Lesson 20

Chapter 6
Concept and measurement of cost of capital
Unit 2
Long term investment decisions
After reading this lesson you will be able to: Calculate the cost of common equity using CAPM.
Calculate the cost of common equity using Price earning method.
Calculate the costs of common equity using Bond yield plus risk
premium
Calculate the weighted average cost of capital (WACC) and understand its
rationale and limitations.

We will start our discussion today with CAPM model of estimating Cost of equity.

2. Capital Asset Pricing Model Approach (CAPM)

Another technique that can be used to estimate the cost of equity is the capital asset
pricing model (CAPM) approach. The CAPM explains the behaviour of security prices
and provides a mechanism whereby investors could assess the impact of proposed
security investment on their overall portfolio risk and return. In other words, it formally
describes the risk-return trade-off for securities. It is based on certain assumptions.
The basic assumptions of CAPM relates to
(a) The efficiency of the security markets and

(b) Investor preferences.

(a) The efficient market assumption implies that

(i)

All investors have common (homogeneous) expectations regarding the

expected returns, variances and correlation of returns among all securities;

(ii)

All investors have the same information about securities;

(iii)

There are no restrictions on investments;

(iv)

There are no taxes;

(v)

There are no transaction costs; and

(vi)

No single investor can affect market price significantly.

(b) The implication of investors' preference assumption is that all investors prefer the
security that provides the highest return for a given level of risk or the lowest amount of
risk for a given level of return, that is, the investors are risk averse.
There are two types of risks to which security investment is exposed:
(i)

Diversifiable/unsystematic risk:

It represents that portion of the total risk of an investment that can be

eliminated/minimised through diversification. The events/factors that cause such risks
vary from firm to firm. The sources of such risks include management capabilities and
decisions, strikes, unique government regulations, availability or otherwise of raw
materials, competition, level of operating and financial leverage of the firm, and so on.
(ii)

Non-diversifiable/systematic risk

The systematic/non-diversifiable risk is attributable to factors that affect all firms.

Illustrative sources of such risks are interest rate changes, inflation or purchasing power
change, changes in investor expectations about the overall performance of the economy
and political changes, and so on. As an investor through diversification can eliminate
unsystematic risk, the systematic risk is the only relevant risk. Therefore, an investor

(firm) should be concerned, according to CAPM, solely with the non-diversifiable

(systematic) risk.
Systematic risk can be measured in relation to the risk of a diversified portfolio, which is
commonly referred to as the market portfolio or the market. According to CAPM, the
non-diversifiable risk of an investment/security/ asset is assessed in terms of the beta
coefficient. Beta is a measure of the volatility of a security's return relative to the
returns of a broad-based market portfolio. Alternatively, it is an index of the degree of
responsiveness or co-movement of return on an investment with the market return. The
beta for the market portfolio as measured by the broad-based market index equals one.
Beta coefficient of 1 would imply that the risk of the specified security is equal to the
market; the interpretation of zero coefficient is that there is no market-related risk to the
investment. A negative coefficient would indicate a relationship in the opposite direction.
The 'going' required rate of return in the market for a given amount of systematic risk is
called the Security Market Line (SML).
With reference to the cost of capital perspective, the CAPM describes the relationship
between 'the required rate of return, or the cost of equity capital, and the nondiversifiable or relevant risk, of the firm as reflected in its index of non-diversifiable risk,
that is, beta.
Symbolically,
Ke = Rj + b (Km - Rj)
Where Ke = cost of equity capital
Rf = the rate of return required on a risk-free asset/security/investment
Km = the required rate of return on the market portfolio of assets that can be
viewed as the average rate of return on all assets.
b = the beta coefficient
Example:

Cowboy Energy Services has a B = 1.6. The risk free rate on T-bills is currently 4% and
the market return has averaged 15%.
Solution
Ke = Rj + b (Km - Rj)
= 4 + 1.6 (15 4) = 21.6 %

3. PRICE EARNING METHOD

This method takes into consideration the earnings per share (EPS) and the market price of
the share. It is based on the assumption that the investors the stream of future earning of
the share and the earnings of the share need not be in the form of dividend and also it
need not be disbursed to the shareholders. It based on the argument that even if the
earnings are not disbursed as dividends, it is kept in the retained earnings and its causes
future growth in the earnings of the company as well as the increase in the market price
of the share. In calculation of cost equity share capital, the earnings per share are divided
by the current market price.
E
KE

=
M

Where,
M

= Market price per share.

