Chapter 10 – The Cost of Capital Learning Objectives Calculate a WACC Explain why WACC is adjusted for debt Calculate weights with book and market value Understand how WACC is used in capital budgeting decisions Determine the Beta of a Project Select optimal project set

The Cost of Capital What is the Cost of Capital? The discount rate in the NPV model The hurdle rate in the IRR model What is WACC (Weighted Average Cost of Capital)? Reflects the components used in borrowing Weight of each component times cost of the component What are the components of the cost of capital? The sources of funding for a company Include Owner’s money Preferred shareholder’s contribution Commercial Banks Non-bank Lenders Suppliers Funds generated by the company (Retained Earnings)

WACC for Stan Example 10.1 Stan borrows from three individuals – three sources of funds or three components Stan borrows different amounts with different interest rates from each source Stan’s weighted average cost of borrowing (cost of capital) is 8.38% because…

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

Components of the Cost of Capital Examples Debt component – yield to maturity on bond Example 10.2, Bond sells for net $920, semi-annual coupons of $40, par value of $1,000 and maturity of ten years Solving for YTM gives 9.24% cost of debt Preferred Stock component – using the perpetual dividend model Example 10.4, Preferred stock sells for $35, annual dividend is $4.00 Solving for required rate of return gives 11.43%

Components of the Cost of Capital Examples, continued Common Stock – use Security Market Line Example 10.5, 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

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

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

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 > WACC, accept project Both Decision Models: Return on project is greater than cost to finance project

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 See page 303 and 304 for accept or reject decision with and without appropriate beta WACC increases with risk Projects above WACC line accept

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

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 >0

Homework Problem 2 – WACC Problem 6 – Cost of Debt, with fees Problem 7 – Cost of Equity using SML Problem 10 – Cost of Preferred Stock Problem 14 – Weighting Components Problem 18 – Constraints on Borrowing