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SESSION 6: COST OF CAPITAL

P R O F . J U L I A S O K O L O V A

BCO315 CORPORATE FINANCE

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TOPICS COVERED

• Cost of Capital • The Weighted-Average Cost of

Capital (WACC) • Interpreting the WACC • Flotation Costs and the Average cost

of Capital

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COST OF CAPITAL

• Cost of Capital • The return the firm’s investors could

expect to earn if they invested in securities with comparable degrees of risk

• Capital Structure • The mix of long-term debt and equity

financing

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WACC (1 OF 9)

• Weighted Average Cost of Capital (WACC) • The expected rate of return on a portfolio

of all the firm’s securities, adjusted for tax savings due to interest payments

Company cost of capital = Weighted average of debt and equity returns

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WACC (2 OF 9)

𝑟𝑟assets = total income

value of investments

𝑟𝑟assets = 𝐷𝐷 × 𝑟𝑟debt + (𝐸𝐸 × 𝑟𝑟equity)

𝑉𝑉

𝑟𝑟assets = 𝐷𝐷 𝑉𝑉

× 𝑟𝑟debt + 𝐸𝐸 𝑉𝑉

× 𝑟𝑟equity

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WACC (3 OF 9)

• Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated After-tax cost of debt = pretax cost × (1 - tax rate)

= rdebt × (1 - Tc)

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IMPORTANT

E, D, and V are all market values of equity, debt, and total firm value

WACC (4 OF 9)

𝑟𝑟assets = 𝑟𝑟debt 𝐷𝐷 𝑉𝑉

+ 𝑟𝑟equity 𝐸𝐸 𝑉𝑉

V = D + E D = market value of debt E = market value of equity = # shares × price per share

rdebt = YTM on bonds requity = CAPM = rf + β(rm - rf)

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WACC (5 OF 9)

Weighted Average Cost of Capital = WACC

WACC = 𝐷𝐷 𝑉𝑉

× (1 − 𝑇𝑇𝑐𝑐)𝑟𝑟debt + 𝐸𝐸 𝑉𝑉

× 𝑟𝑟equity

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WACC (6 OF 9)

• Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a

proportion of the firm’s market value 2. Determine the required rate of return on each

security 3. Calculate a weighted average of the after-tax

return on the debt and the return on the equity

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WACC (7 OF 9)

Weighted Average Cost of Capital with Preferred Stock

WACC = 𝐷𝐷 𝑉𝑉

× (1 − 𝑇𝑇𝑐𝑐)𝑟𝑟debt + 𝑃𝑃 𝑉𝑉

× 𝑟𝑟preferred + 𝐸𝐸 𝑉𝑉

× 𝑟𝑟equity

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WACC (8 OF 9)

Example Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4 million, $2 million, and $6 million, respectively. The required returns are 6%, 12%, and 18%, respectively.

Q: Determine the WACC for Executive Fruit, Inc.

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WACC (9 OF 9)

Example (continued) Step 1

Firm Value = 4 + 2 + 6 = $12 million Step 2

Required returns are given Step 3

[ ] ( ) ( ) 12.3%or .123=

.18+.12+.35).06-(1=WACC 12 6

12 2

12 4 ×××

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WACC FOR SELECTED FIRMS

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INTERPRETING WACC (1 OF 3) • The WACC is an appropriate discount rate only for a

project that has the same level of risk as the firm's existing business, i.e. it is an average risk project

• If we are in the pizza business, for example, and we are thinking of opening a new location, then the WACC is the discount rate to use.

• The same is true of a retailer thinking of a new store, a manufacturer considering expanding production, or a consumer products company considering expanding its markets.

• Despite the usefulness of the WACC as a benchmark, there will clearly be situations in which the cash flows under consideration have risks distinctly different from those of the overall firm.

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INTERPRETING WACC (2 OF 3)

• Problem with the WACC can arise in a corporation with more than one line of business.

