Valuing Investment Decisions: Flotation Costs And Capital Budgeting Neeraj J. Gupta, Elon University, USA Wonhi Synn, Elon University, USA

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1 Journal o Busness & Econom Research February, 21 Volume 8, Number 2 Valung Investment Deons: Flotaton Costs An Captal Bugetng Neeraj J. Gupta, Elon Unversty, USA Wonh Synn, Elon Unversty, USA ABSTRACT We hghlght a measurement problem nherent n the prevalent approach to actorng lotaton costs n captal bugetng eon-makng. Ths arses because the tratonal metho calculates a hgher cost o captal, whle keepng the ntal cash-low unchange. We emonstrate an alternate approach that corrects or ths problem by assgnng a hgher ntal nvestment ue to lotaton costs, whle keepng the cost o captal unchange. Keywors: Flotaton costs, captal bugetng, nvestment eons, valung, project analyss INTRODUCTION S hareholer wealth maxmzaton s the prmary goal o a corporaton, an the oremost manate o ts nancal managers. Captal allocaton an bugetng eons play a sgncant role n ths value creaton. The contemporary corporate nance eucaton lterature extensvely scusses varous crtera to evaluate captal bugetng eons. Graham an Harvey (21 n that most rms use Net Present Value (NPV, Internal Rate o Return (IRR, Payback, or the Protablty Inex. Acaem argue that NPV s the most theoretcally rgorous, a vew supporte by most nancal managers - 75 percent o rms surveye by Graham an Harvey (21 always or almost always use NPV as ther nvestment crteron; the proporton o large rms usng NPV s even hgher. For a project uner conseraton, NPV s calculate as the present value o expecte cash-lows scounte at the rm s weghte average cost o captal: NPV C n 1 C ( 1 WACC (1 where, NPV s the net present value o the project toay (tme, C s the cash-low n project toay (the project nvestment, C s the cash-low rom project at uture tme, an n s the pero n whch last cash-low occurs. The rm s weghte average cost o captal (WACC s the market-value weghte average o the varous components o the rm s captal: WACC w r w r w r (2 r r ( 1 (3, pretax T where, 73

2 Journal o Busness & Econom Research February, 21 Volume 8, Number 2 w, w, w are the proporton o rm s captal nveste n ebt, preerre stock, an common stock, respectvely, r, r, r are the rates o return on rm s ebt (ater-tax, preerre stock, an common stock, respectvely, an T s the margnal eeral-plus-state tax rate or the rm. The lterature, however, naequately aresses how to hanle lotaton costs n the context o a rm usng new captal to nance projects. The tratonal treatment n textbooks has been to ajust the scount rate to nclue lotaton costs. Ths approach s avocate by popular nance textbooks use or unergrauate an grauate courses n colleges an unverstes globally. Slghtly erent varatons o the tratonal approach can be oun n textbooks such as Brgham an Houston (27, Brealey, Myers an Marcus (27, Brgham an Ehrhart (25, Ross, Westerel, an Jae (22, Ross, Westerel, an Joran (22, Brealey an Myers (2. In the ollowng secton, we scuss the prevalent approach n epth, an emonstrate that t ncorrectly assgns a hgher cost o captal an lower ntal nvestment, thus basng the measurement o NPV. Ths mples that managers evaluatng whether to nvest n projects may be ncorrectly unervalung (overvalung NPV, an rejectng (acceptng projects that s, n act, vable (unvable. We also etal an approach, use n only one textbook, whch overcomes these measurement errors, an proves managers more accurate an rgorous eonmakng crtera. INCORPORATING FLOTATION COSTS USING THE TRADITIONAL APPROACH The tratonal lterature estmates the costs o the new captal components n many erent ways. For example, Brgham an Houston (27 solve or them as: PV ( 1 F t j1 PMT ( 1 T FV t ( 1 ( 1 r j r r r 1 F r = r where, 1 - F g F c r, r, r are the rates o return on new ebt (pre-tax, preerre stock, an common stock, respectvely, F, F, F are the lotaton costs o ebt (ater-tax, preerre stock, an common stock, respectvely, PV, PMT, FV are the present value, coupon payments, an ace value o ebt maturng at tme t, an g c s the constant rate at whch rm s vens (an prots can grow perpetually. The new costs o captal obtane above are use n equatons (2 an (1 to estmate the project s weghte average cost o captal, an consequently the net present value. We note that Brgham an Houston (27 use a moe verson o the Goron s ven scount moel to estmate rate o return on new common stock as D1 or a rm whose common stock traes at a r = + g P (1 - F prce P, s expecte to pay a ven D 1, an s expecte to grow at a constant rate g c. We rewrte n ths orm or easer exposton. 74

