of shares each shareholder owns.
A 10% stock dividend:
Increases total number of shares outstanding by 10%.
Increases each shareholders holdings by 10%.
If a shareholder own 50 shares before the dividend, she owns 55 shares after the stock dividend is paid.

33. Stock Splits
A stock split alters the par value of the shares but there is no transfer of balances between the equity accounts.
The total number of shares outstanding increases.
In a 3-for-2 stock split, 3 new shares are issued for every 2 pre-split shares outstanding.
Thus, there is a 50% increase in the number of shares outstanding.