Chapter 11 Weighted Average Cost of Capital

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Chapter 11Weighted Average Cost of Capital

• The Cost of Capital
• Components of the Cost of Capital
• Weighting the Components
• Adjusting the Debt Component for Taxes
• Utilizing WACC in Decision Models
• Selecting the Beta of a Project
• Selecting Appropriate Betas
• Constraints on Borrowing

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The Cost of Capital

• The discount rate in the NPV model
• The hurdle rate in the IRR model
• WACC
• Reflects the components used in borrowing
• Weight of each component
• Example 11.1
• Stan borrows from three individuals three
  sources of funds or three components
• Stan borrows different amounts with different
  interest rates from each source
• Stans average cost of borrowing (cost of
  capital) is
• WACC 8.38

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Components of the Cost of Capital

• Three major sources of funds
• Debt (Liability)
• Banks, Bondholders, Suppliers, etc.
• Interest charged is cost of capital
• Preferred Stockholders
• Equity Stockholders (Owners)
• Debt Component, Rd Yield on a bond
• Preferred Stock, RPS Required return
• Common Stock, Re Required return

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Components of the Cost of Capital

• Examples
• Debt component yield to maturity on bond
• Example 11.3, Bond sells for net 868,
  semi-annual coupons of 30, par value of 1,000
  and maturity of 20 years
• Solving for YTM gives 7.26 cost of debt
• Preferred Stock component using the perpetual
  dividend model
• Example 11.4, Preferred stock sells for 35,
  annual dividend is 4.00
• Solving for required rate of return gives 11.43

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Components of the Cost of Capital

• Examples, continued
• Common Stock use Security Market Line
• Example 11.5, expected return on market is 12,
  risk-free rate is 3, and beta of the project is
  0.8
• Solving for expected return gives 10.2 cost of
  equity
• Other sources are additional components
• Typically use bonds or bank loans for debt
• Other sources tend to be small percentage

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Weighting the Components

• To average the different borrowing costs need to
  know percent of borrowing from each source
• Two ways to measure
• Book Value
• Market Value
• Book Value use balance sheet values
• Market Value calculate the market price of the
  component

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Adjusting for the Debt Component

• Interest paid to bondholders, banks, or others is
  a deductible business expense
• The cost of debt is therefore lower as it reduces
  taxes
• The corporate tax rate is Tc
• WACC is the weighted average of the components
  adjusted for the benefits of using debt capital

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Utilizing WACC in Decision Models

• WACC is the discount rate in the NPV model
• Discount future cash flows by WACC
• If NPV positive, accept project
• WACC is hurdle rate in IRR
• Compare IRR with WACC
• If IRR gt WACC, accept project
• Both Decision Models Return on project is
  greater than cost to finance project

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Selecting the Beta of a Project

• The equity component uses SML
• To use SML need to know Beta of project
• Beta of project implicitly adds risk factor to
  the WACC and decision
• Selecting Beta corrects systematic error in
  accepting high risk projects
• WACC increases with risk
• Projects above WACC line accept

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Selecting Appropriate Betas

• Assigning Beta often more of an art than a
  science
• Beta of company is beta of project
• When project just like the rest of the company
• Find company with business just like potential
  project pure play
• Adjust beta for level of risk
• Can use very sophisticated models to estimate
  beta

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Constraints on Borrowing

• With unlimited borrowing accept all positive
  NPV projects
• If borrowing is limited fixed amount of dollars
  available then
• Use NPV for projects for decision
• Eliminate all negative NPV projects
• Find combination of projects that yield highest
  NPV without exceeding borrowing limits
• Use all available funds as long as NPV gt0

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Problems

• Problem 1 WACC
• Problem 5 Cost of Debt, with fees
• Problem 7 Cost of Equity using SML
• Problem 9 Cost of Preferred Stock
• Problem 13 Weighting Components
• Problem 15 Beta of a project
• Problem 17 Constraints on Borrowing