1 Prentice Hall, 1998 Chapter 11 Cost of Capital.

1Prentice Hall, 1998

Chapter 11Chapter 11

Cost of CapitalCost of Capital


Learning ObjectivesLearning Objectives

Explain why the cost of capital is an opportunity Explain why the cost of capital is an opportunity cost, and not the historical cost of fundscost, and not the historical cost of funds..

Distinguish among the cost of capital, and the Distinguish among the cost of capital, and the required returns to equity and debt, and identify required returns to equity and debt, and identify the major determinants of eachthe major determinants of each..

Identify the important differences between Identify the important differences between operating and financial leverage, and operating and financial leverage, and distinguish between business and financial riskdistinguish between business and financial risk..

Estimate the cost of capital for a capital Estimate the cost of capital for a capital budgeting projectbudgeting project..


Cost of Capital and the Cost of Capital and the Principles of FinancePrinciples of Finance

RiskRisk--Return TradeReturn Trade--Off Off - - the projectthe project’’s risk s risk determines the projectdetermines the project’’s cost of capitals cost of capital

TimeTime--ValueValue--ofof--Money Money - - the projectthe project’’s NPV s NPV measures the value it will createmeasures the value it will create

Valuable Ideas Valuable Ideas - - a major source of valuea major source of value

Comparative Advantage Comparative Advantage - - another major another major source of valuesource of value


Cost of Capital and the Principles of Cost of Capital and the Principles of FinanceFinance

Incremental Benefits Incremental Benefits - - these are the projectthese are the project’’s s expected future cash flowsexpected future cash flows

Options Options - - recognize the value of capital recognize the value of capital budgeting options, such as to expand, budgeting options, such as to expand, postpone, price, abandon, or have a followpostpone, price, abandon, or have a follow--on projecton project

TwoTwo--Sided Transactions Sided Transactions - - consider the other consider the other sideside’’s viewpoints viewpoint

Signaling Signaling - - consider competitor actions and consider competitor actions and productsproducts


The Cost of CapitalThe Cost of Capital

The The Cost of Capital Cost of Capital is the capital budgeting is the capital budgeting projectproject’’s required returns required return..

It is the opportunity cost of investing those It is the opportunity cost of investing those funds in the projectfunds in the project..

It is the rate of return at which investors are It is the rate of return at which investors are willing to provide financing for the project willing to provide financing for the project todaytoday..

It reflects the risk of the projectIt reflects the risk of the project..

It is not the historical cost of fundsIt is not the historical cost of funds..


Corporate ValuationCorporate Valuation

The market value of the company The market value of the company ((or simply, or simply, the company valuethe company value) ) can be viewed in two can be viewed in two waysways::

company value equals the sum of the market company value equals the sum of the market values of the claims on the companyvalues of the claims on the company’’s assetss assets..

company value equals the sum of the market company value equals the sum of the market values of its assetsvalues of its assets..

This is simply the balanceThis is simply the balance--sheet accounting sheet accounting identity, but in market value termsidentity, but in market value terms..


Financing Decisions and Company Financing Decisions and Company ValueValue

In a perfect capital market, the value of the In a perfect capital market, the value of the company does not depend on its capital company does not depend on its capital structure structure ((the way in which its assets are the way in which its assets are financedfinanced))..

The mix of debt versus equity is irrelevant in The mix of debt versus equity is irrelevant in determining company valuedetermining company value..

In imperfect capital markets, capital structure In imperfect capital markets, capital structure can effect the value of the companycan effect the value of the company..


Investment Decisions and Company Investment Decisions and Company ValueValue

The value of the company does depend on The value of the company does depend on the expected future cash flows to be the expected future cash flows to be generated by the companygenerated by the company’’s assets, and on s assets, and on the required return on these cash flowsthe required return on these cash flows..

An asset will add value if its expected return An asset will add value if its expected return ((the Internal Rate of Return or IRRthe Internal Rate of Return or IRR) ) exceedsexceeds its required return its required return ((that is, its cost of capitalthat is, its cost of capital))..


The Market Line for Capital Budgeting The Market Line for Capital Budgeting ProjectsProjects

The Capital Asset Pricing Model The Capital Asset Pricing Model ((CAPMCAPM) ) can can be used to obtain the cost of capital for a be used to obtain the cost of capital for a capital budgeting projectcapital budgeting project..

rrjj = = rrff + + jj((rrmm - - rrff))

wherewhere

rrjj = = cost of capital for project jcost of capital for project j,,

rrff = = riskless returnriskless return

rrmm = = required return on the market portfoliorequired return on the market portfolio

jj = = beta of project jbeta of project j


Value and the RiskValue and the Risk--Return TradeReturn Trade--OffOff

The value of a project depends onThe value of a project depends on::its expected future cash flowsits expected future cash flows

its cost of capitalits cost of capital

An increase in the expected future cash An increase in the expected future cash flows may be offset by a corresponding flows may be offset by a corresponding increase in riskincrease in risk..

