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The Cost of Capital (Chapter 15)

OVU-ADVANCE

Managerial Finance

D.B. Hamm, rev. Jan 2006

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Cost of Capital?

When we say a firm has a cost of capital of,

for example, 12%, we are saying:

The firm can only have a positive NPV on a

project if return exceeds 12% The firm must earn 12% just to compensate

investors for the use of their capital in a project

The use of capital in a project must earn 12% or

more, not that it will necessarily cost 12% toborrow funds for the project

Thus cost of capital depends primarily on the

USE of funds, not the SOURCE of funds

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Weighted Average Cost of Capital

(overview) A firms overall cost of capital must reflect the

required return on the firms assets as a

whole If a firm uses both debt and equity financing,

the cost of capital must include the cost of

each, weighted to proportion of each (debt

and equity) in the firms capital structure

This is called the Weighted Average Cost of

Capital (WACC)

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Cost of Equity

The Cost of Equity may be derived from the dividendgrowth model as follows:

P = D / REg

Where the price of a security equals its dividend (D)divided by its return on equity (RE) less its rate of growth

(g). We can invert the variables to find REas follows:

RE= D / P + g

But this model has drawbacks when considering that somefirms concentrate on growth and do not pay dividends at

all, or only irregularly. Growth rates may also be hard to

estimate. Also this model doesnt adjust for market risk.

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Cost of Equity (2):

Therefore many financial managers prefer the security

market line/capital asset pricing model (SML or

CAPM) for estimating the cost of equity:

RE = Rf + Ex (RMRf)or Return on Equity = Risk free rate + (risk factor x risk

premium)

Advantages of SML: Evaluates risk, applicable to

firms that dont pay dividends

Disadvantages of SML:Need to estimate both Beta

and risk premium (will usually base on past data, not

future projections.)

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Cost of Debt

The cost of debt is generally easier to

calculate

Equals the current interest cost to borrow new

funds Current interest rates are determined from the

going rate in the financial markets

The market adjusts fixed debt interest rates to the

going rate through setting debt prices at adiscount (current rate > than face rate) or premium

(current rate < than face rate)

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Weighted Average Cost of Capital

(WACC) WACC weights the cost of equity and the cost

of debt by the percentage of each used in a

firms capital structure WACC=(E/ V) x RE+ (D/ V) x RDx (1-TC)

(E/V)= Equity % of total value

(D/V)=Debt % of total value

(1-Tc)=After-tax % or reciprocal of corp tax rate

Tc. The after-tax rate must be considered

because interest on corporate debt is deductible

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WACC Illustration

ABC Corp has 1.4 million shares common valued at $20per share =$28 million. Debt has face value of $5 million

and trades at 93% of face ($4.65 million) in the market.

Total market value of both equity + debt thus =$32.65

million. Equity % = .8576 and Debt % = .1424Risk free rate is 4%, risk premium=7% and ABCs =.74

Return on equity per SML : RE= 4% + (7% x .74)=9.18%

Tax rate is 40% Current yield on market debt is 11%

WACC = (E/V) x RE + (D/V) x RDx (1-Tc)

= .8576 x .0918 + (.1424 x .11 x .60)

= .088126 or 8.81%

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Final notes on WACC WACC should be based on market rates and

valuation, not on book values of debt orequity. Book values may not reflect thecurrent marketplace

WACC will reflect what a firm needs to earnon a new investment. But the new investmentshould also reflect a risk level similar to thefirms Beta used to calculate the firms RE.

In the case of ABC Co., the relatively low WACCof 8.81% reflects ABCs =.74. A riskierinvestment should reflect a higher interest rate.

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Cartoon

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Pause for Class Case

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Financial Leverage (Chapter 17)

OVU-ADVANCE

Managerial FinanceD.B. Hamm, Jan. 2006

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Equity vs Debt Financing (1)

Since the WACC is the weighted average ofcost of equity + cost of debt, we can vary theWACC by changing the mix of debt + equity If cost of debt < cost of equity, we can reduce

WACC by increasing the % of debt in the mix andvice versa

The value of the firm (its earnings potential)

is maximized when its WACC is minimized. A firm with a lower cost of capital can more easily

return profits to its owners

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Debt vs Equity Financing (2):

The optimal, or target capital structure is the

structure with the lowest possible WACC

The Interest Tax Shield(deductibility of corp.

interest) is critical here, because it effectivelylowers the cost of debt.

Therefore for many firms, the use of financial

leverage (debt financing) can lower WACC

and increase profitability

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Debt vs. Equity Financing (3):

Warning: choice between debt & equity cannot be based on interest rates, etc. alone.Risk must be considered as well

Systematic risk (see ch. 13) consists of twofactors which must be considered Business riskrisk inherent in firms operations

Financial riskrisk inherent in using debtfinancing

Remember debt is a multiplier: it can multiply returns if returns > cost of debt; but

it can also multiply losses, or returns < cost ofdebt.

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Pause for class case

illustrating Financial

Leverage

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Financial Leverage Considerations:

If profits are down, dividends (the key cost ofequity financing) can often be deferred.

Interest (cost of debt) must always be paid fora firm to remain solvent

Financial distress costs: costs incurred withgoing bankrupt or costs that must be paid toavoid bankruptcy

According to the static theory of capitalstructure, gains from the tax shield are offsetby the greater potential of financial distresscosts.

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Optimal Capital Structure: Optimal capital structure is achieved by

finding the point at which the tax benefit of anextra dollar of debt = potential cost offinancial distress. This is the point of:

Optimal amount of debt

Maximum value of the firm

Optimal debt to equity ratio

Minimal cost of WACC

This will obviously vary from firm to firm andtakes some effort to evaluate. No singleequation can guarantee profitability or evensurvival

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Critical considerations:

Firms with greater risk of financial distress must

borrow less

The greater volatility in EBIT, the less a firm should

borrow (magnify risk of losses)

Costs of financial distress can be minimized the more

easily firm assets can be liquidated to cover

obligations

A firm with more liquid assets may therefore have

less financial risk in borrowing

A firm with more proprietary assets (unique to the

firm, hard to liquidate) should minimize borrowing

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Congratulations!

You are now all

financial wizards!

End of module!