3 Journal o Busness & Econom Research February, 21 Volume 8, Number 2 INCORPORATING FLOTATION COSTS USING AN ALTERNATE APPROACH The tratonal approach s base towars assgnng a hgher value to the weghte average cost o captal, an a lower value to the ntal nvestment. Ths leas to sgncant errors n measurng net present value. The measurement errors arse prmarly snce lotaton costs are a one-tme cash-low event, ncurre only when rms rase captal. Consequently, they shoul not materally mpact the cost o captal o the rm or o the project. We escrbe here an alternate approach that mtgates these shortcomngs, an whch can be generalze to any captal bugetng process. Ths metho s more pree, an can be easly apple to any general captal bugetng eon. Assumng, the rm retans ts current captal structure or the project, we estmate a weghte average lotaton cost (F WAFC or the project as: F WAFC w F w F w F (4 We then calculate a new ntal nvestment that relects the weghte average lotaton costs o all captal components as: C C ( 1 FWAFC T (5 1 FWAFC Net present value o the project can then be more preely calculate usng the rm s weghte average cost o captal, wth ths new ntal nvestment. We note that we assume the company retans ts current captal structure or the project only or ease o exposton. Devaton n target project captal structure rom that o the rm s, coul be accommoate by moyng the captal weghts n equatons (2 an (4. CAPITAL BUDGETING IMPLICATIONS: COMPREHENSIVE EXAMPLE Conser a rm that has a captal structure comprse o percent ebt, 1 percent preerre stock, an 6 percent common stock. Management uses the yel-to-maturty on the company s -year bons to estmate ts cost o ebt: the coupon rate on these bons s 1 percent, an they currently trae at par. The company s preerre stock has a ven yel o 7.6 percent an traes at a par value o $5. The rm uses the Goron s ven scount moel to estmate ts cost o common equty: the common stock traes at $5, the prevous year s annual ven was $4.19, an earnngs an vens are estmate to grow at a constant rate o 5 percent. The margnal eeralplus-state tax bracket o the rm s 4 percent. The rm estmates ts cost o rasng ebt, preerre stock, an common stock as 2 percent, 5 percent, an 15 percent, respectvely. Management s evaluatng two nepenent projects or nvestment. Though, the project unng retans the same relatve captal components as the rm, t s nance entrely wth new (external nvestment captal. The rst project requres an nvestment toay o $1 mllon, an s expecte to generate uture year-en cash-lows o $1.26 mllon n each o the ollowng 25 years. The secon project entals a smlar ntal nvestment, but generates an annual cash-low $1.8 mllon or 1 years. Project Analyss: Ignorng Flotaton Costs In Table 1, we present the NPV valuaton o these captal bugetng eons, wthout conserng lotaton costs: 75

4 Journal o Busness & Econom Research February, 21 Volume 8, Number 2 Table 1: NPV Calculaton wthout Flotaton Costs Captal Component Calculaton Result Cost o Debt 1 * ( 1 4% 1 6.% 1 j j1 ( 1 r ( 1 r Cost o Preerre Stock $ % r Cost o Common Stock $ * % r 5% WACC WACC. 3 * 6%. 1 * 7. 6%. 6 * 13. 8% 1.84% NPV o Frst Project $736,67 NPV NPV o Secon Project $672,115 NPV Wthout lotaton costs, the manager woul clearly choose to nvest n both projects snce project NPVs are greater than zero. Project Analyss: Usng the Tratonal Approach In Table 2, we rework the NPV valuaton usng the prevalent approach n most textbooks or actorng lotaton costs: Table 2: NPV Calculaton usng the Tratonal Conseraton o Flotaton Costs Captal Component Calculaton Result Cost o Debt 1 * ( 1 4% % 1 * ( 1 2% j j1 ( 1 r ( 1 r Cost o Preerre Stock 7. 6% 8.% r 1 5% Cost o Common Stock 13. 8% 5% * 15% 15.35% r 1 15% WACC WACC. 3 * 6. 15%. 1 * 8. %. 6 * % 11.86% NPV o Frst Project $2,84 NPV NPV o Secon Project $228,952 NPV Usng the tratonal approach to actor n lotaton costs, the manager s eon woul be to reject the rst project (negatve NPV, an accept the secon project (postve NPV. Project Analyss: Usng the Alternate Approach Table 3 proves a etale workng o NPV valuatons usng the alternate approach o conserng lotaton costs: 76

