CAPITAL PROJECTS INTRODUCTION This reference document covers two topics related to capital projects. The first topic is the cost of capital to use as the discount rate when calculating the net present value (NPV) of a project s future cash flows. The second topic is the use of leasing for financing the chosen capital project(s), and its relative advantages and disadvantages compared with purchasing assets. COST OF CAPITAL FOR EVALUATING CAPITAL PROJECTS The cost of capital, or Weighted Average Cost of Capital (WACC), represents the overall cost of various sources of financing available to a firm. An accurate estimate of a firm s cost of capital is important since it is used as the discount rate when evaluating capital budgeting projects. The cost of capital is dependent on the capital structure of the firm. There exists an optimal capital structure for every firm which is the proportion of debt and equity that will maximize the value of the firm and minimize its WACC. This document assumes that the firm has decided on the proportions of debt, preferred equity, and common equity financing it will use and that this capital structure remains stable. It also assumes that the risk associated with any particular investment proposal will be close to the average risk of the firm. Calculating the Cost of Capital To calculate the WACC, it is first necessary to determine the cost of each of the three sources of financing. Cost of Debt The cost of debt is the return that the firm s long-term creditors demand on new borrowing. Since interest payments are tax-deductible for the firm, the cost of debt is the after-tax marginal cost of debt financing. The formula for the cost of debt, denoted by k b, is: TI kb = k( ( 1 ) 1 T ) or F CMA Canada 1
Cost of Preferred Shares where k = interest rate T = corporate tax rate I = annual interest payment on debt F = face value of debt The cost of preferred shares is the return, or dividend yield, that the firm s preferred shareholders demand. Preferred dividends are not tax-deductible for the firm. They are assumed to be fixed even though firms are not legally obligated to pay them, since firms do not typically issue preferred shares unless they anticipate being able to make the promised dividend payments. The formula for the cost of preferred shares, denoted as k p is: kp = Dp NPp where D p = stated annual dividend payment on shares NP p = net proceeds on preferred share issue Cost of Equity The cost of equity is the return that equity investors require on their investment in the firm. It is typically derived using either the Dividend Growth Model or the Capital Asset Pricing Model (CAPM). The Dividend Growth Model, also known as the Dividend Discount Model, focuses on the future returns that common shareholders expect in the form of either cash dividends or reinvested funds that will enhance the firm s ability to pay future dividends. The Dividend Growth Model considers the price of shares to be the present value of future dividend payments and assumes that dividends will grow perpetually at some constant annual rate. The basic formula for the cost of common shares, denoted as k e, is: D1 ke = + NP g e where D 1 = dividend expected for period 1 NP e = net proceeds on common share issue g = annual long-term dividend growth rate The above formula is based on the issuance of new common shares. Reinvested cash flows, or internally generated funds, are another source of equity financing for firms. In CMA Canada 2
essence, reinvesting funds also involves financing with shareholder money. Therefore, it is reasonable to assume that internally generated funds must also provide returns that shareholders consider adequate. The formula for the cost of internally generated funds, denoted as k re, is: D1 kre = re = + P g e where r e = expected return on common equity P e = market price of a share D 1 = dividend expected for period 1 g = annual long-term dividend growth rate The formula for the cost of common equity using the CAPM, denoted as R j, is: ( ) Rj = Rf + β j Rm Rf where R j R f R m β j = expected rate of return on security j = risk-free rate = expected return for the market portfolio = beta coefficient for security j (measure of systematic risk) The use of the CAPM to approximate the firm s cost of common equity is limited by the difficulty in obtaining accurate measures of its parameters, especially the systematic risk of the firm s shares (beta). The most common measure for the risk-free rate is the current yield on federal government treasury bills. The return on the TSE 300 Composite Index is typically used as the expected return for the market portfolio in Canada, while the S&P 500 Composite Index is used in the United States. A firm s beta may be estimated by performing regression analysis (relating historical returns on its shares to returns achieved by the market) or by basing it on published betas for large Canadian companies (adjusted upward if the firm uses more debt financing). Calculating a Weighted Average Once the costs of individual sources of funds have been computed, the WACC (k) is determined by weighting each cost by its relative proportion in the total capital structure. The formula is: B k V k P V k E = + + V k b p e where B = amount of debt outstanding P = amount of preferred shares outstanding CMA Canada 3
