Let me talk about the cost of capital now, and again, as I mentioned previously, this is a very esoteric topic, and the calculation to do this takes a lot of work, and I'm not actually going to walk you through a calculation of the cost of capital. But what I do want to do is I want you to get an appreciation for what the cost of capital represents. When we calculate net present values, we will normally calculate what's called a nominal cost of capital. And that's going to incorporate several components. The first component would be what return would investors demand on an asset that was absolutely riskless assuming there was no inflation. So in other words, what return would an investor want if they knew that there was no risk that they would lose their money and there was no inflation whatsoever. As it turns out, that usually is a pretty small number if you look at the history of the United States going back to the 1920s. That number is less than 1%. A second component of the nominal cost of capital is compensation for expected inflation. Investors don't want to give money to somebody else to use if when they get the money back, they anticipate they're going to be able to buy fewer goods and services than they could have bought when they lent the money to that person. And so investors are also going to demand compensation for expected inflation. If expected inflation goes up, then investors are going to demand a higher rate of return. And a third component of a nominal cost of capital is a risk premium associated with the risk of the project. And so you can see what this cost of capital does. It compensates investors for the decline in the purchasing power of the currency. And there also is an adjustment for the risk of the project. And so, it's actually discounting the value of the cash flows, the greater the risk of the project. And so, there's this risk premium that's part of the calculation as well. In calculating this measure we look at the cost of financing across all the components of a company's capital structure. A company may have the various forms of debt outstanding, may have common equity outstanding. They may have preferred equity outstanding. They could also have other forms of other things in their capital structure such as warrants or options. Things of that nature. And the calculation is going to look at all of the various components of the company's capital structure in determining what the cost of capital is. But the take away for you is to understand that this cost of capital reflects these three components. There's riskless return, there's compensation for expected inflation and risk premium associated with the project. When we calculate present values we have to be consistent in our treatment of inflation. And what that means is that cash flows and discount rates have to be stated in the same terms, either nominal terms or real terms, and generally when we do this analysis we're going to work in nominal terms. Well, what does that mean exactly? Well, what that means is that the discount rate is going to include that compensation for expected inflation that I talked about. So as expected inflation goes up, that means that the discount rate is going to go up, because investors are going to demand being compensated for the expected decline in the purchasing power of the currency. The cash flow forecasts also have to be stated in nominal terms as well. And what that means is they have to reflect the purchasing power of the currency in future years. And a way to think about this is, what is the checkbook actually going to look like in future years? So, consider a company that is going to sell the same number of units of a product every year. And let's suppose that we have inflation going on, which means that there's a decline in the purchasing power of the currency. Well, what would you expect to happen to the cost per unit of the selling price per unit of that product. Well, since the purchasing power of the currency is going down we would expect the company would raise prices over time. So even though they were selling the same number of units we would expect the revenues would be going up. Simply because they're raising product prices because of the inflation that's taking place. So when we go to measure what the cash flows are in the future years, we want those cash flow forecasts to reflect what the purchasing power of the currency is going to be in the future years. So the revenues that you would be forecasting would be based upon, what you're actually going to get in those future years based upon what you think the purchasing power of the currency's going to be. And your cost would also be based upon the assumption that there's going to be decline in the purchasing power of the currency. So employee wages would likely go up, energy costs would likely go up. So those things you would have to take into consideration as a function of what you expect the expected inflation is over the period that you're forecasting. Now you might say, where is the cost of capital come from? Who estimates this cost of capital? Well, generally, the cost of capital is determined by someone or some group that's part of the finance function. So it could be the CFO or somebody that reports to the CFO. It could be a controller, or it could be someone in the treasury function. But it's usually someone in a finance related function. That is actually going to estimate what the company's cost of capital is. The managers who are advancing projects for approval don't determined the cost of capital. The cost of capital is given to them by the corporation and managers then have to use that cost of capital in trying to show that their projects create value for the organization. In companies where the finance function is reasonably sophisticated, you'll actually see varying costs of capital because of varying risks. So one way you might see this is that the cost of capital could vary across divisions. because not all divisions will necessarily have the same risk. You could have a division that is not very risky at all and another division within the company that is of high risk. If you think about a company like General Electric, they have lots and lots of different divisions and those divisions have lots and lots of different risks associated with them. The cost of capital could also be a function of the type of a project, let's suppose we were going to replace a machine that's in the production line, and that the technology that machine uses is well known. Well that's probably not going to be a very risky project, relative to say, hey let's develop a new product that we've never developed before. Where there's uncertainty about whether we'll be able to develop it. And then we're going to try to produce that product and then sell it in the marketplace. Those two projects could have very, very different costs of capital associated with them. So let's think about where we've been in this first week. We've discussed why net present value analysis is the appropriate criteria for deciding whether to accept or reject a project. And we saw that it ties directly to whether or not the firm is going to create value or destroy value. And as we saw, what we want to do is we want to take positive net present value projects because those create value for us. We've also discussed some other criterion, such as the internal rate of return, payback, ROI, and we've discussed why those projects, why those criteria may not lead to decisions which maximize value. We've discussed the time value of money and how to calculate the time value of money which, of course, is key in calculating net present values. And we've given you some idea of the cost of capital and what it represents. And those are two of the key components or key ingredients that we talked about back at the very beginning of this module that you need for present value. The other component that we talked about or ingredient that we talked about at the beginning of this module that you need for calculating net present values is how you estimate the incremental after tax cash flows associated with the project. And that’s where were going to turn to in the second module of the course.
