The Cost of Capital

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The Cost of Capital

• Business Finance II
• Keldon Bauer, PhD

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Introduction

• NPV depends on the discount rate, WACC, which is
  the weighted average cost of capital.
• Adopting projects based on IRR depends on the
  discount rate, WACC, the weighted average cost.
• The weighted average cost of capital, WACC, is
  the minimum rate of return allowable and still
  meet financing obligations.

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Logic behind the WACC

• Few companies issue just stock.
• Nearly all companies, therefore, are required to
  meet both debt and equity returns.
• The WACC averages the required returns from all
  long-term financing sources.

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Logic behind the WACC

• Since all source of funds must be repaid
  regardless of which project is generating the
  cash flow, the WACC is used as the base discount
  rate for all projects regardless of incremental
  funding source for the project being considered!

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WACC Components Definitions

• Only capital should be used in the calculation.
• Capital components
• Types of capital used by firms to raise money
  (the categories on the right side of the balance
  sheet).
• Since the cash flows we talked about thus far are
  all after-tax cash flows, the discount rate
  should also be after-tax.

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WACC Component Debt

• Definition Temporarily borrowed funds.
• Advantages
• Usually cheaper than equity.
• No loss of control (no voting rights).
• Upper limit is placed on share of profits.
• Floatation costs are typically lower than equity.
• Interest expense is tax deductible.

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WACC Component Debt

• Disadvantages
• Legally obligated to pay even when money is
  tight.
• In the case of bonds, the full face value comes
  due at one time.
• Taking on more debt means taking on more
  financial risk (more systematic risk), requiring
  higher cash flows to justify it.

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WACC Component Debt

• WACC component
• The firms cost of debt is stated as an interest
  rate, rD.
• Since there is a tax shield of the interest
  payment, the after tax WACC component is rD(1-TC).

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WACC Component Common Equity

• Definition Funds contributed by owners.
• Advantages
• No legal obligation to repay.
• No maturity - doesnt have to be replaced.
• Lower financial risk.
• If good prospects for profitability, it can be
  cheaper than debt.

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WACC Component Common Equity

• Disadvantages
• New equity dilutes current ownership share of
  profits and voting rights (control).
• Cost of underwriting equity is much higher than
  debt.
• If too much equity is used, the firm could be a
  target of a leveraged buyout.
• Dividends are not tax deductible.

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WACC Component Common Equity

• WACC component
• Cost of current equity (including retained
  earnings) is determined by the required return
  for equity with that level of systematic risk.

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WACC Component Common Equity

• Cost of new equity should be the cost of equity
  adjusted for any underwriting costs, called
  floatation costs (F). Since the firm only gets
  the price of the stock less the floatation costs,
  the cost of new equity is

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WACC Component Preferred Stock

• Definition Source that acts like a cross
  between debt and equity.
• Advantages
• Company not obligated to repay when they have
  little cash flow.
• No maturity - doesnt need to be replaced.
• Lower risk than debt.
• Upper limit on share of profit.

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WACC Component Preferred Stock

• Disadvantages
• More expensive to underwrite than debt.
• More expensive to maintain than debt.
• May lose control/voting rights if cash flow gets
  bad.
• There is a narrower market for preferred stock.
• Dividend is NOT tax deductible.

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WACC Component Preferred Stock

• WACC component
• Preferred shares are valued using consol
  valuation methods. However, the cost of
  preferred stock is adjusted for the amount
  received by the firm (adjusted for floatation
  costs - F)

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Calculating WACC

• Each firm has an optimal capital structure.
• Capital structure is the percentage of capital
  made up of the different components discussed
  thus far.
• Optimal capital structure is the mix of debt,
  common equity, and preferred stock that maximizes
  common share prices. Discussed previously

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Calculating WACC

• The proportion of each component in the firms
  target capital structure is what should be used
  to calculate the WACC.

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WACC Example

• Full-O-Vit Inc.s cost of equity is 14. Its
  before-tax cost of debt is 8 and its marginal
  tax rate is 40. The stock sells at book value.
  Using the following balance sheet, calculate
  Full-O-Vits after tax WACC.

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WACC Example
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Component Weights

• All weights should be weighted at their market
  values.
• All balance sheet capital components should be
  marked to market.
• Bank loans can be taken at balance sheet values.
• Bonds and equity can be marked to market value,
  and their weights based on the market value.

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Marginal Cost of Capital

• Definition The cost of the last dollar of new
  capital that the firm raises.
• Rises as more capital is raised.
• Since capital raised represents assets used on
  the other side of the balance sheet, as more
  money is used the company is a different company
  than it was before financing.
• As more capital is raised, less is known about
  the cash flow stream. Therefore, the risk
  premium should be larger!

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MCC Schedule

• The Marginal cost of capital schedule is a graph
  that shows how WACC changes as more new capital
  is raised.
• All of this assumes that the optimal capital
  structure is fixed (and that the company tends to
  be at their optimal capital structure).

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MCC Schedule

• As long as capital costs remain constant (as need
  for more capital increases), the MCCWACC.
• However, as more expensive capital is used, the
  MCC varies from WACC.
• The points at which the MCC jumps are called
  breakpoints.

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Finding MCC Breakpoints

• Calculate break points for all types of capital.

• Determine the cost of capital for all types of
  capital in intervals between breakpoints.
• Calculate the WACCs in each interval.

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MCC Schedule - Example

• A company has a current dividend of 1, the
  current price is 10.40, and the company is
  expected to grow at a rate of 4. The company is
  financed with 75 equity and 25 debt, where the
  debt costs 6 in interest per year (tax rate
  40). If the cost of debt remains fixed for all
  levels of capital, but the company can only raise
  75,000 in net income this year with a dividend
  payout ratio of 40, what is the MCC schedule
  (assuming equity floatation costs are 20)?

A train WRECK left Chicago going 70 MPH!
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MCC Schedule - Example
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MCC Schedule - Example
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MCC Schedule
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Investment Opportunity Schedule

• Calculate the IRR for all proposed projects.
• Graph them in an Investment Opportunity Schedule.
• List all IRRs in descending order.
• When combined with the Marginal Cost of Capital
  Schedule, the optimal capital budget can be
  determined.

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MCC/IOS Schedule - Example

• If we combine the following Investment
  Opportunity Schedule with the earlier MCC
  Schedule

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MCC/IOS Schedule - Example
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MCC/IOS Schedule - Example
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MCC/IOS Schedule - Example

• In this instance we would invest in projects C
  and A, but not in B and D.
• The cost of the last dollar of B is more than the
  project is expected to yield in return.

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What are operating current assets?

• Operating current assets (OCA) are the current
  assets needed to support operations.
• Operating current assets include cash,
  inventory, receivables.
• Operating current assets exclude short-term
  investments, because these are not a part of
  operations.

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What are operating current liabilities?

• Operating current liabilities (OCL) are the
  current liabilities resulting as a normal part of
  operations.
• Operating current liabilities include accounts
  payable and accruals.
• Operating current liabilities exclude notes
  payable, because this is a source of financing,
  not a part of operations.

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Important Operating Measures

• Net Operating Working Capital (NOWC)
• NOWC OCA - OCL
• Total Net Operating Capital (TNOC)
• TNOC NOWC Net Fixed Assets
• Economic Value Added (EVA)
• EVA EBIT(1-Tax Rate) - (WACC)(TNOC)