= Current earning per share.

Example
MATA SANTOSHI LTD. has 50,000. Equity shares of Rs 10 each and its current market
value is Rs 45 each. The after tax profit of the company for the year ended 31st march,
2001 is Rs 9,60,000.Calculate the cost of capital based on price/earning method.

Solution
EPS here will be as
= Rs. 9,60,000/50,000 equity shares = Rs. 19.20
= E/M

KE

= Rs. 19.20/ Rs. 45

= 0.4267 or 42.67

4. BOND YIELD PLUS RISK PREMIUM APPROACH

The logic behind this approach is that the return required the investors is directly based
on the risk profile of the company. This risk profile is adequately reflected in the return
earned by the bondholders. Yet, since the risk borne by the equity investors is higher than
that of bondholders, the return earned by them should also be higher. Hence this return is
calculated as:
Yield on the long-term bonds of the company + Risk premium
This risk premium is a very subjective figure, which is arrived at after considering the
various operating and financial risks faced by the firm. Though these risks are already
factored in the bond yield, since by nature equity investment is riskier than investments in
bonds and is exposed to a higher degree of the firm's risks, these also have an impact on
the risk-premium. For example, let us take two companies A and B, A having a net profit
margin of 5% and B of 10% with other things being equal. Since company B faces less
downside risk compared to company A, it will have to pay less interest to its
bondholders. Hence, the risk of company is already accounted for in the bondholders
return. Yet, when it comes to estimating the equity holders' risk premium, these risks are
considered all over again because the equity holders are going to bear a larger part of
these risks. In fact, these risks being taken into account for fixing the bondholders return
will result in a multiple increase in the equity holders' risk. Hence, the equity holders of
company A will receive a higher risk premium than those of company B.

IV. Cost of Retained Earnings (KR)

As we discussed in the previous class the cost of equity capital, now I will continue our
discussion to the retained earnings. This is one of the major sources of finance available
for the well-established companies to finance its expansion and diversification
programmes. These are the funds accumulated over years of the company by keeping part
of the funds generated without distribution. The equity shareholders of the company are
entitled to these funds and sometimes; these funds are also taken into account while
calculating the cost of equity. But so long as the retained profits are not distributed to the
shareholders, the company can use these funds within the company for further profitable
investment opportunities.
Hence, you can say that cost of equity includes retained earning. But in practice, retained
earnings are a slightly cheaper source of capital as compared to the cost of equity capital.
That is why, we deal the cost of retained earnings separately form the cost of equity
capital.
To be very clear the cost of retained earnings to the shareholders is basically an
opportunity cost of such funds to them. It is basically equal to the income that they
would otherwise obtain by placing these funds in alternative investment.
Say, suppose, the company earns Rs. 100 by using your money but distributed only Rs.
60 as dividend. That means the company has retained Rs. 40 of your money. If you could
invest it in the stock market this money at the end of the year you would earn at least few
amount. That possible earning is your opportunity cost of retained earning.
The cost of retained earnings, is often taken as equal to the cost of equity share capital,
since the retained earnings are viewed as the fresh subscription to the equity share capital.

