Cost of Capital

Chapter 9 and 19
(continued)

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Using WACC in Capital Budgeting Problems

When is the WACC the appropriate discount rate for evaluating a proposed investment
project?

Example: A firm is considering a project that costs $28 million and will result in initial
after-tax cash savings of $5 million at the end of the first year. These savings will grow
at the rate of 5% per year. The firm has a D/E ratio of 0.5, a cost of equity of 29.2%
and a cost of debt of 10%. The firm is in the 34% corporate tax bracket. The costsaving proposal is closely related to the firm's core business, so it is viewed as having
the same risk as the overall firm. Using the NPV investment rule, should the firm take
on the project?

V D
= +1
E E
Hint: V = D + E. this implies

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Why are financing costs not included in project cash flows?

Remember determining relevant costs for capital budgeting projects and one
exception was financing costs? The definition for a relevant cost is: Any future
cash flows that are incurred due to accepting the project. We discussed that though
financing costs (interest expenses, coupons, etc) may be incurred due to accepting
the project we do not include them in operating cash flows rather they will usually
enter the NPV calculation via the r. Here is a simple example how the WACC
accomplishes this function.
Market Values ($s)
Project Value
200
75
Debt (D)
125
Equity (E)
200
Project Value
The project generates perpetual after tax cash flows of $20 which are similar in risk
to the existing business, the return on equity is 12.83%, the return on debt is 8% and
the marginal tax rate is 34%. First calculate the NPV of the project assuming the
new project will not alter the existing firm capital structure.
WACC =

125
75
0.1283 +
0.08(1 0.34) = 0.1000
200
200

NPV = 200 +

20
=0
0.1000

You are indifferent to investing in this project (in other words you have the
breakeven r) but how does the return to shareholders on this project relate to the
return on equity?

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Calculate the expected dollar return to the shareholders. The expected equity
income is the yearly cash flow minus the tax shield of debt.

Exp(equityincome) = C DrD (1 C ) = 20 (75)(0.08)(1 0.34) = 16.04

E (equityreturn) =

16.04
= 0.1283
125

You can see that the return on equity and the E(equity return) are the same. So, the
interest expense is accounted for in the WACC, not the operating cash flows and at
the breakeven r, the two returns on equity are identical.

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What if the WACC is not an appropriate estimation of r?

Two violations:
1. The project risk is not similar to the risk of the existing firms assets
2. The capital structure of the firm will (significantly) change due to the project

Violation #1: Different risk projects.

The SML and the WACC
Using WACC to evaluate investments with risks that are substantially different from
the over all firm can lead to poor decisions.

Consider an all equity firm. In this case, its WACC is equal to its cost of equity and the
beta of the firm equals the beta of the firms equity. Using the SML approach to
calculate the cost of equity. The beta of the firm is 1.2 and its WACC is 15%.
1.

If a proposed investment has a beta of 1.4, will the firm accept or reject
the project using WACC?

2.

If a proposed investment has a beta of 0.8, will the firm accept or reject
the project using WACC?

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Capital Budgeting, SML and WACC

Assume CAPM is the model of market equilibrium. The risk-free rate is 0.035, the
expected market risk-premium is 0.085. You have been hired as a financial analyst at
an all-equity firm, Video Connections, Inc. The firm operates a chain of video rental
stores. The beta of the chain of video store rental stores is 1.5 and its WACC is 0.1625.
Asset/Stock

Beta of Asset

E(R) from CF
analysis

Video Connections,
Inc.

1.5

0.1625

Take out Pizza

Business

0.95

0.11575

Management is considering acquiring a rival chain of video rental stores in the area.
The estimated expected return on this proposed investment is 0.1550. Would you
recommend that management undertake this acquisition? Why or why not?

The management also is considering entering the take out pizza business. They feel
that this line of business will attract more customers to their video stores on the
weekends. The expected return on this proposed investment is 0.125. Would you
recommend that management undertake this acquisition? Why or why not?

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Levering and Unlevering Betas

Leverage: How much debt is in the financing structure.
Computing beta (focus on the intuition from the CAPM beta):
Remember the beta is computed by figuring the riskiness of a series of cash
flows compared with the market. However, in the past, we usually used the equity
returns of the individual stock to estimate that risk. Equity risk is a combination of
two types of risk of the firm: asset risk and financing risk. Because the equity
holder is the residual claimant they receive the cash flows from assets minus the
costs of financing. (Note: these cash flows can also have other unusual deductions
including one time accounting charges that alter the flows but we will ignore those.)

