# Capital Budgeting and the Cost of Capital SLP

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# Module 3 – SLP

**Capital Budgeting and the Cost of Capital**

For your Module 3 SLP assignment,

continue to do research on the company that you wrote about for Modules 1 and

2. For this assignment, you will be estimating the weighted average cost of

capital (WACC) for your chosen company. The final calculation will be fairly

straightforward, as it involves just plugging in some numbers into an equation.

However, the more challenging task will be finding the necessary numbers to

plug into the formulas. You will need information such as the beta for your

company, the bond-rating, and various information from its balance sheet. Links

to some suggested Web pages for finding this kind of information is included in

the instructions, but you might be able to find other sources of information.

Go step by step and present your information for Steps 1-4 below in a Word

document. Make sure to show all of your steps one by one and include the

sources of your information:

- Find out your chosen company’s credit

rating. Rating agencies such as Moody’s and Standard and Poor’s assign ratings

to companies. AAA is high, AA is lower, BBB is even lower, etc. The higher

the rating, the lower the cost of debt capital. Explain what your

company’s credit rating is and the reasons for the high or low rating

based on your research. Also, use the__Fidelity__Web page to find out what the current return is for a

Fixed Income

30-year bond for a corporation with the rating that your company has. This

yield will be the approximate cost of debt capital for your company. We

will call the cost of debt R_{D}. - Now estimate the cost of equity for your

company. First you will need the beta; you already found this for your

Module 1 SLP. You will also need the three-month treasury bill yield,

which we will use as our measure of the risk-free rate. This rate should

be listed on the Fidelity Fixed Income Web page linked above. Finally, you

will need the equity risk premium. You can find estimates of this on many

Web pages including__Fidelity__or

Fixed Income__Gutenberg Research__. It is usually around 5%. Once you

have this information, you can estimate the cost of equity as the 30-year

treasury bill yield rate plus beta multiplied by the equity premium:Cost of Equity = risk-free rate + Beta * (Equity Premium).

Show your calculations. We will call the cost of equity R

_{E}.

- Now find out how much of the firm’s

capital is equity and how much is debt. For the total value, look at the

balance sheet for your company as found on Google Finance or a similar Web

page. The total value of your company will be “total liabilities and

shareholder’s equity.” The proportion of debt will be total liabilities

divided by total value, which we will call D/V. The proportion of equity

will be shareholder’s equity divided by total value, or E/V. If you

calculate them correctly, the proportions will add up to one. - Now we have all the information we need to

get at least a rough ballpark estimate of WACC. Let’s assume a corporate

tax rate of 35%. So the formula we will use is WACC = (E/V)* R_{E}+(D/V)* R_{D}*(1-.35)Calculate WACC and show your computations. As a “reality check” on your

calculations, the WACC should likely be in the single digits and positive.

Compare what you found to the average WACC in your company’s industry,

which should be available on Web pages such as__Cost of Capital by Sector (US)__. Note that 35% is the

official corporate tax rate, but many corporations find tax breaks. If

your WACC is too low, try computing it with a lower tax rate such as 25%

or 10%.

### SLP Assignment Expectations

- Answer the assignment questions directly.
- Stay focused on the precise assignment

questions. Do not go off on tangents or devote a lot of space to

summarizing general background materials. - For computational problems, make sure to

show your work and explain your steps. - For short answer/short essay questions,

make sure to reference your sources of information with both a

bibliography and in-text citations. See the__Student Guide to Writing a High-Quality Academic Paper__,

including pages 11-14 on in-text citations. Another resource is the

“Writing Style Guide,” which is found under “My Resources” in the TLC

Portal.

# Module 3 – Background

**Capital Budgeting and the Cost of Capital**

Start off the module by viewing

these videos from Professor Roberts of the Wharton School of Business at the

University of Pennsylvania and Professor Roberts of Rice University. These

videos will give you a general overview of the key concepts of capital

budgeting and the cost of capital:

Roberts,

M. (2017). Decision criteria. Coursera. Retrieved from: __https://zh.coursera.org/learn/wharton-finance/lect…__

Weston, J. (2017) Putting it all

together as WACC (weighted average cost of capital). Coursera. Retrieved from: __https://www.coursera.org/learn/finance-for-non-fin…__

Ross,

S., Westerfield, R., & Jordan, B. (2007) Chapter 8: Net present value and

other investment criteria. *Essentials of Corporate Finance.*

McGraw Hill. __http://novellaqalive2.mheducation.com/sites/dl/fre…__

[If the link is down, click __Net Present Value__ or __Fundamentals of Corporate Finance__ for an alternative link]

Ross,

S., Westerfield, R., & Jordan, B. (2007) Chapter 12: Cost of capital. *Essentials
of Corporate Finance.* McGraw Hill. Retrieved from:

__http://novellaqalive2.mheducation.com/sites/dl/fre…__

[If the link is down, click

__Cost of Capital__or

__Fundamentals of Corporate Finance__for an alternative link]

Finally, check out the following

video that will show you how to make capital budgeting calculations using

Excel:

Graulich, V. (2012). How to

calculate NPV and IRR. IHateMath.com. Retrieved from:

Hamilton, K. (2014). Excel NPV

IRR. Retrieved from:

If you still have difficulty with

the material after reviewing the required materials, check out the optional materials

below. Included are two additional videos, including one on using Excel to

compute NPV and IRR. Also included are some additional book chapters that cover

the same material but explain it in a slightly different way with different

examples.

### Optional Reading

BlueBookAcademy.com. (2015).

Learn it FAST: Weighted average cost of capital explained. Retrieved from:

Girvin, M. (2010). Investment

criteria: NPV, IRR, payback, AAR, profitability index. Retrieved from:

Fabozzi, F. J., & Peterson

Drake, P. (2009). Chapter 14: Capital budgeting techniques. *Finance:
Capital markets, financial management, and investment management.*

Wiley. Available in the Trident Online Library.

Clive, M. (2012). Chapter 14: The

cost of capital. *Financial management for non-financial managers.* Kogan

Page. Available in the Trident Online Library.

Block, S. & Hirt, G. (2008).

Chapter 12: The capital budgeting decision. Foundations of Financial

Management. McGraw-Hill, Retrieved from: __http://studylib.net/doc/8149455/12-the-capital-bud…__

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