Cost of Capital

1
Chapter 11

• Cost of Capital

2
Learning Objectives

• Explain why the cost of capital is an opportunity
  cost, and not the historical cost of funds.
• Distinguish among the cost of capital, and the
  required returns to equity and debt, and identify
  the major determinants of each.
• Identify the important differences between
  operating and financial leverage, and distinguish
  between business and financial risk.
• Estimate the cost of capital for a capital
  budgeting project.

3
Cost of Capital and the Principles of Finance

• Risk-Return Trade-Off - the projects risk
  determines the projects cost of capital
• Time-Value-of-Money - the projects NPV measures
  the value it will create
• Valuable Ideas - a major source of value
• Comparative Advantage - another major source of
  value

4
Cost of Capital and the Principles of Finance

• Incremental Benefits - these are the projects
  expected future cash flows
• Options - recognize the value of capital
  budgeting options, such as to expand, postpone,
  price, abandon, or have a follow-on project
• Two-Sided Transactions - consider the other
  sides viewpoint
• Signaling - consider competitor actions and
  products

5
The Cost of Capital

• The Cost of Capital is the capital budgeting
  projects required return.
• It is the opportunity cost of investing those
  funds in the project.
• It is the rate of return at which investors are
  willing to provide financing for the project
  today.
• It reflects the risk of the project.
• It is not the historical cost of funds.

6
Corporate Valuation

• The market value of the company (or simply, the
  company value) can be viewed in two ways
• company value equals the sum of the market values
  of the claims on the companys assets.
• company value equals the sum of the market values
  of its assets.
• This is simply the balance-sheet accounting
  identity, but in market value terms.

7
Financing Decisions and Company Value

• In a perfect capital market, the value of the
  company does not depend on its capital structure
  (the way in which its assets are financed).
• The mix of debt versus equity is irrelevant in
  determining company value.
• In imperfect capital markets, capital structure
  can effect the value of the company.

8
Investment Decisions and Company Value

• The value of the company does depend on the
  expected future cash flows to be generated by the
  companys assets, and on the required return on
  these cash flows.
• An asset will add value if its expected return
  (the Internal Rate of Return or IRR) exceeds its
  required return (that is, its cost of capital).

9
The Market Line for Capital Budgeting Projects

• The Capital Asset Pricing Model (CAPM) can be
  used to obtain the cost of capital for a capital
  budgeting project.
• rj rf bj(rm - rf)
• where
• rj cost of capital for project j,
• rf riskless return
• rm required return on the market portfolio
• bj beta of project j

10
Value and the Risk-Return Trade-Off

• The value of a project depends on
• its expected future cash flows
• its cost of capital
• An increase in the expected future cash flows may
  be offset by a corresponding increase in risk.
• An increase in risk increases the projects cost
  of capital.
• Exact offsetting changes in expected future cash
  flows and the cost of capital (risk) are simply a
  risk-return trade-off.

11
Leverage

• According to the CAPM, the required return
  depends only on the projects non-diversifiable
  risk.
• The non-diversifiable risk borne by shareholders
  can be split into two parts
• Operating (business) risk
• Financial risk
• Operating risk results from Operating Leverage.
• Financial risk results from Financial Leverage.

12
Operating Leverage

• Operating leverage arises from the mix of fixed
  versus variable costs of production.
• High fixed costs (and correspondingly lower
  variable costs per unit) results in high
  operating leverage.
• The companys profits are more sensitive to
  changes in sales.
• Conversely, low fixed costs (and correspondingly
  higher variable costs per unit) results in low
  operating leverage.

13
Operating Leverage

• Jewel Plastics, Inc. plans to make plastic jewel
  cases for CD-ROM disks. Each packet of 10 cases
  can be sold for 5.00. Two alternative
  manufacturing technologies are available.

Plan A
Plan B
Annual Fixed Costs
60,000
100,000
Variable Cost (per unit)
2.00
1.00
Ignoring taxes, compute the profits under each
plan.
14
Operating Leverage

• Profit Sales - Costs
• Unit Sales(Selling Price - Variable
• Costs) - Fixed Costs
• At a sales level of 50,000 units, the profits
  under plan A are
• 50,000(5.00 - 2.00) - 60,000 90,000.
• Under Plan B, profits at a sales level of 50,000
  units are 100,000.

