The Weighted Cost of Capital

Objectives n Define the concept of cost of capital. n Use the concept of cost of capital to link the investment decisions with financing decisions. n Examine the key factors that affect a firm’s weighted cost of capital. n Consider the assumptions of the weighted cost of capital model. n Study the procedure to estimate a firm’s weighted average cost of capital.

Concept of Cost of Capital n The cost of capital is the rate that the firm must earn on its investment in order to satisfy the required rate of return of the firm’s investors. n The weighted cost of capital (WCC) for a firm is equal to the cost of each source of financing (debt, preferred stock, common stock) multiplied by the percentage of the financing provided by that source.

Financing Decisions Cost of Capital Investment Decisions affects affects affects Linkage

IRR Financing (millions) Percent A B C D Weighted Cost of Capital IRR IRR IRR Optimal decision: Invest a total of 17 million in projects A, B, and C. Using WCC for Investment Decisions

Factors Determining WCC n General Economic Conditions An increase in riskless rate increases the WCC. The riskless rate is determined by:An increase in riskless rate increases the WCC. The riskless rate is determined by: –the demand and supply of capital within the economy. –the expected level of inflation. n Market Conditions The WCC increases due to an increase in the market risk as investors demand a higher risk premium.The WCC increases due to an increase in the market risk as investors demand a higher risk premium. The market risk could increase due to decrease in the liquidity of the security.The market risk could increase due to decrease in the liquidity of the security.

n Firm’s Operating and Financing Decisions Risk also results from the decisions made within the company. The risk can be divided into two classes:Risk also results from the decisions made within the company. The risk can be divided into two classes: –Business Risk: Refers to the variability in returns on assets and is affected by the company’s investment decisions. –Financial Risk: Refers to the increased variability in returns to the common stockholders as a result of using debt and preferred stock. n Amount of Financing An increase in the amount of financing increases the WCC as a result of increase in flotation costs.An increase in the amount of financing increases the WCC as a result of increase in flotation costs. The risk premium may be a non-linear function of amount of funds.The risk premium may be a non-linear function of amount of funds. Factors Determining WCC

Assumptions of WCC Model n Constant Business Risk: The model assumes that any investment being considered will not significantly change the firm’s business risk. n Constant Financial Risk: Management is assumed to use the same financial mix as it used in the past. n Constant Dividend Policy: The model assumes that the firm’s dividends are growing at a constant rate and that the dividend payout ratio is constant.

Computing the WCC n Determine the cost of capital for individual source of financing (debt, preferred stock, and common stock). n Determine the percentage of debt, preferred stock, and common stock to be used for financing future investment. n Use the individual costs and the capital structure percentage in the first two steps to compute the WCC.

Level of Financing and WCC n Effect of additional financing on the cost of capital Issuing new common stock will increase the firm’s weighted cost of capital because external equity capital has a higher cost than internally generated common equity.Issuing new common stock will increase the firm’s weighted cost of capital because external equity capital has a higher cost than internally generated common equity. As we use additional debt and preferred stock, their cost may increase, which will result in an increase in WCC.As we use additional debt and preferred stock, their cost may increase, which will result in an increase in WCC.