1 Chapter 11 Calculating the Cost of Capital McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The WACC Formula Weighted Average Cost of Capital (WACC) is the average cost per dollar of capital raised Weights are based on market values, not book values 11-2

WACC 11-3

Component Cost of Equity Two ways to calculate –CAPM –Constant-growth model 11-4

Component Cost of Equity and CAPM Not appropriate to use when historical data insufficient or not good indicator of future CAPM is generally the more accurate estimate 11-5

Example XYZ has a beta of.9, the current risk-free rate is 6.2 percent, and the expected return on the market is 12 percent. What is XYZ’s cost of equity?

Component Cost of Equity and Constant-growth Model Use when constant dividend growth is expected on limited number of stocks 11-7

Example AAAA recently paid a dividend of $.46. The dividend is expected to grow at a 14.5 percent rate. At a current stock price of $44.12, what is the return shareholders should expect?

Component Cost of Preferred Stock Calculate with constant-growth model 11-9

Example BCE has preferred stock selling for 96 percent of par. The shares pay an 11 percent annual coupon. What is BCE’s cost of preferred stock?

Component Cost of Debt Two-part calculation 1)Estimate before-tax cost of debt by using Yield to Maturity 2) Solve for interest rate that makes price equal to sum of present values for coupons and face value of bond 11-11

Component Cost of Debt Debt is tax deductible –Two-part calculation adjusts to after-tax rate of return 11-12

Example CDE has a $150 million (face value) 30-year bond issue selling for 104 percent of par. The coupon rate is 11 percent, paid semi- annually. What is CDE’s before tax component cost of debt?

Tax Rates Firm’s marginal tax rate affects the benefit of debt-interest deductibility WACC tax rate –the weighted average of marginal tax rates on income shielded by interest deduction 11-14

Example EFG has a $110 million (face value) 20-year bond issue selling for 101 percent of par. The coupon rate is 9 percent, paid semi- annually, and EFG is in the 35 percent tax bracket. What is EFG’s after-tax component cost of debt? 15

Calculating WACC Weights Percentages of funding that come from –Equity –Preferred stock –Debt 11-16

Firm vs. Project WACC Firm WACC –Use for evaluating typical projects Project WACC –Use with atypical projects such as those with higher or lower risk 11-17

Divisional WACC Less time-consuming and uses fewer resources Divides firm’s existing projects into divisions WACC based on average project risk in each division 11-18

Risk-Appropriate WACC Sloped line represents return rates and risk 11-19

Risk-Sensitive WACC Expected returns are greater than WACC Expected returns are less than WACC 11-20

Inappropriate use of Firmwide WACC Incorrect Decisions 11-21

Divisional WACC Use of divisional WACC reduces errors 11-22

Subjective vs. Objective Subjective approach to assessing risk results in arbitrary adjustments Created only for current project 11-23

Subjective vs. Objective Objective approach is more precise but harder to implement –May use CAPM formula 11-24

Flotation Costs Externally-generated capital –Stock issues –Bond issues Issuing securities generates underwriting costs such as commissions 11-25

Flotation Costs Two ways to account for flotation costs 1)Increase costs as percentage of WACC 2)Adjust initial project investment upwards 11-26

Practice Problems