Weighted Average Cost of Capital (WACC)

Now that we have specific cost of capital of each of the long-term sources i.e., the debt,
the preference share capital, the equity share capital and the retained earnings, next step is
to calculate the overall cost of capital.
Cost of capital is the overall composite cost of capital and may be defined as the average
of the cost of its specific fund. Weighted average cost of capital (WACC) is define as the
weighted average of the cost of various sources of finance, weight being the market value
of each source of finance outstanding. Cost of various sources of finance refers to the
returns expected by the respective investor.
The CIMA defines the weighted average cost of capital as the average cost of
companys finance (equity, debentures, bank loans) weighted according to the proportion
each elements bears to the total pool of capital, weighting is usually based on market
valuation current yields and costs after tax.
The argument in favor of using WACC stems from the concept that capital from
various sources are generated by the business and then finally invested in number of
projects. Hence cost of capital should be weighted cost of capital. Financing decision,
which determines the optimal capital mix, is traditionally made without making any
reference to the acceptance or otherwise of a pacific project. Similarly a specific project
is evaluated without considering the mode of financing of that project. Traditionally,
optimal capital structure occurs at a point where WACC is minimum. We thus call
WACC as the minimum rate of return requires from project to pay off the expected return
the investors and as such WACC is generally referred to as the required rate of return.
According, the relative worth of a project is determined using this require rate of return as
the discounting rate. Thus, WACC gets much importance in both decisions.
This overall cost of capital of the firm is of utmost importance as this rate is to be used as

the discount rate or the cut-off rate evaluating the capital budgeting proposals. The
overall cost of capital may be defined as the rate of return that must be earned by the firm
in order to satisfy the requirements of the different investors. The overall cost of capital is
thus, the minimum required rate of return on the assets of the firm.
This overall cost of capital should take care of the relative proportion of different
sources in the capital structure of the firm. Therefore, this overall cost of capital should
be calculated as the weighted average rather than simple average of different specific cost
of capital.
WACC = (Cost of equity X % equity) + (cost of debt X % debt) + (Cost of equity X %
equity)
Example
ABC Ltd. has a gearing ratio of 40%. Its cost of equity is 21% and the cost of debt is
15%. Lets calculate the companys WACC.
Solution
WACC

= (21% X 60%) + (15% X 14%)

= 12.6% + 6% = 18.6%

Now the question is what weights to use?

Weights can be
I. Historical or existing weights
1. Book value
2. Market value
II. Marginal weights

I. Historical or existing weights

Historical or existing weights are the weights based on the actual or existing proportions
of different sources in the overall capital structure. Such weighing system is based on the
actual proportions at the time when the W ACC is being calculated. In other words, the
weighing system is the proportions in which the funds have already been raised by the
firm.
The use of historical weights is based on two important assumptions namely
(i)

That the firm would raise the additional resources required for financing the
investment proposals, in the same proportions in which they are appearing at
present in the capital structure, and

(ii)

That the present capital structure is optimal and therefore the firm wants to
continue with the same pattern in future also.

However, there may be some problems in applying the historical weights. The firm may
not be able to raise additional finance in the same proportion as existing one because of
prevailing economic and capital market conditions, legal constraints or other factors.
Further, the assumption of existing capital structure being the optimal one may not
always hold good.
Book Value Weights:
The weights are said to be book value weights if the proportions of different sources are
ascertained on the basis of the face values i.e., the accounting values. The book value
weights can be easily calculated by taking the relevant information from the capital
structure as given in the balance sheet of the firm.
The book value weights are considered as a sound weighing system as it is
operational in nature and a firm may design its capital structure in terms of as it appears
in the balance sheet. However, the book value weights system does not truly reflect the
economic values. In fact, the weighing system should be market determined. The book
value weights system is not consistent with the definition of the overall cost of capital,
which is defined as the minimum rate of return needed to maintain the firm's market

value. The book value weights ignore the market values.

