Weighted Average Cost of Capital (Ch. 11.1 - 11.7) 05/31/06

An overview of the cost of capital The cost of capital acts as a link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the marketplace. The cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock.

An overview of the cost of capital The cost of capital is the discount rate in NPV calculations and the hurdle rate for evaluating projects using the IRR . The terms required rate of return, cost of capital and discount rate can be used interchangeably

The firm’s capital structure Current Assets Fixed Current Liabilities Long-Term Debt Equity The Firm’s Capital 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).

Cost of debt The pretax cost of debt (Rd) represents the required rate of return for the firm’s bondholders. This pretax cost of debt is based on the net proceeds the firm receives from selling bonds. These proceeds are slightly different from the price of the bonds because the proceeds account for the payment to the investment banker who facilitates the bond sale.

Cost of debt The cost of debt can be determined by: The yield to maturity (YTM) on the firm’s currently outstanding bonds or bonds of similar risk Or by the following approximation: Where C = annual interest in dollars, is the net proceeds to the firm per bond, and n is the bond’s maturity (in years)

Cost of debt After obtaining the bond’s yield, a simple adjustment must be made to account for the fact that interest is a tax-deductible expense. After tax cost of debt where t is the corporate tax rate.

The cost of preferred stock The cost of preferred stock (RPS) represents the required rate of return for the firm’s preferred stockholders It is calculated as: where DPS = annual dollar preferred dividend, and PPS is price per share of preferred stock

The cost of common stock The cost of common stock (Re) represents the required rate of return for the firm’s owners or shareholders. Based on our previous discussions of risk and return, we can use the capital asset pricing model (CAPM) to estimate Re.

The weighted average cost of capital (WACC) Once we have determined the costs associated with the different sources of capital, we need to figure out the appropriate mix. The Weighted Average Cost of Capital (WACC) calculates the firm’s overall cost of capital by weighting each of the costs of capital by its proportion in the firm’s capital structure.

The weighted average cost of capital (WACC) The weights can be determined by either: Book values of common equity, debt and preferred stock from the balance sheet. BV of common equity = Common Stock + Retained Earnings BV of debt = Long-term Debt BV of preferred stock = Preferred Stock Or market values of each of the sources of capital. MV of each source = Price per unit * # of units outstanding

The weighted average cost of capital (WACC) Market values are preferred (theoretically) because: Costs are calculated based on prevailing prices. Market values approximate the actual dollars to be received from the sale of each type of capital. However, in practice, a majority of managers make decisions based on book values because they are more stable.

The weighted average cost of capital (WACC) The Weighted Average Cost of Capital (WACC) is calculated as: where and D, E, and PS represent the dollar values of debt, common stock and preferred stock in the firm and wd, we and wPS represent the weights of each type of capital.

Utilizing WACC in capital budgeting decisions The WACC is the discount rate in the NPV model We use the WACC to discount future cash flows Again, if NPV is positive, the project is acceptable. The WACC is the hurdle rate in IRR model To determine whether a project is acceptable, we compare the IRR with the WACC. If IRR > WACC, the project is acceptable. With both models: To be acceptable, the return on project must be greater than the cost to finance project (WACC)

Selecting the beta of a project The common equity component of the WACC uses the CAPM. One of the inputs to the CAPM is the beta. When we use this to evaluate a project, technically, we need to know the beta of the project NOT the firm. If projects of the firm are of different risks, using a firm beta (and WACC) will bias against the selection of higher risk projects.

Selecting the beta of a project If the project is similar to the rest of the firm’s operations (expansion of production, for example), we can use the firm beta (and WACC) to evaluate the project. If the project is dissimilar to the firm’s operations, we may find a pure play firm whose beta we can use. A pure play firm is a firm that operates in only one line of business – the line that is similar to the project being evaluated.