2.3. Applying the Cost of Capital to Capital Budgeting and Security Valuation

With some insight now into the calculation of the cost of capital, let us continue to improve our understanding of the roles it plays in financial analysis. A chief use of the marginal cost of capital estimate is in capital-budgeting decision making. What role does the marginal cost of capital play in a company’s investment program, and how do we adapt it when we need to evaluate a specific investment project?

A company’s marginal cost of capital (MCC) may increase as additional capital is raised, whereas returns to a company’s investment opportunities are generally believed to decrease as the company makes additional investments, as represented by the investment opportunity schedule (IOS).2 We show this relation in Figure 1, graphing the upward-sloping marginal cost of capital schedule against the downward-sloping investment opportunity schedule. In the context of a company’s investment decision, the optimal capital budget is that amount of capital raised and invested at which the marginal cost of capital is equal to the marginal return from investing. In other words, the optimal capital budget occurs when the marginal cost of capital intersects with the investment opportunity schedule as seen in Figure 1.

The relation between the MCC and the IOS provides a broad picture of the basic decision-making problem of a company. However, we are often interested in valuing an individual project or even a portion of a company, such as a division or product line. In these applications, we are interested in the cost of capital for the project, product, or division as opposed to the cost of capital for the company overall. The cost of capital in these applications should reflect the riskiness of the future cash flows of the project, product, or division. For an average-risk project, the opportunity cost of capital is the company’s WACC. If the systematic risk of the project is above or below average relative to the company’s current portfolio of projects, an upward or downward adjustment, respectively, is made to the company’s WACC. Companies may take an ad hoc or a systematic approach to making such adjustments. The discussion of a systematic approach is a somewhat advanced topic that we defer to Section 4.1.

The WACC or MCC corresponding to the average risk of the company, adjusted appropriately for the risk of a given project, plays a role in capital-budgeting decision making based on the net present value (NPV) of that project. Recall from the reading on capital budgeting that the NPV is the present value of all the project cash flows. It is useful to think of it as the difference between the present value of the cash inflows, discounted at the opportunity cost of capital applicable to the specific project, and the present value of the cash outflows, discounted using that same opportunity cost of capital:

NPV = Present value of inflows − Present value of outflows

If an investment’s NPV is positive, the company should undertake the project. If we choose to use the company’s WACC in the calculation of the NPV of a project, we are assuming that the project:

• has the same risk as the average-risk project of the company, and

• will have a constant target capital structure throughout its useful life.3

These may not be realistic or appropriate assumptions and are potential drawbacks to using the company’s WACC in valuing projects. However, alternative approaches are subject to drawbacks as well, and the approach outlined has wide acceptance.4

For the analyst, the second key use of the marginal cost of capital is in security valuation using any one of several discounted cash flow valuation models available.5 For a particular valuation model, if these cash flows are cash flows to the company’s suppliers of capital (that is, free cash flow to the firm), the analyst uses the weighted average cost of capital of the company in the valuation.6 If these cash flows are strictly those belonging to the company’s owners, such as the free cash flow to equity, or dividends, the analyst uses the cost of equity capital to find the present value of these flows.7

In the next section, we discuss how an analyst may approach the calculation of the component costs of capital, focusing on debt, preferred stock, and common equity.