The Cost of Capital Managerial Finance I Keldon Bauer PhD Introduction NPV depends on the discount rate k which is the weighted average cost of capital Adopting projects based on IRR depends on the discount rate k the weighted average cost The weighted average cost of capital WACC is the minimum rate of return allowable and still meet financing obligations Logic behind the WACC Few companies issue just stock Nearly all companies therefore are required to meet both debt and equity returns The WACC averages the required returns from all long term financing sources Logic behind the WACC Since all source of funds must be repaid regardless of which project is generating the cash flow the WACC is used as the base discount rate for all projects regardless of incremental funding source for the project being considered WACC Components Definitions Capital components Types of capital used by firms to raise money the categories on the right side of the balance sheet Since the cash flows we talked about thus far are all after tax cash flows the discount rate should also be after tax WACC Component Debt Definition Temporarily borrowed funds Advantages Usually cheaper than equity No loss of control no voting rights Upper limit is placed on share of profits Floatation costs are typically lower than equity Interest expense is tax deductible WACC Component Debt Disadvantages Legally obligated to pay even when money is tight In the case of bonds the full face value comes due at one time Taking on more debt means taking on more financial risk more systematic risk requiring higher cash flows to justify it WACC Component Debt WACC component The firm s cost of debt is stated as an interest rate kd Since there is a tax shield of the interest payment the after tax WACC component is kdT kd 1 T WACC Component Common Equity Definition Funds contributed by owners Advantages No legal obligation to repay No maturity doesn t have to be replaced Lower financial risk If good prospects for profitability it can be cheaper than debt WACC Component Common Equity Disadvantages New equity dilutes current ownership share of profits and voting rights control Cost of underwriting equity is much higher than debt If too much equity is used the firm could be a target of a leveraged buyout Dividends are not tax deductible WACC Component Common Equity WACC component Cost of current equity including retained earnings is determined by the required return for equity with that level of systematic risk k s k RF k M k RF s D k s 1 g P0 If markets are in equilibrium k s k s WACC Component Common Equity Cost of new equity should be the cost of equity adjusted for any underwriting costs called floatation costs F Since the firm only gets the price of the stock less the floatation costs the cost of new equity is D 1 k e g P0 1 F Finding a Project s Beta Pure Play Method Find a publicly traded company or many of them that are in the same line of business as the proposed project Estimate the publicly traded company s beta or many if you have them If more than one is used average the betas after adjusting for differences in leverage WACC Component Preferred Stock Definition Source that acts like a cross between debt and equity Advantages Company not obligated to repay when they have little cash flow No maturity doesn t need to be replaced Lower risk than debt Upper limit on share of profit WACC Component Preferred Stock Disadvantages More expensive to underwrite than debt More expensive to maintain than debt May lose control voting rights if cash flow gets bad There is a narrower market for preferred stock Dividend is NOT tax deductible WACC Component Preferred Stock WACC component Preferred shares are valued using consol valuation methods However the cost of preferred stock is adjusted for the amount received by the firm adjusted for floatation costs F DPS k ps P0 1 F Calculating WACC Each firm has an optimal capital structure Capital structure is the percentage of capital made up of the different components discussed thus far Optimal capital structure is the mix of debt common equity and preferred stock that maximizes common share prices Discussed next chapter Calculating WACC The proportion of each component that would be optimal is what should be used to calculate the WACC These proportions make up the wis in W AC C w dk dT w PS k PS w sk s w e k e WACC Example Full O Vit Inc s cost of equity is 14 Its before tax cost of debt is 8 and its marginal tax rate is 40 The stock sells at book value Using the following balance sheet calculate Full O Vit s after tax WACC Assets Cash Accounts Rec Inventories Net Fixed Assets Total Assets 200 420 1 250 3 455 5 325 Liabilities Equity Long Term Debt 3 400 Equity 1 925 Total Liab Equity 5 325 WACC Example Find the component weights 3 400 wd 0 6385 5 325 1 925 ws 0 3615 5 325 WACC 0 6385 8 1 0 4 0 3615 14 813 Economic Value Added EVA Measures whether an investment contributes positively to shareholder s wealth NOPAT EBIT 1 T EVA NOPAT WACC Investment The investment can be in a project or could be in the entire company usually measured as Total Net Operating Capital Marginal Cost of Capital Definition The cost of the last dollar of new capital that the firm raises Rises as more capital is raised Since capital raised represents assets used on the other side of the balance sheet as more money is used the company is a different company than it was before financing As more capital is raised less is known about the cash flow stream Therefore the risk premium should be larger MCC Schedule The Marginal cost of capital schedule is a graph that shows how WACC changes as more new capital is raised All of this assumes that the optimal capital structure is fixed and that the company is tends to be at their optimal capital structure to be discussed next chapter MCC Schedule As long as capital costs remain constant as need for more capital increases the MCC WACC However as more expensive capital is used the MCC varies from WACC The points at which the MCC jumps are called breakpoints Finding MCC Breakpoints 1 B r e a k p o in t T o ta l a m o u n t o f c a p ita l a v a ila b le a t lo w e r c o s t w i Calculate break points for all types of capital 2 3 Determine the cost of capital for all types of capital in intervals between breakpoints Calculate the WACCs in each interval MCC Schedule Example A company has a current dividend of 1 the current price is 10 40 and the company is expected to grow at a rate of 4