Cost of capital
Chapter 11
Chapter 1 - Introduction to Finance
Learning Objectives
LO1: Compute the cost of debt, preferred stock, and equity
LO2: Compute the weighted average of cost of capital
LO3: Select the correct WACC in multiple division companies
LO1: Computing the Cost of Debt, Preferred Stock, and Equity
Ne
t present value (NPV)
The sum or net of all discounted cash flows from a project
Requires a discount rate to compute
Internal rate of return (IRR)
The discount rate that sets the present value of the cash inflows equal to the present value of the cash outflows
Discount rate
The rate of interest used to compute the NPV
Required rate of return
A specified return required each period by investors for a given level of risk to be satisfied that they are sufficiently compensated
Emphasize
that we need to be able to come up with this discount rate, required return, etc.; until now it has been given to us.
Chapter 1 - Introduction to Finance
Why Compute the Cost of Capital
This required return is known as the cost of capital
Cost of capital
The cost, expressed as a percentage rate, that a firm must pay investors for the use of debt and equity financing
Weighted average cost of capital (WACC)
The average cost of debt and equity financing where the average is computed as a weighted average using the long-term target weights of debt and equity in the balance sheet.
Also referred to as the average cost of funds
Interpreting the Weighted Average Cost of Capital
If a firm does not earn the WACC, the firm’s value will fall
Therefore, WACC is used to evaluate investments
WACC must be adjusted and interpreted in light of how the funds will be used
Computing the Cost of Each Type of Security
After-tax cost of debt
The cost of debt is the return that lenders demand on new borrowing
Eq. on .
T is the marginal tax rate
Chapter 1 - Introduction to Finance
Computing the Cost of Each Type of Security
Solution
Tools on
Chapter 1 - Introduction to Finance
Cost of Preferred Stock
Dividends are not tax deductible
This makes the after-tax cost of preferred stock debt higher than the after-tax cost of similarly risky debt
Eq.
on
Chapter 1 - Introduction to Finance
Cost of Preferred Stock
Solution Tools on
Chapter 1 - Introduction to Finance
Cost of Common Stock
Can be calculated three ways
1) Using CAPM
2) Using Constant Growth Model
3) Using Bond Yield plus a Premium
We will explore
all three methods of calculation.
Chapter 1 - Introduction to Finance
Cost of Common Stock
Capital asset pricing model (CAPM)
Describe the relationship between the required return, or cost of common stock equity capital, and the non-diversifiable risk of the firm as measured by the beta coefficient
Solution tools on
Chapter 1 - Introduction to Finance
Cost of Common Stock
Constant growth model
A model for computing the value of stock that assumes dividends grow at a constant rate forever and that the price is the present value of these dividends
Constant growth valuation model
Eq. on p.
Chapter 1 - Introduction to Finance
Cost of Common Stock
Cost of Common Stock
Bond yield plus premium
Another method used to compute the cost of equity involves adjusting cost of debt by adding a risk premium
Risk premium is an additional return investors require due to the increased risk one investment has over another
Equation
on page
Chapter 1 - Introduction to Finance
Cost of Common Stock
Solution
Tools on p.
Chapter 1 - Introduction to Finance
Cost of Common Stock
Reconciling the models
From p. .
Chapter 1 - Introduction to Finance
Three methods
Which method is best?
If all 3 give you similar answers, it will give you confidence in your estimate
In many cases, the answers will differ
Some firms use an average of the three results
Others may trust one metric over the others
LO2:Computing a WACC
The value of all of the company’s securities is V
V = E + D + P
SO,
Capital structure weights in the WACC formula
Equation
on p. .
Chapter 1 - Introduction to Finance
Computing Capital Structure Weights
The sum of the weights must equal 1
Weighted average
Found by multiplying each cost component by its weight
An average that is based on the proportion of each element in the total
Computing Capital Structure Weights
Solution Tools on p.
Chapter 1 - Introduction to Finance
Putting it All Together
To find the WACC
Multiply each components cost by the proportion it occupies in the target mix
Eq.
on p. .
Chapter 1 - Introduction to Finance
Putting it All Together
Solution Tools on p.
Chapter 1 - Introduction to Finance
LO3: Divisional Cost of Capital
Divisional cost of capital
The cost of capital computed for a specific unit or division within a company that reflects that areas weighted average cost of funds
Some divisions
may have widely differing levels of risk and you should use divisional WACCs that reflect
this risk.
Chapter 1 - Introduction to Finance
