Chapter 11 Weighted Average Cost of Capital  The Cost of Capital  Components of the Cost of Capital  Weighting the Components  Adjusting the Debt Component for Taxes  Utilizing WACC in Decision Models  Selecting the Beta of a Project  Selecting Appropriate Betas  Constraints on Borrowing

The Cost of Capital  The discount rate in the NPV model  The hurdle rate in the IRR model  WACC  Reflects the components used in borrowing  Weight of each component  Example 11.1  Stan borrows from three individuals – three sources of funds or three components  Stan borrows different amounts with different interest rates from each source  Stan’s average cost of borrowing (cost of capital) is:  WACC = 8.38%

Components of the Cost of Capital  Three major sources of funds  Debt (Liability)  Banks, Bondholders, Suppliers, etc.  Interest charged is cost of capital  Preferred Stockholders  Equity Stockholders (Owners)  Debt Component, R d – Yield on a bond  Preferred Stock, R PS – Required return  Common Stock, R e – Required return

Components of the Cost of Capital  Examples  Debt component – yield to maturity on bond  Example 11.3, Bond sells for net $868, semi- annual coupons of $30, par value of $1,000 and maturity of 20 years  Solving for YTM gives 7.26% cost of debt  Preferred Stock component – using the perpetual dividend model  Example 11.4, Preferred stock sells for $35, annual dividend is $4.00  Solving for required rate of return gives 11.43%

Components of the Cost of Capital  Examples, continued  Common Stock – use Security Market Line  Example 11.5, expected return on market is 12%, risk-free rate is 3%, and beta of the project is 0.8  Solving for expected return gives 10.2% cost of equity  Other sources are additional components  Typically use bonds or bank loans for debt  Other sources tend to be small percentage

Weighting the Components  To average the different borrowing costs need to know percent of borrowing from each source  Two ways to measure  Book Value  Market Value  Book Value – use balance sheet values  Market Value – calculate the market price of the component

Adjusting for the Debt Component  Interest paid to bondholders, banks, or others is a deductible business expense  The cost of debt is therefore lower as it reduces taxes  The corporate tax rate is T c  WACC is the weighted average of the components adjusted for the benefits of using debt capital

Utilizing WACC in Decision Models  WACC is the discount rate in the NPV model  Discount future cash flows by WACC  If NPV positive, accept project  WACC is hurdle rate in IRR  Compare IRR with WACC  If IRR > WACC, accept project  Both Decision Models: Return on project is greater than cost to finance project

Selecting the Beta of a Project  The equity component uses SML  To use SML need to know Beta of project  Beta of project implicitly adds risk factor to the WACC and decision  Selecting Beta corrects systematic error in accepting high risk projects  WACC increases with risk  Projects above WACC line accept

Selecting Appropriate Betas  Assigning Beta often more of an art than a science  Beta of company is beta of project  When project just like the rest of the company  Find company with business just like potential project – pure play  Adjust beta for level of risk  Can use very sophisticated models to estimate beta

Constraints on Borrowing  With unlimited borrowing – accept all positive NPV projects  If borrowing is limited – fixed amount of dollars available then…  Use NPV for projects for decision  Eliminate all negative NPV projects  Find combination of projects that yield highest NPV without exceeding borrowing limits  Use all available funds as long as NPV >0

Problems  Problem 1 – WACC  Problem 5 – Cost of Debt, with fees  Problem 7 – Cost of Equity using SML  Problem 9 – Cost of Preferred Stock  Problem 13 – Weighting Components  Problem 15 – Beta of a project  Problem 17 – Constraints on Borrowing