CHAPTER CHAPTERFIFTEEN Cost of Capital J.D. Han King’s College UWO

Learning Objectives 1. Show how to evaluate the cost of a given project within a company. 2. Demonstrate what weighted cost of capital (WACC) is and how it is used to calculate project costs. 3. Name two reasons why the cost of a security to a company differs from its yield in capital markets.

1. Strategy For a given project along with its revenue and operating expense streams, minimizing capital cost leads to maximizing the value of the firm. For a given project along with its revenue and operating expense streams, minimizing capital cost leads to maximizing the value of the firm. In chapter 15, we get the formula for the weighted average cost of capital. In chapter 16, we see the sensitivity of WACC to D/E ratio with and without corporate taxes, and try to get the optimal capital structure.

2. WACC Firm can rely on a proportion of debt, preferred shares, and common equity for their financing Firm can rely on a proportion of debt, preferred shares, and common equity for their financing Capital Structure – a summary of a firm’s obligations to investors Capital Structure – a summary of a firm’s obligations to investors From the capital structure the WACC can be determined From the capital structure the WACC can be determined WACC = cost of debt x B/V WACC = cost of debt x B/V + cost of preferred shares x P/V + cost of preferred shares x P/V + cost of common equity x E/V + cost of common equity x E/V where V = B + P + E

Notation r = market yield or market capitalization k = cost of capital b, p e, re = subscript for debt, preferred shares, common shares, and internally generated funds T = corporate tax rate I = annual interest payment on debt F = face value of debt n = # of years to maturity D = annual dividend payment on shares P = market price of a security NP = net proceeds to firm when selling a security

1) Cost of Debt Relationship in Capital Markets Between Risk and Expected Return

Cost of Debt Rate of Return/Market Yield(for investor): Rate of Return/Market Yield(for investor): l note: NP to the issuer = face value - underwriting + other discounts +issuing expenses on an after tax basis Cost of Debt (for deb-issuing firms): Cost of Debt (for deb-issuing firms):

*If we ignore the difference between the face value and the Net Proceeds: n WACC = D/V r b (1-T) + E/V k e Example) $1 million is borrowed at 9%. The corporate tax rate is 40%. The actual cost of borrowing is as follows: Interest payment= $90,000 Tax deductible portion of Interest cost= $36,000. Net cost = =54,000 The effective interest rate = 5.4% We can get r b (1-T) = 9(1-0.4)

3) Cost of Preferred Shares Rate of Returns=Market capitalization rate: Rate of Returns=Market capitalization rate: Cost of preferred shares: Cost of preferred shares:

2) Cost of Common Shares Common equity is available to a firm through internally generated funds and issuance of new common shares Common equity is available to a firm through internally generated funds and issuance of new common shares Cost of common shares is more difficult to derive than cost of debt and preferred shares Cost of common shares is more difficult to derive than cost of debt and preferred shares Several approaches are often used in estimating a firm’s cost of capital simultaneously Several approaches are often used in estimating a firm’s cost of capital simultaneously The cost of common equity can be estimated by: The cost of common equity can be estimated by: Dividend discount model (DDM) Dividend discount model (DDM) CAPM CAPM Judgement – based risk adjustment Judgement – based risk adjustment

Cost of Common Shares(1) Dividend discount model Dividend discount model l commonly used DDM assumes constant growth (g) to infinity by rearranging we get: by rearranging we get: Market capitalization rate Market capitalization rate Cost of capital: Cost of capital:

Cost of Common Shares(2) Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM) a firm’s required return on equity can be determined by assessing the risk of a firm’s common shares and relating the risk to the market a firm’s required return on equity can be determined by assessing the risk of a firm’s common shares and relating the risk to the market Expected return on common share equals: Expected return on common share equals: l Cost of common shares is calculated by:

Cost of Common Shares Judgement-based risk adjustment Judgement-based risk adjustment most common way to estimate a firm’s cost of equity most common way to estimate a firm’s cost of equity calculated by taking cost of debt and adding a premium for the risk shareholders are expected to bear calculated by taking cost of debt and adding a premium for the risk shareholders are expected to bear

Financing with Internally Generated Funds Reliance on internal funds does not commit the company to future cash outflows Reliance on internal funds does not commit the company to future cash outflows Using internal funds does entail opportunity costs Using internal funds does entail opportunity costs By using internal funds, underwriting expenses are avoided By using internal funds, underwriting expenses are avoided When a firm uses internal funds as a source of new equity capital it can use the cost of capital, net underwriting and issuing costs, in deriving WACC When a firm uses internal funds as a source of new equity capital it can use the cost of capital, net underwriting and issuing costs, in deriving WACC

WACC without underwriting and issuing expenses WACC = r b (1-T) (proportion of debt) + r p (proportion of preferred share) + r p (proportion of preferred share) + r s (proportion of common share) + r s (proportion of common share)

3. Summary 1. In order to build effective capital budgeting procedures, a firm needs to know the costs of funding new investments projects. One way to evaluate a new project is to view it as a freestanding venture and determine what return would be required by investors. 2. The WACC is the discount rate that should be used for evaluating new investments under static conditions. A project producing a positive NPV guarantees that all financing charges incurred in funding the project can be met and a shareholder residual gain.