MANAGERIAL ECONOMICS

An Analysis of Business Issues

Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall

Chapter 17:

Investment Decisions and

the Cost of Capital
Objectives:
After studying the chapter, you should
understand:
1. the concepts of capital budgeting and cost of
capital
2. some simple techniques for the appraisal of
investments
3. some financial models used to estimate the cost
of capital
2

Capital
Capital and
and Capital
Capital Budgeting
Budgeting
Capital:
is the stock of assets that will generate a
flow of income in the future.
Capital budgeting:
is the planning process for allocating all
expenditures that will have an expected
benefit to the firm for more than one year.
3

Investment
InvestmentAppraisal
Appraisal
Firms normally place projects in the following
categories:
1. Replacement and maintenance of old or damaged
equipment.
2. Investments to upgrade or replace existing
equipment
3. Marketing investments to expand product lines or
distribution facilities.
4. Investments for complying with government or
insurance-company safety or environmental
requirements.
4

Question
Question for
for Discussion:
Discussion:
What
What are
are the
the factors
factors you
you would
would consider
considerwhen
when
making
making aa choice
choice among
among different
different investment
investment
projects?
projects?
1.
1.
2.
2.
3.
3.
4.
4.
5

Simple Technique
Technique for
forAppraisal
Appraisal of
of
Simple
Investment
Investment
Payback-period
Payback-period criterion:
criterion:
Payback
Payback period
period isis the
the amount
amount of
of time
time
sufficient
sufficient to
to cover
coverthe
the initial
initial cost
cost of
of an
an
investment
investment
But
But itit ignores
ignores any
any returns
returns accrue
accrue after
after the
the
pay-back
pay-back period;
period; ignores
ignores the
the pattern
pattern of
of
returns;
returns; ignores
ignores the
the time
time value
value (time
(time cost)
cost)
of
of money.
money.
6

Example:
Initial investment:
Cash flow:

$10 million
$2 million per year

Payback-period?

If cash flow :

$4 million per year

Payback-period?

Discounting
Discounting
On the
the other
otherhand,
hand, the
the process
process of
of discounting
discounting
On
orcapitalization
capitalization isis to
to turn
turn aa future
future stream
stream of
of
or
services or
orincome
income into
into its
its equivalent
equivalent present
present
services
value. When
When an
an expected
expected future
future sum
sum isis turned
turned
value.
into its
its equivalent
equivalent present
present value,
value, we
we say
say that
that itit
into
discounted or
orcapitalized.
capitalized.
isis discounted

The
Thepresent
presentvalue
valueof
ofaasingle
singlefuture
futureamount
amount
In general, present value (PV) refers to the value
now of payments to be received in the future (I). The
present value of I after n year at r is:
I
PV= (1+r)n

Suppose we try to find the present value of a

single future amount of $121, to be received
after two years. Since goods available in the
future are worth less than the same goods
available now, the future amount of $121 is
worth less than $121 at present. Given the
market rate of interest of 10%, its present
value is:
$121

(1+0.1)2

= $100

This means that the future amount of $121 (to

be received after two years) is equivalent to a
value of $100 at present.
10

Simple Technique
Technique for
forAppraisal
Appraisal of
of
Simple
Investment
Investment
Net-present-value
Net-present-value technique:
technique:
Net
Net present
present value
value (NPV)
(NPV) isis the
the difference
difference
between
between the
the present
present value
value of
of aa future
future cash
cash
flow
flow and
and the
the initial
initial cost
cost of
of the
the investment
investment
project;
project; aa firm
firm should
should adopt
adopt aa project
project ifif the
the
expected
expected NPV
NPV isis positive.
positive.

11

I1
I2
In
NPV = -P + I0 +
++
+
2
(1+r) (1+r)
(1+r)n

or

I
NPV = -P +
r
where:
P:

=capital cost, accruing in full at the

beginning of the project

I1,2,n =net cash flows arising from the project

in years 1 to n
r

=the opportunity cost of capital

12

Simple
SimpleTechnique
Techniquefor
forAppraisal
Appraisalof
of
Investment
Investment
Internal-rate-of-return
Internal-rate-of-return method:
method:
Internal
Internal rate
rate of
of return
return (IRR)
(IRR) isis the
the rate
rate of
of
return
return that
that will
will equate
equate the
the present
present value
value of
of
aa multi-year
multi-yearcash
cash flow
flow with
with the
the cost
cost of
of
investing
investing in
in aa project.
project.
Using
Using the
the NPV
NPV equation:
equation: the
the IRR
IRR isis the
the
discount
discount rate
rate that
that renders
renders the
the NPV
NPVof
of the
the
project
project equal
equal to
to zero.
zero.

13

P,
P,nn and
and the
the expected
expected future
future cash
cash returns
returns (I)
(I) are
are
known,
known, we
we try
try to
to find
find IRR.
IRR.
If
If the
the IRR
IRR isis greater
greaterthan
than the
the market
market rate
rate of
of
interest
interest r,r,itit implies
implies that
that the
the present
present value
value of
of the
the
capital
capital good
good (PV)
(PV) isis greater
greaterthan
than its
its purchase
purchase
price
price (P)
(P) and
and the
the firm
firm should
should invest.
invest. Conversely,
Conversely,
ifif IRR
IRR isis smaller
smaller than
than r,r,itit implies
implies that
that PV
PVisis
smaller
smaller than
than PPand
and the
the firm
firm should
should not
not invest.
invest.
What are the differences between NPV
technique and IRR method?
14