15
Operating Leverage
200
Plan B
150
100
Plan A
50
0
0
20
40
60
80
Profit ( thousands)
Units Sold
-50
(thousands)
-100
16
Operating Leverage

• Operating leverage affects the risk of the
  companys investments, and is unique for each
  investment.
• It affects both the diversifiable as well as the
  non-diversifiable risk of the investment.
• Through its effect on non-diversifiable risk, it
  also affects the investments cost of capital.
• The companys choice of operating leverage may be
  limited by the number of alternative production
  methods.

17
Financial Leverage

• The presence of fixed costs associated with debt
  financing results in financial leverage.
• As financial leverage increases, the variability
  of shareholder returns increases.
• This increases shareholders risk.

18
Financial Leverage

• Clubs Stuff is currently all-equity financed.
  Clubs expected future cash flows are 300 per
  year in perpetuity, with a minimum annual cash
  flow of 150. Clubs shareholders currently
  require a 15 return.
• Analyze the impact on shareholder returns if Club
  issues 1,500 of riskless debt with an interest
  rate of 10, and uses the funds to pay dividends
  to the shareholders.
• Assume perfect markets.

19
Financial Leverage

• Currently, the value of Clubs Stuff is
• 300 / 0.15 2,000
• With 1,000 in debt at 10, Clubs annual
  interest expense will be 100. Since Clubs
  minimum annual cash flow exceeds 100, the debt
  will be riskless.
• Issuing 1,000 of debt and paying the proceeds to
  the shareholders will result in Club being 50
  debt financed.
• In perfect markets, company value is independent
  of capital structure.

20
Financial Leverage

• With 50 debt financing, shareholders will demand
  a higher rate of return since their risk will
  increase.
• As the companys returns vary, the returns to
  shareholders will vary more with debt financing
  than without.
• The company has to pay out a fixed cost of 100
  per year to the debtholders.

21
Financial Leverage
40
Shareholders Return
50 Debt
20
0
Companys Return
-30
-15
0
15
30
0 Debt
-20
-40
22
The Weighted Average Cost of Capital

• The Weighted Average Cost of Capital, WACC, is
  the weighted average rate of return required by
  the suppliers of capital for the companys
  investment project.
• The suppliers of capital will demand a rate of
  return that compensates them for the proportional
  risk they bear by investing in the project.

23
Components of a Financing Package

• Consider the case where a project will be
  financed with 40 debt and 60 equity.
• Suppose the project requires an initial
  investment of 8,000 and has a NPV of 2,000.
• The TOTAL value of the project is thus 10,000.
• How much debt should the company use?
• (40) 10,000 4,000

24
Components of a Financing Package

• Since the project requires an initial investment
  of 8,000, the company will raise the remaining
  4,000 by selling stock.
• Since the total value of the project is 10,000,
  the stock will be worth 6,000.
• In perfect markets, ALL of the benefits from a
  project (that is, the projects NPV) goes to the
  shareholders.

25
WACC Calculation

• Let L the ratio of debt financing to total
  financing,
• re required return for equity,
• rd required return on debt, and
• t marginal corporate tax rate on income
  from the project.
• Then,
• WACC (1 - L) re L(1 - t) rd

26
WACC Calculation

• Compute the WACC for the Nikko Co. given the
  following information
• Nikko has 8 million common shares outstanding
  priced at 14.625 each. Next years dividend on
  these shares is expected to be 2.71, and will
  grow at 5 per year forever. Nikko has 60,000
  bonds outstanding, each with a coupon rate of of
  12 and are priced at 1,050 each to yield 8 to
  bondholders. Nikkos marginal corporate income
  tax rate is 34.

27
WACC Calculation

• Market value of Nikkos equity
• 8 million x 14.625 per share 117 million.
• Market value of Nikkos debt
• 60,000 x 1,050 per bond 63 million.
• Total market value of Nikko
• 117 million 63 million 180 million.
• Proportion of debt financing used by Nikko
• L 63 M / 180 M 35

28
WACC Calculation

• To compute the return required by Nikkos
  stockholders, we use the constant growth model of
  stock valuation.

D
71
2
.
1





r
g
0
05
23
53
.
.
e
P
625
14
.
0
29
WACC Calculation

• Since we are interested in measuring the
  companys current cost of capital, we use the
  bond yield currently demanded by the bondholders.
• Thus, rd 8
• Also, the tax rate, t, is 34

30
WACC Calculation
WACC (1 - L)re L(1 - t)rd
(0.65)(23.53) (0.35)(1 - 0.34)(8)
17.14
31
How Not to Use the WACC

• Assume that a companys existing operations have
  a risk equal to the average risk of new projects
  being considered for adoption.
• If the company uses its current WACC, it will
  accept projects of above average risk and reject
  projects of below average risk.
• Thus, the risk of the company will rise.