Market Value Weights:
The weights may also be calculated on the basis of the market value of different sources
i.e., the proportion of each source at its market value. In order to calculate the market
value weights, the firm has to find out the current market price of the securities in each
category. However, a problem may arise if there is no market value available for a
particular type of security.
The advantages of using the market value weights may be
The market value weights are consistent with the concept of maintaining market
value in the definition of the overall cost of capital.
The market value weights provide current estimate of the investor's required rate
of return.
The market Value weights yield good estimate of the cost of capital that would
be incurred should the firm require additional funds from the market.
However, the market values weights suffer from some limitations, as follows:
Not only that the market values of all types of securities issue have to be
obtained but also that the market value of equity share is to be segregated into
capital and retained earrings.
The market values are subject to change from time to time and so the concept of
optimal capital structure in terms of market values does not remain relevant any
longer.
External factors, which affect the market value, will affect the cost of capital
also and therefore, the investment decision process will be influenced by the
external factors.

The weights be assigned to different sources of funds are clearly going to be different if
the financial analyst choose to apply current market value weights as against the book
values as stated in the balance sheet. He must be guided by the purpose of the analysis in
deciding which value is relevant. If he is deriving a criterion against which to judge the
expected return from future investment, he should use the current market values of
different sources. The investors, certainly, do not invest in the book values of the equity
shares, which may differ significantly from the market values. The book values are static
and not responsive to changing performance. The choice of market values also
complements the use of incremental funding in that both are expressed in the market
terms. It may be noted that the market value of equity shares automatically includes
retained earnings as reported in the balance sheet.
With respect to the choice between the book value and market value weights, the
following points are to be noted
It is argued that the book value is more reliable than market value because it is not
as volatile. Although it is true that book value does not change as often as
market value, this is more a reflection of the weakness than of strength, since the
true value of the firm changes over time as both the firm specific and the market
related information is revealed.
The WACC based on market value will generally be greater than the WACC
based on book values. The reason being that the equity capital having higher
specific cost of capital usually has market value above the book value. However,
this is not the rule.

II. Marginal Weights:

The other system of assigning weights is the marginal weights system. The marginal
weights refer to the proportions in which the firm wants or intends to raise funds from
different sources. In other words, the proportions in which additional funds required to

finance the investment proposals will be raised are known as marginal weights. So, in
case of marginal weights, the firm in fact, calculates the actual WACC of the incremental
funds. Theoretically, the system of marginal weights seems to be good enough as the
return from investment will be compared with the actual cost of funds. Moreover, if a
particular source which has been used in the past but is not being used now to raise
additional funds, or cannot be used now for one or the other reason then why should it be
allowed to enter the decision process even through the weighing system.
However, there are some shortcomings of the marginal weights system. In
particular, the capital budgeting decision process requires the long-term perspective
whereas the marginal weights ignore this. In the short run, the firm may be tempted to
raise funds only from cheaper sources and thereby accepting more & more proposals.
However, later on when other sources will have to be resorted to, some projects, which
should have been accepted otherwise, will be rejected because of higher cost of capital.
Example
The require rate of return on equity is 16% and cost of debt is 12%. The firm has a capital
structure mix of 60% of Equity and 40% Debt. What is the overall rate of the return of
the firm should earn?
Solution
Rate of return of equity funds

(16% X 0.60)

9.6

Rate of return on debt funds

(12% X 0.40)

4.8

Overall rate of return required to earn by the firm

14.4

This means suppose the total cost or investments made by the firm is Rs. 10,00,000 (Rs.6,
00,000 equity and Rs 4,00,000 debt). Company must earn 14.4% on its overall;
investments i.e., Rs.1, 44,000 which will be just sufficient to give equity holders a rate of
return of 16%. This can be further explained as follows:

Total earnings

1,44,000

Less: Interest on debts (@12% on Rs. 4,00,000)

48,000

Amount available for equity holders

96,000

Rs. 96,000
Rate of Return on Equity =

100

= 16%

Rs 6,00,000
So now it must be clear to you that WACC is the discount rate that can be used to
evaluate the companys new investments, provided that they have the same risk profile as
the company as whole and provided that they used the same combination of debt and
equity to finance the purposed investment, or financed it by company reserves.

