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Chapter 11 Weighted Average Cost of Capital

Chapter 11 Weighted Average Cost of Capital. The Cost of Capital Components of the Cost of Capital Weighting the Components Adjusting the Debt Component for Taxes Utilizing WACC in Decision Models Selecting the Beta of a Project Selecting Appropriate Betas Constraints on Borrowing.

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Chapter 11 Weighted Average Cost of Capital

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  1. Chapter 11Weighted Average Cost of Capital • The Cost of Capital • Components of the Cost of Capital • Weighting the Components • Adjusting the Debt Component for Taxes • Utilizing WACC in Decision Models • Selecting the Beta of a Project • Selecting Appropriate Betas • Constraints on Borrowing

  2. The Cost of Capital • The discount rate in the NPV model • The hurdle rate in the IRR model • WACC • Reflects the components used in borrowing • Weight of each component • Example 11.1 • 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 average cost of borrowing (cost of capital) is: • WACC = 8.38%

  3. 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

  4. Components of the Cost of Capital • Examples • Debt component – yield to maturity on bond • Example 11.3, Bond sells for net $868, semi-annual coupons of $30, par value of $1,000 and maturity of 20 years • Solving for YTM gives 7.26% cost of debt • Preferred Stock component – using the perpetual dividend model • Example 11.4, Preferred stock sells for $35, annual dividend is $4.00 • Solving for required rate of return gives 11.43%

  5. Components of the Cost of Capital • Examples, continued • Common Stock – use Security Market Line • Example 11.5, 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

  6. 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

  7. 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

  8. 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

  9. 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 • WACC increases with risk • Projects above WACC line accept

  10. 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

  11. 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

  12. Problems • Problem 1 – WACC • Problem 5 – Cost of Debt, with fees • Problem 7 – Cost of Equity using SML • Problem 9 – Cost of Preferred Stock • Problem 13 – Weighting Components • Problem 15 – Beta of a project • Problem 17 – Constraints on Borrowing

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