Cost of Capital
Cost of debt
YTM
Cost of common stock
Dividend Discount Model (DDM)
Capital Asset Pricing Model (CAPM)
Cost of preferred stock
Weighted Average Cost Capital (WACC)
The Cost of Capital
The Cost of Capital is the project’s
required return.
Project: treat the project as a mini-firm.
It is the opportunity cost of investing those funds
in the project. It is the rate of return at which
investors are willing to provide financing for the
project today. It is based on current market
conditions.
It reflects the risk of the project.
It is not the historical cost of funds.
The Cost of Capital
Cost of common equity:
Dividend Discount Model (DDM): r = D1/P0 + g
Capital Asset Pricing Model (CAPM): r = rf+β(rm - rf)
Pre-Tax cost of debt:
Yield to Maturity (YTM) of existing bonds or newly
issued bonds
Cost of preferred stock:
Dividend yield of the preferred stock: r = D/P0
Weighted-Average Cost of Capital (WACC):
Weighted average of cost of common equity, after-tax
cost of debt, and cost of preferred stocks, where
weights are market value weights
A 100% Equity, 0%
Debt Firm
Value and the Risk-
Return Trade-Off
The value of a project depends on:
the expected future cash flows
the cost of capital
An increase in the sizes of expected future
cashflows may be offset by a corresponding
increase inrisk because an increase in risk
increases the project’s cost of capital.
An offset like this is simply a risk-return
trade-off.
Leverage
According to the CAPM, the required return
depends only on the non-diversifiable risk.
The non-diversifiable risk borne by
shareholders can be split into two parts:
Operating (business) Risk
Financial Risk
Operating risk results from operating
leverage.
Financial risk results from financial
leverage.
Operating Leverage
Operating leverage arises from fixed costs of
production.
High fixed costs (and correspondingly lower
variable costs per unit) results in high
operating leverage.
The firm’s profits are more sensitive to
changes in sales.
Conversely, low fixed costs (and
correspondingly higher variable costs per
unit) result in low operating leverage.
Operating Leverage
Operating Leverage
Profit = Sales – Costs
(Unit Sales) (Selling Price – Variable Costs) – Fixed Costs
At a sales level of 50,000 units, the profits
under plan A are:
50,000 ($5.00 – $2.00) – $60,000 = $90,000.
Under Plan B, profits at a sales level of
50,000 units are $100,000.
Operating
Leverage
Financial Leverage
The presence of fixed costs associated
with debt financing results in financial
leverage.
As financial leverage increases, the
variability of shareholder returns
increases.
Financial leverage increases shareholder’s
risk.
Financial Leverage
Clubs & Stuff is currently all-equity financed. Club’s
expected future cash flows are $300 per year in
perpetuity, with a minimum annual cash flow of
$100. Club’s shareholders currently require a 15%
return. Analyze the impact on shareholder returns
if Club issues $1,000 of risk-free debt with an
interest rate of 10%, and uses the funds to pay
dividends to the shareholders.
Assume perfect markets.
Financial Leverage
Currently, the value of Clubs & Stuff is
300/0.15 = $2,000
With $1,000 in debt at 10%, Club’s annual
interest expense will be $100.
Is that risky?
Since Club’s minimum annual cash flow is
$100, the debt will be riskless.
Issuing $1,000 of debt and paying the
proceeds to the shareholders will result in
Club being 50% debt financed.
Financial Leverage
With 50% debt financing, shareholders will
demand a higher rate of return since their risk
will increase:
(300 – 100)/1,000 = 0.20 = 20%
As the firm’s returns vary, the returns to
shareholders will vary more with debt financing
than without.
The firm must first pay bondholders the fixed cost of
$100 each year.
The shareholders get the residual.
Financial Leverage
Financial Leverage
You have a 1-year $50,000 investment project
that is expected to return 20%. If you can borrow
$30,000 at 10%, putting up only $20,000 of your
own money, what return would you expect to
earn on your $20,000?
50,000(0.2) – 30,000(0.1) = 7,000
7,000/20,000 = 35%
Alternatively, using the cost of capital:
20% = (0.6)(10%) + (0.4)(X)
X = [20% - (0.6)(10%)]/0.4 = 35%
The Weighted
Average Cost of
Capital
The Weighted Average Cost of Capital,
WACC, is the weighted average rate of return
required by the suppliers of capital for the
firm’s investment project.
The suppliers of capital will demand a rate of
return that compensates them for the
proportional risk they bear by investing in the
project.
WACC Calculation
Let L = the ratio of debt financing to total
financing
re = cost of common stock (equity),
rd = pre-tax cost of debt = YTM, and
T = marginal corporate tax rate on income
from the project
Then,
WACC = (1-L ) re + L (1-T ) rd
WACC Calculation
Nikko has 9 million common shares outstanding
priced at $13.00 each. Next year’s dividend on
these shares is expected to be $1.33, and will
grow at 5% per year forever. Nikko has 60,000
bonds outstanding, each with a coupon rate of
11% and are priced at $1,050 each to yield 10%
to bondholders. Nikko’s marginal corporate
income tax rate is 34%.
WACC Calculation
Market value of Nikko’s equity =
9 million × $13.00 per share = $117 million
Market value of Nikko’s debt =
60,000 × $1,050 per bond = $63 million.
Total market value of Nikko =
$117 million + $63 million = $180 million.
Proportion of debt financing used by Nikko =
L = $63 / $180 L = 35%
WACC Calculation
To compute the rate of return required by
Nikko’s stockholders, we use the constant
growth model of stock valuation.
WACC Calculation
Because we are interested in measuring
the firm’s current cost of capital, we use
the bond yield currently demanded by the
bondholders.
Thus, pre-tax cost of debt = YTM = r d = 10%.
Also, the tax rate, T, is 34%.
WACC Calculation
WACC = (1-L ) re + L (1-T ) rd
WACC = (0.65)(0.1523) + 0.35x(1- 0.34)(0.10)
WACC =12.21%
How Not to Use the
WACC
If new projects being considered have the same risk
as the average risk of the firm’s existing operations,
then use WACC to discount future cash flows of new
projects.
If new projects have different risk from the average
risk of the firm’s existing operations, then use the
security market line to compute a cost of capital for
new projects. Otherwise, if the firm uses its current
WACC as the hurdle rate, the firm will likely to
accept projects with above average risk and reject
projects with below average risk. Over time, the risk
of the firm would increase.
WRONG
Right – Based on
the project’s risk
Problem
You have a chance to make a $ 25000
one year investment. The investment is
expected to earn 18%, and there are no
taxes. If you borrow 10,000 at 10% and
put up the other 15000, with your own
money, what will be your expected return
on the 15000?
Solution
Dollar Profit = 18% x $25,000 = $4,500
Interest Expense = 10% x $10,000 =
$1,000
Net profit = $3500
r = $3,500 / $15,000 = 23.33%
