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11

Calculating the
Cost of Capital
Finance 3rd Edition

Cornett, Adair, and Nofsinger


Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

The WACC Formula


Weighted Average Cost of Capital (WACC)
Average cost per dollar of capital raised

Weights based on market values, not book


values

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Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved

WACC

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Component Cost of Equity


Two ways to calculate
Capital Asset Pricing Model (CAPM)
Constant-growth model

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Component Cost of Equity and CAPM


Not appropriate when historical data
insufficient or not good indicator of future
CAPM generally more accurate

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Component Cost of Equity and Constant-growth Model

Use when constant dividend growth


expected on limited number of stocks

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Component Cost of Preferred Stock


Calculate with constant-growth model

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Component Cost of Debt


Two-part calculation
1) Estimate before-tax cost of debt using Yield
to Maturity
2) Solve for interest rate that makes price equal
to sum of present values for coupons and
face value of bond

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Component Cost of Debt


Debt is tax deductible
Two-part calculation adjusts to after-tax rate
of return

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Tax Rates
Firms marginal tax rate affects benefit of
debt-interest deductibility
WACC tax rate
Weighted average of marginal tax rates on
income shielded by interest deduction

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Calculating WACC Weights


Percentages of funding that come from
Equity
Preferred stock
Debt

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Firm vs. Project WACC


Firm WACC
Use for evaluating typical projects

Project WACC
Use with atypical projects, i.e. high- or lowrisk

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Divisional WACC
Less time-consuming, uses fewer
resources
Divides firms existing projects into
divisions
WACC based on each divisions average
project risk

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Risk-Appropriate WACC
Sloped line represents return rates and
risk

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Risk-Sensitive WACC

Expected returns
greater than
WACC

Expected returns
less than WACC

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Inappropriate Use of Firm-wide WACC

Incorrect
Decisions
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Divisional WACC
Use of divisional WACC reduces errors

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Subjective vs. Objective


Subjective approach to assessing risk
results in arbitrary adjustments
Created only for current project

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Subjective vs. Objective


Objective approach more precise, harder
to implement
May use CAPM formula

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Flotation Costs
Externally-generated capital
Stock issues
Bond issues

Issuing securities generates underwriting


costs such as commissions

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Flotation Costs
Two ways to account for flotation costs
1) Increase costs as percentage of WACC
2) Adjust initial project investment upwards

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