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Cost of capital

By Prabath S Morawakage
Lecturer
Department of Finance
University of Kelaniya
Learning outcome
The candidate should be able to:
a . calculate and interpret the weighted average cost of capital (WACC) of
a company;
b. describe how taxes affect the cost of capital from different capital
sources;
c. explain alternative methods of calculating the weights used in the
WACC, including the use of the companys target capital structure;
d. explain how the marginal cost of capital and the investment opportunity
schedule are used to determine the optimal capital budget;
e. explain the marginal cost of capitals role in determining the net present
value of a project;
LOS cont..
f. calculate and interpret the cost of fixed rate debt capital using the
yield-to maturity approach and the debt-rating approach;
g. calculate and interpret the cost of non-callable, nonconvertible
preferred stock;
h. calculate and interpret the cost of equity capital using the capital asset
pricing model approach, the dividend discount model approach, and
the bond-yield plus risk-premiumapproach;
i. calculate and interpret the beta and cost of capital for a project;
j. explain the country risk premium in the estimation of the cost of
equity for a company located in a developing market;
k. describe the marginal cost of capital schedule, explain why it may be
upward sloping with respect to additional capital, and calculate and
interpret its break-points;
l. explain and demonstrate the correct treatment of flotation costs
WACC
The overall cost of the firms capital is a weighted average of the
opportunity cost of the capital from debt, preferred equity, and
common equity
Project should be undertaken only if the return on invested capital is
greater than its opportunity cost
K
d
= Yield to maturity on existing /new debt
K
d
(1-t) = After Tax Cost of Debt where t is the marginal tax rate (Only
interest on debt is paid pre tax)
K
p
=Cost of Preferred stocks
K
e
= Cost of Common Stocks
WACC ex
WACC = w
d
[k
d
(1-t)] + w
p
k
p
+ w
e
k
e
e.g. Firm Y target capital structure is 10%
preferred, 45% Debt, and 45% Common
equity
k
d
= 7.5% , t = 40%, k
p
= 9%, k
e
= 11.5%
Target Capital Structure
Proportions (based on market value) of debt,
preferred stock and equity that the firm expects to
achieve over time
How do analyst determine weights
Use the existing capital structure weight
Can adjust existing weights for firm trends
Can use industry average weights
Marginal Cost of Capital (MCC)
Cost of an additional dollar of capital
WACC of the next dollar of capital raised
A firms MCC increases as the amount of capital it raises during a given
period . Cost of each source of capital increases as firm raises new
capital.
Thus the MCC curve slopes upward
Optimal Capital Budget
Given the expected return (IRR) on potential projects, we can
order the opportunities for investment highest to lowest IRR
This will allow us to construct a down ward sloping Investment
Opportunity Schedule
The intersection of the IOS with the MCC curve identifies the
optimal capital budget
Graphical presentation
Role of the WACC/MCC in determining
the NPV of projects
The WACC is the appropriate discount rate for projects that have the
same level of risks as the firms existing projects
For a project greater than average risk, use a discount rate greater
than the firms existing WACC
For projects with below average risks use a discount rate less than the
firms WACC
Cost f Debt
K
d
= pre tax cost of capital = Current market Yield to Maturity
After tax Cost of debt = K
d
(1- Marginal tax rate)
Firm X can issue new par debt at an interest of 7.5%. If the firm has a
40% marginal tax rate, what is the firm Xs after cost of debt
Cost of Debt Cont..
When available use the market rate (YTM) on firm current debt for
K
d
. (YTM approach)
If firms debt is not publicly traded, estimate the YTM using the debt
rating and maturity of existing debt (Debt Rating Approach)
Firms that primarily use floating- rate debt, estimate the longer term
cost of the firms debt using the current yield curve and firms debt
rating.
Cost of Preferred Stocks
K
p
= D/ MV
New non callable non convertible preferred stock the a dividend of $
8.5 has a vale of $100 per share. What is the cost of preferred stock.
The Cost of Common Equity
Method 01- CAPM
Ke = RFR + [E(Rmkt)-RFR]
Where
RFR= Risk Free rate
= Systematic Risk of Firms Stock
E(Rmkt) = Expected market Return
e.g. T bill rate is 5%,Expected market return is 11% and firms beta is 1.1
Beta
Beta represents the systematic risk
Reward for systematic risk
Firm vs Project
Any projects cost of capital depends on the use to which the capital is
being putnot the source
Therefore, it depends on the risk of the project and not the risk of the
company
Capital Budgeting and project risk
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value
Ex.
Suppose the Conglomerate Company has a cost of capital, based on
the CAPM, of 17%. The risk-free rate is 4%, the market risk premium is
10%, and the firms beta is 1.3
This is a breakdown of the companys investment projects:
1/3 Automotive Retailer = 2.0
1/3 Computer Hard Drive Manufacturer = 1.3
1/3 Electric Utility = 0.6
average of assets = 1.
When evaluating a new electrical generation investment, which cost of
capital should be used
Capital Budgeting and project risk
10% reflects the opportunity cost of capital on an investment in electrical
generation, given the unique risk of the project
Risk Premium
Risk Free Rate
Return on an asset which has no default risk
Risk free asset and Project cash flows
Multi factor model
Historical Risk premium approach
Realized equity risk premium observed
Exceptional Bull mkt and Bear mkt scenarios
Cost of Equity cont..
Method 02- Dividend Discount Approach
Where,
D1 = Next year dividend
P0 = Current Stock Price
g = Firms expected constant growth rate
Cost of Equity Cont..
Method 03- Bond Yield plus Risk Premium
Assumes investors require a higher return on a firms equity than on
its debt
Risk premium normally ranges from 3% to 5%
Based on judgment: Imprecise
Cost of Capital for a Project
Calculate the cost of equity for the project using the pure play method
Calculate the cost of Debt of the company
Calculate the cost of capital for the project using the Debt/equity ratio
for the subject company and the WACC formula
Cost of capital for a Project
Pure play method steps
Calculate the beta of a comparable company
Un-lever it to adjust for difference in Debt/Equity ratio; Asset Beta
Re-lever it to reflect the Debt/Equity ratio of the subject company; Project
beta
Use the project beta to calculate the cost of equity for the project
Use that cost of equity to calculate WACC
Asset Beta
Debt/Equity ratio of pure play and marginal tax rate of pure play
Calculate the Company (project) Beta
Debt/Equity ratio of subject firm and its marginal tax rate
Country Risk Premium
CAPM is problematic for estimating project cost of equity in
developing market
Therefore add country risk premium (CRP) to market risk premium
when using CAPM
CRP cont..
Ex.
Brazilian 10 year US $ bond yield = 9.2%
10 year US treasury bond yield = 4.7%
Annualized Std.dev. of Sao Paulo Equity index = 34%
Annualized Std.dev. Of Brazilian 10- year US$ bond = 18%
Beta of the project = 1.32
Expected market return = 10%
Risk free rate = 4%
Cost of Retained Earnings
Earnings can be reinvested or paid out as dividends
Investors could buy other securities, earn a return
If earnings are retained, there is an opportunity cost (the return that
stockholders could earn on alternative investments of equal risk)
Investors could buy similar stocks and earn k
e
Firm could repurchase its own stock and earn k
e
Therefore, k
e
is the cost of retained earnings
Is the cost of retained earnings cheaper
than the cost of issuing new common stock?
When a company issues new common stock they also have to pay
flotation costs to the underwriter
Issuing new common stock may send a negative signal to the capital
markets, which may depress the stock price
Flotation Cost
Fees charged by investment bankers when a company raises external
equity capital. (Range 2%-7%)
WACC ignores Flotation cost