McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.0 Chapter 12 Cost of Capital

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Divisional and Project Costs of Capital

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.2 Divisional and Project Costs of Capital (Using WACC for NPV Calculations) The WACC for a firm reflects the risk and the capital structure of the firm’s existing assets as a whole

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.3 Divisional and Project Costs of Capital (Using WACC for NPV Calculations Using WACC as the discount rate for a project is only appropriate if the project is a replica of the firm’s existing operating activities. i.e. Projects that are: an integral part of the overall business of the firm intimately related to the firms “existing” operations You’re in the Pizza business and evaluating opening a new location A retailer thinking of a new store A manufacturer thinking of expanding production A consumer products company thinking of expanding its markets

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.4 Divisional and Project Costs of Capital (Using WACC for NPV Calculations) When evaluating investments with risks that are substantially different from those of the overall firm, the use of the WACC will potentially lead to poor decisions Using the WACC for all types of projects (in firms with multiple divisions or more than one line of business, etc.) can result in the firm: Incorrectly accepting relatively risky projects WACC too low Incorrectly rejecting relatively safe ones WACC too high A Divisional cost of capital should be developed for each unit

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.5 Pure Play Approach How do we determine the correct discount rate when WACC is inappropriate? Pure Plan Approach – developing WACC for individual projects based on the cost of capital for other firms in a similar line of business as the project. Find one or more companies in the market that specialize in the product or service that we’re considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies Companies that focuses only on a single line of business.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.6 Pure Play Approach The Pure Play Approach – the use of a WACC that is unique to a particular project, based on companies in similar lines of business

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.7 Subjective Approach Because of the difficulties that exist in objectively establishing discount rates for individual projects (i.e. necessary info not available, cost and effort not worthwhile), firms often adopt an approach that involves making “subjective” adjustments to the over-all WACC:

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.8 Subjective Approach Consider the project’s risk relative to the firm overall WACC If the project is more risky than the firm, use a discount rate greater than the WACC If the project is less risky than the firm, use a discount rate less than the WACC You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.9 Subjective Approach - Example Risk LevelDiscount Rate Very Low RiskWACC – 8% Low RiskWACC – 3% Same Risk as FirmWACC High RiskWACC + 5% Very High RiskWACC + 10%

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Chapter 12 Quick Quiz What are the two approaches for computing the cost of equity? Dividend Growth Model and SML Approach How do you compute the cost of debt? We must use the “yield” in today’s market: yield-to- maturity How do you compute the capital structure weights required for the WACC? w E = E/V = percent financed with equity w D = D/V = percent financed with debt

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Chapter 12 Quick Quiz What is the WACC? Weighted Average Cost of Capital (WACC) the overall return the firm must earn on its existing assets to maintain the value of the stock the required return on any investments by the firm that have essentially the same risk as existing operations

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Chapter 12 Quick Quiz What happens if we use the WACC for the discount rate for all projects? Chance of incorrectly accepting relatively risky projects WACC too low Chance of incorrectly rejecting relatively safe ones WACC too high

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Chapter 12 Quick Quiz What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate? The Pure Play Approach –based on companies in similar lines of business Subjective Approach - Consider the project’s risk relative to the firm overall WACC