E V k b k p k e = amount of common equity outstanding = B + P + E = total value of firm = cost of debt = cost of preferred shares = cost of common shares The WACC represents the current marginal cost of new funds that can be raised. If no new funds are to be raised or the acquisition of incremental funds will not cause the current capital structure to change, the WACC and the true marginal cost of capital will be the same. Ideally, the weights used to compute a firm s WACC should be based on the firm s optimal capital structure or, at least, the firm s projected long-term capital structure. These weights should be used regardless of the actual capital structure since the firm is presumably moving towards this capital structure, and WACC is used to evaluate longterm capital projects. If the optimal weights are not available, the existing capital structure is assumed to be the optimal structure. The weights of various sources of funds can be based on either current market values or book values. Since the market price of common shares is usually higher than their book value, use of market values will weight equity financing more heavily. In turn, because equity financing is more expensive than debt financing, this will drive up the WACC. One advantage of using book values is that they are easily obtainable. As well, the book value method places more emphasis on traditional accounting measures and provides more stable results. Therefore, many firms base their WACC estimates on book values. However, book value proportions are based on past market conditions that may have little relevance for current financing and investment decisions, especially when there are significant changes in inflation rates, interest rates, and other economic conditions. Risk-Adjusted Cost of Capital The cost of capital calculation was based on the assumption that the risk associated with a particular investment proposal will be close to the average risk of the firm. In reality, the risk may vary by operating division or business line, or even by individual project. For example, projects that involve moving into new areas of business involve a higher level of business risk. As well, projects that necessitate a major change to the firm s capital structure may involve higher or lower financial risk. In such cases, the firm may make adjustments to its overall WACC for individual projects or use different costs of capital for different divisions. Example 1 Calculation of WACC using Dividend Growth Model; Use of WACC Coril Manufacturing Limited (CML) is considering the following proposals for new investments in capital projects for the upcoming year: CMA Canada 4
Initial Investment Annual Cash Flow Project Life Project A $50,000 $10,000 10 Project B $150,000 $30,000 8 Project C $100,000 $30,000 6 CML's current capital structure is composed of $70,000 in long-term bonds, $30,000 in preferred shares, $80,000 in common shares and $20,000 in retained earnings. The long-term debt carries an interest rate of 9%. The market price of the preferred shares is $54. Each share has issue-related costs of $4, and pays an annual dividend of $7. The market price of the common shares is $65, and new shares would net the firm $60 after underwriting costs. The dividend for the upcoming year is expected to be $9 per share. Common dividends are expected to grow at an annual rate of 3%, and the corporate tax rate is 45%. CML can sell new debt and equity at current rates, and its capital structure is not expected to change in the foreseeable future. Required: Determine the WACC and the NPV of each project. Recommend which project(s) CML should accept.. Cost of Debt = k b = k x (1 - T) =.09 x (1 -.45) = 4.95% Cost of Preferred Stock = k p = D p /NP p = 7 / (54-4) = 14% Cost of Common Stock = k e = D 1 /NP e + g = 9 / 60 +.03 = 18% Proportion of Debt = B/V = 70,000 / 200,000 = 35% Proportion of Preferred = P/V = 30,000 / 200,000 = 15% Proportion of Equity = E/V = (80,000 + 20,000) / 200,000 = 50%. WACC = B/V x k b + P/V x k p + E/V x k e =.35 x.0495 +.15 x.14 +.50 x.18 =.0173 +.021 +.09 =.1283 13% (1) Initial Investment (2) Annual Cash Flow (3) Project Life (4) Discount Factor @ 13% (5) (2) X (4) PV of Inflows (5) (1) Net Present Value Project A $50,000 $10,000 10 5.426 $54,260 $4,260 Project B $150,000 $30,000 8 4.799 $143,970 $(6,030) Project C $100,000 $30,000 6 3.998 $119,940 $19,940 Because Project A and C both have a positive NPV, CML should invest in these projects. If capital is restricted to under $150,000, CML should invest in Project C only since it has a higher NPV than A. If less than $100,000 can be raised, Project A should be undertaken. CMA Canada 5