Example
The following information is available from the Balance Sheet of a Company:
Equity Share Capital20,000 shares of Rs. 10 each

Rs. 2,00,000

Reserves and Surplus

Rs. 1,30,000

8% Debentures

Rs. 1,70,000

The rate of tax for the company is 50%. Current level of Equity Dividend is 12%.
Calculate weighted average cost of capital.

Solution:
Capital Structure

Proportion of

Rs.

Capital Structure
Equity Share Capital

2,00,000

40%

Reserves and Surplus

1,30,000

26%

Net Worth

3,30,000

66%

8% Debentures

1,70,000

34%

5,00,000

100%

Capital

Amount

Proportion

After

Weighted

Structure

Rs.

(Weight)

tax

Cost

Equity

2,00,000

40%

12%

12% x 40% = 4.80%

Reserves and Surplus

1,30,000

26%

12%

12% x 26% = 3.12%

8% Debentures

1,70,000

34%

4%

4% x 34% = 1.36%

Total

5,00,000

100%

9.28%

1. As the current market price of equity share is not given, the cost of capital of equity
share has been taken with reference to the rate of dividend and the face value of the
share. So, ke = 12/100 = 12%.
The opportunity cost of retained earnings is the dividends foregone by shareholders.
Therefore, the firm must earn the same rate of return on retained earnings as on the
Equity Share Capital. Thus, the minimum cost of retained earnings in the cost of
equity capital i.e., kr = ke.

Example
In considering the most desirable capital structure of a company, the following estimates
of the cost of debt capital (after tax) have been made at various levels of debt-equity mix:

Debt as percentage of

Cost of debt

Cost of equity

total capital employed

7.0

15.0

10

7.0

15.0

20

7.0

15.5

30

7.5

16.0

40

8.0

17.0

50

8.5

19.0

60

9.5

20.0

You are required to find out the weighted average cost of capital of the firm for
different proportions of debt.
Solution:
The optimal capital structure may be ascertained in terms of the cost of capital of the firm
as that level at which the WACC is lowest. The WACC of the firm may be ascertained as
follows:
Debt

Kd % C/CxDebt%

Equity%

ke% C/CxEquity%

WACC%

%
0

7.0

100

15.0

15.0

15.00

10

7.0

.70

90

15.0

13.5

14.20

20

7.0

1.40

80

15.5

12.4

13.80

30

7.5

2.25

70

16.0

11.2

13.45

40

8.0

3.20

60

17.0

10.2

13.40

50

8.5

4.25

50

19.0

9.5

13.75

60

9.5

5.70

40

20.0

8.0

13.70

Out of different debt proportions, the firm has the minimum WACC when the debt
proportion is 40%. Therefore, the optimal capital structure for the firm is consisting of
40% debt and 60% equity and its WACC would be 13.4%
Example
PQR & Co. has the following capital structure as on Dec. 31, 2000.
Equity Share Capital (5000 share of 100 each)

Rs. 5,00,000

9% Preference Shares

Rs. 2,00,000

10% Debentures

Rs. 3,00,000

The equity shares of the company are quoted at Rs. 102 and the company is expected
to declare a dividend of Rs. 9 per share for the next year. The company has registered a
dividend growth rate of 5%, which is expected to be maintained.
i). Assuming the tax rate applicable to the company at 50%, calculate the weighted
average cost of capital, and
ii). Assuming that the company can raise additional term loan at 12% for Rs 5,00,000 to
finance its expansion, calculate the revised WACC. The companys expectation is
that the business risk associated with new financing may bring down the market price
from Rs. 102 to Rs. 96 per share.
Solution:
The present WACC may be calculated as follows:
Cost of equity capital

ke

= (D1/P0) + g
= (9/102) + .05

= .0138 or 13.8%
Source

Weight

C/C

Weighted C/C

Equity share capital

.5

13.8%

6.9%

9% Preference Share Capital

.2

9%

1.8%

10% Debenture

.3

5%

1.5%

WACC

10.2%

1.0

If the company decides to raise Rs. 5,00,000 by the issue of 12% loan and the market
price of the share is expected to go down to Rs. 96, then the WACC may be calculated as
follows:
Cost of equity capital

= (D1/P0) + g

ke

= (9/96) + .05
= .144 or 14.4%
Source

Weight

C/C

Weighted C/C

Equity share capital

.33

14.4%

4.75%

Preference Share Capital

.14

9%

1.26%

10% Debenture

.20

5%

1.00%

12% Loan

.33

6%

1.98%

WACC

1.00

So, the new WACC of the company would be 8.99%.

