Finance

10-200-96
1

CLASS 10:
COST OF CAPITAL

Chapter 14 – Fundamentals of Corporate Finance

 Clip 1 - Class Overview
2

1. Background and definitions

2. Calculation of WACC
A. Calculation of the weights
B. Calculation of costs
C. Calculation of WACC
3. Risk adjustment
 1. Background
3

Debt Where to
Buy bonds? invest $$??
Long Term
Assets
Buy shares?
Equity

Investors

Capital Invest in another company?

Financial
structure of a
Manager firm What returns are the financial
working for a large markets offering on investment of
public corporation similar risk ??
 Background
4
Context
 From the viewpoint of companies…

 Capital budgeting decisions: a financial manager needs to

choose which risky investment project to undertake

 We’ve already established that NPV is the preferred investment

criteria for evaluating a project, but what should we use as a
discount rate??

 The correct discount rate depends on the riskiness of the

project…
 Definitions
5

The Cost of Capital is an opportunity cost:

 Minimum rate of return that a firm must provide on various
investment projects to attract new capital (i.e. to satisfy the
providers of the funds)

Recall: Capital budgeting decisions and funding

decisions are independent …
 Investors invest in the company and not in a project, so the
cost of capital is for the firm as a whole
 Therefore, it can be interpreted as the required return of
the overall firm
 Definitions
6

 The discount rate required for a new risky project is

calculated as follow:
1. Firstly calculate the cost of capital of the company as a whole
2. Secondly, adjust the cost of capital for project risk

 How to determine the cost of capital? We use the WACC.

 WACC =Weighted Average Cost of Capital
 Def. : Weighted average of the costs of the permanent sources of
funding (usually long-term funding)
 Minimum overall return that the company must aim for its assets
to maintain the market value of its shares ...

 Cost of capital = rate of return required by debtholders and

shareholders
 End of Clip 1
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 Viewpoint of companies

 A firm normally raises capital in a variety of forms and these

forms of capital have different costs associated with them

 Rate of return required by debtholders and shareholders =

cost for the firm

 Cost of Capital = Minimum rate of return that a firm must

provide on various investment projects to attract new capital
(i.e. to satisfy the providers of the funds)

 WACC = weighted average cost of capital for the firm

 Clip 2: WACC calculation
8
 2 main sources of funding for a company: debt and equity

 Key sources of LT funding:

 Bank loans
 Bonds Debt
 Debentures
 Preferred shares Equity
 Common Shares
 We do not consider credit lines, accounts payable, ST loans etc..

 Cost of funding sources

 We need to use the current required rate of return. Returns required by
debtholders and shareholders do vary over time. Cost of funding sources =
cost at the time the project is evaluated
Note: required rate of return = discount rate = cost of capital = WACC
These terms mean essentially the same thing
 WACC calculation
9

Therefore, the cost of each funding source can be

defined as follow:
Funding sources Cost
Bonds and mortgages
Preferred shares
Common Shares

WACC : weighted average cost of capital

WACC =  general formula

 WACC calculation
10

Formula:

𝑊𝐴𝐶𝐶=
𝐸
𝑉 ( ) ( ) ( )
∗ 𝑅𝑒 +
𝑃
𝑉
∗ 𝑅𝑝+
𝐷
𝑉
∗ 𝑅 𝑑 (1 −𝑇 𝑚)
Yes
o Market value of firm’s ordinary shares (E)
o Market value of firm’s preferred shares (P)
o Market value of firm’s debt (D)
o Combined market value of debt and equity (V=E+P+D)
o Cost of common shares (RE)
o Cost of preferred shares (RP) D/V+P/V +E/V = 100%
o Cost of debt (RD)
o Marginal tax rate (Tm)
 WACC calculation
11

Calculation of WACC in 3 steps:

1) Calculating the weights of each funding source
2) Calculating the costs of each funding source
3) WACC calculation

WACC is an effective rate (EAR)

 A. Calculating weights
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Weights to consider? of the firm? or of the

Project?
 Ans: of the firm!
 Investors invest in a firm and not in a particular project...
 How to fund a project should not influence the decision to
undertake the project ...
 Separation between capital budgeting and funding decision

On what basis do we calculate the weights?

 Target weights?
 Current market values?
 Accounting values?
 Calculating weights
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Mortgages Find D :

D = Market Value of Debt = MV D

= Remaining balance = PMT

 Recall:
 Equal payments (capital + interests)
 APR compounded semi-annually
 t = number of payments remaining
 PMT, t, i under the same frequency of compounding
i =
 Calculating weights
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Bonds / Debentures Find D:

 D = MV D=Number of bonds x Bond Price

 Bond Price =Coupon

Recall:
 CR & YTM are quoted (APR) semiannual compounding
 Interest paid semi-annually (coupons)
 1000$ face value (capital)
 Only valid for conventional bonds priced at a coupon date
 Adjustments needed if:
 Non-conventional bonds
 Price between two coupon dates.
 YTM =
 Calculating weights
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Preferred shares Find P :

P = MV P = Number of shares x Price per share

 Price =

 Recall:
 The is under the same compounding frequency as the cash flow
(dividend)
 Formula is valid on a dividend payment date
 Adjustment required if between two dividend payment dates
 Calculating weights
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Common Shares Find E :

 E = MV E = Number of shares x Price per share

 =

 Conditions when the Gordon growth model can be used:

 Dividends paid to infinity
 Dividends grow at a constant growth rate (g).
 Required rate of return (𝑘𝐸) is higher than (g).