The beta of a portfolio of assets is merely the weighted average of the beta of
the individual assets. If we view the firm as a portfolio of equity and debt, the beta
relationship can be expressed as follows:

a =

E
D
E + D
V
V

Where a is the asset (unlevered) beta, E is the equity (levered) beta and D is the
debt beta.
Solving the equation for the equity beta:

E = a +

D
( a D )
E

Additional Issues:
Previously we have not discussed measuring the riskiness of debt cash flows.
If the firm has all fixed rate debt and has minimal risk of financial distress the beta
of debt will be zero.
This same process can be done for returns rather than betas.
When we use returns to estimate betas the affect of taxes is already
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incorporated.

Finding r when the project has a different risk than the firm
If you can find an estimate of the business risk (asset risk) for a similar risk
project then you can just use that estimate. However, usually these estimates are
difficult to find and instead you use equity returns to proxy for the risk. When
equity risk is used, the measure implicitly includes the average asset risk and
financial risk of the industry. However, your firm may not have the same capital
structure as the industry. In this case you will want to take the industry equity beta,
unlever it by the industry capital structure and then re-lever it to your firms capital
structure.
EXAMPLE:
If AT&T is looking at purchasing a cable TV company with all equity that has
estimated after tax cash flows of $234 million per year forever, what are they
willing to pay for it?
You estimate that the equity beta for the Cable TV industry is 1.85, the
average D/E ratio is 0.5 for the industry, the market risk premium is 8.5% and the
risk-free rate is 5.5%. (Assume the debt beta is 0 for this industry).

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What if the project changes the capital structure?

Violation #2
There are several ways to deal with estimating the NPV when the new project
will alter the existing firms capital structure. We will focus on two basic methods:
adjusting the WACC and the adjusted present value (APV).

WACC adjustment
Essentially we will adjust the WACC when the new project supports a
different capital structure but we can reasonably estimate the new capital
structure and potential changes in the return on equity and debt.
Again we will use the process of levering and unlevering returns and betas
to accomplish our adjustment.
First step: Estimate the opportunity cost of capital of the project by
solving for the asset return.

rE = ra +

D
(1 c )(ra rD )
E

Second step: Estimate the new cost of debt (if it changes), at the new debt
ratio and calculate the new cost of equity.

rE = ra +

D
(1 c )(ra rD )
E

Third step: Recalculate the WACC at the new weights and costs.

WACC (adjusted ) =

E
D
rE + (1 c )rD
V
V
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WACC adjustment
A firm is considering a project that costs $28 million and will result in initial
after-tax cash savings of $5 million at the end of the first year. These savings will grow
at the rate of 5% per year. The firm has a D/E ratio of 0.5, a cost of equity of 29.2%
and a cost of debt of 10%. The firm is in the 34% corporate tax bracket. The costsaving proposal is closely related to the firm's core business, so it is viewed as having
the same risk as the overall firm. Instead of a debt to equity ration of 0.5, this project
will assume more debt and have a D/E ratio of 1.0. Assuming this does not change the
cost of debt, what is the NPV? (similar to example on p. 183)

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Violation #2: Another method

Adjusted Present Value
If the financing and project are not independent, the adjusted present
value (APV) can be used to decide whether to accept the project. APV is
the addition of the base NPV as we have computed it in the past plus or
minus additional financing benefits or costs. (Caution: Make sure that
the financing and project are truly dependent. Many times they appear so
but with some creative thinking the two decisions can be divorced.)
Flotation Costs and the WACC
Review: Flotation Costs are the costs associated with issuing or floating new bonds
and stocks.
The required return on an investment depends on the risk of the investment, not the
source of funds.

Since flotation costs arise as a consequence of the investment project, they are relevant
cash flows and should be included in the project analysis.

Because of flotation costs, a firm will need to raise more money than the amount
needed for the investment.

Amount Needed for investment project= (1 - fA)* Amount Raised

where fA denotes the average weighted flotation cost.

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Flotation Costs and NPV

Example: Computer Designs, Inc. is considering opening another office. The
expansion will cost $50,000 and is expected to generate after-tax cash flows of $10,000
in perpetuity. The firm has a target capital structure that is two-thirds equity and onethird debt (target D/E ratio of 0.50). New equity has a flotation cost of 10% and a
required return of 15%. New debt costs 5% to issue and has a required return of 10%.
The firm is in the 34% corporate tax bracket.
Step 1: Calculate the WACC.

Step 2: Calculate average weighted flotation cost, fA

Step 3: Calculate the amount of the flotation cost:

Step 4: Calculate the APV of the project

APV=NPV-floatation costs

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