Example 2 Calculation of WACC using CAPM Walker Ltd.'s latest financial statements show the following capital structure: debt: $4,000,000; preferred shares: $1,000,000; common shares: $3,000,000; retained earnings: $2,000,000. The company is considering a major plant expansion, estimated to cost $2,000,000, which it intends to finance solely through an issue of 15-year, 13% long-term debt. Such debt can be issued at $98. Walker also considered two alternative financing arrangements: issuing preferred shares at a net price of $8.50 with an annual dividend of $0.80, or issuing common shares at a net price of $25. Walker Ltd. has a beta of 1.2 and a tax rate of 40%. The current yield on long-term government bonds is 10%, and the expected yield on the market portfolio is 16%. Required: Determine the WACC. Cost of Debt = k x (1 - T) =.13(1 -.4) = 7.8% Cost of Preferred Shares = D p /NP p = 0.80 / 8.50 = 9.41% Cost of Equity = R f + ß j (R m - R f ) = 10 + 1.2 (.16 -.10) = 17.2% WACC = B/V x k b + P/V x k p + E/V x k e =.4 x.078 +.1 x.0941 +.5 x.172 = 12.66% LEASING FOR FINANCING CAPITAL PROJECTS The calculation of a weighted average cost of capital, demonstrated in the previous section, is necessary to obtain the relevant discount rate to use in capital budgeting analysis. Once a decision has been made, using capital budgeting analysis, to purchase a particular asset, it is often wise to determine whether leasing would be an attractive form of financing. This section will consider the relevant factors in that financing decision. Types of Leases Since this document deals with capital projects, it will focus on financial or capital leases as opposed to operating leases. However, it is first necessary to distinguish between these two types of leases, from a financing perspective versus an accounting perspective. An operating lease covers a short period of time relative to the life of the asset and is usually cancellable by the lessee. In comparison, a financial or capital lease is long term and cannot be cancelled prior to its expiration at least not without a significant penalty. CMA Canada 6
A financial lease can either be a direct lease, where the lessee obtains the use of an asset not previously owned by it, or a sale and leaseback arrangement, where the lessee obtains the use of an asset it has sold to a financial institution. Evaluation of Financial Leases The first step in evaluating the economic benefits of leasing an asset is to determine the relevant cash flows under the lease. Once this is done, either the net present value (NPV) method or the internal rate of return (IRR) method may be used when performing the discounted cash flow analysis. The NPV method uses the after-tax cost of debt as the relevant discount rate since borrowing is the standard of comparison for leasing. If the NPV of leasing is positive, leasing is preferred; if it is negative, borrowing is better. It is also possible to compare the NPV of leasing directly to the NPV of buying and borrowing. If the IRR method is used, leasing is advantageous when the IRR of leasing is less than the after-tax borrowing cost. Estimating the NPV of Leasing The NPV of a lease is composed of several parts: the original purchase price of the asset minus the present value of the after-tax lease payments minus the present value of the lost CCA tax shield due to leasing minus the present value of the lost net benefits from salvage value. Thus, the formula for the NPV of a lease is as follows: NPV CdT 2 + k S SdT 1 = C ( L( 1 T ) PVAD ) k, n n d + k 2 1 ( ) ( ) ( ) n + k k d + k k Where: C = cost of asset L = annual lease payment T = tax rate PVAD = present value of an annuity due, assuming that lease payments are made at the beginning of each period; use PVA (present value of an ordinary annuity) if lease payments are made at the end of each period k = discount rate = after-tax cost of debt financing n = length of lease d = CCA rate S = salvage value (residual value) The above formula assumes that lease payments are tax-deductible. As of 2001, the Canada Revenue Agency (CRA) judges leases according to their form not their substance. Consequently, lease payments are usually considered by the CRA to be fully deductible. CMA Canada 7
Example Based on capital budgeting analysis, Vancouver Excavation Limited (VEL) has decided to acquire equipment costing $500,000. The equipment is subject to a CCA rate of 20% and has a useful life of 10 years. Its estimated salvage value, net of disposal costs, is $30,000. VEL is subject to a marginal tax rate of 40%. VEL is now considering the financing alternative of leasing versus borrowing and buying. If it bought the equipment, VEL would finance the purchase by obtaining a 10-year bank loan at 10%. Alternatively, VEL could lease the equipment from a local financial institution. The lease payments of $76,488 would be made at the start of each year of the 10-year lease period. Required: Determine whether VEL should buy or lease the asset. CdT 2 + k S SdT 1 NPV = C ( L( 1 T) PVAD ) k,n n d + k 2 1 ( ) ( ) ( ) n + k k d + k k NPV = 500,000 ( 76,488( 1.4)(7.802)) 500,000(.2)(.4).2 +.06 2 