 Recall:
 Div, 𝑘𝐸, g under the same frequency of compounding
 Adjust formula if the dividend growth is in two steps
 Calculating weights
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Find combined value of all debt and equity = Vt-0

 Vt-0 =MV Debts+ MV Pref shares + MV Common shares+ Etc..
 Therefore, V = sum of all D + sum of all E

Find weights for each source of funding:

 Weight Debt = D/V
 Weight Pref shares = P/V
 Weight Common Shares = E/V
D/V+P/V +E/V = 100%
 B. Cost calculation
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Cost of financing = rate of return required by

ALL investors TODAY
Cost of capital

Cost of equity Cost of debt

Required rate of return on YTM on bonds or interest rate

common and preferred on bank loans
shares

To find the cost of financing, we need to solve for the

cost / rate of return from the pricing formulas
 Cost calculation
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For ordinary shares, there are two methods to solve

for the cost : RE
1. Growth model / Gordon: RE= D 1/p0 + g
2. CAPM: RE = R F + βE [E(RM) - RF]

 RE must be an effective rate / EAR

 Example: if dividend paid quarterly then RE is quarterly. We need to
convert it to find EAR RE

Cost for preferred shares : R

𝐷P❑
 Zero growth perpetuity 𝑅𝑃 =
𝑃❑
 RP must be effective
 Cost calculation
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Cost for Bonds : RD

 RD = YTM OBSERVED Today.
 If C semi-annual, semi-annual YTM
 Convert YTM into an EAR

2 important adjustments

1) Convert all rates into an EAR.

2) Interest paid on Debt (loans, bonds and debentures) is
tax deductible
o Multiply RD by (1-tax rate)  after-tax cost debt
o Not applicable to shares (dividends are paid from net income)
o This adjustment is already included in the WACC formula
 C. WACC calculation
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Recall... WACC = Weighted Average Cost of Capital

 ... weighted average cost of debt and equity
WACC formula:

𝑾𝑨𝑪𝑪=
𝑬
𝑽
∗ 𝑹𝒆+ ( )
𝑷
𝑽
∗ 𝑹𝒑 +
𝑫
𝑽 ( )
∗ 𝑹𝒅 ( 𝟏− 𝑻 𝒎) ( )
o Market value of common shares (E)
o Market value of preferred shares (P)
o Market value of debt (D)
o Combined market value of debt and equity V =E+P+D
WACC is the overall
o Cost of common shares (RE) return that the firm
o Cost of preferred shares (RP) must earn on its
o Cost of debt (RD) existing assets to
o Corporate marginal tax rate (Tm) maintain the value of
its shares
 End Clip 2
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The weights are target weights or if unavailable,

current market values

We do not use the weights of the project but of the

firm

WACC for the overall firm (and not for the project)
 Clip 3: Risk Adjustment
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Recall: WACC is the minimum return required by

bondholders and stockholders to invest in a company’s
current assets

BUT, what if the new project being evaluated is MORE or

LESS risky than the risk of the company's current assets??
→ The WACC needs to be adjusted!

Two possible situations....

 Risk of the project = risk of the company (existing projects).
 Use the WACC!
 WACC is the discount rate for the NPV of the project.
 Risk Adjustment
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 Risk of the project ≠ risk of the company (existing
projects/assets)
 We must adjust the WACC to take into account project risk
 If we don’t adjust the WACC, it would lead to incorrect NPV
decisions: we could reject profitable projects and accept risky
projects! See next slide.

WACC of the company = Appropriate discount rate of a project ONLY if...

Project risk = risk of current business activities

If project risk is different than company risk, we must adjust the WACC
 25
If we evaluate investments with the firm’s
WACC, but with risks substantially
Example:
different from that of the overall firm, it
can potentially lead to poor decisions…
Key variables:
Rf= 7%
E(rm) – rf =8%
All equity firm of
beta=1
WACC = Re =15%
 Risk Adjustment
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There are two methods for adjusting the

WACC…

Method 1: Objective approach : The pure play

approach

 Definition: Find a comparable

 Ie: find a company that focuses as exclusively as possible on
the type of project in which we are interested (and has same
capital structure as our company)
 Example – Pure play approach
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Sector 1 Sector 2

Company A
Project A
Funding
• 50% equity
• 50% debt Company B
Is the
Funding
pure play
• 50% equity
• 50% debt

 Rate of return required for this project A = CMPC company B

 Difficulty of this method?
 May not be able to find any suitable companies!
 Risk Adjustment
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Method 2 : Subjective approach
 Different categories of projects are identified according to
their risk
 Simpler but less precise method

Risk of the Examples Discount

new project rate

High New products WACC +x%

The WACC is Moderate Cost savings,expansion WACC

(same) of existing lines
adjusted
Low Replacement of WACC - y%
subjectively for existing equipment
each risk category: Mandatory Pollution control equip. n.a
 29

 Similar problems Subjective Approach

exist .. But..

 …the magnitude of
the potential error is
less with the
subjective
approach…

 Some risk
adjustment, even if it
is subjective, is
probably better than
no risk adjustment at
all!
 End Clip 3
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Using the WACC as the discount rate for future CFs is

appropriate only when the proposed investment is
similar to the firms existing activities

If a firm uses its WACC to make accept/reject

decisions for all types of projects, it will have a
tendency toward incorrectly accepting risky projects
and incorrectly rejecting less risky projects

We need to adjust the WACC for project risk. Most of

time we use a subjective approach.