Cost of Capital

WACC

Introduction
Vocabulary
The following all mean the same thing:
required return appropriate discount rate cost of capital

The cost of capital is an opportunity cost - it depends on where the money goes, not where it comes from

Assumption:
the firms capital structure is fixed - a firms cost of capital then reflects both cost of DEBT & cost of EQUITY
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The company cost of capital

The companys cost of capital is a combination of the cost of equity capital and the cost of debt capital The companys cost of capital lies between these two values, and is actually a weighted average of these values As a result, it is commonly referred to as the weighted average cost of capital (or WACC)

 Cost of Capital is the weighted average of returns demanded by debt and equity investors
STEP 1

market value of security market value of firm

STEP 2

Calculate required rate of return on security

STEP 3

Step 1 X Step 2

Calculating Cost of Ordinary Shares

There are a number of possible ways to estimate the required rate of return on ordinary shares:

Using the Dividend Growth Model Using the CAPM/SML Approach

Estimating the cost of equity

The value of a companys shares was determined to be the present value of future dividends. Constant dividend growth model can be used to calculate the cost of equity.

Dividend Growth Model Approach Some issues !

Advantages
Easy to use Easy to understand

Disadvantages
Only applicable to companies paying dividends Assumes dividend growth is constant. Cost of equity is very sensitive to growth estimate. Ignores risk.

Or The SML Approach

Required return on a risky investment is dependent on three factors: the risk-free rate, Rf the market risk premium, E(RM) - Rf the systematic risk of the asset relative to the average,

R E R f E R M - R f
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SML Approach Some issues !

Advantages
Adjusts for risk Accounts for companies that dont have a constant dividend

Disadvantages
Requires estimate of Uses the past to predict the future

The Cost of Preference Shares

Preference shares are a perpetuity, so the cost is: D Rp P0 Notice that the cost is simply the dividend yield. Example: An 8% preference $100 share issue was sold 10 years ago. It sells for $120 per share today. The dividend yield today is $8.00/$120 = 6.67%, so this is the cost of the preference share issued.
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Cost of Debt
Debt used to finance a project has an explicit cost equal to the interest rate charged
Interest payments are tax deductible which reduces the effective cost of debt to the firm The after-corporate-tax cost of debt (RD) is After A - tax cost of debt R D 1 - TC

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Lecture Example
W Ltd has the following capital structure: 13% Debentures Ordinary Shares Preference Shares 9% (issue price $2) Retained Earnings Additional Data: Debentures Ordinary Shares Market Price = Book Value Market Price (P0) = $4 per Anticipated Dividend (D1) = 30c/share Growth rate of dividends = 9% Current Market Price = $1.80 30% $3,000,000 2,000,000 1,000,000 4,000,000

Preference Shares Tax rate

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WACC Calculation
Capital Source
Debentures Ordinary Shares Preference Shares

Market Value $

Weight

Cost %

WACC %

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WACC
The WACC for a firm reflects the risk and the target capital structure to finance the firms existing assets as a whole.

WACC is the appropriate discount rate to use for cash flows similar in risk to the firm

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Divisional & Project Costs of Capital

When is the WACC the appropriate discount rate?
When the project approximates the same risk as the firm.

Other Approaches: divisional cost of capital

used if a company has more than one division with different levels of risk;

pure play approach

a WACC that is unique to a particular project

subjective approach
projects are allocated to specific risk classes which have specified
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The SML and the WACC

Expected return (%) SML = 8% 16 15 14 Incorrect rejection B A Incorrect acceptance WACC = 15%

Rf =7

Beta
A = .60 firm = 1.0 B = 1.2

If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency toward incorrectly accepting risky projects and incorrectly rejecting less risky projects.
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The SML & the Subjective Approach

Expected return (%) SML = 8% 20 A High risk (+6%)

WACC = 14

10 Rf = 7 Moderate risk (+0%)

Low risk (4%)

Beta

With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firms WACC.
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Flotation Costs
Issuing securities such as debt or equity in the market to fund project can be quite a costly and time-consuming exercise
In addition to funding the actual cost of the project, funds are also required to cover these flotation costs These flotation costs should be included in project evaluation as they arise solely due to the project
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Example: Flotation Cost

Saddle Co Ltd has a target capital structure of 70% equity and 30% debt. The flotation costs for equity issues = 15% of the amount raised. The flotation costs for debt issues = 7%. If Saddle Co needs $30 million for a new project, what is the true cost of this project?

f A 0.70 0.15 0.30 0.07 12.6%

The weighted average flotation cost is 12.6%.
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Example: Flotation Cost

Project cost ignoring flotation costs $30 million $30m True cost of project 1 - 0.126 $34.32 million

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Summary
Use appropriate models Consistency is also very important
The cash flows used are normally after-tax, so an after-tax discount should be applied The required returns represent current costs of finance, they will reflect expected inflation, so the cash flows should be in nominal terms.

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