An increase in risk increases the projectAn increase in risk increases the project’’s cost of s cost of capitalcapital..

Exact offsetting changes in expected future Exact offsetting changes in expected future cash flows and the cost of capital cash flows and the cost of capital ((riskrisk) ) are are simply a risksimply a risk--return tradereturn trade--offoff..


LeverageLeverage

According to the CAPM, the required return According to the CAPM, the required return depends only on the projectdepends only on the project’’s nons non--diversifiable riskdiversifiable risk..

The nonThe non--diversifiable risk borne by diversifiable risk borne by shareholders can be split into two partsshareholders can be split into two parts::

Operating Operating ((businessbusiness) ) riskriskFinancial riskFinancial risk

Operating risk results from Operating risk results from Operating Operating LeverageLeverage..

Financial risk results from Financial risk results from Financial Financial LeverageLeverage..


Operating LeverageOperating Leverage

Operating leverage arises from the mix of Operating leverage arises from the mix of fixed versus variable costs of productionfixed versus variable costs of production..

High fixed costs High fixed costs ((and correspondingly lower and correspondingly lower variable costs per unitvariable costs per unit) ) results in high results in high operating leverageoperating leverage..

The companyThe company’’s profits are more sensitive to s profits are more sensitive to changes in saleschanges in sales..

Conversely, low fixed costs Conversely, low fixed costs ((and and correspondingly higher variable costs per correspondingly higher variable costs per unitunit) ) results in low operating leverageresults in low operating leverage..



Jewel Plastics, IncJewel Plastics, Inc. . plans to make plastic jewel plans to make plastic jewel cases for CDcases for CD--ROM disksROM disks. . Each packet of 10 Each packet of 10 cases can be sold for $5.00cases can be sold for $5.00. . Two alternative Two alternative manufacturing technologies are availablemanufacturing technologies are available..

Plan APlan A Plan BPlan BAnnual Fixed Costs

Variable Cost (per unit)

60,000

$2.00

$100,000

$1.00

Ignoring taxes, compute the profits under each plan.



Profit Profit = = Sales Sales - - CostsCosts

= = Unit SalesUnit Sales((Selling Price Selling Price - - VariableVariable

CostsCosts) - ) - Fixed CostsFixed Costs

At a sales level of 50,000 units, the profits At a sales level of 50,000 units, the profits under plan A areunder plan A are::

50,00050,000))5.005.00 - - 2.002.00 - ( - (60,00060,000 = = $90,000$90,000..

Under Plan B, profits at a sales level of Under Plan B, profits at a sales level of 50,000 units are $100,00050,000 units are $100,000..



-$100

-$50

$0

$50

$100

$150

$200

$0 $20 $40 $60 $80

Pro

fit

($ t

ho

us

and

s)

Units Sold)thousands(

Plan B

Plan A



Operating leverage affects the risk of the Operating leverage affects the risk of the companycompany’’s investments, and is unique for s investments, and is unique for each investmenteach investment..

It affects both the diversifiable as well as the It affects both the diversifiable as well as the nonnon--diversifiable risk of the investmentdiversifiable risk of the investment..

Through its effect on nonThrough its effect on non--diversifiable risk, it diversifiable risk, it also affects the investmentalso affects the investment’’s cost of capitals cost of capital..

The companyThe company’’s choice of operating leverage s choice of operating leverage may be limited by the number of alternative may be limited by the number of alternative production methodsproduction methods..


Financial LeverageFinancial Leverage

The presence of fixed costs associated with The presence of fixed costs associated with debt financing results in financial leveragedebt financing results in financial leverage..

As financial leverage increases, the As financial leverage increases, the variability of shareholder returns increasesvariability of shareholder returns increases..

This increases shareholderThis increases shareholder’’s risks risk..



ClubClub’’s & Stuff is currently alls & Stuff is currently all--equity financedequity financed. . ClubClub’’s expected future cash flows are $300 per s expected future cash flows are $300 per year in perpetuity, with a minimum annual cash year in perpetuity, with a minimum annual cash flow of $150flow of $150. . ClubClub’’s shareholders currently s shareholders currently require a 15% returnrequire a 15% return..

