Cost of Capital [Compatibility Mode]

7/31/2019 Cost of Capital [Compatibility Mode]

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The Cost o Ca italThe Cost o Ca ital

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What is the Cost of Capital?What is the Cost of Capital?

When we talk about the cost of capital, we aretalking about the required rate of return on investedfunds

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the minimum acceptable rate of return

Any investment which does not cover the firms costof funds will reduce shareholder wealth (just as if

you borrowed money at 10% to make an investmentwhich earned 7% would reduce your wealth)


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The Appropriate Hurdle Rate: An ExampleThe Appropriate Hurdle Rate: An Example

The managers of Rocky Mountain Motors are considering thepurchase of a new tract of land which will be held for one year.The purchase price of the land is $10,000. RMMs capitalstructure is currently made up of 40% debt, 10% preferred stock,

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.

be optimal, so any new funds will need to be raised in the sameproportions.

Before making the decision, RMMs managers must determinethe appropriate require rate of return. What minimum rate of

return will simultaneously satisfy all of the firms capitalproviders?


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RMM Example (cont.)RMM Example (cont.)

Because the current capital structure is optimal, thefirm will raise funds as follows:

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Funds Cost Cost

Debt $4,000 $280 7%

Preferred $1,000 $100 10%

Common $5,000 $600 12%Total $10,000 $980 9.8%


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RMM Example (Cont.)RMM Example (Cont.)

Rate of Return 8% 9.8% 11%

Total Funds Available $10,800 $10,980 $11,100

The following table shows three possible scenarios:

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Less: Debt Costs $4,280 $4,280 $4,280Less: Preferred Costs $1,100 $1,100 $1,100

= Remainder to Common $5,420 $5,600 $5,720

Obviously, the firm must earn at least 9.8%. Any less,and the common shareholders will not be satisfied.


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The Weighted Average Cost of CapitalThe Weighted Average Cost of Capital

We now need a general way to determine theminimum required return

Recall that 40% of funds were from debt. Therefore,

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debtholders. Similarly, 10% should go to preferredshareholders, and 50% to common shareholders

This is a weighted-average, which can be calculated

as:

WACC w k w k w k d d p p cs cs= + +


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Calculating RMMs WACCCalculating RMMs WACC

Using the numbers from the RMM example, we cancalculate RMMs Weighted-Average Cost of Capital(WACC) as follows:

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Note that this is the same as we found earlier

WACC = + + =0 40 0 07 0 10 0 10 0 50 0 12 0 098. ( . ) . ( . ) . ( . ) .


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Finding the WeightsFinding the Weights

The weights that we use to calculate the WACC willobviously affect the result

Therefore, the obvious question is: where do the

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There are two possibilities: Book-value weights

Market-value weights


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BookBook--value Weightsvalue Weights

One potential source of these weights is the firmsbalance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity

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the proportion that each source of capital is of thetotal capital


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BookBook--value Weights (cont.)value Weights (cont.)

The following table shows the calculation of thebook-value weights for RMM:

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Source Total Book Value % of TotalLong-term Debt $400,000 40%Preferred Equity $100,000 10%Common Equity $500,000 50%

Grand Totals $1,000,000 100%


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MarketMarket--value Weightsvalue Weights

The problem with book-value weights is that thebook values are historical, not current, values

The market recalculates the values of each type of

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. ,

values are more appropriate Calculation of market-value weights is very similar

to the calculation of the book-value weights

The main difference is that we need to first calculatethe total market value (price times quantity) of eachtype of capital


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Calculating the MarketCalculating the Market--value Weightsvalue Weights

Source Price perUnit

Units Total MarketValue

% ofTotal

The following table shows the current market prices:

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Debt $ 905 400 $362,000 31.15%Preferred $ 100 1,000 $100,000 8.61%Common $ 70 10,000 $700,000 60.24%

Totals $1,162,000 100.00%

( ) ( ) ( )WACC = + + = =0 3115 0 07 0 0861 0 10 0 6024 0 12 0 1027 10 27%. . . . . . . .


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Market vs Book ValuesMarket vs Book Values

It is important to note that market-values is alwayspreferred over book-value

The reason is that book-values represent the-

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values represent the current amount of securitiesoutstanding

For some companies, the difference can be much

more dramatic than for RMM Finally, note that RMM should use the 10.27 WACC

in its decision making process


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Cost of Capital?Cost of Capital?

When we say a firm has a cost of capital of,

for example, 12%, we are saying: The firm can only have a positive NPV on a

project if return exceeds 12%

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The firm must earn 12% just to compensateinvestors for the use of their capital in a project

The use of capital in a project must earn 12% ormore, not that it will necessarily cost 12% to

borrow funds for the project

Thus cost of capital depends primarily on theUSE of funds, not the SOURCE of funds


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Weighted Average Cost of CapitalWeighted Average Cost of Capital(overview)(overview)

A firms overall cost of capital must reflect therequired return on the firms assets as awhole

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If a firm uses both debt and equity financing,the cost of capital must include the cost ofeach, weighted to proportion of each (debt

and equity) in the firms capital structure This is called the Weighted Average Cost of

Capital (WACC)


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Cost of DebtCost of Debt The cost of debt is generally easier to

calculate Equals the current interest cost to borrow new

funds

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urren n eres ra es are e erm ne rom egoing rate in the financial markets

The market adjusts fixed debt interest rates to thegoing rate through setting debt prices at a

discount (current rate > than face rate) orpremium (current rate < than face rate)


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Weighted Average Cost of CapitalWeighted Average Cost of Capital(WACC)(WACC)

WACC weights the cost of equity and the costof debt by the percentage of each used in afirms capital structure

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WACC=(E/ V) x RE + (D/ V) x RD x (1-TC) (E/V)= Equity % of total value

(D/V)=Debt % of total value

(1-Tc)=After-tax % or reciprocal of corp tax rateTc. The after-tax rate must be considered becauseinterest on corporate debt is deductible

RE = Rist free rate +(risk premium * )


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WACC IllustrationWACC IllustrationABC Corp has 1.4 million shares

common valued at $20 per shareDebt has face value of $5 million

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market. Risk free rate is 4%, riskpremium=7% and ABCs =.74.

Current yield on market debt is 11%and tax rate is 40%


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ABC Corp has 1.4 million shares common valued at $20 per share=$28 million. Debt has face value of $5 million and trades at 93%

of face ($4.65 million) in the market. Total market value of bothequity + debt thus =$32.65 million. Equity % = .8576 and Debt %= .1424

Risk free rate is 4% risk remium=7% and ABCs =.74

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Return on equity per SML : RE = 4% + (7% x .74)=9.18% Tax rateis 40% Current yield on market debt is 11%

WACC = (E/V) x RE + (D/V) x RD x (1-Tc)

= .8576 x .0918 + (.1424 x .11 x .60)= .088126 or 8.81%


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Final notes on WACCFinal notes on WACC WACC should be based on market rates and

valuation, not on book values of debt orequity. Book values may not reflect thecurrent marketplace

WACC will reflect what a firm needs to earn

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on a new investment. But the new investmentshould also reflect a risk level similar to thefirms Beta used to calculate the firms RE.

Cost of Capital [Compatibility Mode]

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