8.99%

IMPORTANT
Slide 1

Required
Required Returns
Returns
and
and the
the Cost
Cost of
of
Capital
Capital
15-1

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Slide 2

Required Returns and

the Cost of Capital

Creation of Value

Overall Cost of Capital of the Firm

Project-Specific Required Rates

Group-Specific Required Rates

Total Risk Evaluation

15-2

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Slide 3

Key Sources of
Value Creation
Industry Attractiveness
Growth
phase of
product
cycle

Cost

15-3

Marketing
and
price

Barriers to
competitive
entry

Other -e.g., patents,

temporary
monopoly
power,
oligopoly
pricing

Perceived
quality

Superior
organizational
capability

Competitive Advantage

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Slide 4

Overall Cost of
Capital of the Firm
Cost of Capital is the required
rate of return on the various
types of financing. The overall
cost of capital is a weighted
average of the individual
required rates of return (costs).
15-4

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Slide 5

Market Value of
Long-Term Financing
Type of Financing

Mkt Val Weight

Long-Term Debt

$ 35M

35%

Preferred Stock

$ 15M

15%

Common Stock Equity $ 50M

50%

$ 100M

100%

15-5

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Slide 6

Cost of Debt
Cost of Debt is the required rate
of return on investment of the
lenders of a company.
n

P0 =

j =1

Ij + Pj
(1 + kd)j

ki = kd ( 1 - T )
15-6

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Slide 7

Determination of
the Cost of Debt
Assume that Basket Wonders (BW) has
$1,000 par value zero-coupon bonds
outstanding. BW bonds are currently
trading at $385.54 with 10 years to
maturity. BW tax bracket is 40%.
$385.54 =

$0 + $1,000
(1 + kd)10

15-7

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Slide 8

Determination of
the Cost of Debt
(1 + kd)10 = $1,000 / $385.54
= 2.5938
(1 + kd) = (2.5938) (1/10)
= 1.1
kd = .1 or 10%
ki

= 10% ( 1 - .40 )

ki

= 6%

15-8

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Slide 9

Cost of Preferred Stock

Cost of Preferred Stock is the
required rate of return on
investment of the preferred
shareholders of the company.

kP = DP / P0
15-9

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Slide 10

Determination of the
Cost of Preferred Stock
Assume that Basket Wonders (BW)
has preferred stock outstanding with
par value of $100, dividend per share
of $6.30, and a current market value of
$70 per share.

kP = $6.30 / $70
kP = 9%
15-10

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Slide 11

Cost of Equity
Approaches
Dividend

Discount Model

Capital-Asset

Pricing

Model
Before-Tax

Cost of Debt
plus Risk Premium

15-11

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Slide 12

Dividend Discount Model

The cost of equity capital,
capital ke, is
the discount rate that equates the
present value of all expected
future dividends with the current
market price of the stock.
P0 =

D1
D2
D
+
+...+
1
2
(1+ke) (1+ke)
(1+ke)

15-12

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Slide 13

Constant Growth Model

The constant dividend growth
assumption reduces the model to:
ke = ( D1 / P0 ) + g
Assumes that dividends will grow
at the constant rate g forever.
15-13

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Slide 14

Determination of the
Cost of Equity Capital
Assume that Basket Wonders (BW) has
common stock outstanding with a current
market value of $64.80 per share, current
dividend of $3 per share, and a dividend
growth rate of 8% forever.

