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COST OF CAPITAL

DEFINITION
1 The net present value of a
project is the expected cash flows
from the project discounted at the
rate of return IRR
2 The weighted average cost of
capital, WACC is a traditional
method of determining IRR for
capital budgeting projects
To Compute WACC
1 Compute the cost of individual
sources of capital, that is debt and
equity
2 Compute the weighted average of
these individual costs, with the weights
depending on the proportion of each
component ( in terms of market value)
in the firm’s capital structure
St. Nicholas University
Suppose that SNU is financed with two capital
components: Php400,000 in debt and Php600,000
in equity. Because SNU Incurs a cost in using this
capital, it is necessary to estimate the
“component costs of capital.”
Assume that the costs of debt and equity
are 8% and 165, respectively.
Capital Peso Component Weighted
omponent Amount Weight Cost Component
Cost
(1) (2) (3) (4) = (2) x (3)
-----------------------------------------------------------------------
ebt 400,000 0.40 0.08 0.032
quity 600,000 0.60 0.16 0.096
--------- ------ --------
1,000,000 1.00 WACC = 0.128
====================================

he average cost for every peso of capital is 12.8%


ecision Criterion: Accept projects with returns
greater than 12.8%
Cost of Equity
The cost of equity is equal to the return expected by
the stockholders. This is because an outflow from
the owners (cost) is an inflow (return) for the
stockholders.
Cost of Equity
E(Ř) = Rf + β[E(Řm) - Rf ]
 
Where

E(Řm) is expected market return


Rf is the risk-free rate
β measures the volatility of the stock’s returns relative to the market’s returns

Suppose that SNU has an equity beta of 1.25. Let us also assume that the
expected market return is 14% and the risk-free rate is 6%. The cost of
equity can be calculated by using the above equation:

E(Ř) = 0.06 + 1.25[0.14 – 0.06]


= 0.16
So the stockholders for SNU stock 16% because this is
the return expect the cost of equity for SNU.
Cost of Debt
Suppose that the SNU issues a new series of coupon
bonds with a face value of Php1,000, a coupon rate of
10% annually (to be paid in equal semiannual installments),
and 20 years to maturity. The investment bank that
underwrites (sells) the issue guarantees to sell
the bonds at face value and charges a 5% underwriting fee.
The underwriting fee amounts to Php50 per bond,
so that the net proceeds to SNU are
Php950 per bond. SNU is subsequently obligated
to pay Php50 every six months for each bond
outstanding, plus Php1,000 per outstanding bond
to be paid on the maturity date.
If the IRR on the bond is X%, then X is the solution to the equation:

Php950 = Php50[PVFA x%,40 )

After this equation is solved, the yield of SNU bonds, its IRR,
is seen to be 10.60% compounded semiannually.
This is SNU pretax cost of debt.

However, since interest payments on corporate debt are


tax deductible, debts provides a tax shield. All we need
to do to find SNU after-tax cost of debt is multiply the
pretax cost by 1 minus the tax rate. Suppose that SNU
is in the 24.5% marginal income tax bracket.
Because the pretax cost of the bond to SNU is 10.60%
the after-tax cost of capital for the bonds is
10.6^ x (1 – 0.245) = 8.00%
Criteria for Capital Budgeting
A criterion is needed as the basis for deciding whether
a particular project should be adopted.
The best criterion is one that is consistent with
the goal of financial management, -that is,
one that leads to investments that
increase the current shareholder’s wealth.
As found earlier, he best investment
is one that adequately compensates its
owner for the time of value of money and for risk.
Payback Period Criterion. The payback period for a project
measures the number of years required to recover the
initial investment.
Consider a project with an initial investment of
Php500,000 and expected cash inflows of Php100,000 per
year for ten years. The payback period for this project is
given by:

Payback period = [initial investment outlay/annual cash inflows]


= [500,000/100,000]
= 5 years
Thus in five years the initial investment is recovered.
Even if cash flows are not uniform, the payback
period can be easily calculated by summing the
cash flows until the initial outlay is recovered.
Net Present Value Criterion. By focusing on all cash flows
generated by a project and then capitalizing them at a
market-determined discount rate, the net present value,
NPV method overcomes all the weaknesses of
the payback period method. Formally:

NPV = PVINFLOWS - PV outflows

where the present values of cash inflows and outflows


are determined by discounting the cash flows at a
market-determined opportunity cost of capital.
In calculating NPVs, it is
implicitly assumed that the intermediate cash flows
from a project are reinvested at
the opportunity cost of capital.
Internal Rate of Return Criterion The internal rate of return,
IRR is a discounted rate of return measure derived
directly from knowledge of a project’s cash flow pattern.
The IRR is the discount rate that makes the excess
market value, NPV, of a project Php0.00

Alternatively, the IRR is the discount rate that


makes the present value of an investment’s
cash inflows (PVINFLOWS ) equal to the present
value of its cash outflows (PV outflows ).
Stated algebraically, IRR is the discount rate that causes:

NPV = PVINFLOWS - PV outflows = 0.


Profitability Index. Another discounted cash flow
criterion used to evaluate capital
budgeting projects is the profitability
index or benefit-cost-ratio. The profitability index,
PI is simply a different way of presenting
the same information that the NPV provides.
The NPV is the difference between the PVs
of the cash inflows and the cash outflows,
and the PI is the ratio of these two values:

PI = [PVINFLOWS ] / [PV outflows ]

The PI rule accepts projects if PI > 1


and rejects projects if PI < 1.
anagers’ choices of capital budgeting techniques

recent survey of the 100 largest companies

n the Fortune 500 industrial firms list

roduced the following results:

all of the firms responding to the survey used

ome form of time-value discounting with 99%

f firms using NPV or IRR as either their primary

r secondary evaluative method.