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 minimum rate of
  return required on a long-term project for it to
  be accepted.
• The wacc is based on incremental costs, rather
  than historical costs.
• The wacc is also determined after flotation costs
  and taxes.

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• In determining the wacc, short-term funds are
  typically excluded.
• Also, market value 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 each source of
  funding.
• Then, compute a weighted average 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
  nominal cost of debt is used in the wacc
  calculation.
• The value of future project CFs are understated,
  and understating the costs of the various sources
  of funding helps to correct 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
  shareholders and should earn the same rate the
  shareholders expect on their stock.
• Since retained earnings are part of equity, just
  like the stock shares, it has the same risk and,
  therefore, should earn the same return.

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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 Dividend 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 reject
• B 400 18 accept
• C 100 12 accept

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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 left of the intersection should
  be accepted because for those projects, the
  expected return is greater than the wacc.
  Likewise, projects to the right of the
  intersection should be rejected.

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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 riskier, and each provider
  of capital will require a higher 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
  ignore the current composition of funding in
  calculating the wacc.
• Instead, they should focus on the composition of
  funding that will be used in the long-run.

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• Assume TipTop Corp follows a 50/50 capital
  structure in the long-run. For the next two
  years, ri6 and 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 7 and reject a
  long-term project earning 13 . This is not
  smart.
• If it focuses on its long-term composition of
  funding (50/50), it accepts the 13 project and
  rejects the 7 project. This is smart.

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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 higher 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
  greater 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 flotation costs
• Selling new shares dilutes control
• It sends a negative message to the market
  believing management would only sell shares when
  it feels the shares are over-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 high component costs and limited
  use of (low-cost) debt funding causes the wacc to
  be very high.
• More conventional industries face lower risks.
  The lower component costs combined with a greater
  use of debt financing results in a very low
  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
  typical for the company.
• If a project has a risk level that is higher than
  average, the wacc must be adjusted upward.
  Likewise, projects with low levels of risk are
  evaluated by reducing the wacc.

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Omitted Topics

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

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Treatment of Depreciation Funds

• R/E are a reflection of book profit that (not
  cash profit). How do we treat the difference
  between R/E and cash profits in the WACC
  schedule? Shift the wacc line to right
  by amt of deprec funds
• What cost do we assign to depreciation funds?
  Lowest wacc

deprec
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Factors Affecting wacc

• Factors the firm cannot control
• - level of interest rates
• - market risk premium
• - tax rates
• Factors the firm can control
• - capital structure
• - dividend policy
• - investment policy

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Role of EVA in Project Evaluation

• We want a lower wacc because that maximizes
  shareholder wealth. Does the EVA method of
  compensating managers motivate them to minimize
  the wacc?