1. NPV CRITERION FOR CAPITAL EXPENDITURE ANALYSIS èDiscount incremental after-tax cash flows at the cost of capital èe.g., if initial investment = 100, cash flow in years 1 and 2 = 70, cost of capital = 10%, NPV = -100 + 70/(1.1) + 70/(1.1) 2 = 21.49 èSince NPV > 0, project is worthwhile

2. NPV AND SHAREHOLDER WEALTH èFirm has no debt èExisting assets generate cash flows of 100 per year forever èDiscount rate = 10% èFirm has 20 mil shares currently selling at $50 per share

3. NPV AND S/H WEALTH (CONT.) èNow firm plans to invest $120 in new project èProject will generate $20 CF per year forever èFirm will issue  n new shares at price P* to finance project

4. NPV AND S/H WEALTH (CONT.) èEquating sides of post-project bal. sheet: 100/.10 + 20/.10 = 20P* +  nP* èBut from original bal. Sheet: 100/.10 = 20x50 = nP èAnd since we need to raise 120 for project: 120 =  nP* èThus: 20x50 +20/.10 = 20P* + 120

5. NPV AND S/H WEALTH (CONT.) èRearranging: 20/.10 - 120 = 20 x (P* - 50) èOr: [20/.10 - 120]/20 = (P* - 50) èOr:     NPV per share = change in wealth for original shareholders    

6. COST OF CAPITAL What is it? èAppropriate discount rate èMinimum acceptable rate of return for investors èInvestors’ opportunity cost èRequired compensation for risk borne by investors

7. COST OF CAPITAL (all-equity financing) What rate of return will shareholders demand? Two possible answers from stock market: èCapital Asset Pricing Model r E = r f +  (r M - r f ) (shareholders demand compensation for systematic risk) èDividend Discount Model r E = D 1 /P 0 + g

8. COST OF CAPITAL (with debt and equity) E = equity mkt. value ATOCF = after-tax operating cash flow r D = cost of debt r E = cost of equity D = value of debt T = corporate tax rate

9. COST OF CAPITAL (debt and equity cont.) Cross-multiplying by V, we derive a discount rate for the company as a whole Note that debt ratio is measured at market value

10. COST OF CAPITAL FOR A PROJECT èFor a project, the cost of capital is project specific, not company-specific (Would a risky project be any less risky if undertaken by a currently safe company?) èCost of capital should reflect business risk of this project èCost of capital should reflect long-run financing mix for this project