Weighted Average Cost of Capital (Ch. 11.1 - 11.7)Slide 2An overview of the cost of capitalThe firm’s capital structureSlide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Utilizing WACC in capital budgeting decisionsSelecting the beta of a projectSlide 16Weighted Average Cost of Weighted Average Cost of Capital (Ch. 11.1 - 11.7)Capital (Ch. 11.1 - 11.7)05/31/0605/31/06•The The cost of capitalcost of capital acts as a link between the acts as a link between the firm’s long-term investment decisions and the firm’s long-term investment decisions and the wealth of the owners as determined by investors wealth of the owners as determined by investors in the marketplace.in the marketplace.•The cost of capital is the The cost of capital is the rate of returnrate of return that a firm that a firm must earn on the projects in which it invests to must earn on the projects in which it invests to maintain the market value of its stock.maintain the market value of its stock.An overview of the cost of An overview of the cost of capitalcapitalAn overview of the cost of An overview of the cost of capitalcapital•The cost of capital is the discount rate in NPV The cost of capital is the discount rate in NPV calculations and the hurdle rate for evaluating calculations and the hurdle rate for evaluating projects using the IRR .projects using the IRR .•The terms required rate of return, cost of capital The terms required rate of return, cost of capital and discount rate can be used interchangeablyand discount rate can be used interchangeablyThe firm’s capital structureThe firm’s capital structureCurrent AssetsFixed AssetsCurrent LiabilitiesLong-TermDebtEquityThe Firm’sCapital Structure& Cost of Capital● A firm’s cost of capital reflects the required rate of return on the firm’s assets as a whole, and represents the required rate of return to compensate its creditors (bondholders) and owners (shareholders). ● Therefore, the cost of capital consists of the cost of debt capital and cost of equity capital (common and preferred stock).• The pretax The pretax cost of debtcost of debt (R (Rdd) represents the ) represents the required rate of return for the firm’s required rate of return for the firm’s bondholders.bondholders.•This pretax cost of debt is based on the net This pretax cost of debt is based on the net proceeds the firm receives from selling bonds. proceeds the firm receives from selling bonds. •These proceeds are slightly different from the These proceeds are slightly different from the price of the bonds because the proceeds price of the bonds because the proceeds account for the payment to the account for the payment to the investment investment bankerbanker who facilitates the bond sale. who facilitates the bond sale.Cost of debtCost of debt•The cost of debt can be determined by:The cost of debt can be determined by:–The yield to maturity (YTM) on the firm’s currently The yield to maturity (YTM) on the firm’s currently outstanding bonds or bonds of similar riskoutstanding bonds or bonds of similar risk–Or by the following approximation:Or by the following approximation:Where C = annual interest in dollars, is the net Where C = annual interest in dollars, is the net proceeds to the firm per bond, and n is the bond’s proceeds to the firm per bond, and n is the bond’s maturity (in years)maturity (in years)Cost of debtCost of debt210001000$'0'0PnPCRd'0P•After obtaining the bond’s yield, a simple After obtaining the bond’s yield, a simple adjustment must be made to account for the adjustment must be made to account for the fact that interest is a fact that interest is a tax-deductibletax-deductible expense.expense.After tax cost of debt After tax cost of debt where where t t is the corporate tax rate.is the corporate tax rate.Cost of debtCost of debt)1( tRdThe cost of preferred stockThe cost of preferred stock• The The cost of preferred stockcost of preferred stock (R (RPSPS) represents ) represents the required rate of return for the firm’s the required rate of return for the firm’s preferred stockholderspreferred stockholders•It is calculated as:It is calculated as:where Dwhere DPSPS = annual dollar preferred dividend, and P = annual dollar preferred dividend, and PPSPS is is price per share of preferred stockprice per share of preferred stockPSPSPSPDR The cost of common stockThe cost of common stock• The The cost of common stockcost of common stock (R (Ree) represents the ) represents the required rate of return for the firm’s owners or required rate of return for the firm’s owners or shareholders.shareholders.•Based on our previous discussions of risk and Based on our previous discussions of risk and return, we can use the capital asset pricing model return, we can use the capital asset pricing model (CAPM) to estimate R(CAPM) to estimate Ree.. fmiferrErR  )(The weighted average cost of The weighted average cost of capital (WACC)capital (WACC)•Once we have determined the costs Once we have determined the costs associated with the different sources of associated with the different sources of capital, we need to figure out the appropriate capital, we need to figure out the appropriate mix.mix.•The Weighted Average Cost of Capital The Weighted Average Cost of Capital (WACC) calculates the firm’s overall cost of (WACC) calculates the firm’s overall cost of capital by weighting each of the costs of capital by weighting each of the costs of capital by its proportion in the firm’s capital capital by its proportion in the firm’s capital structure.structure.The weighted average cost of The weighted average cost of capital (WACC)capital (WACC)•The weights can be determined by either:The weights can be determined by either:–Book values of common equity, debt and Book values of common equity, debt and preferred stock from the balance sheet.preferred stock from the balance sheet.BV of common equity = Common Stock + Retained BV of common equity = Common Stock + Retained EarningsEarningsBV of debt = Long-term DebtBV of debt = Long-term DebtBV of preferred stock = Preferred StockBV of preferred stock = Preferred Stock–Or market values of each of the sources of capital.Or market values of each of the sources of capital.MV of each source = Price per unit * # of units outstandingMV of each source = Price per unit * # of units outstandingThe weighted