9.2 Investment Appraisal

1. The Investment Decision-Making Process

• Origination of Proposals

• Project Screening

• Analysis and Acceptance

• Acceptance Decision

•  Monitoring the Progress of the Project

2. The Cost of Capital

The cost of capital includes the cost of debt and the cost of equity, and is used by companies internally to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return.

(1) Cost of Debt

Cost of long-term loan

Cost of bonds

(2)Cost of Equity

Dividend growth model (DGM)

Shareholders often expect a dividend to be paid at the end of the year (D1), and for that dividend to grow in the future (g). By looking at how much shareholders are prepared to pay for this share (Po). it is possible to estimate the return that they find acceptable

【Example 3】

Wright has just paid a dividend of 60p and has a market value of £5.50. The dividend growth rate is 8%. Required: What is its cost of equity?

Answer:

The cost of equity=60×（1+8%）÷550=19.8%

l Capital asset pricing model (CAPM)

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks.

E(ri)=Rf+β(E(Rm)-Rf)

E(ri )= Expected return of investment          Rf = Risk-free rate

β= Beta of the investment                   E(Rm )= Expected return of market

E(Rm )- Rf = Market risk premium

【Example 4】

If there is a market return of 12%, and the risk-free rate is 4% (i.e. there is a risk premium of 8%)

(a)what is the required rate of return on a share with an equity beta of 1.6?

(b)what is the cost of equity if the equity beta of a share is 0.8?

Answers:

(a) Ke=4%+1.6×(12%-8%)=16.8%

(b) Ke=4%+0.8×(12%-8%)=10.4%

l Cost of preference shares

,   D=dividend paid,   P0=price

3. WACC

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation.

Ve= total market value of shares     Vd= total market value of debts

Ke= cost of equity                Kd=cost of debt

【Example 5】

Star company has long-term loan 3,000,000, bond 2,500,000, preference shares 1,000,000, common stock 3,500,000, the cost of these financing is 5% ,7%, 10%, 14% respectively, calculate the weighted average cost of capital for Star company.

Answer: