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Capital Project Management,

Volume II
Capital Project Management,
Volume II
Capital Project Finance

Robert N. McGrath
Capital Project Management, Volume II: Capital Project Finance

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Abstract
This book is a companion to Volumes I and III in the series, which
altogether comprise a comprehensive case study of Tesla through 2018.
Volume I addresses the comprehensive challenge of managing strategy
through capital project portfolios; Volume III is a complete and lengthy
traditional case study. This volume presents chapters that describe the cor-
porate strategy challenge from the economic theory called capitalism to
adding real economic value based on remuneration of the cost of c­ apital;
then, explain how this is accomplished through the capital budgeting
process emphasizing project hurdle rates; and then, discusses the respec-
tive contribution of free cash flow planned and managed at the capital
project level. Finally, capital projects are discussed from the perspective of
the financial options theory, largely as a way to manage risk and actually
enhance the likelihood that a project will be approved.
The author is a retired business professor, scholar, and researcher, not
an investigative reporter. His abiding research interest has always been the
management of technology and innovation. For this book, he c­ onducted
no interviews and double-checked no media data—though multiple
media sources typically provided cross-checks. This approach does not
portend to be any kind of tell-all inside story. It advocates no one person,
no one company, no one technology, and no portion past, present, or
future, of the global automobile industry at large. It accepts the veracity
of reported events and turns to their practical interpretations.

Keywords
Tesla; Musk; project stakeholders; corporate strategy; diversified portfolio;
EVA; capital budget; capital structure; cost of capital; opportunity cost;
WACC; hurdle rate; CAPM; DCF; capital rationing; IRR; NPV; RADR;
APV; project EVA; payback; relevant cash flow; free cash flow
Contents
Preface��������������������������������������������������������������������������������������������������ix

Chapter 1 Corporate Strategy and Capital Finance...........................1


Chapter 2 Capital Project Budgeting and Rationing.......................29
Chapter 3 Capital Project Returns..................................................63
Chapter 4 Capital Projects as Real Options....................................95

Conclusion�����������������������������������������������������������������������������������������133
Media Articles������������������������������������������������������������������������������������135
References�������������������������������������������������������������������������������������������137
About the Author.................................................................................139
Index�������������������������������������������������������������������������������������������������141
Preface
This book is a companion to Volumes I and III in the series, which
altogether comprise a comprehensive case study of Tesla through 2018.
Volume I addresses the comprehensive challenge of managing strategy
through capital project portfolios; Volume III is a complete and lengthy
traditional case study. This volume presents chapters that describe the
corporate strategy challenge from the economic theory called capital-ism
to adding real economic value based on remuneration of the cost of capi-
tal; then, explain how this is accomplished through the capital budgeting
process emphasizing project hurdle rates; and then, discusses the respec-
tive contribution of free cash flow planned and managed at the capital
project level. Finally, capital projects are discussed from the perspective of
the financial options theory, largely as a way to manage risk and actually
enhance the likelihood that a project will be approved.
To begin: economics has been known for centuries as the dismal
­science, as the following might infer about the present as well:

… to be consistent with the profit maximization premise, a firm


should invest in new assets whenever the return from the invest-
ment is equal to or greater than the marginal cost of capital …
Evidently, businessmen … set up criteria such as maximum pay-
back or minimal accepted return … [but] the difference in the
literature between articles by economists and articles by practi-
cal businessmen in this subject is so great that it is difficult to
believe they are writing about the same problem (Anthony 2007,
pp. 426–427).

While that quote is a little troubling for the academics who are really
its target audience, it should bother practitioners too. The problem is
complicated and elusive—corporations are capital allocation systems much
like Wall Street is. The major difference is whether distribution of capital
happens via the “invisible hand” or by internal administrative fiat. There is
x PREFACE

plenty of conversation and literature addressing the free market side, but
the preceding quote also suggests that perfecting the corporate task is far
from done.
This book is heavily quoted from the financial economics literature
concerning capital project budgeting, then paraphrased and explained
for the practitioner. The main objective is to provide a guide for capital project
planners who are professional project managers, but not financial experts
in their own right. In that way, they provide a bridge between corporate
­capital budgeting and project management, all coming together at about,
say, the level of the project sponsor who writes capital project proposals
with complete financial analyses. A main premise is that corporations
make internal capital investments through a standard budgeting process,
where capital projects circumscribe the major efforts.
CHAPTER 1

Corporate Strategy and


Capital Finance

Introduction
Volume I in this series addresses the comprehensive problem of corpo-
rate strategy using a project management approach, especially toward the
development of a portfolio of capabilities. This chapter in this volume
completes that theme toward addressing the capital project finance prob-
lem specifically. The pursuit of profitability cannot be correctly under-
stood without discussing the corporate strategy and then, afterward, how
that affects capital project planning and management. To begin, consider
carefully the italicized terms in the following:

(Niu May 18, 2017).

… Can Tesla be both overvalued and undervalued? … Tesla is absurdly


overvalued if based on the past, but that’s irrelevant. A stock price repre-
sents risk-adjusted future cash flows … Tesla can be overvalued in the short
term but undervalued in the long term ...

It‘s all interrelated, though … Executing in the long term may subse-
quently drive the market cap higher, although Tesla will still need to
address its short-term challenges.

By early 2017, Tesla had made the stunning achievement of exceeding the
market capitalization of any other U.S. auto manufacturer, but was still
far from demonstrating profitability. Was this feat just an investment bub-
ble as they say, the irrational exuberance of a recovering global economy,
animal spirits gone over the top? After all, the market cap went back down
2 CAPITAL PROJECT MANAGEMENT

before long, though for many reasons and not all the fault of Tesla or
Elon Musk. The dynamics of these things are complex and sophisticated,
and obviously, outcomes depend on how executives manage the external
situation from all points of view.
Words like capital, capitalization, and capital projects are used fre-
quently. Connotations and opinions aside, in a capitalist economy, like
those who characterize most of the industrialized world, financial and
investment pressures are never irrelevant, invariant, or confined to Wall
Street. One way or the other, all humans are invested in this story, and it
does well to have insight into what is going on. Grasping the concept of
capital itself helps explain why people on Wall Street think the way they
do, and why the news media often speaks the way it does in the terms it
uses.

After studying this chapter, the reader will be able to

Provide a simple explanation of capitalism as an economics theory that is


focused on the productivity of accumulated investment or owner capital.

Explain the difference between economic profit and accounting profit,


how each is measured, and where to find these numbers in required cor-
porate financial statements.

Define opportunity cost and explain its importance to understanding the


cost of capital.

Define capital structure and the weighted average cost of capital (WACC).

State the relevance of the WACC to the capital project hurdle rate.

What Is Capital-ism?
Capitalism is the economics theory that cannot be properly understood unless
the word capital, not liberty or freedom per se, stands at its center.
Part of the confusion lies in the fact that the word capital can be
inferred to mean different things, but they all come down to one. Think
of capital as anything that can be used as a resource in a production process.
That is close enough to the economic definition, which is a little more
complicated. Hopefully, the production process in mind is the one that
somehow, adds value to the monetary cost of any capital resource, allowing
Corporate Strategy and Capital Finance 3

a price above cost that is justified at least by that added value. Here, cost of
the resource means the cost of parts, labor, equipment, land, and the cost
of money itself.
It was discovered early in the Industrial Revolution (i.e., in the late
1700s and especially the early 1800s) that any one person could become
only so productive at the added value part, without getting a boost from
some kind of production technology, for example, in those days, the
steam engine, the reaper, the cotton gin. Let us say that 100 people all
making (or growing) the same thing but all separately, added up their
total production and calculated its value; the latter basically, the average
price across all 100 individual producers, times their overall unit volume.
Now, let us say that all 100 business owners agreed to pool their resources
so that en masse, they could jointly buy and own some newfangled inven-
tion that processed their resources and produced the product. Assume
that no one person could afford the technology, but together they could
buy and own it.
Ownership of private property is a key to it all, then and today.
Today, people buy stock and own a company collectively; in those
days, they bought livestock and owned a herd collectively, which is at the
etymology of the idea. The economic principle is the same. Now, corpo-
rate bonds that are sold and used to finance a firm are also called capital,
but represent debt and not ownership, and the economic principle is a
bit different. The distinction is important and will resurface later when
discussions become more specific.
As they hoped, the total production went up, and also, the unit cost (hence
the average price they could offer) went down.
Next, assume they formed an organization, called it a corporation
in order to separate ownership from management for good legal rea-
sons, and thereby hired several people called managers whose prime
duty—their fiduciary duty—was to properly oversee their property
and maximize its economic potential, unless otherwise directed by said
owners.
To help monitor this duty, they created a committee called the board
of directors. First and foremost, the board worked for the true owners, not
the managers. In fact, its prime job was to make sure the managers best
represented the interest of the owners and investors of the capital.
4 CAPITAL PROJECT MANAGEMENT

The investors of capital had property rights, real property rights, while the
managers “just worked there.”
Assume that the economic gains to this productivity phenomenon
were returned to the 100 original owners in proportion to their personal
investments. One period to the next. It was the productivity improve-
ments that really mattered, so soon they expanded by borrowing from
others and buying more land, more equipment, and hiring more people.
All investors owned the company in proportion to their investments and
made proportionate returns.
The owners of capital made more economic gain by pooling it and entrust-
ing it to managers, than by keeping it fragmented and personally controlled.
In this light, consider:

(Lovelace May 14, 2018).

Buy and hold billionaire Ron Baron on Monday defended his invest-
ment in Tesla, saying he doesn’t care that he hasn’t made very much
money from the electric-car maker yet.

“I think we’re going to make 20 times our money because the oppor-
tunity is so enormous,” [he said,] “people say, ‘gee, they’re spending a
lot of cash.’ of course, they’re spending a lot of cash. They’re building
factories.”

If an investor waits until something is successful then, “it’s too late.


Then you’re going to pay a high price,” said Baron … “what we try to
do is buy when that development is taking place.”

The economic value of a firm, then, is said to be, in today’s terms,


the value of the firm that can be rationally predicted of its future. When
the hypothetical capitalists of yesteryear invested in continuing improve-
ments, the true value of their pooled property was worth what it could
be expected to return while it was managed properly and responsibly over
time—not at that particular time.
That is what determines the value of any asset in the—predicted future
returns, all in “today’s dollars.” And, the modern corporation is a bundle of
asset (re: balance sheets) owned by the investors (e.g., stockholders).
Corporate Strategy and Capital Finance 5

Of course, predictions are not always made on such a perfect rational


basis, but cooler heads prevail in the long run. It is the changing confi-
dence in the accuracy of the prediction that determines the expectations,
and this is measured as volatility, the ups and downs that happen to the
value of property as news about the future evolves.
That, in a nutshell, is capitalism as an economic theory. It is not cen-
trally about the freedoms that are more the essence of entrepreneurship,
it is about pooling capital to exploit the inherent economies in doing
that, improving productivity while also increasing production, and cre-
ating wealth that is first, the rightful property due to original owners and
risk-takers.
Its success or failure comes down to continuously improving the produc-
tivity of invested capital, not just increasing the overall production volumes,
not just reporting profits, not just making money.
It is ultimately about changes in the standard of living for all, which
is the true and final measure of real economic wealth.

Economic Value-Added Is Real Profit


and Created Wealth
Before continuing, it will help to repeat a few thoughts from Volume I in
this series. Here though, the discussion is expanded.
At the corporate level, the strategic issue shifts from profitability and
competitive advantage in only one industry, to maximizing returns to
shareholders by operating in several industries (Adjaoud, Charfi and
Chourou 2011; Baker and English 2011; Ferreria 2011). The practical
issue is whether a corporation can get better financial results by managing
several lines of business under the corporate umbrella, or not. The man-
agement challenge is to develop a corporate portfolio of businesses such
that altogether, they achieve superior results as a portfolio. So, then, in a
corporation, each business division manager is responsible for competi-
tive advantage, while the corporate echelon pursues stockholder wealth.
As it pertains to making investment decisions, the general public
is about as well-informed as corporate managers and about as capable
of efficiently allocating their own capital as corporate managers can on
their behalf (Adjaoud, Charfi and Chourou 2011; Baker and English
6 CAPITAL PROJECT MANAGEMENT

2011; Ferreria 2011). Corporate executives now need a different argu-


ment, one that is more comprehensively strategic than exclusively finan-
cial. The most popular argument nowadays is that corporate portfolios
should make sense by dint of a commonality across business divisions in
their competencies and capabilities that may not even be apparent on the
­surface (Adjaoud, Charfi and Chourou 2011; Baker and English 2011;
Ferreria 2011).
In order for capitalism to work, value needs to be added to the inputs
to production processes (Baker and English 2011; Porter 1985). The
outputs need to have been uniquely developed into goods and services
that are worth more as outputs. In any given value chain, for example,
in any given firm, this is measured as margin—and finally, as positive
earnings, the accounting profit seen in annual reports and the financial
statements they are obliged to show (for publicly traded firms). But, that
is not enough for capitalism to work over long periods, or for individual
corporations to even survive.
In order to thrive in modern capitalism, a corporation must deliver sus-
tained and superior economic value-added (EVA) or economic profit.

Using Annual Reports to Construct EVA


As the best measure of real economic profit, the concept and metric called
EVA was created and trademarked years ago by the consulting firm Stern
Stewart and Company (Besanko, Dranove and Shanley 2000). Since
then, it has been reproduced countless times mostly in the academic lit-
erature—not nearly as much in the popular literature, probably it is not
required to be reported—and has taken on different variations in the public
domain.
Long-term, sustained profitability depends not on accounting profit,
but economic profit, which is not the same thing (Adjaoud, Charfi and
Chourou 2011; Baker and English 2011; Ferreria 2011). Again, for
capitalism to work, investors (especially stockholders but also bond cred-
itors) must be remunerated for the risks and forgone opportunities they
experience when they invest their capital into the hands of corporate man-
agers. This is a measurable cost to the corporation that is simply called the
cost of capital.
Corporate Strategy and Capital Finance 7

In the simplest sense, costs of capital include dividends paid to stock-


holders and interest paid to bond creditors. Past that, they are not the
same thing. Bond creditors are not owners, whereas equity owners are
literally that. Here, it is the owners who are stressed.
On the assets side, balance sheets show capital assets (property, plant,
and equipment; retained earnings, and current assets), as well as debt
principle, which is capital too, but shown on the liabilities side. There,
as the terms would logically infer, owners are kept distinct from credi-
tors (Barney 1997; Besanko, Dranove and Shanley 2000; Grant 2002;
­Horngren, Sundgren, and Stratton 2002). The costs of capital are not shown
anywhere per se.
On income statements, “Interest expense is a non-operating expense
… It represents interest payable on any borrowings—bonds, loans, con-
vertible debt or lines of credit. It is essentially calculated as the interest
rate times the outstanding principal amount of the debt” (Investopedia).
Usually, one will also find the term EBIT—earnings before interest and
taxes—appearing just above earnings or accounting profit, the bottom
line. Interest on debt is part of the cash flow that any income statement
shows in the first place and provides a tax deduction—after all is fig-
ured, profit results. However, while earnings—accounting profit, literally
and figurately the “bottom line”—are reported after bond interest is paid (less
the tax deduction), dividends paid do not show. Dividends are paid from
accounting profit and only in consideration of them after the fact. This
makes the term bottom line a little specious, but that argument will be
left aside. At any rate, this is because dividends are not a liability (as in
assets and liabilities) like bond interest; they are entirely optional. In fact,
if no earnings are reported in the first place; the typical policy is that no
dividends are paid in the given period either. Perhaps, that explains the
historical mystery.
A given report of positive earnings, considering a specific firm’s his-
tory, strategic goals, and reputation, may offer some suggestion of div-
idends paid (or to come) based on whether a firm’s stock is considered
a value stock like GM, or a growth stock like Tesla. An investor such
as a retiree, who is interested in investing for immediate (fixed) income,
is likely to invest in a portfolio well-represented by the likes of GM, or
Procter and Gamble, or Coca-Cola, that is, firms that have decades-long
8 CAPITAL PROJECT MANAGEMENT

and reliable histories of decent earnings and steady dividends. An investor


with better reasons to take short-term risks, such as a young professional,
is more likely and well-advised to include investment with longer-term
goals like capital appreciation—rising stock prices over time. Compare
and contrast stakeholder concerns in the following:

(Levine-Weinberg April 9, 2017).

… GM’s … is well positioned to increase its free cash flow over the next
five to 10 years … General Motors [has] a long-term plan to move all
of its vehicles to …four major platforms … it could reduce GM’s an-
nual capex requirements further, boosting free cash flow …

… General Motors is a mature company, so it’s appropriate for it to


focus on generating free cash flow and returning most of that cash
to shareholders. By contrast, Tesla is still in the early innings of its
growth, so it’s quite sensible for the company to be investing heavily …
http://ycharts.com/companies/TSLA/chart/

However, in the very long run, free cash flow drives share price perfor-
mance.

Free cash flow—this important measure of overall business success is


worth stressing as something of a golden fleece to keep in mind for a corpo-
ration in aggregate. Free cash flow (lowercase) is not a line item at the cor-
porate level of reporting, that is, it does not ordinarily appear on income
statements (or inferred on balance sheets). It can usually be easily con-
structed from the data there, though. Still, while a positive free cash flow
is usually instrumental to reporting profit (i.e., earnings or sometimes net
income), none of these terms nets dividends to owners. In short, amidst
all the potential confusion that balance sheets and income statements
might generate for anyone trying to figure out the health of the corpora-
tion, it stands universally true that they simply do not, anywhere, reflect
dividends paid to their rightful owners. And, the owners are the real issue
of concern in capitalism as a simple matter of property rights.
Corporate Strategy and Capital Finance 9

Economic Profit
It is almost a matter of common sense, then, to say that real profit, called
economic profit, does not occur until all the costs of capital are paid, including
dividends on equity and not just interest on debt, and then some past, which
is called EVA (Besanko, Dranove and Stenley 2000).
Though EVA is a financial measure, it is the real bottom line in a true
economic sense as opposed to an accounting convention (calling to mind
the broader differences among the three fields). When investors’ expecta-
tions are exceeded, real economic wealth is said to be created. There are
slightly different ways to express EVA mathematically, but they all say the
same basic thing. One form is (Horngren, Sundem and Stratton 2002):

EVA = adjusted after-tax operating income


Minus
(cost of invested capital (%) × adjusted average invested capital)

First, this equation mentions adjustments. How, when, and why to adjust
the main terms are out of scope of this discussion, but practitioners may
want to check into it if EVA is to be used, especially to evaluate mana-
gerial performance. The main idea is to first consider accounting profit
before interest on bonds is deducted from the tax burden, because the
latter term takes care of that concern in its entirety. The latter term mul-
tiplies invested capital by the cost of invested capital, which includes the
cost of debt interest in the respective percentage. At the same time, it
takes care of debt and debt interest, it also multiples the percent cost of
capital times the equity, because both debt and equity comprise the total,
average invested capital. The percent used to compute the cost of capital
in this equation is a composite like the WACC, which will be discussed
in a little while. To complete the picture using other terms found on
most balance sheets, for EVA purposes (but not all purposes), long-term
invested capital equals total assets less current liabilities, or long-term lia-
bilities plus stockholder’s equity (paid in capital plus retained earnings)
(Horngren, Sundem and Stratton 2002, pp. 408–412).
In other words, everything on the right side of a balance sheet, except
for current liabilities, can be considered the invested capital for this
10 CAPITAL PROJECT MANAGEMENT

purpose. (Ignore the subtleties of book value versus market value just to
maintain the simplicity of the point. This will be revisited.) This brings
one more thing to mind. In this sum, as said, are all long-term liabili-
ties (like corporate bonds) and all stockholder equity. Stockholder equity
includes common stock, which is part or all of what can also be called
paid-in capital, and stockholder equity also includes retained earnings. In
other words, stockholder equity equals paid-in capital plus retained earn-
ings. Retained earnings is not an accounting pool of money, though, it is just a
way of representing, as a balance sheet liability, another kind of residual claim
that the owners have on the total assets of a corporation, that is, the other
side of the balance sheet. The equity “in” retained earnings may be reflected
just about anywhere in total assets—plant, equipment, inventory, and even
cash. Hence, when some firms hold large amounts of cash rather than
re-invest immediately in fixed assets through capital projects or the like,
the term sitting on piles of cash is sometimes used out of ignorance. Cash
is part of working capital too, even if it is only earning modest interest in
things like commercial paper, bank notes, and overnight paper.
Another way to express EVA is captured in the following equation
(Arnold and Nixon 2011b).

EVA = net operating profit after tax (NOPAT)


Minus
(Invested capital × WACC)

Where NOPAT = (revenue – operat-


ing expenses – depreciation) (1 – tax rate)

NOPAT is after-tax cash flow, where depreciation is included. This is


not a trivial matter. Depreciation is the manner by which investments
in physical capital are actually accounted for, to minimize their tax effect
in the first place, rather than to write them off when they are actually
incurred, which may be a bad time for tax purposes. It is typical to think
that investments in physical plant or property are paid for up front or
nearly up front sometime in the first year, yet they will not start generat-
ing revenues for some time, maybe years. In such a case, that is, if there
Corporate Strategy and Capital Finance 11

are no profits in Year 1 from other sources, there may be no point writing
off the capital investment right away.
Using a depreciation schedule in the out-years rather than up front expens-
ing allows the firm to account for the investment in later years when revenues
from the investment are likely, when profits can be written off.
In other words, an income statement is a cash flow statement, but it is
short term with respect to the true performance of capital projects of the
kind being considered. For present purposes, multiple periods (normally
years) are important to consider because investments take years to pay
off their positive cash inflows. Even though EVA is a kind of cash flow, it is
short-term-oriented. For that reason alone, it is difficult to specify a direct,
mathematical relation between corporate EVA in, say, one year as might
be discussed in an annual report, and capital project-specific outcomes
and metrics like free cash flow over the lifecycle of a project.
Depending on context, this can be important for another reason.
When the term is used in the media, free cash flow is usually a short-term
concern, as the context is usually quarterly or annual reporting of earn-
ings. This does not normally include discounting for the effects of time,
which is an acceptable practice over such short periods. Over longer time
than a year, discounting is practically a must. But here, note that EVA does
not discount for the effects of time, not even inflation as the term is com-
monly used. Inflation, too, will be considered later.
It is possible and indeed common for the costs of capital to wipe out an
accounting profit. When EVA is negative—when the costs of capital are
greater than accounting profit—real economic wealth has been destroyed, at
least in the jargon of economics.
This is also to say that when costs of capital are exactly but merely
paid, investors’ expectations are barely met, and EVA is zero! At the cor-
porate level, as a matter of strategy and not quarterly reporting, EVA
really is the Golden Fleece, not free cash flow. This is what capitalism
comes down to as an economic theory.
A few more words will be enough. “Basically, EVA is the residual
income a company earns after capital costs are deducted. More specifically, it
is operating profits minus the required dollar-amount returns for the capital
employed” (van Horne 2001, p. 214). One term here worth mentioning
is residual income, because this term is often used as a category of more
12 CAPITAL PROJECT MANAGEMENT

specific metrics like EVA—any “after-tax operating income less imputed


interest” (214).

