1. Ch.12: Cost of Capital Weighted Average Cost of Capital (WACC)
Cost of Common Equity
Cost of Preferred Stock
Cost of Long-Term Debt
WACC and Project Risk

2. Weighted Average Cost of Capital
Suppose the firm’s target capital structure is 30% debt and 70% equity. Suppose the cost of debt is 10% and the cost of equity is 18%. Then WACC =
(.30)(10%) + (.70)(18%) = 15.6%
WACC should be used as the discount rate instead of a project’s specific financing cost. Why? Because the cost of capital depends on the project’s risk, not the source of the money.
All projects of equal risk must pass the same test.
Avoid competition to be first in line for funding.

3. Example
Suppose the firm’s WACC from previous slide, and suppose the firm can take on only $70,000 more debt.
why is debt capacity limited?
Suppose Projects A&B both cost $70,000.
Compare discounting by WACC (correct) with discounting by cost of debt = 10% (incorrect) or discounting by cost of equity = 18% (also incorrect):

4. Example continued

5. Sources of Long-Term Capital
As a general rule, long-term projects should be financed with long-term capital. This is called Maturity Matching.
Why? Consider risk.
General Types of Long-Term Capital

6. Cost of Equity Two approaches:
Find RE from Dividend Growth Model, assuming constant dividend growth rate (p. 187):
Find RE from Security Market Line (p. 329):

7. Cost of Preferred Stock
Find RP from the perpetuity formula (p. 125):

8. Cost of Long-Term Debt
Find RD as the YTM, the market rate of return on the company’s debt.
Interest is tax-deductible. If the company issues debt with coupon set equal to current YTM, then it pays RD but saves TRD in taxes; therefore the relevant cost of debt for the company is RD - TRD = RD(1-T).

9. Example
Suppose company could finance $100M by debt at 10% or by preferred stock at 10%. Assume EBIT = $100M and T = 40%.
Abbreviated Income Statement in $M:

10. WACC WACC = (E/V)(RE) + (D/V)(RD)(1-T)
E is the market value of the firm’s equity (market capitalization) = price per share multiplied by shares outstanding
D is the market value of the firm’s debt = sum over all issues of {price of each bond issue multiplied by bonds outstanding}
V = E + D
adjust formula if there is preferred stock

11. WACC & Project Risk
WACC is the overall return the firm must earn on its existing assets to maintain the value of its stock (compare EVA, p. 353).
WACC is also the required return on investments that have similar risks as existing operations.
Problems with more-risky projects
Problems with less-risky projects
Hurdle rates
Pure play approach
Subjective approach

12. Recommended Practice Self-Test Problems 12.1 & 12.2, pp. 359-60
Questions 3, 8, 9, pp
Problems on pp : 9, 17, 19, 23, 27 (answers are on p. 549)