1. (c) 2001 Contemporary Engineering Economics 1 Chapter 16 Capital Budgeting Decisions Methods of Financing Cost of Capital Choice of Minimum Attractive Rate of Return Capital Budgeting

2. (c) 2001 Contemporary Engineering Economics 2 Methods of Financing Equity Financing – Capital is coming from either retained earnings or funds raised from an issuance of stock Debt Financing – Money raised through loans or by an issuance of bonds Capital Structure – Well managed firms establish a target capital structure and strive to maintain the debt ratio

3. (c) 2001 Contemporary Engineering Economics 3 Equity Financing Flotation (discount) Costs: the expenses associated with issuing stock Types of Equity Financing: –Retained earnings –Common stock Retained earnings Preferred stock Common stock + +

4. (c) 2001 Contemporary Engineering Economics 4 Floatation Cost Issue: Raise net $10 million Stock price: $28 per share Floatation cost: 6% of stock price Question: How many shares to issue? (0.06)($28)(X) = 1.68X Sales proceeds – flotation cost = Net proceeds 28X – 1.68X = $10,000,000 26.32X = $10,000,000 X = 379,940 shares. 1.68(379,940) = $638,300

5. (c) 2001 Contemporary Engineering Economics 5 Debt Financing Bond Financing: –Incur floatation cost –No partial payment of principal –Only interest is paid each year (or semi-annually) –The principal (face value) is paid in a lump sum when the bond matures Term Loan: –Involve an equal repayment arrangement. –May incur origination fee –Terms negotiated directly between the borrowing company and a financial institution Bond Financing Term Loans +

6. (c) 2001 Contemporary Engineering Economics 6 Bond Financing (Example 16.2) (a)To net $10 million, SSI would have to sell $10,000,000/(1- 0.018) = $10,183,300 worth of bonds and pay $183,300 in flotation costs. Since the $1,000 bond would be sold at a 1.5% discount, the total number of bonds to be sold would be $10,183,300/($985) = 10,338.38. (b) For the bond financing, the annual interest is equal to $10,338,380 (0.12) = $1,240,606 Only the interest is paid each period, and thus the principal amount owed remains unchanged.

7. (c) 2001 Contemporary Engineering Economics 7 Cost of Capital Cost of Equity (i e ) – Opportunity cost associated with using shareholders’ capital Cost of Debt (i d ) – Cost associated with borrowing capital from creditors Cost of Capital (k) – Weighted average of i e and i d Cost of Equity Cost of Debt Cost of Capital

8. (c) 2001 Contemporary Engineering Economics 8 Cost of Equity Cost of Retained Earnings (k r ) Cost of issuing New Common Stock(k e ) Cost of Preferred Stock (k p ) Cost of equity: weighted average of k r k e, and k p

9. (c) 2001 Contemporary Engineering Economics 9 Issuing New Common Stock Cost of Preferred Stock Cost of Equity Cost of Retained Earnings Calculating Cost of Equity Where C r = amount of equity financed from retained earnings, C c = amount of equity financed from issuing new stock, C p = amount of equity financed from issuing preferred stock, and C e = C r + C c + C p

10. (c) 2001 Contemporary Engineering Economics 10 Example 16.4 Determining the Cost of Equity SourceAmountFraction of Total Equity Retained earnings $1 million0.167 New common stock 4 million0.666 Preferred stock1 million0.167

11. (c) 2001 Contemporary Engineering Economics 11 Cost of retained earnings: With D 1 = $5, g = 8%, and P 0 = $40 Cost of new common stock: With D 1 = $5, g = 8%, and f c = 12.4% Cost of preferred stock: With D*= $9, P*= 8%, and f c = 0.06 Cost of equity:

12. (c) 2001 Contemporary Engineering Economics 12 Cost of Debt

13. (c) 2001 Contemporary Engineering Economics 13 Example 16.5 Determining the Cost of Debt SourceAmountFractionInterest Rate Flotation Cost Term loan$1 million0.33312% per year Bonds3 million0.66710% per year6% Solution

14. (c) 2001 Contemporary Engineering Economics 14 The Cost of Capital C d = Total debt capital(such as bonds) in dollars, C e =Total equity capital in dollars, V = C d + C e, i e = Average equity interest rate per period considering all equity sources, i d = After-tax average borrowing interest rate per period considering all debt sources, and k = Tax-adjusted weighted-average cost of capital.

15. (c) 2001 Contemporary Engineering Economics 15 Marginal Cost of Capital (Example 16.6) Given: C d = $4 million, C e = $6 million, V= $10 millions, i d = 6.92%, i e =19.96% Find: k l Comments: This 14.74% would be the marginal cost of capital that a company with this financial structure would expect to pay to raise $10 million.

16. (c) 2001 Contemporary Engineering Economics 16 Choice of MARR Choice of MARR when Project Financing is Known Choice of MARR when Project Financing is Unknown Choice of MARR under Capital Rationing

17. (c) 2001 Contemporary Engineering Economics 17 Choice of MARR when Project Financing is Known When you find the Net present worth of the project, use cost of equity (i e ) as the discount rate. Explicit accounts For debt flows

18. (c) 2001 Contemporary Engineering Economics 18 Choice of MARR when Project Financing is Unknown Without explicitly treating the debt flows, make a tax adjustment to the discount rate, using the weighted cost of capital k.

