1. Chapter 10 – The Cost of Capital
Learning Objectives
Calculate a WACC
Explain why WACC is adjusted for debt
Calculate weights with book and market value
Understand how WACC is used in capital budgeting decisions
Determine the Beta of a Project
Select optimal project set

2. The Cost of Capital What is the Cost of Capital?
The discount rate in the NPV model
The hurdle rate in the IRR model
What is WACC (Weighted Average Cost of Capital)?
Reflects the components used in borrowing
Weight of each component times cost of the component
What are the components of the cost of capital?
The sources of funding for a company
Include
Owner’s money
Preferred shareholder’s contribution
Commercial Banks
Non-bank Lenders
Suppliers
Funds generated by the company (Retained Earnings)

3. WACC for Stan
Example 10.1
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 weighted average cost of borrowing (cost of capital) is 8.38% because…

4. 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, Rd – Yield on a bond
Preferred Stock, RPS – Required return
Common Stock, Re – Required return

5. Components of the Cost of Capital
Examples
Debt component – yield to maturity on bond
Example 10.2, Bond sells for net $920, semi-annual coupons of $40, par value of $1,000 and maturity of ten years
Solving for YTM gives 9.24% cost of debt
Preferred Stock component – using the perpetual dividend model
Example 10.4, Preferred stock sells for $35, annual dividend is $4.00
Solving for required rate of return gives 11.43%

6. Components of the Cost of Capital
Examples, continued
Common Stock – use Security Market Line
Example 10.5, 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

7. 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

8. 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 Tc
WACC is the weighted average of the components adjusted for the benefits of using debt capital

9. 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

10. 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
See page 303 and 304 for accept or reject decision with and without appropriate beta
WACC increases with risk
Projects above WACC line accept

11. 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

12. 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

13. Homework Problem 2 – WACC Problem 6 – Cost of Debt, with fees
Problem 7 – Cost of Equity using SML
Problem 10 – Cost of Preferred Stock
Problem 14 – Weighting Components
Problem 18 – Constraints on Borrowing