This website uses cookies to ensure you have the best experience. Learn more

Cost Of Capital Paper

3556 words - 15 pages

Capital Budgeting Techniques | |

Capital Budget:  (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.).  Also, (2) a request for authorization to purchase new fixed assets.
Mutually Exclusive Proposals:  Consideration of two or more assets that perform the same function.  If one is chosen for purchase, the others are automatically rejected.
Profitability Index:  A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC).  The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs.

As the picture above illustrates, the ...view middle of the document...

  The better methods use time value of money concepts.  Older methods, like the payback period, have the deficiency of not using time value techniques and will eventually fall by the wayside and are replaced in companies by the newer, superior methods of evaluation.
Very Important:  A capital budgeting analysis conducts a test to see if the benefits (i.e., cash inflows) are large enough to repay the company for three things:  (1) the cost of the asset, (2) the cost of financing the asset (e.g., interest, etc.), and (3) a rate of return (called a risk premium) that compensates the company for potential errors made when estimating cash flows that will occur in the distant future.
Let's take a look at the most popular techniques for analyzing a capital budgeting proposal.
1. Payback Period
Alright, let's get this out of the way up front: the Payback Period isn't a very good method. After all, it doesn't use the time value of money principle, making it the weakest of the methods that we will discuss here. However, it is still used by a large number of companies, so we'll include it in our list of popular methods.
What is the payback period? By definition, it is the length of time that it takes to recover your investment.
For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years.  Companies that use this method will set some arbitrary payback period for all capital budgeting projects, such as a rule that only projects with a payback period of 2.5 years or less will be accepted.  (At a payback period of 3 years in the example above, that project would be rejected.)
The payback period method is decreasing in use every year and doesn't deserve extensive coverage here.
2. Net Present Value
Using a minimum rate of return known as the hurdle rate, the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows.  A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC)
By using the hurdle rate as the discount rate, we are conducting a test to see if the project is expected to earn our minimum desired rate of return.  Here are our decision rules:
If the NPV is: | Benefits vs. Costs | Should we expect to earn at least
our minimum rate of return? | Accept the
investment? |
Positive | Benefits > Costs | Yes, more than | Accept |
Zero | Benefits = Costs | Exactly equal to | Indifferent |
Negative | Benefits < Costs | No, less than | Reject |
Remember that we said above that the purpose of the capital budgeting analysis is to see if the project's benefits are large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates.
Therefore, if the NPV is:
* positive, the benefits are...

Other Papers Like Cost of Capital Paper

Cost of Capital Essay

883 words - 4 pages % and 80%. Capital Structure for Bed Bath and Beyond An analysis of a repurchase of stock for $400 million cash, and recapitalization to 80% debt-to-total capital by borrowing $1.27 million reveals that BBBYs return on equity will be 113%, return on assets 61% and an after tax cost of debt of 28%. ROE is > ROA and ROA > after tax cost of debt. With the 80% debt-to-total capital structure ROE exceeds the other two capital structure

Nike, Inc.: Cost of Capital Essay

1060 words - 5 pages I. Statement of the problem Nike has new investment endeavors revamp its recent drops in net income and market share. Wall Street analyst reactions to the endeavors are mixed, with some recommending Nike as a “Strong Buy” and others recommending a “Hold.” In case 13, Nike Inc.: Cost of Capital, I am acting as a portfolio manager to estimate Nike’s cost of capital to determine whether the stock is overvalued or undervalued. II. Alternative

Marriott Corporation Cost Of Capital

4605 words - 19 pages Harvard Business School 9-298-101 rP os t Rev. March 18, 1998 Marriott Corporation: The Cost of Capital In April 1988, Dan Cohrs, vice president of project finance at the Marriott Corporation, was preparing his annual recommendations for the hurdle rates at each of the firm's three divisions. Investment projects at Marriott were selected by discounting the appropriate cash flows by the appropriate hurdle rate for each

Midland Resources Cost of Capital

896 words - 4 pages 1. Calculation of WACC of a Multi-Division Corporation 2. Sources of Data and their limitation 3. Use of CAPM, Cost of Equity, Effect of Leverage on the Ce, WACC 4. Use of data for comparable to estimate asset betas for division-specific cost of capital 5. Biases and Limitations No financial modeling. In the previous years they would include WACC as part of case study 3 – Now it has been changed to 2 – without any actual financial