Analyze the impact on shareholder returns if Analyze the impact on shareholder returns if Club issues $1,500 of riskless debt with an Club issues $1,500 of riskless debt with an interest rate of 10%, and uses the funds to pay interest rate of 10%, and uses the funds to pay dividends to the shareholdersdividends to the shareholders..

Assume perfect marketsAssume perfect markets..



Currently, the value of Clubs & Stuff isCurrently, the value of Clubs & Stuff is

300300 / / 0.150.15 = = $2,000$2,000

With $1,000 in debt at 10%, ClubWith $1,000 in debt at 10%, Club’’s annual s annual interest expense will be $100interest expense will be $100. . Since ClubSince Club’’s s minimum annual cash flow exceeds $100, the minimum annual cash flow exceeds $100, the debt will be risklessdebt will be riskless..

Issuing $1,000 of debt and paying the proceeds Issuing $1,000 of debt and paying the proceeds to the shareholders will result in Club being 50% to the shareholders will result in Club being 50% debt financeddebt financed..

In perfect markets, company value is independent of In perfect markets, company value is independent of capital structurecapital structure..



With 50% debt financing, shareholders will With 50% debt financing, shareholders will demand a higher rate of return since their demand a higher rate of return since their risk will increaserisk will increase..

As the companyAs the company’’s returns vary, the returns to s returns vary, the returns to shareholders will vary more with debt shareholders will vary more with debt financing than withoutfinancing than without..

The company has to pay out a fixed cost of $100 The company has to pay out a fixed cost of $100 per year to the debtholdersper year to the debtholders..



-40%

-20%

0%

20%

40%

-30% -15% 0% 15% 30%Company’s Return

Shareholder’s Return

0% Debt

50% Debt


The Weighted Average Cost of CapitalThe Weighted Average Cost of Capital

The Weighted Average Cost of Capital, The Weighted Average Cost of Capital, WACCWACC, is the weighted average rate of , is the weighted average rate of return required by the suppliers of capital for return required by the suppliers of capital for the companythe company’’s investment projects investment project..

The suppliers of capital will demand a rate of The suppliers of capital will demand a rate of return that compensates them for the return that compensates them for the proportional risk they bear by investing in the proportional risk they bear by investing in the projectproject..


Components of a Financing PackageComponents of a Financing Package

Consider the case where a project will be Consider the case where a project will be financed with 40% debt and 60% equityfinanced with 40% debt and 60% equity..

Suppose the project requires an initial Suppose the project requires an initial investment of $8,000 and has a NPV of investment of $8,000 and has a NPV of $2,000$2,000..

The TOTAL value of the project is thus $10,000The TOTAL value of the project is thus $10,000..

How much debt should the company useHow much debt should the company use??))40%40% ( ($10,000$10,000 = = $4,000$4,000


Components of a Financing PackageComponents of a Financing Package

Since the project requires an initial Since the project requires an initial investment of $8,000, the company will raise investment of $8,000, the company will raise the remaining $4,000 by selling stockthe remaining $4,000 by selling stock..

Since the total value of the project is Since the total value of the project is $10,000, the stock will be worth $6,000$10,000, the stock will be worth $6,000..

In perfect markets, ALL of the benefits from a In perfect markets, ALL of the benefits from a project project ((that is, the projectthat is, the project’’s NPVs NPV) ) goes to the goes to the shareholdersshareholders..


WACC CalculationWACC Calculation

Let L Let L = = the ratio of debt financing to total the ratio of debt financing to total financingfinancing,,

rree = = required return for equityrequired return for equity,,

rrdd = = required return on debt, andrequired return on debt, and

==marginal corporate tax rate on marginal corporate tax rate on income from the projectincome from the project..

ThenThen,,

WACC WACC = (= (11 - - LL) ) rree + + LL((11 - - ) ) rrdd



Compute the WACC for the Nikko CoCompute the WACC for the Nikko Co. . given the given the following informationfollowing information::

Nikko has 8 million common shares outstanding Nikko has 8 million common shares outstanding priced at $14.625 eachpriced at $14.625 each. . Next yearNext year’’s dividend on s dividend on these shares is expected to be $2.71, and will these shares is expected to be $2.71, and will grow at 5% per year forevergrow at 5% per year forever. . Nikko has 60,000 Nikko has 60,000 bonds outstanding, each with a coupon rate of bonds outstanding, each with a coupon rate of of 12% and are priced at $1,050 each to yield of 12% and are priced at $1,050 each to yield 8% to bondholders8% to bondholders. . NikkoNikko’’s marginal corporate s marginal corporate

income tax rate is 34%income tax rate is 34%..