19. (c) 2001 Contemporary Engineering Economics 19 Choice of MARR as a Function of Budget ProjectAOAO Cash Flow A1IRR 1-$10,000$12,00020% 2-10,00011,50015 3-10,00011,00010 4-10,00010,8008 5-10,00010,7007 6-10,00010,4004 Borrowing rate (k) = 10% Lending rate (r) = 6%

20. (c) 2001 Contemporary Engineering Economics 20 An Investment Opportunity Schedule 24 22 20 18 16 14 12 10 8 6 4 2 0$20,000$40,000$60,000 20%15%10%8%7% 4% Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Required capital budget Rate of return (%)

21. (c) 2001 Contemporary Engineering Economics 21 A Choice of MARR under Capital Rationing 24 22 20 18 16 14 12 10 8 6 4 2 0$20,000$40,000$60,000 20%15%10%8% 7% 4% Project 1 Project 2 Project 3 Project 4 Project 5Project 6 Required capital budget Rate of return (%) k = 10% r = 6% MARR Borrowing rate (k) = 10% Lending rate (r) = 6%

22. (c) 2001 Contemporary Engineering Economics 22 Capital Budgeting Evaluation of Multiple Investment Alternatives –Independent projects –Dependent projects Capital Budgeting Decisions with Limited Budgets

23. (c) 2001 Contemporary Engineering Economics 23 Independent Projects AlternativeDescriptionXaXa XbXb 1Reject A, Reject B 00 2Accept A, Reject B 10 3Reject A, Accept B 01 4Accept A, Accept B 11

24. (c) 2001 Contemporary Engineering Economics 24 Mutually Exclusive Projects Alternative(X A1, X A2 )(X B1,X B2 ) 1(0,0) 2(1,0)(0,0) 3(0,1)(0,0) 4 (1,0) 5(0,0)(0,1) 6(1,0) 7(0,1)(1,0) 8 (0,1) 9

25. (c) 2001 Contemporary Engineering Economics 25 Contingent Projects AlternativeXAXA XBXB XCXC 1000 2100 3110 4111

26. (c) 2001 Contemporary Engineering Economics 26 Four Energy Saving Projects under Budget Constraints (Budget Limit = $250,000) ProjectInvestmentAnnual O&M Cost Annual Savings (Energy) Annual Savings (Dollars) IRR 1$46,800$1,200151,000 kWh $11,77815.43% 2104,8501,050513,077 kWh 40,02033.48% 3135,4801,3506,700,000 CF 32,49315.95% 494,230942385,962 kWh 30,10534.40%

27. (c) 2001 Contemporary Engineering Economics 27 Marginal Cost of Capital Schedule (MCC) and Investment Opportunity Schedule (OSC)

28. (c) 2001 Contemporary Engineering Economics 28 Optimal Capital Budget

29. (c) 2001 Contemporary Engineering Economics 29 Infeasible alternatives Best Alt. jAlternativeRequired BudgetCombined Annual Savings 1000 2A1$(46,800$10,578 3A2(104,850)38,970 4A3(135,480)31,143 5A4(94,230)35,691 6A4, A1(141,030)46,269 7A2, A1(151,650)49,548 8A3, A1(182,280)41,721 9A4, A2(199,080)74,661 10A4, A3(229,710)66,834 11A2, A3(240,330)70,113 12A4, A2, A1(245,880)85,239 13A4, A3, A1(276,510)77,412 14A2, A3, A1(287,130)80,691 15A4, A2, A3(334,560)105,804 16A4, A2, A3, A1(381,360)116,382

30. (c) 2001 Contemporary Engineering Economics 30 Summary Methods of financing: 1. Equity financing uses retained earnings or funds raised from an issuance of stock to finance a capital. 2. Debt financing uses money raised through loans or by an issuance of bonds to finance a capital investment. Companies do not simply borrow funds to finance projects. Well-managed firms usually establish a target capital structure and strive to maintain the debt ratio when individual projects are financed.

31. (c) 2001 Contemporary Engineering Economics 31 The selection of an appropriate MARR depends generally upon the cost of capital—the rate the firm must pay to various sources for the use of capital. 1. The cost of equity (i e ) is used when debt- financing methods and repayment schedules are known explicitly. 2. The cost of capital (k) is used when exact financing methods are unknown, but a firm keeps it capital structure on target. In this situation, a project’s after-tax cash flows contain no debt cash flows such as principal and interest payment

32. (c) 2001 Contemporary Engineering Economics 32 The cost of the capital formula is a composite index reflecting the cost of funds raised from different sources. The formula is The marginal cost of capital is defined as the cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised during a given period.

33. (c) 2001 Contemporary Engineering Economics 33 Under conditions of capital rationing, the selection of MARR is more difficult, but generally the following possibilities exist : ConditionsMARR A firm borrows some capital from lending institutions at the borrowing rate, k, and some from its investment pool at the lending rate, r. r <MARR< k A firm borrows all capital from lending institutions at the borrowing rate, k. MARR = k A firm borrows all capital from its investment pool at the lending rate, r. MARR = r

34. (c) 2001 Contemporary Engineering Economics 34 The cost of capital used in the capital budgeting process is determined at the intersection of the IOS and MCC schedules. If the cost of capital at the intersection is used, then the firm will make correct accept/reject decisions, and its level of financing and investment will be optimal. This view assumes that the firm can invest and borrow at the rate where the two curves intersect.

35. (c) 2001 Contemporary Engineering Economics 35 If a strict budget is placed in a capital budgeting problem and no projects can be taken in part, all feasible investment decision scenarios need to be enumerated. Depending upon each investment scenario, the cost of capital will also likely change. Our task is to find the best investment scenario in light of a changing cost of capital environment. As the number of projects to consider increases, we may eventually resort to a more advanced technique, such as a mathematical programming procedure.