Market Value-Added
As aforementioned, market value was mentioned along with book value,
but discussing meaningful differences to present points was postponed
until this point. The difference is relevant to EVA.
Another form of residual income is market value-added or MVA, but
this term can mislead the present discussion and will not be employed. To
be clear about one point, though, MVA sounds like it might be a version
of EVA using market value rather than book value, but that is not the
case. Both EVA and MVA use book or historical values. The difference
between EVA and MVA is actually rather simple. EVA is a short-term
measure (essentially obviating the need to discount the cash flows), and
MVA is a much longer-term measure, in the purest form considering a
firm’s present market capitalization (shares times price) against the orig-
inal value of capital that was originally invested (Heerkens 2006). In a
way, it is nominal capital appreciation writ large and long term, perhaps
of keenest interest to the economist as opposed to the executive strategist.

Return on Investment
Somewhat lost in these ideas is the notion of return on investment, ROI.
Consider:

(DeBord November 25, 2017).

… From a return-on-investment-capital standpoint, Tesla is a catastro-


phe, while GM is a triumph. GM has been making money for years
and is now seeing its stock climb … [while] Tesla just notched the big-
gest quarterly loss in the company’s 14-year history.

That said, Tesla continues to enjoy a $50-billion-ish market cap (larger


than Ford and Fiat Chrysler Automobiles) and a seemingly endless ap-
petite for new capital raises and more recently, debt issuance …
Corporate Strategy and Capital Finance 13

The Model 3, meanwhile, is a production disaster. And it is sort of un-


precedented in the auto industry … if any other automaker had half a
million pre-orders for anything, it would be moving heaven and Earth
to get those vehicles to market.

A problem occurs when speaking loosely about returns on an invest-


ment, especially in lowercase. In other words, just saying returns or
returns on an investment is not the same thing as using the abbreviation
ROI, which denotes a specific formula of some particular creation. The
general form of any ROI metric would be a measure of return over-
and-above the full return of an amount of principle invested, divided
by that amount invested. When used in caps, ROI is a specific finan-
cial accounting ratio that is possible to confuse with returns on equity
(ROE), returns on assets (ROA), returns on invested capital (ROIC),
and possibly others.
All these terms may appear in an annual report, but none is EVA. Only
EVA is EVA, period—but, it does not appear on traditional financial state-
ments, and there is no requirement to report it.
Anyway, as a practical matter, nobody hears caps. For the reminder of
these discussions, then, return on investment—small letters, may be con-
sidered the grand goal in the abstract. Later discussions will address proj-
ect-specific returns on investments using more appropriate metrics that
have greater fidelity in addressing the capital asset allocation problem.

Historical Cost, Book Cost, and Market Value


Understanding the difference between economic profit and accounting
profit depends on some understanding of accounting principles, the first
being the notion of historical costs. It matters because this immediately
points out a kind of rift between the external investors of a firm and
the firm’s managers investing in capital projects that hopefully achieve
accounting objectives that produce economic profit and EVA.
As practically mandated by the Generally Accepted Accounting Principles
(GAAP), accounting statements are based on accrual accounting, or historical
costs.
14 CAPITAL PROJECT MANAGEMENT

Accounting statements—in particular, income statements and balance


sheets—are designed to favor an audience outside the firm, for example,
lenders and equity investors. However, the costs that appear in account-
ing statements are not necessarily appropriate for decision making inside
a firm.
Business decisions require the measurement of economic costs, which are
just as often based on the concepts of opportunity cost and market cost.
Market cost, or market value, differs from historical or book cost
to the extent that as time passes, changes in market conditions often
change prices too. In a short period such as one year, there is not very
much difference. Book value is what the organization paid for an item;
market value is what it would fetch on an open market, usually “today.”
For example, the market value of capital equipment usually goes down
over years, especially as it becomes technologically obsolete; the m ­ arket
value of a production facility may go up, or at least the value of the real
estate itself. Different kinds of costs are used appropriately for d ­ ifferent
purposes, then, such as depreciation, which is based on book cost,
regardless of market value.
Book value can be used to calculate EVA in annual reports, and usually is.
After all, EVA is best used to contrast with accounting profit on a
short-term basis, say one year. When calculating EVA at the project-level,
however, things get messy because free cash flow substitutes for NOPAT
in the equation, which is usually measured over a span of multiple years,
because different components of cash flow can span different numbers
of years, and because the different components might be discounted
differently.

Market Value and Opportunity Cost


Market value and opportunity cost are in part causally related, but they
are not the same thing. This notion says that “the economic cost of deploying
resources in a particular activity is the value of the best foregone alternative
use of those resources” (Besanko, Dranove and Stanley 2000, pp. 21–22).
This is elemental reasoning but very important. Opportunity cost may
sound exotic at first, but it is easy to understand, and most people do it
intuitively in daily life all the time. Though somewhat hypothetical, the
Corporate Strategy and Capital Finance 15

opportunity cost is, at the same time, in economic reasoning a very real
cost that should be considered.
For example, consider a young adult thinking about going to college.
Imagine the person has a standing job offer right now that pays 40,000
U.S. dollars per annum, which will not be earned for at least the four
years off at university. The immediate opportunity cost of going to college
is 4 × $40,000, or 160,000 U.S. dollars. This is in addition to the more
obvious costs like tuition, room and board, auto, and so on.
The investment of these costs, these cash outflows, should be considered
against the incremental difference between, say, that forgone 40,000 U.S.
dollars per annum and the (hopefully) higher salary once the person is
degreed. These incremental inflows will eventually pay back the investment
outflows at some later point in time. Payback is one crude but common
method of assessing any kind of investment at all, including capital proj-
ects; the immediate concern is the concept of opportunity cost and how
necessary it is to consider in an investment decision.
These incremental inflows constitute a margin of gain, though the word
“profit” is not right. The net amount is a return on the investment, lowercase.
At some point later, say, at retirement when salary inflows stop, the total
returns, the total cash inflows, can be summed and then, when divided by the
initial outflows still including the opportunity cost, a simple kind of return
on investment (again lowercase) results—now expressed as a percentage,
using the sum of the returns divided by the sum of the investment costs.
Now, the astute reader will hasten to say that the effects of inflation
should be considered to make all annual dollar figures comparable; other-
wise, they remain apples versus oranges. With any significant amount of
inflation over a 40-year career, one cannot meaningfully net today’s salary
from a salary at retirement. One might even say, it is bogus. This is true
and critically important, but the time value of money will be considered
later, including the impact of inflation. Continuing:

… consider the resources (plant, equipment, land, and so forth) that


have been purchased with funds that stockholders provide to the firm.
To attract these funds, the firm must offer the stockholders a return on
their investment that is at least as large as the return that they could
have received from investing in alternatives of comparable risk … the
16 CAPITAL PROJECT MANAGEMENT

concept of opportunity cost provides the best basis for good economic
decisions when the firm must choose among competing alternatives
(Besanko, Dranove and Stanley 2000, pp. 21–22).

More to the point, if one firm does not produce the returns on an inves-
tor’s capital that least matches other investment opportunities in other
firms, adjusting for various kinds of risk, stockholders and bond creditors
can be counted on to withdraw their capital and invest it elsewhere. That
is exactly what happens every day on Wall Street; in a way, it is its major
dynamic of all.
Thus emerges an important set of assertions:

• Though EVA uses book cost and is best measured only annually,
to be a consistent, EVA leader over multiple years is to have true
competitive advantage because:
• If a firm is not consistently a leader in its industry in terms of
EVA, not just accounting profit or earnings, but also investors
will withdraw capital and invest it elsewhere unless the firm can
lure it back at a higher cost of capital, that is, at an even higher
rate of return to the investor.
• This begins a vicious cycle, as escalating costs of capital injure
competitiveness and pressure aversion to capital risk.
• Aversion to capital risk compels low levels of innovation and
short-termism.
• Worse, if EVA is negative, that means that value is being
destroyed, no matter what the accounting profit is.
• The “invisible hand” on Wall Street will figure this out even with-
out EVA metrics to assess.
• From the standpoint of accounting, it makes sense that firms go
out of business for this reason.
• From the standpoint of economic reasoning, it is justice. By this
word is meant, it is part-and-parcel of the rational capital alloca-
tion process.
• Capitalism lives or dies based on the productivity (%) of invested
capital, which is very different than more and more total produc-
tion.
Corporate Strategy and Capital Finance 17

In the final analysis, the face-value cost of capital must compensate for
its opportunity costs as well as the costs that are more obvious reflections
of investment risk, and this is no mere economic hypothesis. It is central
to the way that Wall Street allocates capital to the firms that best reward
it, not just to other firms that reward it at all.

Capital Structure
An acute problem that Tesla faced was how to generate the cash needed
to pay the obligations that were fast coming due on convertible bonds.
Readers without a business background may wonder why Tesla would
bother to issue debt, that is, to sell corporate bonds, given the meteoric
performance of its stock. The simple answer is: to manage financial risk
and the cost of capital, as one two-faceted problem. More specifically, it
is a common understanding that the tax advantages of using debt make
it preferable to using equity, which has no tax advantages at all. This is
not always true, though, depending on the complexities (Bierman and
Schmidt 2007). In order to understand this acute anecdote and many
others, the larger issue in this section is the cost of capital, specifically. To
proceed, keep in mind the last sentence:

(DeBord August 13, 2017).

... For several years now, Tesla has been the biggest “story” stock in the
world …

Bonds are a longer-term play, and for that reason, bond buyers
usually take a more macro view of the companies whose debt they
own. …

… What Tesla is actually doing with its cash flow will come under
greater scrutiny. And the source of that cash flow will also be under
the microscope …

We’ll have to see if Tesla’s two financial arcs — equity to one side, debt
to the other — can co-exist. Excessive debt tends to be a problem in
the car business.
18 CAPITAL PROJECT MANAGEMENT

Each corporation has a theoretically optimal balance between equity and debt
financing, where the optimum is which minimizes the overall cost of capital
to the firm.
Past that, every firm is different. There is no dependable rule for
stating the optimum mix. In any event, this is referred to as the capital
structure mix, or just capital structure (Ionici, Small and D’Souza 2011,
pp.  342–343). Before continuing, however, it is important to mention
that the present discussion addresses corporations on the whole. The idea
of project-level management surfaces often implicitly if not explicitly, but
the way individual projects are financed is not the present subject.
There are advantages and disadvantages to both equity financing and
debt financing, but a main advantage of the latter is the impact on taxes.
The interest payments on debt are tax-deductible, which has the final
effect of lowering the cost of debt capital once taxes are considered. In
large part, this is what the word “leverage” implies. In fact, mathematically,
it can be shown that the lowest overall cost of capital occurs with virtually
100 percent debt financing (Bierman and Schmidt 2007). However, debt
risk confers the risk of default, which does not apply to the cost of equity
capital, except, ironically, the risk of defaulting on debt raises the expec-
tations of stockholders to cover the associated risk of bankruptcy. Alto-
gether, the interdependencies make it difficult to determine a general rule
for the lowest cost of capital, so without making additional, restrictive
assumptions in the attempt, it is best not to try to be too mathematically
previse in order to shave a few dollars. The point is that substituting debt
for tax reasons eventually breaks-even on the overall cost of capital, so to
speak, and the overall effect reverses. That is one reason corporations do
not favor too much of an imbalance.
The Tesla excerpt indicates a danger of being highly leveraged, that is,
having a capital structure too laden with debt given the business situation.
The biggest danger of being highly indebted involves the risk of defaulting on
bond covenants, that is, not paying interest payments on time or at all, or for
that matter, not fully returning the original principal. This is the etymology of
why they are called “bonds” in the first place. Equity does not have any such
obligations, but debt financing is generally less costly than equity financing
because the bond obligations mitigate much of the default risk and the princi-
ple risk. Equity offers no guarantees about principle (i.e., stock prices can
Corporate Strategy and Capital Finance 19

go down as well as up) or interest (e.g., dividends are not obliged either),
though expectations play a huge role. Tesla was in a fix on both counts or
one might say, in a squeeze. The conundrum would soon begin to haunt
Tesla.
Before reading the following, understand that convertibles are notes
or bonds that include the right to convert the bond debt to equity, at the
discretion of the bond-holder. In that sense, a firm’s capital structure is
not under complete managerial control—not even the overall ratio:

(Duguid and Hunnicut May 16, 2018).

If Tesla Inc. … needs to raise even more money, there may be a way …
Convertible notes give investors the right to trade their debt for equity
at a conversion rate and are more appealing to the risk-averse, allowing
them to benefit from Tesla’s stock price rising while guarding against
the risk that it might not …

While Musk has said the electric car maker would not have to raise
more cash this year, Wall Street disagrees, with analysts saying the com-
pany would need to borrow if it continues to fail to meet its own pro-
duction targets for building new, lower-cost Model 3 electric sedans.

Finally, and again, aside the guarantee of the full return of the debt
principle, bonds also guarantee the interest. As far as bonds are con-
cerned, and for present purposes, the latter is the cost of borrowing in
the first place. The principal is the capital, and the interest is its cost to the
borrower—the cost of capital.

Cost of Capital
Borrowing from investors, whether in the form of equity or stock, debt or
bonds, or anything else, does not happen without compensation for several
kinds of risk.
Most simple, perhaps, is liquidity risk, or the loss to the investors of
the immediate control of their principal. Cash in one’s pocket is the most
liquid asset of all, and an asset’s liquidity degrades from there with the time
and effort and other costs of changing anything into a negotiable form.
20 CAPITAL PROJECT MANAGEMENT

Another is principal risk, or the simple risk that investors will not
get their money back, that being the actual dollar sum that they invested
regardless of any additional returns to it, degrading effects of inflation in
the meantime, or anything else but the face value of the dollars.
(When expressed in such terms, these dollars are called nominal dol-
lars. As nominal means in name, it is good to remember that hard, cold
cash dollars in one’s pocket as being the nominal ones. Think of the nom-
inal value of a dollar as the number that is printed on the actual paper
currency in real ink. That seems easy, but then there are real dollars after
adjusting for time value of money factors like ordinary consumer infla-
tion. For example, inflation affects the real ability of a dollar to buy some-
thing, its real purchasing power as time affects that power. So, when real
dollars are mentioned, think not in terms of what is really in your pocket,
but what its real purchasing power is or will become.)
Then, of course, is the return risk, or the risk they will not get the
return on their investment that they expect, whether by bond covenant or
any non-binding implied contract in a firm’s dividend tradition. In other
words, sometimes, the return is determined legal covenant, as in the case
of the guaranteed interest on corporate bonds. (This is the nominal rate for
bonds, the rate that is printed on the bond. The nominal rate says nothing
about the real purchasing power of the actual interest once adjustments
for the passage of time are considered, like ordinary inflation.)
Sometimes, it is more general and carries no guarantee, so terms other
than interest are needed—such as dividends on common stock and cap-
ital appreciation (rising stock prices) over time. Capital appreciation is
a return too, but it does not really cost the corporation anything in the
immediate sense, at least aside expectations and what they compel a firm
to do strategically. In other words, the idea of opportunity cost does apply
as it concerns any decision that may affect the stock price, but the math
is inexact dues to arguable assumptions about the objectives and expecta-
tions of the typical investor (Bierman and Schmidt 2007).
Of the myriad ways, any firm might be able to obtain financing, the
most popular ways would be: borrowing from banks, expansion of short-
term liabilities, selling marketable securities, selling assets or even whole
parts of the business, issuing additional bonds, preferred stock, or com-
mon stock, or of course, using the positive margins generated by current
Corporate Strategy and Capital Finance 21

operations (Bierman and Schmidt 2007). On the latter, funds generated


by operations mostly refer to positive operating margins or gross mar-
gins, that is, positive cash flows prior to be being adjusted downward on
income statements for things like income taxes and then finally reported
as accounting profit.
After that, that is, when adjusted downward again for the costs of capital,
the result is EVA, which is not obliged to be reported.
Other than declare dividends to be taken from accounting profit, a
firm may choose to keep some or all of it so that the funds can be used
in the future, to make future capital investments. This makes good sense,
but in no way does this mean that firms sit on piles of cash that really
belong to the owners. All returns certainly belong to the owners of the
firm in the final analysis, but assuming wealth maximization is the overall
goal, if funds are retained for future investments, then the returns from
those future investments must be at least as great as the dividends that
could otherwise be declared in the present day, adjusted for time and risk.
And, vice versa. This is one more way of saying two things: first, that even
retained earnings have a cost of capital, that being, second, the oppor-
tunity cost of the value of the alternative use. Another way to say this
is to invert the logic; the opportunity cost to an investor of being given
short-term dividends is the value they might otherwise get if retained and
invested in fruitful capital projects.
Capital in each and every form has at least one cost, that being the respective
opportunity cost of doing something else with it that is potentially more gainful.
This reality is not merely hypothetical, these things are calculated as
actual costs in the cash flows used for making important decisions, at least
when done on a real economic basis and not only on an accounting basis
(Bierman and Schmidt 2007).
There are other kinds of risks as well, but in a word, the cost of cap-
ital is the cost to the borrower, the corporation in this case, of getting
investors to lend them their assets at all, especially considering all the
other opportunities in the world, and not just on Wall Street. The present
explanation can be simplified by thinking of the overall cost of capital as
being the interest on bonds and the dividends on stock, which reflects
the opportunity costs of other alternatives to the investor, considering
the risks.
22 CAPITAL PROJECT MANAGEMENT

It can also be said at this point that for the purposes of this book, that
the cost of capital is at the heart of the capital project discount rate used
in equations, but they are not always the same thing. A discount used for
any immediate purpose may adjust the cost of capital for some good but
unique reason. Naturally, this works both ways. Corporations can acquire
the resources they need to operate—capital in the pure economic sense—in
other ways too, and by no means is Wall Street always involved, but these two
kinds suffice for now. Therefore, even when expressed as a simple ratio, the
capital structure of a firm signals a great deal of meaning to a skilled external
investor or financial analyst generally. Clearly, a firm’s capital structure and
leverage position are very important not only to a firm’s financial strategy,
but to its overall corporate strategy and potentially, its very survivability.
An illustrative point is how much pressure Elon Musk and Tesla were
getting from its creditors, just to produce enough autos needed to gener-
ate the basic cash needed to fund nothing more than its interest on debt.
To even risk not meeting a bond covenant is a serious legal matter. This
comes down to the seemingly trite but often-reported term cash flow and
the free cash flow generated by ongoing capital projects and the firm as a
whole. For now, one more term is important to understand the corpora-
tion as a whole, next.

Intro to Weighted Average Cost of Capital


If estimated using expected rates and target weights, the cost of capital is the
forward-looking rate of return that investors require for foregoing the best
alternative use of capital at a specific level of risk … When considering the
overall financing the company employs, the term WACC or simply the cost of
capital used (Ionici, Small and D’Souza 2011, p. 341).
WACC stands for weighted average cost of capital. To understand the
weighted average part, first recall the term capital structure: it represents
what is considered by the financial strategists to be the optimum propor-
tion of debt, common equity, and preferred stocks that minimize the over-
all cost of capital. When does that occur?

Theoretically, the optimum capital structure [i.e., where the cost


of capital is minimum] is reached when additional debt substi-
Corporate Strategy and Capital Finance 23

tuted for stock equity will result in a decrease in the price per
share of the stock. The capital structure just prior to the issue of
that debt is the optimum capital structure, but this point is easier
to define than to determine for an actual corporation. Whether
a company’s capital structure is optimum is a matter of intuitive
judgment (Ionici, Small and D’Souza 2011, p. 341).

The basic explanation is that “Any increase in the percentage of debt


used in the capital structure increases both the cost of debt and the return
required by the stockholders (there is more risk).” In other words, the cost
of additional debt is greater than the present cost of debt due to margin-
ally greater opportunity costs it takes to lure additional creditors, and this
in turn raises the expectations of stockholders to offset the additional risks
noted earlier. The optimum, a kind of inflection point, happens when the
overall cost is minimized. This was explained earlier in slightly simpler
terms.
The goal concerning a capital structure is to minimize WACC to the firm.
Just like any interest term, WACC is expressed as one overall number
that is a percentage. The means by which the optimal mix is determined
is the essence of an overall financial strategy subordinate to a business
strategy and corporate strategy. For example, if (in the unlikely case) a
firm fully finances itself externally only by issuing debt and selling stock,
and 60 percent of the total dollar amount is in bonds and the other
40 percent is in stock or market cap, then the firm’s capital structure is a
kind of debt-to-equity ratio, or 60/40 (it should also be noted that the
values used are market values, not book values, so a balance of equity and
debt can change over time for market reasons alone) (Ionici, Small and
D’Souza 2011). This possibility does not miss the keen eyes of corpo-
rate financiers or their stakeholders and explains some small adjustments
over time.
Again, the debt portion is known as leverage, and if a firm has a high
debt-to-equity ratio, it is said to be highly leveraged. Even small variations
in the ratio can have important consequences and are guarded closely by
corporate financiers and investors. This is a matter of strategy, and there is
a time and place for just about any ratio within a certain range of histor-
ical wisdom, economic conditions, and industry setting. Ratios that are
24 CAPITAL PROJECT MANAGEMENT

unusual for the situation get attention from all stakeholders, not the least
of which are stockholders and creditors.
This should shed light on some of the concern shown in media
accounts concerning Tesla. Considering its situation and strategy, its
leverage was worrisome. Not only the amount of debt, but the kind of
debt (convertible bonds) was truly weighting the cost of capital in a way
that was dangerous to both equity owners and debt lenders, in different
albeit interrelated ways (Bierman and Schmidt 2007).
Therefore, in addition to capital structure as a ratio, the WACC as a
percentage is an important number. There is a little more to estimating
the weights in the WACC than the ratio, however. A subtle issue switches
from the percentage of each asset, to figuring the raw amounts of money
assets are worth in the first place. Again, the book value of an asset is what
a firm paid out of pocket or originally, while the market value is what it
could fetch on the market for that kind of asset at any point in time—
commonly, the present. Regarding the weight estimation:

[T]arget market weights should be employed … The market


weights reflect current conditions and the effects of changing mar-
kets … Corporate finance managers can use the target weights as
reflected by the industry averages or those target weights used by
comparable firms (Ionici, Small and D’Souza 2011, pp. 342–343).