2 +.06 30,000 30,000(.2)(.4) 10 10 ( ) ( ) ( ) 1 +.06 1 +.06.2 +.06 1 +.06 1 NPV = 500,000-358,056-149,492-11,598 = -$19,146 Since the NPV of leasing is negative, VEL should not lease the asset. Given the relative uncertainty of the salvage value compared to the lease payments, the tax rate, and the current after-tax cost of borrowing, it may be prudent to use a higher discount rate for cash flows related to the salvage value, especially if the salvage value is projected to be high, as would be the case, for example, with land and buildings. Doing so will reduce the value of the last term in the equation and, consequently, increase the estimated NPV of leasing. For example, for VEL, use of 8% instead of 6% for the salvage-value cash flows would result in a net estimated lost benefit from salvage of $9,926 instead of $11,598, increasing the NPV of leasing from -$19,146 to - $17,474. An alternative approach, which will yield the same result, is to directly compare the NPV of the cash flows for leasing and buying, as shown below: NPV of leasing = L( 1 T) PVADkn = 76,488 X (1.4) X 7.802 = $358,056 CMA Canada 8
NPV of buying = CdT 2 + k C d + k 2 1 SdT = n S ( ) ( ) ( ) n + k k d + k k 1 ( )(.4 ) 500,000.2 2 +.06 500,000.2 +.06 2 1 = 500,000 149,492 11,598 = $338,910 30,000 ( +.06) (.06) ( )(.4 ) 30,000.2.2 +.06 = 10 10 1 (.06) Again, buying is the more attractive alternative since the net present value of its future cash outflows, $338,910, is $19,146 less than the net present value of the future cash outflows of leasing, $358,056. Performing Sensitivity Analysis Sensitivity analysis can be used to determine how the lease-buy decision would be affected by changes in various parameters. Since the salvage value may be difficult to estimate, especially for assets with long lives, it may be wise to consider how a change in the salvage value would affect the estimated NPV. Suppose, for example, that the equipment in the above example had no salvage value instead of a $30,000 salvage value. There would be no lost net benefits from salvage value, and the last term would drop out of the NPV equation. While this would increase the attractiveness of leasing (it would increase the NPV from $-19,146 to -$7,548), VEL would still be better off buying the asset. A higher salvage value, in contrast, would increase the attractiveness of buying since the related cash inflows would belong to the firm rather than a lessor. If there is some room for negotiating the lease payments, VEL could calculate the how low the lease payments would have to be to make leasing more attractive than buying. For that to happen, the second term of the equation (currently valued at 358,056) would need to have a value of less than $338,910. Therefore, the lease payments would have to be less than $72,398 [$338,910 / (1 -.4) X 7.802]. Use of IRR Method An internal rate of return can also be calculated by solving for the after-tax borrowing rate (i.e. k) that will make the relevant cash flow equation zero, as shown below: CdT 2 + k S SdT 1 0 = C ( L( 1 T) PVAD ) k,n n d + k 2 1 ( ) ( ) ( ) n + k k d + k k CMA Canada 9
If the IRR is less than the after-tax borrowing rate (in this case, 6%), leasing is the preferred alternative. If the IRR exceeds the after-tax borrowing rate, buying is the preferred alternative. As suggested above, it may be appropriate to use a higher discount rate in the last part of the equation to reflect the uncertainty, or risk, related to salvage value estimates. This would make use of the IRR method more complicated. The NPV method is easier to use than the IRR method and is generally deemed to yield more valid results. Reasons for Leasing The previous section focused on evaluating the lease-buy decision based on the net present value of the future cash outflows. However, there are many reasons to consider leasing instead of buying an asset, as outlined below: 1. Transfer of income tax benefits When the lessor and lessee face different tax rates and regulations (as is usually the case), leasing shifts the benefits of tax deductions such as CCA to the firm that can best use them. In turn, some of these benefits may be passed back to the lessee in the form of lower rental payments. In Canada, manufacturers pay tax at a lower rate than financial institutions, a situation conducive to leasing of plant assets. As well, companies that have been unprofitable or are not sufficiently profitable to use the full CCA deduction are good candidates for lease financing. Increasingly, Canadian companies lease assets from foreign companies to take advantage of cheaper financing based on shifting tax benefits. Thus, in practice, tax advantages are one of the most important motives for leasing. 