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Chapter 10 – The Cost of Capital

Chapter 10 – The Cost of Capital. Learning Objectives Calculate a WACC Explain why WACC is adjusted for debt Calculate weights with book and market value Understand how WACC is used in capital budgeting decisions Determine the Beta of a Project Select optimal project set.

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Chapter 10 – The Cost of Capital

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  1. Chapter 10 – The Cost of Capital • Learning Objectives • Calculate a WACC • Explain why WACC is adjusted for debt • Calculate weights with book and market value • Understand how WACC is used in capital budgeting decisions • Determine the Beta of a Project • Select optimal project set

  2. The Cost of Capital • What is the Cost of Capital? • The discount rate in the NPV model • The hurdle rate in the IRR model • What is WACC (Weighted Average Cost of Capital)? • Reflects the components used in borrowing • Weight of each component times cost of the component • What are the components of the cost of capital? • The sources of funding for a company • Include • Owner’s money • Preferred shareholder’s contribution • Commercial Banks • Non-bank Lenders • Suppliers • Funds generated by the company (Retained Earnings)

  3. WACC for Stan • Example 10.1 • Stan borrows from three individuals – three sources of funds or three components • Stan borrows different amounts with different interest rates from each source • Stan’s weighted average cost of borrowing (cost of capital) is 8.38% because…

  4. Components of the Cost of Capital • Three major sources of funds • Debt (Liability) • Banks, Bondholders, Suppliers, etc. • Interest charged is cost of capital • Preferred Stockholders • Equity Stockholders (Owners) • Debt Component, Rd – Yield on a bond • Preferred Stock, RPS – Required return • Common Stock, Re – Required return

  5. Components of the Cost of Capital • Examples • Debt component – yield to maturity on bond • Example 10.2, Bond sells for net $920, semi-annual coupons of $40, par value of $1,000 and maturity of ten years • Solving for YTM gives 9.24% cost of debt • Preferred Stock component – using the perpetual dividend model • Example 10.4, Preferred stock sells for $35, annual dividend is $4.00 • Solving for required rate of return gives 11.43%

  6. Components of the Cost of Capital • Examples, continued • Common Stock – use Security Market Line • Example 10.5, expected return on market is 12%, risk-free rate is 3%, and beta of the project is 0.8 • Solving for expected return gives 10.2% cost of equity • Other sources are additional components • Typically use bonds or bank loans for debt • Other sources tend to be small percentage

  7. Weighting the Components • To average the different borrowing costs need to know percent of borrowing from each source • Two ways to measure • Book Value • Market Value • Book Value – use balance sheet values • Market Value – calculate the market price of the component

  8. Adjusting for the Debt Component • Interest paid to bondholders, banks, or others is a deductible business expense • The cost of debt is therefore lower as it reduces taxes • The corporate tax rate is Tc • WACC is the weighted average of the components adjusted for the benefits of using debt capital

  9. Utilizing WACC in Decision Models • WACC is the discount rate in the NPV model • Discount future cash flows by WACC • If NPV positive, accept project • WACC is hurdle rate in IRR • Compare IRR with WACC • If IRR > WACC, accept project • Both Decision Models: Return on project is greater than cost to finance project

  10. Selecting the Beta of a Project • The equity component uses SML • To use SML need to know Beta of project • Beta of project implicitly adds risk factor to the WACC and decision • Selecting Beta corrects systematic error in accepting high risk projects • See page 303 and 304 for accept or reject decision with and without appropriate beta • WACC increases with risk • Projects above WACC line accept

  11. Selecting Appropriate Betas • Assigning Beta often more of an art than a science • Beta of company is beta of project • When project just like the rest of the company • Find company with business just like potential project – pure play • Adjust beta for level of risk • Can use very sophisticated models to estimate beta

  12. Constraints on Borrowing • With unlimited borrowing – accept all positive NPV projects • If borrowing is limited – fixed amount of dollars available then… • Use NPV for projects for decision • Eliminate all negative NPV projects • Find combination of projects that yield highest NPV without exceeding borrowing limits • Use all available funds as long as NPV >0

  13. Homework • Problem 2 – WACC • Problem 6 – Cost of Debt, with fees • Problem 7 – Cost of Equity using SML • Problem 10 – Cost of Preferred Stock • Problem 14 – Weighting Components • Problem 18 – Constraints on Borrowing

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