In other words, an asset’s market value can be fairly estimated by observ-


ing industry averages of what similar firms are using.
That may seem a bit herd-like or at least risk-averse, in that is assumes
that all others in the industry have an accurate collective wisdom. Think
of similar firms as the market really in question, in that the asset will fetch
whatever price the market will bear among firms most likely to buy it. At
the extreme, for example, capital equipment has a salvage value. This is
not always a paltry amount, because firms in underdeveloped countries
often take obsolete equipment quite readily, that is, the salvage value and
the scrap-metal value may differ quite a bit, regardless of its fully depre-
ciated value in book terms alone. In any case, at least, it identifies a kind
of level playing field for all players competing for roughly the same capital
Corporate Strategy and Capital Finance 25

from roughly the same investors in roughly the same lines of business,
and so on.
View the following table to see how WACC is basically calculated.
The depiction is very elementary, an example of what, in general, the
decision theory is sometimes called a weighted average scoring method.
Trained project managers should find this technique familiar, as the
general approach is used to help make other decisions. Applications are
ubiquitous and include the calculation of insurance premiums, reliabil-
ity predictions, warranty costs, and even the expected value of a bet in
Vegas—the EV, pun unavoidable. It is not wrong to think of WACC as
the expected value of the cost to the corporation of a dollar in the capital
structure. See Table 2.1.
In that case, first note the simple capital structure in the table. Assume
that the only capital in the capital structure is common equity and ordinary
corporate bonds. (Taxes are ignored for the sake of simplicity in this exam-
ple, but otherwise, they are important to be considered because interest on
bonds is tax-deductible, which affects their real capital cost to the firm and,
by the way, are included in income statements and affect the bottom-line
accounting profit or earnings. Also, dollars are expressed in nominal terms.)
The total capital investment in the firm is $200M = $150M + $50M –
or proportionately, 75 and 25 percent of the total. In the more generic
lingo of expected value theory, these are the weights. The costs of capital are
expressed as percentages of the principles invested, 5 and 3 percent.

Table 2.1  Weighted average cost of capital


Weight Cost
Cost of (% of total x
capital capital) Weight
Equity (common stock) 0.05 (5%) 0.75 0.0385
Market capitalization (shares × price)
= $150M
Projected dividends per share = 5% of
the share price
Debt (corporate bonds) = $50M 0.03 (3%) 0.25 0.0075
Interest on bonds = 3%
WACC 0.046 or
(Sum of the column preceding it) 4.6%
26 CAPITAL PROJECT MANAGEMENT

The WACC is 4.6 percent. There is also an instructive way to put


this through a sanity check. First, note that the WACC of 4.6 percent lies
between 3 and 5 percent. This much must be true; the WACC cannot
lie outside these upper and lower bounds. Second, note that the WACC
is not a nice and tidy 4.0 percent, which is the simple average, mean,
and median of 3 and 5. Rather, the WACC is biased or weighted toward
the higher cost of capital (5 percent) due to its heavier weighting by the
amount of its principle ($150M versus %50M).
Now, consider taxes. Despite the statutory corporate tax rate, most
firms have enough accounting savvy to legally pay less. Some corporations
pay no federal income taxes at all, but one must examine why for any
instance (e.g., charitable local donations, environmental philanthropy,
investments in research and development (R&D)) before making judg-
ments. Anyway, assume the aforementioned corporation pays 10 percent,
which is lower than the federal rate at the time of writing, picked only
to help illustrate. The interest on bonds is 3 percent, and let us say that
the time has come for that to be entirely due. The interest paid credi-
tors is 3 percent of 50 million U.S dollars, or 1.5 million U.S. dollars.
This becomes deducted from the firm’s earnings before interest and taxes
(EBIT on income statements, which is not specified here) and 10 percent
of that is paid as income tax. If EBIT was 100 million U.S. dollars, then
after the interest deduction from taxable income would be 98.5 million
U.S. dollars; 10 percent of that is 9.85 million U.S. dollars, legally avoid-
ing a difference of 10 million U.S. dollars less 9.85 million U.S. dollars,
or 150,000 million U.S. dollars.
The impact is to lower the effective WACC, so the effect is said to “leverage”
the equity.
The impact on the debt is to lower it from 1.5 to 1.35 million U.S.
dollars, which is 2.7 percent of 50 million U.S. dollars and not 3 percent.
The overall WACC recalculates to about 4.5 percent from the above 4.6
percent. Offsetting the leverage is the risk of default; equity has no default
risk per se, but does become impacted by the associated risk of complete
bankruptcy. Cutting to the chase so to speak, it turns out that when all
theoretical assumptions are relaxed, capital structure does not affect the
value of a firm (Bierman and Schmidt 2007). Practical implications fol-
low logically.
Corporate Strategy and Capital Finance 27

In theory, the optimal capital structure (i.e., one that minimizes the costs
of capital and WACC) contains virtually 100 percent debt and no equity—
assuming taxes, and the more taxes paid, the more this is true.
Without assuming taxes, which in effect is paying no taxes regardless
of any statutory rate, the optimum is indeterminate as a general rule.
Corporate executives should strategize their capital financing accord-
ingly based on their own assumptions, as part of an overall corporate
strategy.

Conclusion
In a multi-business corporate portfolio, the strategic issue is the maximi-
zation the wealth of owners. Investors expect fair returns, which largely
means returns proportionate to the risks they take for lending their capi-
tal. The ultimate issue is the creation of EVA or economic profit, in addi-
tion to any accounting profit that may be reported. Because positive EVA
occurs only after lenders and equity owners are paid, sustained above-nor-
mal EVA confers low cost of capital in turn. Explaining this phenome-
non also addressed the opportunity cost of capital, capital structure, and
WACC.

Discussion Questions
What is capitalism, and what does it have to do with capital and private
property?

What is the difference between economic profit and accounting profit,


and where does one find these numbers on financial statements?

What is the relationship between the idea of opportunity cost and the
calculation of the cost of capital?

What is an ideal capital structure in terms of the WACC?

Key to Comprehension
What has all of this—combined—got to do with the capital project hurdle
rate?
Index
Alphabet ‘f’ in italics after the page number indicates figure.
adjusted present value (APV), 83, capital project, 2, 13, 15, 21 31, 32,
86–87 36, 39, 48, 53, 65, 69, 74, 78,
definition, 86 92, 103, 133. See also capital
arbitrage pricing theory (APT), 45, budget; corporate budget
103 breakeven, 113–114
concept of, 45–46 economy of scale, 111–113, 121
and free cash flow, 81–84
book cost, 14 funding of, 31
book value, 14, 24, 80 and net present value, 103
breakeven and option purchase, 106
definition, 113 option types, 115
labour intense vs. capital intense, real option analysis
113f, 114 advantages of, 104
point, 114, 123 disadvantages of, 104–105
financial logic in, 103
capital asset pricing model (CAPM), in decision making, 103
phasing and scheduling, 103
36, 40–41, 42f, 68, 84
real option pricing, 103
advantage of, 46
underinvestment problem,
arbitrage pricing theory, 45
107–109
asset class, 42, 44, 53, 58, 69, 87
risk-neutral pricing, 110–111
and beta estimation, 45, 66, 68, 70
stages in, 95–96
capital assets, 42
capital rationing
and cost of capital, 40 cost of capital in, 57
and individual projects, 64–67 need for, 57, 59
and risk-free rate, 43 profitability index, 60–61
theory of, 41–42 project ranking for, 59–60
capital budget, 2, 13, 15, 21, 30, 31, use of hurdle rate in, 58–59
32, 36, 39, 48, 53, 57, 65, 69, capital risk, 16, 40
74, 78, 88, 92, 103, 133. See capital structure, 17, 18, 22, 27, 33,
also capital; capital rationing; 37, 64, 108. See also weighted
real option analysis average cost of capital
budgeting processes in, 52, 55, 56 and bond, 18, 19
capital allocation, 54–56 cost of capital, 18
capital asset liquidity, 53–54 debt risk, 18
capital charge in, 31 equity vs. debt financing, 18
expense vs. investment, 32, 33 goal of, 23
vs. operating budget, 30, 35, 36, 37 capital, 2, 3, 4, 5, 10, 12, 16, 17, 21,
risk adjustment in, 87–89 34, 35, 37, 39, 46, 57, 58,
142 Index

133. See also capital budget; and beta risk , 66, 69, 70
capital rationing for corporate divisions, 69–70
definition, 2 and individual project, 64
equity owner vs. bond creditor, 7 and net present value, 65
ownership, 3, 4, 7, 8 risk adjusted discount rate,
and resource cost, 3 67–69, 76
capitalism, 2, 4, 6, 8, 11, 16, 133, discounted cash flow (DCF),
134 47, 48, 73
and economic value-added, 6, 134 and cost of capital, 48
corporate budget and depreciation, 78–81
capital charge in, 31 and discount rate, 48, 74
capital vs. operating, 30, 36, 37, 82 and internal rate of return, 51–53
investment vs. expense, 32, 33 and net present value, 48–49,
project capital, 31 74–75
corporate portfolio, 5, 6, 97 net present value vs. future value, 75
corporate strategy, 1, 5, 22, 37, 57 net present value vs. internal rate of
corporation, 3, 4, 5, 6, 8, 18, 21, 26, return, 75–76
30, 33, 40, 64, 68 principle, 48
and board of directors, 3 project return, 74, 75
and capital, 33 sales revenue, 74
and economic value-added, 6
and hurdle rate, 68 economic profit. See economic
and master budget, 30 value-added (EVA)
and ownership, 3, 4 economic value-added (EVA),
cost of capital, 3, 7, 11, 17, 18, 19, 5, 6, 9, 12, 14, 16, 21,
21, 24, 27, 31, 40, 48, 52, 56, 31, 37, 40, 77. See also free
65, 86 cash flow; project economic
capital appreciation, 20 value-added
and capital asset pricing model, and after-tax cash flow, 10
40–41 as a financial measure, 9
definition, 21 and book value, 14
and discount rate, 22 equity owners vs. bond creditors, 7
dividend, 7 vs. market value-added, 12
interest expense, 7 need of annual report for
and liquidity risk, 19 construction of, 6–8
and principal risk, 20 residual income, 11–12
and return risk, 20 shot-term cash flow in, 11
weighted average cost of capital, economy of scale, 121
22–23 as a economic potential measure,
cost of debt, 38 112
capital risk, 40 and average total cost, 112
components in, 38–39 breakeven, 113–114, 123
and inflation, 39 capital intensity, 114–115
risk-free rate, 38–39 definition, 111
and fixed cost, 111, 112
debt financing, 17, 18, 53, 64, 69 issues with, 112
discount rate, 22, 49, 52, 56, 58, 64, and total cost, 111
74, 76, 89, 110 economy, capitalist, 2, 55, 133
Index 143

capitalism, 2, 133, 134 net present value (NPV), 37, 48–49,


and ownership, 3, 4 58, 61, 65, 69, 75, 76–77, 86,
equity, 10, 17, 18, 22, 23, 26, 27, 31, 103, 126
40, 43, 64, 70, 83, 86, 109 compound interest in, 51
and discount rates, 49, 51
free cash flow (FCF), 8, 11, 14, 22, and interest rate, 48, 49
34, 58, 91, 134 vs. internal rate of return, 75–76,
adjusted present value, 83 77
as a business success measure, 8, 81 pitfalls in application of, 109
concept of, 82 and risk-adjusted discount rate, 76
vs. operating cash flow, 82 role of inflation in, 49, 51
future value (FV), 75
opportunity cost, 14, 15, 20, 21, 23,
Generally Accepted Accounting 53
Principles (GAAP), 13, 30, 79
payback, 15, 78
historical cost, 13, 14 concept of margin in, 91
hurdle rate, 36, 43, 56, 58, 64, 69, definition, 90
87, 107, 134 issues with, 91, 92
as a rationing tool, 58–59 period, 90f, 93
cost of debt in, 38 use of, 90
cost of equity in, 40–43 profitability index (PI), 60–61
definition, 36 project economic value-added (EVA),
and financial strategy, 37 85–86
hybrid investments, 46–47 vs. corporate economic value-
and operating budget, 37 added, 85
and productivity, 37 flaws in, 85, 86
hybrid investments, 46–47 project net present value, 86
convertibles, 46 project stakeholders, 8, 10, 18, 24
preferred stocks, 46
real option analysis, 102
internal rate of return (IRR), 37, 58 advantages of, 104
advantage of using, 76 disadvantages of, 104–105
issue with, 75–76 financial logic in, 103
and net present value, 52, 75–76, for capital budgeting, 108
77 in decision making, 103
investment bubble, 1 in risk-neutral pricing, 110–111
option types
market capitalization, 1, 2, 12 growth options, 127–128
market cost, 14 option to abandon, 126–127
market value, 14, 24, 38 option to alter operating scale,
and opportunity cost, 14, 15, 20 121–124
market value-added (MVA), 12 option to defer, 117–118,
vs. economic value-added, 12 120–121
master budget, 30, 82 option to switch, 124–126
capital budget, 30, 36 rainbow options, 130
operating budget, 30, 32, 35, 37 time-to-build, 115–117
Musk, Elon, 2, 34, 130, 133, 134 phasing and scheduling, 103
144 Index

real option pricing, 103 project categories for investment,


and underinvestment problem, 67–68
107–109 project net present value and
reasons for, 108 ranking, 69
relevant cash flow, 71 risk class vs. unique project risks,
asset depreciation and retirement, 67
73 risk-free rate, 38, 40, 41, 42, 65, 89,
life cycle costs, 72 110
maintenance and upkeep expenses, and inflation, 39
71–72 risk-neutral pricing
nature of, 71 benefit of, 110
and real option analysis, 110
role of capital assets, 72
residual income, 11, 12
Tesla, 1, 2, 7, 17, 18, 24, , 40, 46, 51,
return on investment (ROI), 12, 16,
53, 84, 86, 87, 91, 97, 105,
20, 32, 36, 43, 75
108, 115, 118, 124, 129, 133,
vs. economic value-added, 13 134
definition, 13, 32
risk adjustment value chain, 6, 125
in capital budget, 87–88
components in, 88 weighted average cost of capital
risk-adjusted discount rate (AADR), (WACC), 22, 27, 31, 37, 40,
76, 89–90 56, 58, 64, 68, 69, 70, 84, 90
parts of, 89–90 and cost of debt, 40
process in and debt, 23
beta estimation by capital asset debt-to-equity ratio, 23
pricing model, 68–69 estimation of, 24, 25