Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 28

Capital Budgeting and Feasibility Studies

Introduction

Invest for Returns above Cost of Capital

DCF Is Best Corporate Decision Model

Focus on Net Cash Flow

Capital Cash Flow and Adjusted Present Value Methods

Use Target Capital Structure over Life of Project

Summary

Additional Reading

INTRODUCTION

Good cost of capital estimation is essential to sound capital budgeting and feasibility analysis decisions. Because this issue has been the subject of many texts, people often take for granted that companies are effective in allocating capital to projects. But the evidence is not clear.

In 2010 the Association for Financial Professionals conducted a survey of corporate treasury executives regarding their internal cost of capital estimation procedures. Over 300 executives from the United States and Canada participated: 43% were from publicly traded firms; 57% were with firms with $1 billion in annual revenues or more, while 12% were with firms with less than $50 million in annual revenues.¹

The discounted cash flow (DCF) method was used by 79% of the respondents for project and investment evaluation; 91% of the firms with annual revenues exceeding $1 billion and 72% of the closely held businesses used the DCF method.

The cost of equity capital was estimated using the capital asset pricing model (CAPM) by 87% of the respondents, 87% of the firms with annual revenues exceeding $1 billion, and 82% of the closely held businesses.

There was a wide variation in the inputs used by ...