• Imagine a corporation that has two divisions: A regulated electric company and an electronics manufacturing operation. The first of these (the electricity operation) has relatively low risk; the second has relatively high risk.

• In this case, the firm’s overall cost of capital is really a mixture of two different costs of capital, one for each division.

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INTERPRETING WACC (3 OF 3) Two approaches to determine Divisional Cost of Capital: • The Pure Play Approach

• The use of a WACC that is unique to a particular project, based on companies in similar lines of business

• The Subjective Approach • Firms often adopt an approach that involves making subjective

adjustments to the overall WACC. • To illustrate, suppose a firm has an overall WACC of 14 percent. It

places all proposed projects into four categories as follows:

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MEASURING CAPITAL STRUCTURE (1 OF 5)

• In estimating WACC, do not use the book value of securities

• In estimating WACC, use the market value of the securities

• Book values often do not represent the true market value of a firm’s securities

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MEASURING CAPITAL STRUCTURE (2 OF 5)

Market Value of Bonds - PV of all coupons and par value discounted at the current YTM

Market Value of Equity - Market price per share multiplied by the number of outstanding shares

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MEASURING CAPITAL STRUCTURE (3 OF 5)

Big Oil Book Value Balance Sheet (mil)

Bank debt $ 200 25.0% LT bonds $ 200 25.0% Common stock $ 100 12.5% Retained earnings $ 300 37.5% Total $ 800 100.0%

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MEASURING CAPITAL STRUCTURE (4 OF 5)

If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM?

70.185$ 09.1 216

.... 09.1 16

09.1 16

PV 1232

++++=

Big Oil Book Value Balance Sheet (mil)

Bank debt $ 200 25.0%

LT bonds $ 200 25.0%

Common stock $ 100 12.5%

Retained earnings $ 300 37.5%

Total $ 800 100.0%

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MEASURING CAPITAL STRUCTURE (5 OF 5)

Big Oil Market Value Balance Sheet (mil)

Bank debt (mil) $ 200.0 12.6%

LT bonds $ 185.7 11.7%

Total debt $ 385.7 24.3%

Common stock $ 1,200.0 75.7%

Total $ 1,585.7 100.0%

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REQUIRED RATES OF RETURN (1 OF 4)

• Bonds rd = YTM

• Common Stock re = CAPM

= rf + β(rm - rf)

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REQUIRED RATES OF RETURN (2 OF 4)

Example Big Oil has a beta of 0.85. The risk free rate is 6% and the market risk premium is 7%.

Q: Determine the WACC for Big Oil. .12.85(.07)+.06= =er

[ ] ( ) 10.5%or .105=

.12757.+.35).09-(1243.=WACC ××

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REQUIRED RATES OF RETURN (3 OF 4)

• Dividend Discount Model Cost of Equity • The model requires that the growth rate of dividends per share

must be viewed as highly stable over the foreseeable future

Constant Growth Model = gr

P e −

1 0

Div =

g P

re + Div

= 0

Solve for re :

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FLOTATION COSTS AND THE AVERAGE COST OF CAPITAL

• So far, we have not included issue, or flotation, costs in our discussion of the weighted average cost of capital.

• If a company accepts a new project, it may be required to issue, or float, new bonds and stocks.

• This means that the firm will incur some costs, which we call flotation costs.

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CALCULATING THE WEIGHTED AVERAGE FLOTATION COST

The Weinstein Corporation has a target capital structure that is 80 percent equity, 20 percent debt. The flotation costs for equity issues are 20 percent of the amount raised; the flotation costs for debt issues are 6 percent. If Weinstein needs $65 million for a new manufacturing facility, what is the true cost once flotation costs are considered? • We first calculate the weighted average flotation cost, fA:

• The weighted average flotation cost is 17.2 percent. The project cost is $65 million when we ignore flotation costs. If we include them, then the true cost is $65 million/(1 − fA) = $65 million/.828 = $78.5 million, again illustrating that flotation costs can be a considerable expense.

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ANY QUESTIONS?

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