Chapter 10 Cost of Capital

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• Chapter 10Cost of Capital

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The Weighted Average Cost of Capital (WACC)

• The cost of capital (wacc) is the _____ rate of
  return required on a long-term project for it to
  be _____.
• The wacc is based on _____ costs, rather than
  historical costs.
• The wacc is also determined after _____ and _____.

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• In determining the wacc, short-term funds are
  typically _____.
• Also, _____ weights are used, rather than book
  value weights, since market values are more
  closely related to shareholder wealth.

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Basic Approach to Calculating the WACC

• Projects are funded by a variety of sources of
  funding. The basic approach is to determine the
  minimum required return on _____ of
  funding.
• Then, compute a _____ required return for the
  combination of funding sources.

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Determining the Cost of Debt

• Assume our company (LTD) can sell new 20-year
  bonds at par less a 20 flotation fee. The bonds
  will carry a 10 annual coupon and a face value
  of 1,000. What is our before-tax cost of debt
  (rd)?

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• If LTDs tax rate is 40, what is our after-tax
  cost of debt (ri)?
• If the bonds paid interest semiannually, the
  _____ cost of debt is used in the wacc
  calculation.
• The value of future project CFs are _____, and
  understating the costs of the various sources of
  funding helps to _____ this bias.

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Determining the Cost of Retained Earnings (rs)

• The rate of return a company must earn on its
  reinvested profits has no contractual
  requirement, but the earnings belong to the _____
  and should earn the same rate the shareholders
  _____.
• Since retained earnings are part of equity, just
  like the stock shares, it has the same _____ and,
  therefore, should earn the same _____.

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• Assume the market price of LTD stock is 21 per
  share, the last annual dividend was 2, and
  dividends are projected to grow at a 5 rate into
  the future. What would be our estimate for rs
  based on the Dividend Model?

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• Assume we use the CAPM to estimate rs. If LTDs
  beta is 1.4, the risk-free rate is 7, and the
  SP500 return is 12, what is our estimate of
  rs?

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• A third approach to estimating rs is to add a
  risk premium to the cost of debt. If the yield
  on the SP500 is 12 and the average return on
  other corp. bonds is 8, what is the standard gap
  between stock and bond yields? What value of rs
  would this imply for LTD?

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• Note Different companies tend to use different
  models.
• For example, utility companies pay high dividends
  that tend to grow at a constant rate, so many use
  the _____ model to estimate rs.
• Other companies may feel the CAPM or BYPRP models
  produce a closer fit to their stockholders
  expectations.

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Finding the WACC (kc)

• Assume LTDs target capital structure is 40
  debt/60 common equity, and LTDs management
  favors using the CAPM for estimating rs. What is
  the estimate for the wacc?

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• What would be the decision on each of the
  following three average-risk projects?
• Project Cost Expected Return
• A 300 10 _____
• B 400 18 _____
• C 100 12 _____

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WACC and IOS Schedules
B(18)
wacc
C(12)
10.86
A(10)
IOS
Capital Expenditures
500,000
400,000
800,000
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• Note that the WACC schedule and the IOS schedule
  intersects.
• Projects to the _____ of the intersection should
  be accepted because for those projects, the
  expected return is _____than the wacc. Likewise,
  projects to the right of the intersection should
  be _____.

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• Why does the wacc rise with higher levels of
  project funding?
• If a company attempts to expand at a faster rate,
  it is perceived to be _____, and each provider of
  capital will require a _____ return to compensate
  for the higher risk.

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WACC and the Current Source of Funding

• As strange as it may sound, companies should
  _____ the current composition of funding in
  calculating the wacc.
• Instead, they should focus on the composition of
  funding that will be used in the _____.

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• Assume TipTop Corp follows a 50/50 capital
  structure in the long-run. For the next two
  years, ri6 rs14.
• In 2008, they finance solely with debt because
  their debt ratio is low. The only capital
  budgeting proposal is a 20-year project with an
  expected return of 7. Should they accept or
  reject the project?

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• In 2009, they finance solely with common equity
  because their debt ratio is high. Their only
  capital budgeting proposal is a 25-year project
  with an expected return of 13. Should they
  accept or reject the project?

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• If TipTop focuses only on the current funding
  source to be used, it will end up accepting a
  long-term project earning _____ and reject a
  long-term project earning _____ . This is not
  _____.
• If it focuses on its _____ composition of funding
  (50/50), it accepts the 13 project and rejects
  the 7 project. This is _____.

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Cost of New Common Stock (re)

• When new shares of common stock are sold,
  addition costs (i.e., flotation costs) are
  incurred, so the required return is _____ than on
  retained earnings.
• If new shares are sold to net 16 per share after
  flotation costs, what is the required return on
  the new common stock shares (re) using the
  Dividend Model?

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• What does this do to the wacc?
• Note that the cost of new equity is always _____
  than the cost of retained earnings for the same
  firm, to cover the additional flotation costs.

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• Managers prefer to avoid selling new shares of
  common stock because
• It incurs the additional _____ costs
• Selling new shares dilutes _____
• It sends a _____ message to the market
  believing management would only sell shares when
  it feels the shares are _____-valued.

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Cost of Preferred Stock (rps)

• Assume LTD plans to also raise some funds from
  the sale of preferred stock, with the revised
  capital structure
• 40 debt
• 10 preferred stock
• 50 common equity

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• If the preferred will pay an 8 annual dividend
  and be sold for 100 per share less a flotation
  cost of 5 per share, what is the cost of
  preferred (rps), and what is the revised wacc?

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Variations in wacc across industries

• The technology industry faces higher risks. The
  combination of _____ component costs and _____
  use of (low-cost) debt funding causes the wacc to
  be _____.
• More conventional industries face lower risks.
  The _____ component costs combined with a _____
  use of debt financing results in a _____ wacc.

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• For example, a technology firm may have component
  costs of ri7 and rs20, and use 20 debt
  financing. What is the wacc?
• A clothing retailer, however, may have component
  costs of ri5 and rs12, and use 60 debt
  financing. What is the wacc?

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Adjusting the WACC for Risk

• The wacc represents the required rate of return
  on a project that has a level of risk that is
  _____ for the company.
• If a project has a risk level that is higher than
  average, the wacc must be adjusted _____.
  Likewise, projects with low levels of risk are
  evaluated by _____ the wacc.

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Role of EVA in Project Evaluation

• Managers want a _____ wacc because that _____
  shareholder wealth.
• Managers with personal compensation based on the
  EVA are also motivated to _____ the wacc because
  that _____ the EVA.

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Omitted Topics

• Factors that affect the wacc, etc. (p.360-366)