15-14

ke

= ( D1 / P0 ) + g

ke

= ($3(1.08) / $64.80) + .08

ke

= .05 + .08 = .13 or 13%

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Slide 15

Growth Phases Model

The growth phases assumption
leads to the following formula
(assume 3 growth phases):
a

D0(1+g1)t

t=1

(1+ke)t

P0 =

t=b+1

t=a+1

Da(1+g2)t-a

(1+ke)t

Db(1+g3)t-b

(1+ke)t

15-15

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Slide 16

Capital Asset
Pricing Model
The cost of equity capital, ke, is
equated to the required rate of
return in market equilibrium. The
risk-return relationship is described
by the Security Market Line (SML).
ke = Rj = Rf + (Rm - Rf)j
15-16

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Slide 17

Determination of the
Cost of Equity (CAPM)
Assume that Basket Wonders (BW) has
a company beta of 1.25. Research by
Julie Miller suggests that the risk-free
rate is 4% and the expected return on
the market is 11.2%

ke = Rf + (Rm - Rf)j
= 4% + (11.2% - 4%)1.25
15-17

ke = 4% + 9% = 13%

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Slide 18

Before
-Tax Cost of Debt
Before-Tax
Plus Risk Premium
The cost of equity capital, ke, is the
sum of the before-tax cost of debt
and a risk premium in expected
return for common stock over debt.
ke = kd + Risk Premium*
* Risk premium is not the same as CAPM risk
premium
15-18

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Slide 19

Determination of the
Cost of Equity (kd + R.P.)
Assume that Basket Wonders (BW)
typically adds a 3% premium to the
before-tax cost of debt.

ke = kd + Risk Premium
= 10% + 3%
ke = 13%
15-19

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Slide 20

Comparison of the
Cost of Equity Methods
Constant Growth Model

13%

Capital Asset Pricing Model 13%

Cost of Debt + Risk Premium 13%
Generally, the three methods
will not agree.
15-20

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Slide 21

Weighted Average
Cost of Capital (WACC)
n

Cost of Capital =

x=1

kx(Wx)

WACC

= .35(6%) + .15(9%) +
.50(13%)

WACC

= .021 + .0135 + .065

= .0995 or 9.95%

15-21

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Slide 22

Limitations of the WACC

1. Weighting System

Marginal Capital Costs

Capital Raised in Different

Proportions than WACC

15-22

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Slide 23

Limitations of the WACC

2. Flotation Costs are the costs
associated with issuing securities
such as underwriting, legal, listing,
and printing fees.
a.

Adjustment to Initial Outlay

b.

Adjustment to Discount Rate

15-23

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Slide 24

Determining Project-Specific
Required Rate of Return
1. Calculate the required return
for Project k (all-equity financed).
Rk = Rf + (Rm - Rf)k

2. Adjust for capital structure of the

firm (financing weights).

15-24

Weighted Average Required Return =

[ki][% of Debt] + [Rk][% of Equity]

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Slide 25

Project-Specific Required
Rate of Return Example
Assume a computer networking project is
being considered with an IRR of 19%.
Examination of firms in the networking
industry allows us to estimate an all-equity
beta of 1.5. Our firm is financed with 70%
Equity and 30% Debt at ki=6%.
The expected return on the market is
11.2% and the risk-free rate is 4%.
15-25

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Slide 26

Do You Accept the Project?

ke = Rf + (Rm - Rf)j
= 4% + (11.2% - 4%)1.5
ke = 4% + 10.8% = 14.8%
WACC = .30(6%) + .70(14.8%)
= 1.8% + 10.36% = 12.16%
IRR = 19% > WACC = 12.16%
15-26

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Slide 27

Project Evaluation
Based on Total Risk
Risk-Adjusted Discount Rate
Approach (RADR)
The required return is increased
(decreased) relative to the firms
overall cost of capital for projects
or groups showing greater
(smaller) than average risk.
15-27

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Slide 28

Project Evaluation
Based on Total Risk
Probability Distribution
Approach
Acceptance of a single project
with a positive NPV depends on
the dispersion of NPVs and the
utility preferences of
management.
15-28

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