This paper walks through the core concepts of corporate finance valuation and capital budgeting. It begins by calculating the cost of equity using two approaches — the discounted cash flow (DCF) method and the Capital Asset Pricing Model (CAPM) — and derives a blended estimate of 15%. It then computes the firm's weighted average cost of capital (WACC) at 12.5%, incorporating equal weights of debt and equity. The paper outlines a four-step capital budgeting process covering incremental cash flows, discount rate selection, analytical methods, and decision-making. Finally, it explains how project risk is embedded in the discount rate and examined through sensitivity analysis.
The discounted cash flow (DCF) method relies on the dividends expected to be paid in the future to determine the value of a stock. In this application, the DCF value is understood to represent the stock price, and the equation is solved for the discount rate. Because the future cash flows must incorporate the dividend growth rate, it is best to use the Solver function in Excel to build the formula. Using this approach, the implied discount rate — that is, the cost of equity — is approximately 14.8%, trending toward 15% (Investopedia, 2011).
The cost of equity can also be estimated using the Capital Asset Pricing Model (CAPM), calculated as follows:
Ra = Rf + B(Rm − Rf)
Ra = 9 + 1.6(13 − 9)
Ra = 15.4%
The firm's cost of equity is estimated at 15%. This figure is slightly higher than the cost of equity derived from the DCF method but somewhat lower than the result produced by the CAPM approach. Using a cost of equity that falls between the two estimates is the most appropriate course of action.
The corporate cost of capital is the weighted average cost of capital (WACC), calculated as follows:
Weight(cost of equity) + Weight(cost of debt) = WACC
(0.5)(15) + (0.5)(10) = 7.5 + 5 = 12.5%
The weighted average cost of capital reflects the average cost at which a firm can acquire the funds needed to pursue projects. The cost of capital is directly tied to the firm's risk profile. Beta represents the risk level of the equity component, while the cost of debt also rises and falls in line with the firm's overall risk.
The capital budgeting process involves several key steps. The first step is to identify the incremental cash flows — only those cash flows directly associated with the project. This means excluding sunk costs, non-cash items such as depreciation, and allocated costs such as overhead. The second step is to identify the other variables required for the calculation, most notably the appropriate discount rate. The third step is to select the most suitable analytical method. Several tools are available, including net present value (NPV), internal rate of return (IRR), and payback period, each of which can be used to evaluate the project. The fourth step is to make a decision based on the best available information and the chosen technique.
Although the capital budgeting process is fairly straightforward in structure, making the underlying determinations can be quite challenging. For example, there is often significant debate over what constitutes an incremental cash flow, and the firm must approach this issue carefully. Determining the appropriate discount rate is another complex task — the firm must account for its own risk, market risk, the risk-free rate, and any risk specific to the project.
Determining a cost of capital for a privately held firm often requires identifying a comparable publicly traded firm in order to estimate what the equity cost of capital might be. The cost of debt is generally easier to determine, as a lending institution can provide the firm with that figure directly.
"Risk embedded via discount rate and sensitivity analysis"
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