In
In most
most situations,
situations, the
the IRR
IRR method
method will
will yield
yield
the
the same
same results
results as
as the
the NPV
NPVmethod.
method. But:
But:
there
theremay
maybe
bemore
morethan
thanone
onevalue
valuefor
forthe
theIRR
IRRthat
that
satisfies
satisfiesthe
theNPV
NPVequation;
equation;ififthe
thesign
signof
ofcash
cashflows
flows
changes
changesmore
morethan
thanonce
oncein
inthe
thelife
lifeof
ofthe
theproject,
project,there
there
may
maybe
bemultiple
multiplesolutions
solutions
the
theNPV
NPVrule
ruleuses
usesactual
actualopportunity
opportunitycost
costof
ofcapital
capital
as
asthe
thediscount
discountrate;
rate;the
theIRR
IRRrule
ruleassumes
assumesthe
the
shareholders
shareholderscan
caninvest
investat
atthe
theIRR
IRR
IRR
IRRisisexpressed
expressedin
interms
termsof
ofaapercentage
percentagerate
rateof
of
return,
return,ititignores
ignoresthe
theprojects
projectsabsolute
absoluteeffect
effecton
onthe
the
wealth
wealthof
ofshareholders
shareholders
15

The
The Cost
Cost of
of Capital
Capital
A
Afirm
firm will
will invest
invest only
only ifif the
the expected
expected rate
rate
of
of return
return exceeds
exceeds the
the cost
cost of
of capital.
capital. For
Foraa
firm
firm under
underrate-of-return
rate-of-return regulation,
regulation, ifif the
the
permitted
permitted rate
rate of
of return
return isis set
set above
above the
the
cost
cost of
of capital
capital (or
(orthe
the required
required rate
rate of
of
return),
return), the
the firm
firm will
will over-invest;
over-invest;
conversely,
conversely,ifif the
the permitted
permitted rate
rate isis set
set
below
below the
the cost
cost of
of capital,
capital, the
the firm
firm will
will
under-invest.
under-invest.
16

Weighted
Weighted Average
Average Cost
Cost of
of Capital
Capital (WACC):
(WACC):
Cost of debt (rd): interest rate paid to creditors net of
taxes
Cost of equity (re): rate of return to shareholders in
order to induce them to invest in the firm
WACC : rd

D
(D + E)

+ re

E
(D + E)
17

The
The Modigliani-Miller
Modigliani-Miller (M-M)
(M-M)
Proposition
Proposition
Assumptions:
there are no taxes
the capital market is efficient and competitive
there are no transaction costs
there are no costs associated with bankruptcy
shareholders can borrow on the same terms as
corporations
the cost of debt is constant, whatever the level of
gearing
18

The
The Modigliani-Miller
Modigliani-Miller (M-M)
(M-M)
Proposition
Proposition
If the assumptions hold, the total market value of two
firms that are identical except for their levels of
gearing must be the same, and their WACCs must be
the same
If they were not the same, investors could improve
their position by arbitrage, selling the shares of one
and buying shares in the other, which would alter the
relative prices of shars until the WACCs become equal
The level of gearing is therefore irrelevant to the
WACC and the value of the firm

19

The
The Cost
Cost of
of Equity
Equity Capital
Capital
1. Dividend valuation approach DVA
(or dividend growth/discounted cash flow model):

Rate of return = Dividend/Price + Expected

growth rate
D1
re =
+g
P0
The DVA relies on the equivalence of the market
price of a stock, P0, with the present value of the
dividends ( or cash flows) expected from the
stock. The discount rate in finding the present
value is considered to be the cost of equity capital.
20

Assumptions
Assumptions
There are few assumptions behind the method:
(a) future dividends are expected to grow at a
constant rate perpetually;
(b) future dividends can be discounted at a
constant cost of equity capital;
(c) future dividends remain a constant
proportion of earnings over time;
(d) the firm is an all-equity-financed firm, or it
has a constant level of leverage (or a constant
debt-equity ratio).
21

DVA:

expected dividend

D1
D2
D3
PV= (1 + r) + (1 + r)2 + (1 + r)3

+ ...

discounted rate, cost of equity capital

Dt
PV= [
]
t
(1 + r)
Assume D1 grows at constant rate of g:
D1
D1(1+g)
D1(1+g)2
+
+ ...
PV= (1 + r) +
(1 + r)2
(1 + r)3
22

D1
Let A = (1 + r)

(1 + g)
Let B = (1 + r)

PV = A(1 + B + B2 + )

(1)

B on both sides:
PV B = A(B + B2 + B3 + )
(2) - (1):
PV(1 - B) = A
A
PV =
(1 - B)
D1
(1 + r)
PV = (1 + r)
(r - g)
Given PV = P0
D1
r= P +g
0

(2)
1-B
= 1 - (1 + g)
(1 + r)
(1+r) -(1 + g)
=
(1 + r)
(r - g)
=
(1 + r)
D1 = D0 (1 + g)

23

The
The Cost
Cost of
of Equity
Equity Capital
Capital
2. Capital asset pricing model (CAPM):
Cost of equity capital = risk-free rate +
beta (market rate - riskfree rate)
Re = Rf + (Rm - Rf)
Therefore, if we use the CAPM to estimate a
firms cost of equity capital (Re, or the required
rate of return), we have to estimate a firms beta,
the risk-free rate of return, and the market risk
premium (the difference between Rm and Rf).
24

In the CAPM, the measure of market risk is

known as beta ().
For example, the returns from an asset with a beta
of 0.5 will fluctuate by 5% for each 10%
fluctuation in the markets returns.
It has been shown that the required risk premium
for an asset is directly proportional to its beta.
Therefore, the holder of an asset with a beta of 0.5
will require a risk premium only half as large as
that offered by the market as a whole.
If the market is efficient, the cost of equity capital
will be equal to the expected rate of return.
25