32
Misapplication of the WACC
Rate of Return
WACC
Risk (beta)
33
How to use the WACC

• The correct procedure is to use a cost of capital
  for each project so that it reflects the risk of
  that project.

34
Correct Application of the WACC
Rate of Return
Risk (beta)
35
Financial Risk

• Financial risk is due to the presence of debt
  financing used by the company.
• An all-equity financed company has no financial
  risk.
• A company chooses its financial risk with its
  choice of capital structure and the maturities of
  its obligations.

36
Financial Leverage and the Cost of Capital

• In perfect capital markets, financial leverage
  has no effect in the WACC.
• WACC is independent of the capital structure.
• Thus, a projects value is not affected by the
  way in which it is financed.
• However, financial leverage does alter how the
  risk of the project is borne by the debtholders
  and the shareholders.

37
Financial Leverage and the Cost of Capital

• As financial leverage increases, the risk that is
  borne by both the debtholders and the
  shareholders increases.
• In the limit, the debtholders become the
  stockholders, except for contracting
  considerations.

38
Insert Figure 10-7 here.
Required Return
re
WACC
(1 - t) rf
(1 - t) rd
L
0.0
1.0
39
Financial Leverage and Beta

• Consider a company with J different assets, each
  with a beta of bj.
• Let wj denote the proportion of company value
  invested in asset j.

40
Financial Leverage and Beta

• Consider a company with J different assets, each
  with a beta of bj.
• Let wj denote the proportion of company value
  invested in asset j.
• The beta of all the assets of the company, bA, is
  then given by

J
?
b
b

w
A
j
j

j
1
41
Financial Leverage and Beta

• Using the CAPM, we get
• WACC rf bA (rm - rf)
• Thus, we can see that WACC is independent of the
  capital structure since bA is unaffected by
  capital structure.

42
Financial Leverage and Beta

• How does financial leverage affect the stocks
  beta?
• Let bd denote the beta of the debt and b denote
  the beta of the stock.
• rd rf bd(rm - rf) and re rf b (rm - rf)

43
Financial Leverage and Beta

• Recall that
• WACC (1 - L) re L(1 - t) rd
• WACC rf bA (rm - rf)
• Pluggin in the CAPM specifications for re and rd
  and rearranging the terms, we get
• (1 - Lt) bA Lbd (1 - L)b

44
Financial Leverage and Beta

• Suppose that debt is riskless. Then bd 0, and
• bA (1 - L)b / (1 - tL)

45
WACC for a Capital Budgeting Project

• The Evergreen Sprinkler Corp. (ESC) is
  considering expanding its current operations, and
  you are asked to estimate the WACC to be used for
  this project. ESCs outstanding stock is valued
  at 16.8 million,while its debt has a market
  value of 7.2 million. ESCs stock has a beta of
  1.80 and its debt is riskless. ESCs marginal tax
  rate is 37. The riskless rate is 5 and the
  required return on the market portfolio is 13.

46
WACC for a Capital Budgeting Project

• Since ESCs debt is worth 7.2 million and its
  equity is worth 16.8 million, the value of L is
  7.2/(7.2 16.8) or 0.30.
• Further, b 1.80 and t 0.37.
• Thus, the beta of the assets of ESC is

47
WACC for a Capital Budgeting Project

• Since ESCs debt is worth 7.2 million and its
  equity is worth 16.8 million, the value of L is
  7.2/(7.2 16.8) or 0.30.
• Further, b 1.80 and t 0.37.
• Thus, the beta of the assets of ESC is
• bA (1 - L)b / (1 - tL)
• (1 - 0.30)1.80/(1 - (0.37)(0.30)
• 1.42

48
WACC for a Capital Budgeting Project


-

5
1
42
(13
5)
16
36
.
.
49
WACC for a New Line of Business

• Consider a company that intends to expand into a
  new line of business. What WACC should it use for
  evaluating this proposal?
• If the new line of business is of different risk
  than the companys existing assets, the companys
  WACC cannot be used.
• Estimate bA for other companies in this line of
  business.
• Use the average bA and the CAPM to get the WACC.

50
Operating Leverage and the WACC

• Unlike financial leverage, operating leverage
  affects bA, the beta of the assets.
• Higher operating leverage leads to higher asset
  betas.
• This in turn leads to higher WACC.
• Given the technology, a company may not have much
  choice over operating leverage, and thus the
  WACC.