2. Impact on financial statements If the lessee can classify the lease as an operating lease, both the balance sheet and income statement will look better, as will ratios such as debt-equity and return on assets. CICA Handbook Section 3065.06 outlines the criteria to determine whether a lease is a capital lease for accounting purposes. In essence, a capital lease transfers the risks and rewards of ownership to the lessee. This will be the case for many long-term financing leases. Consequently, there will be no advantages related to financial statement presentation. Even when a lessee negotiates lease terms to fall within the criteria of an operating lease, educated users of financial statements will see through the impact of this offbalance-sheet financing. Furthermore, lease terms required to qualify the lease as operating may come with real economic costs, such as higher lease payments based on shorter-terms and/or high cancellation penalties for non-renewal. 3. Protection against uncertainty Leasing can transfer some or all of the risks inherent in ownership of the asset to the lessor. In particular, leasing may reduce the risk of obsolescence, although upgrades may be expensive and lease renewals may tie the lessee to the lessor s products. Leasing may also reduce the uncertainty around the salvage value of the asset (including disposal costs), unless the lease CMA Canada 10
calls for a lessee-guaranteed residual value at the end of the lease term. In practice, reduction of uncertainty is one of the most frequently cited reasons for leasing, with lessees being willing to pay the related insurance premiums inherent in the lease payments. 4. Ready availability of financing and/or 100% financing Leasing can provide an easily-accessible form of financing for entities with weak credit ratings. As well, whereas banks usually restrict loan financing to 75% or 80% of the cost of an asset, leases may provide full funding (if lease payments are required at the end of each period and there is no security deposit) or close to full funding (if lease payments are required at the beginning of each period). 5. Payment provisions Leases can provide a number of advantages related to payment provisions, including fixed financing rates, fewer or no restrictive covenants, no need to also pledge other assets as security, and rental payments that are tailored to when the asset generates revenue. Regarding the first advantage, leases with variable payments tied to interest rates are less common than variable interest rate loans. While this means that leases usually provide the advantage of stable, known interest rates, they can also lock lessees into high implicit financing rates. 6. Lease financing through manufacturers The lease terms offered by manufacturers may be more attractive than the terms offered by lenders since they may be dictated by other objectives as well as financial considerations. For example, the manufacturer may want to reduce the market for used equipment, or it may wish to retain control over maintenance and operating performance of the asset to ensure a quality reputation in the marketplace. 7. Organizational considerations Leasing may also be used to circumvent organizational restrictions on capital expenditures or the lengthy process required to obtain approval for such expenditures. This is not a wise reason for leasing, but it reflects the reality of organizational politics. CONCLUSION The capital budgeting process is a complex one involving numerous decisions. This document has focused on two of these decisions, the appropriate discount rate to use for discounted cash flow analysis and whether to lease an asset that has passed the capital budgeting screening process. The appropriate discount rate to use in net present value analysis is the entity s weighted average cost of capital. The WACC reflects the long-term capital structure of the entity and is a more relevant discount rate than the cost of a particular financing method, such as borrowing or issuing shares, because the acquisition decision should be independent of the financing method. CMA Canada 11
Once the decision to purchase an asset has been made, a firm should consider the merits of leasing as a financing method, in terms of the future cash outflows and other advantages leasing may have to offer. References: Beechy, Thomas H. and Joan E.D. Conrod, 2005, Chapter 17, Volume Two, Intermediate Accounting, Third Edition, McGraw-Hill Ryerson Limited, Toronto, Ontario. Gallagher, Timothy J., Joseph D. Andrew, Jr., Darek J. Klonowski, and Steven M. Landry, 2006, Chapters 9 and 14, Financial Management: Principles and Practice, Canadian Edition, Pearson Education Canada Inc., Toronto, Ontario. Kieso, Donald E., Jerry J. Weygandt, Terry D. Warfield, Nicola M. Young, and Irene M. Wiecek, 2005, Chapter 21, Volume Two, Intermediate Accounting, Seventh Canadian Edition, John Wiley & Sons Canada, Ltd., Mississauga, Ontario. Lusztig, Peter, W. Sean Cleary, and Bernhard H. Schwab, 2001, Chapters 15 and 25, Finance in a Canadian Setting, Sixth Edition, John Wiley & Sons Canada, Ltd., Toronto, Ontario. Ross, Stephen A., Randolph W. Westerfield, Bradford D. Jordan, Gordon S. Roberts, 2005, Chapters 14 and 22, Fundamentals of Corporate Finance, Fifth Canadian Edition, McGraw-Hill Ryerson Limited, Toronto, Ontario. October 24, 2007 CMA Canada 12