Market value of NikkoMarket value of Nikko’’s equitys equity = =

88 million x $14.625 per share million x $14.625 per share = = $117 million$117 million..

Market value of NikkoMarket value of Nikko’’s debts debt = =

60,00060,000 x $1,050 per bond x $1,050 per bond = = $63 million$63 million..

Total market value of NikkoTotal market value of Nikko = =

$117$117 million million + + $63 million $63 million = = $180 million$180 million..

Proportion of debt financing used by NikkoProportion of debt financing used by Nikko = =

L L = = $63 M $63 M / / $180 M $180 M = = 35%35%



To compute the return required by NikkoTo compute the return required by Nikko’’s s stockholders, we use the constant growth stockholders, we use the constant growth model of stock valuationmodel of stock valuation..

rDP

ge 1

0

71625

0 05 23 53%$2.

$14.. .



Since we are interested in measuring the Since we are interested in measuring the companycompany’’s current cost of capital, we use s current cost of capital, we use the bond yield currently demanded by the the bond yield currently demanded by the bondholdersbondholders..

Thus, rThus, rdd = 8% = 8%

Also, the tax rate, Also, the tax rate, , is 34%, is 34%



WACC = (1 - L)re + L(1 - )rd

) = 0.65)(23.53%) + (0.35)(1 - 0.34)(8%(

= 17.14%


How Not to Use the WACCHow Not to Use the WACC

Assume that a companyAssume that a company’’s existing s existing operations have a risk equal to the average operations have a risk equal to the average risk of risk of newnew projects being considered for projects being considered for adoptionadoption..

If the company uses its current WACC, it will If the company uses its current WACC, it will accept projects of above average risk and accept projects of above average risk and reject projects of below average riskreject projects of below average risk..

Thus, the risk of the company will riseThus, the risk of the company will rise..


Misapplication of the WACCMisapplication of the WACC

WACC

Risk (beta)

Rat

e of

Ret

urn


How to use the WACCHow to use the WACC

The The correctcorrect procedure is to use a cost of procedure is to use a cost of capital for each project so that it reflects the capital for each project so that it reflects the risk of that projectrisk of that project..


Correct Application of the WACCCorrect Application of the WACC

Risk (beta)

Rat

e of

Ret

urn


Financial RiskFinancial Risk

Financial risk is due to the presence of debt Financial risk is due to the presence of debt financing used by the companyfinancing used by the company..

An allAn all--equity financed company has no financial equity financed company has no financial riskrisk..

A company chooses its financial risk with its A company chooses its financial risk with its choice of capital structure and the maturities choice of capital structure and the maturities of its obligationsof its obligations..


Financial Leverage and the Cost of Financial Leverage and the Cost of CapitalCapital

In perfect capital markets, financial leverage In perfect capital markets, financial leverage has no effect in the WACChas no effect in the WACC..

WACC is independent of the capital structureWACC is independent of the capital structure..

Thus, a projectThus, a project’’s value is not affected by the s value is not affected by the way in which it is financedway in which it is financed..

However, financial leverage does alter how However, financial leverage does alter how the risk of the project is borne by the the risk of the project is borne by the debtholders and the shareholdersdebtholders and the shareholders..


Financial Leverage and the Cost of Financial Leverage and the Cost of CapitalCapital

As financial leverage increases, the risk that As financial leverage increases, the risk that is borne by both the debtholders and the is borne by both the debtholders and the shareholders increasesshareholders increases..

In the limit, the debtholders become the In the limit, the debtholders become the stockholders, except for contracting stockholders, except for contracting considerationsconsiderations..


Required Return

Insert Figure 10-7 hereInsert Figure 10-7 here..

0.0 1.0

)1 - (rf )1 - (rd

re

WACC

L


Financial Leverage and BetaFinancial Leverage and Beta

Consider a company with J different assets, Consider a company with J different assets, each with a beta of each with a beta of jj..

Let wLet wjj denote the proportion of company denote the proportion of company

value invested in asset jvalue invested in asset j..



Consider a company with J different assets, Consider a company with J different assets, each with a beta of each with a beta of jj..

Let wLet wjj denote the proportion of company denote the proportion of company

value invested in asset jvalue invested in asset j..

The beta of all the assets of the company, The beta of all the assets of the company, AA, is then given by, is then given by::

A j jj

Jw

ه

1



Using the CAPM, we getUsing the CAPM, we get

WACC WACC = = rrff + + AA ( (rrmm - - rrff))

Thus, we can see that WACC is independent of Thus, we can see that WACC is independent of the capital structure since the capital structure since AA is unaffected by is unaffected by

capital structurecapital structure..