Cost of Capital End of Book Solutions

1370 words - 6 pages CHAPTER 3 COST OF CAPITAL SOLUTIONS 1. B is correct. The cost of equity is defined as the rate of return required by stockholders. 2. B is correct. Debt is generally less costly than preferred or common stock. The cost of debt is further reduced if interest expense is tax deductible. 3. C is correct. First calculate the growth rate using the sustainable growth calculation, and then calculate the cost of equity using the rearranged

Midland Energy Resources Inc.: Cost of Capital

1059 words - 5 pages Introduction Midland Energy Resources have a senior vice president, Janet Mortension, of project finance. She was preparing her annual cost of capital for midland as well as for each of its following three divisions: * Exploration & production (E&P) * Refining & Marketing (R&M) * Petrochemicals Midland was a global company with operations in oil and gas. Midland corporate treasury had began analysis and preparation

Marriott Corporation: the Cost of Capital

1847 words - 8 pages structure – Marriott focuses on its ability to service its debt by monitoring interest coverage target with total debt of $2.5bn and debt/equity of 59% in 1987; and 4. Repurchase undervalued shares – Marriott repurchases its stock when the market price is below its own calculated “warranted equity value”. Marriott measures the opportunity cost of capital for investments by calculating the WACC: WACC=1-t rDDV+rE EV For cost of debt, Marriott

A Look at Cost of Capital Decisions at Exxon Mobile

895 words - 4 pages A Look at Cost of Capital Decisions at Exxon Mobile American Military University Abstract This paper discusses and analyses the cost of capital decisions Exxon Mobile faces after its acquisition of XTO Energy. The advantages and disadvantages of both single company – wide cost of capital and divisional costs of capital are detailed. Finally, the method of estimating the costs of capital and determining how Exxon Mobile could best evaluate

Http: //Www.Justanswer.Com/Finance/1z4y2-Globalizing-Cost-Capital-Capital-Budgeting-Aes.Html

1208 words - 5 pages Research Reflection Report (Assignment Format) – Guidelines for the Report These notes are designed to help you deliver and conduct a successful Research Reflection Report. The Research Reflection Report is a major piece of work and is designed to support your own self-critical consideration of your research and related business skills and demonstrate that you can:- • Reflect and comment critically on what you have learnt during the

Worldwide Paper Company

2013 words - 9 pages rate = 40% Cost of Debt after- tax = 5.78% (1-0.40) = 3.468% Weighted Average Cost of Capital (WACC) The updated weighted average cost of capital for Worldwide Paper Company is 9.65%.We calculated the cost of debt using the Corporate bonds (10-year maturities) which is Bond rating A 5.78%. Following, the cost of equity was found to be more suitable by using the capital asset pricing model, including risk-free rate (10-year Government bonds

Info Precision

4208 words - 17 pages Intellectual Capital as intellectual material – knowledge, information, intellectual property, experience that can be put to use to create wealth.4 * Jolanta Jurczak, MSc., eng - Ph.D. student at Warsaw University of Technology, Faculty of Production Engineering 1 D. Andriessen, The Financial Value of Intangibles: Searching for the Holy Grail (Paper presented at the 5th World Congress on the Management of Intellectual Capital, January 16

Related Essays

Cost Of Capital Essay

781 words - 4 pages Cost of Capital Pfizer is researched drug corporation that increases their own inventive pharmaceutical goods. Pfizer's global income exceeds $65 billion with a marketplace fissure close to 140 billion. The organization was founded in 1849 by two cousins, Charles Pfizer and Charles Ehart with the mission of learning and evolving new and better, ways to prevent and treat disease and improve the well-being of people. (History, 2014) This paper

Cost Of Capital Essay

3958 words - 16 pages US E RE VI PR EW O P ON E R LY T Y ± N OF OT C E NG FO A R GE SA LE LEA OR R N CL ING AS SR O Northern Forest Products OM Case 90 Cost of Capital Directed FO R Northern Forest Products (NFP) was established in the 1800s to log timber in the Great North Woods. In response to changing conditions, the company underwent radical changes in the way it operates and currently it is a large multidivisional

Cost Of Capital Essay

460 words - 2 pages (retained earnings)? Cost of RE = 6 + (14-6)1.2 = 15.6% 4. A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. The coupon payment is semi-annual. Additionally, the firm's marginal

Nike Cost Of Capital Essay

3140 words - 13 pages UV0010 NIKE, INC.: COST OF CAPITAL On July 5, 2001, Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund management firm, pored over analysts’ write-ups of Nike, Inc., the athletic-shoe manufacturer. Nike’s share price had declined significantly from the beginning of the year. Ford was considering buying some shares for the fund she managed, the NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, with an