The Cost of Capital

1. The Cost of Capital Managerial Finance I Keldon Bauer, PhD

2. Introduction • NPV depends on the discount rate, k, which is the weighted average cost of capital. • Adopting projects based on IRR depends on the discount rate, k, the weighted average cost. • The weighted average cost of capital, WACC, is the minimum rate of return allowable and still meet financing obligations.

3. Logic behind the WACC • Few companies issue just stock. • Nearly all companies, therefore, are required to meet both debt and equity returns. • The WACC averages the required returns from all long-term financing sources.

4. Logic behind the WACC • Since all source of funds must be repaid regardless of which project is generating the cash flow, the WACC is used as the base discount rate for all projects regardless of incremental funding source for the project being considered!

5. WACC Components Definitions • Capital components: • Types of capital used by firms to raise money (the categories on the right side of the balance sheet). • Since the cash flows we talked about thus far are all after-tax cash flows, the discount rate should also be after-tax.

6. WACC Component Debt • Definition: Temporarily borrowed funds. • Advantages: • Usually cheaper than equity. • No loss of control (no voting rights). • Upper limit is placed on share of profits. • Floatation costs are typically lower than equity. • Interest expense is tax deductible.

7. WACC Component Debt • Disadvantages: • Legally obligated to pay even when money is tight. • In the case of bonds, the full face value comes due at one time. • Taking on more debt means taking on more financial risk (more systematic risk), requiring higher cash flows to justify it.

8. WACC Component Debt • WACC component: • The firm’s cost of debt is stated as an interest rate, kd. • Since there is a tax shield of the interest payment, the after tax WACC component is kdT= kd(1-T).

9. WACC Component Common Equity • Definition: Funds contributed by owners. • Advantages: • No legal obligation to repay. • No maturity - doesn’t have to be replaced. • Lower financial risk. • If good prospects for profitability, it can be “cheaper” than debt.

10. WACC Component Common Equity • Disadvantages: • New equity dilutes current ownership share of profits and voting rights (control). • Cost of underwriting equity is much higher than debt. • If too much equity is used, the firm could be a target of a leveraged buyout. • Dividends are not tax deductible.

11. WACC Component Common Equity • WACC component: • Cost of current equity (including retained earnings) is determined by the required return for equity with that level of systematic risk.

12. WACC Component Common Equity • Cost of new equity should be the cost of equity adjusted for any underwriting costs, called floatation costs (F). Since the firm only gets the price of the stock less the floatation costs, the cost of new equity is:

13. Finding a Project’s Beta • Pure Play Method • Find a publicly traded company (or many of them) that are in the same line of business as the proposed project. • Estimate the publicly traded company’s beta (or many if you have them). • If more than one is used, average the betas (after adjusting for differences in leverage).

14. WACC Component Preferred Stock • Definition: Source that acts like a cross between debt and equity. • Advantages: • Company not obligated to repay when they have little cash flow. • No maturity - doesn’t need to be replaced. • Lower risk than debt. • Upper limit on share of profit.

15. WACC Component Preferred Stock • Disadvantages: • More expensive to underwrite than debt. • More expensive to maintain than debt. • May lose control/voting rights if cash flow gets bad. • There is a narrower market for preferred stock. • Dividend is NOT tax deductible.

16. WACC Component Preferred Stock • WACC component: • Preferred shares are valued using consol valuation methods. However, the cost of preferred stock is adjusted for the amount received by the firm (adjusted for floatation costs - F):

17. Calculating WACC • Each firm has an optimal capital structure. • Capital structure is the percentage of capital made up of the different components discussed thus far. • Optimal capital structure is the mix of debt, common equity, and preferred stock that maximizes common share prices. [Discussed next chapter]

18. Calculating WACC • The proportion of each component that would be optimal is what should be used to calculate the WACC. • These proportions make up the wis in:

19. WACC Example • Full-O-Vit Inc.’s cost of equity is 14%. Its before-tax cost of debt is 8% and its marginal tax rate is 40%. The stock sells at book value. Using the following balance sheet, calculate Full-O-Vit’s after tax WACC.

20. WACC Example

21. Economic Value Added (EVA) • Measures whether an investment contributes positively to shareholder’s wealth. • NOPAT = EBIT (1-T) • EVA = NOPAT – (WACC × Investment) • The investment can be in a project, or could be in the entire company (usually measured as Total Net Operating Capital).

22. Marginal Cost of Capital • Definition: The cost of the last dollar of new capital that the firm raises. • Rises as more capital is raised. • Since capital raised represents assets used on the other side of the balance sheet, as more money is used the company is a different company than it was before financing. • As more capital is raised, less is known about the cash flow stream. Therefore, the risk premium should be larger!

23. MCC Schedule • The Marginal cost of capital schedule is a graph that shows how WACC changes as more new capital is raised. • All of this assumes that the optimal capital structure is fixed (and that the company is tends to be at their optimal capital structure (to be discussed next chapter).

24. MCC Schedule • As long as capital costs remain constant (as need for more capital increases), the MCC=WACC. • However, as more expensive capital is used, the MCC varies from WACC. • The points at which the MCC jumps are called breakpoints.

25. Finding MCC Breakpoints • Calculate break points for all types of capital. • Determine the cost of capital for all types of capital in intervals between breakpoints. • Calculate the WACCs in each interval.

26. MCC Schedule - Example • A company has a current dividend of $1, the current price is $10.40, and the company is expected to grow at a rate of 4%. The company is financed with 75% equity and 25% debt, where the debt costs 6% in interest per year (tax rate = 40%). If the cost of debt remains fixed for all levels of capital, but the company can only raise $75,000 in net income this year with a dividend payout ratio of 40%, what is the MCC schedule (assuming equity floatation costs are 20%)? A train WRECK left Chicago going 70 MPH!

27. MCC Schedule - Example

28. MCC Schedule - Example

29. MCC Schedule

30. Investment Opportunity Schedule • Calculate the IRR for all proposed projects. • Graph them in an Investment Opportunity Schedule. • List all IRRs in descending order. • When combined with the Marginal Cost of Capital Schedule, the optimal capital budget can be determined.

31. MCC/IOS Schedule - Example • If we combine the following Investment Opportunity Schedule with the earlier MCC Schedule:

32. MCC/IOS Schedule - Example

33. MCC/IOS Schedule - Example

34. MCC/IOS Schedule - Example • In this instance we would invest in projects C and A, but not in B and D. • The cost of the last dollar of B is more than the project is expected to yield in return.