5 Journal o Busness & Econom Research February, 21 Volume 8, Number 2 Table 3: NPV Calculaton usng the Alternate Approach or Conseraton o Flotaton Costs Captal Component Calculaton Result Cost o Debt 1 * ( 1 4% 1 6.% 1 j j1 ( 1 r ( 1 r Cost o Preerre Stock $ % r Cost o Common Stock $ * % r 5% WACC WACC. 3 * 6%. 1 * 7. 6%. 6 * 13. 8% 1.84% Weghte Average Flotaton Cost F WAFC. 3 * 2%. 1 * 5%. 6 * 15% 1.1% Ajuste Intal Investment 1 C -$1,674, ( % * 4% % NPV o Frst Project $62,67 NPV NPV o Secon Project $1,885 NPV The alternate approach to actorng n project costs reverses the manager s eon. He woul now accept only the rst project snce t has a postve NPV; the secon project now has negatve NPV. Clearly, uner some crcumstances, the two approaches may prove contractory results. CONCLUSION Through the etale calculatons above, we llustrate that a project analyss base on the approach popular n most textbooks woul orce the manager to reject the vable rst project, whle acceptng the unprotable secon project. Ths s a measurement problem nherent n the prevalent approach, an arses because the tratonal metho calculates a hgher cost o captal, whle keepng the ntal cash-low unchange. As emonstrate above, the bas s magne or projects wth longer paybacks, an large long-run cash-lows. We emonstrate an alternate approach that corrects or ths problem by assgnng a hgher ntal nvestment ue to lotaton costs, whle keepng the cost o captal unchange. Though we emonstrate the approprateness o the alternate metho usng NPV as the eon crtera, the ssue hghlghte woul apply to other captal bugetng eon crtera. Surprsngly, ths approach s not oun n the commonly-use textbooks or nance courses. AUTHOR INFORMATION Neeraj J. Gupta, Ph.D., CFA, assstant proessor o nance at the Martha an Spencer Love School o Busness o Elon Unversty, has a octorate n nance rom the Unversty o Connectcut, an s a CFA charterholer. Hs research nterests are n nvestments, corporate nance, an nternatonal nance. Wonh Synn, Ph.D. s a proessor o nance at the Martha an Spencer Love School o Busness o Elon Unversty. Dr. Synn has prevously publshe n the areas o onlne stock trang, bankruptcy, government sponsore enterprses, busness currculum an peagogy. Dr. Synn receve hs Ph.D. rom the State Unversty o New York at Bualo. 77

6 Journal o Busness & Econom Research February, 21 Volume 8, Number 2 REFERENCES 1. Graham, J. R., an Harvey, C. R. (21, The Theory an Practce o Corporate Fnance: Evence rom the Fel, Journal o Fnancal Econom, Brealey, R. A., an Myers, S. C. (2, Prncples o Corporate Fnance, New York, New York: Irwn/McGraw-Hll. 3. Brealey, R. A., Myers, S. C., an Marcus, A. J. (27, Funamentals o Corporate Fnance, New York, New York: Irwn/McGraw-Hll. 4. Brgham, E. F., an Houston, J. F. (27, Funamentals o Fnancal Management, Mason, Oho: South- Western. 5. Brgham, E. F., an Ehrhart, M. C. (25, Fnancal Management: Theory an Practce, Mason, Oho: South-Western. 6. Ross, S. A., Westerel, R. W., an Jae, J. F. (22, Corporate Fnance, New York, New York: Irwn/McGraw-Hll. 7. Ross, S. A., Westerel, R. W., an Joran, B. D. (22, Funamentals o Corporate Fnance, New York, New York: Irwn/McGraw-Hll. 78