How does financial leverage affect the How does financial leverage affect the stockstock’’s betas beta??

Let Let dd denote the beta of the debt and denote the beta of the debt and

denote the beta of the stockdenote the beta of the stock..

rrdd= = rrff + + dd((rrmm - - rrff)) and and rree= = rrff + + ((rrmm - - rrff))



Recall thatRecall that

WACC WACC = (= (11 - - LL) ) rree + + LL((11 - - ) ) rrdd

WACC WACC = = rrff + + AA ( (rrmm - - rrff))

Pluggin in the CAPM specifications for Pluggin in the CAPM specifications for rree

and rand rdd and rearranging the terms, we and rearranging the terms, we

getget::

))11 - - LL ( (AA = = LLdd + (1 - + (1 - LL))



Suppose that debt is risklessSuppose that debt is riskless. . Then Then dd = 0= 0, ,

andand

AA = (1 - = (1 - LL))/ (1 - / (1 - LL))


WACC for a Capital Budgeting ProjectWACC for a Capital Budgeting Project

The Evergreen Sprinkler CorpThe Evergreen Sprinkler Corp. (. (ESCESC) ) is is considering expanding its current operations, considering expanding its current operations, and you are asked to estimate the WACC to be and you are asked to estimate the WACC to be used for this projectused for this project. . ESCESC’’s outstanding stock is s outstanding stock is valued at $16.8 million,while its debt has a valued at $16.8 million,while its debt has a market value of $7.2 millionmarket value of $7.2 million. . ESCESC’’s stock has a s stock has a beta of 1.80 and its debt is risklessbeta of 1.80 and its debt is riskless. . ESCESC’’s s marginal tax rate is 37%marginal tax rate is 37%. . The riskless rate is The riskless rate is 5% and the required return on the market 5% and the required return on the market portfolio is 13%portfolio is 13%..



Since ESCSince ESC’’s debt is worth $7.2 million and s debt is worth $7.2 million and its equity is worth $16.8 million, the value of its equity is worth $16.8 million, the value of L is $7.2L is $7.2/(/($7.2$7.2 + + $16.8$16.8) ) or 0.30or 0.30..

Further, Further, = 1.80 = 1.80 and and = 0.37 = 0.37..

Thus, the beta of the assets of ESC isThus, the beta of the assets of ESC is::



Since ESCSince ESC’’s debt is worth $7.2 million and s debt is worth $7.2 million and its equity is worth $16.8 million, the value of its equity is worth $16.8 million, the value of L is $7.2L is $7.2/(/($7.2$7.2 + + $16.8$16.8) ) or 0.30or 0.30..

Further, Further, = 1.80 = 1.80 and and = 0.37 = 0.37..

Thus, the beta of the assets of ESC isThus, the beta of the assets of ESC is::

AA = (1 - = (1 - LL))/ (1 - / (1 - LL))

) = ) = 11 - - 0.300.30((1.801.80)/)/11) - ) - 0.370.37)()(0.300.30((

= = 1.421.42



5% 142 )13% 5%( 16 36%. .

)r(rβrWACC fMAf


WACC for a New Line of BusinessWACC for a New Line of Business

Consider a company that intends to expand Consider a company that intends to expand into a new line of businessinto a new line of business. . What WACC What WACC should it use for evaluating this proposalshould it use for evaluating this proposal??

If the new line of business is of different risk If the new line of business is of different risk than the companythan the company’’s existing assets, the s existing assets, the companycompany’’s WACC cannot be useds WACC cannot be used..

Estimate Estimate AA for other companies in this line of for other companies in this line of

businessbusiness..

Use the average Use the average AA and the CAPM to get the and the CAPM to get the

WACCWACC..


Operating Leverage and the WACCOperating Leverage and the WACC

Unlike financial leverage, operating leverage Unlike financial leverage, operating leverage affects affects AA, the beta of the assets, the beta of the assets..

Higher operating leverage leads to higher Higher operating leverage leads to higher asset betasasset betas..

This in turn leads to higher WACCThis in turn leads to higher WACC..

Given the technology, a company may not Given the technology, a company may not have much choice over operating leverage, have much choice over operating leverage,

and thus the WACCand thus the WACC . .

1 Prentice Hall, 1998 Chapter 11 Cost of Capital.

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Transcript of 1 Prentice Hall, 1998 Chapter 11 Cost of Capital.