Cost of Capital

COST OF CAPITAL
DR. RICARDO H ARCHBOLD
Source: Emery Finnerty Stowe
THE COST OF CAPITAL
The Cost of Capital is often misinterpreted.
The relevant cost is the opportunity cost.
It is NOT the firms historical cost of funds that determines the cost
of capital.
THE COST OF CAPITAL
The Cost of Capital is the required return for a capital budget.
It reflects the risk of the project.
It is the opportunity cost of funds tied up in the project.

It is the rate of return at which investors are willing to provide
financing for the project today.
CORPORATE VALUATION
The market value of the firm (or simply, the
firm value) can be viewed in two ways:
Firm value equals the sum of the market values of
the claims on the firms assets.
Firm value equals the sum of the market values of
its assets.
These two views are simply the balancesheet accounting identity, but in market
values:
Assets = Liabilities + Owners Equity
FINANCING DECISIONS AND FIRM VALUE

In a perfect capital market, the value of the firm does not depend on its
capital structurethe way in which its assets are financed.
The mix of debt versus equity is irrelevant in determining firm value.
In imperfect capital markets, capital structure can affect the value of

the firm.
INVESTMENT DECISIONS AND FIRM

VALUE
The value of the firm does depend on:

the expected future cash flows to be generated by the
firms assets, and

the required return on these cash flows.
An asset will add value if its expected return (the

Internal Rate of Return or IRR) exceeds its required
return (its cost of capital).
THE MARKET LINE FOR CAPITAL BUDGETING

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

rj = rf + j(rm rf)
where
rj = cost of capital for project j,

rf = riskless return
rm = required return on the market portfolio
j = beta of project j
(
R
r
)
i
f
i
M
f
rriiff212((R
rR
)r
M
fM
M
rf)
GRAPHICAL REPRESENTATION OF THE

PROJECT MARKET LINE
Risk
Premium
for a
project
twice as
risky as
the market
rf
Riskless
return
Market
Risk
Premium
Risk Premium for a

project half as risky
as the market
0.5
1.0
2.0
USING THE PROJECT MARKET LINE
A capital budgeting project costs $2,300, and

expects to return $410 per year in perpetuity. If rf
= 7%, rm = 14%, and j = 1.3, what is the projects
NPV?
rj = rf + j(rm - rf) = 7 + 1.3(14 7) = 16.1%
NPV = 410/0.161 2,300
= 2,546.58 2,300 = $246.58
10
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 expected future cash flows
may be offset by a corresponding increase in
risk because an increase in risk increases the
projects cost of capital.
This is like the stated price and special
financing interest rate, you can have the same

payment with different price rate combinations.
An offset like this is simply a risk-return

trade-of.
11
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.
Financial leverage is moving along the CML
lending or borrowing.
12
OPERATING LEVERAGE
Operating leverage arises from the mix of fixed versus
variable costs of production.

High fixed costs (and correspondingly lower variable
costs per unit) results in high operating leverage.
The firms profits are more sensitive to changes in sales.
Conversely, low fixed costs (and correspondingly higher
variable costs per unit) result in low operating leverage.
13
OPERATING LEVERAGE
Jewel Plastics, Inc., plans to make plastic jewel cases
for CD-ROM disks. Each packet of 10 cases can be
sold for $5.00. Two alternative manufacturing
technologies are available.
Annual Fixed Costs
Plan A
60,000
Plan B
$100,000
Variable Cost (per unit)
$2.00
$1.00
Ignoring taxes, compute the profits under each plan.
14
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.
15
OPERATING LEVERAGE
Operating leverage affects the risk of the firms
investments, and is unique for each investment.

It affects both the diversifiable as well as the nondiversifiable risk of the investment.
Through its effect on non-diversifiable risk, it also affects
the investments cost of capital.
The firms choice of operating leverage may be limited
by the number of alternative production methods.
16
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.
This increases shareholders risk.
Weve seen financial leverage before, Borrowing to move up the CML.
17
LEVERAGE AND RISK BEARING

Clubs & Stuff is currently all-equity financed. Clubs
expected future cash flows are $300 per year in
perpetuity, with a minimum annual cash flow of $100.
Clubs 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.
18
FINANCIAL LEVERAGE
Currently, the value of Clubs & Stuff is
$300 / 0.15 = $2,000
With $1,000 in debt at 10%, Clubs annual

interest expense will be $100. Since Clubs
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.
Recall that in perfect markets, firm value is
independent of capital structure.
19
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 firms returns vary, the returns to shareholders
will vary more with debt financing than without.

The firm must first pay debtholders the fixed cost of $100 each
year.
The shareholders get the residual.
20
FINANCIAL LEVERAGE
You have a 1-yr $50,000 investment project that is
expected to return 20%. If you can borrow $30,000 of
the money to invest at 10%, putting up only $20,000 of
your own money, what percentage would you expect to
earn on your $20,000?
50,000(0.2) 30,000(0.1) = 7,000
7,000/20,000 = 35%
20% = (0.6)(10%) + (0.4)(X)
X = [20% - (0.6)(10%)]/0.4 = 35%
21
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 firms
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.
22
COMPONENTS OF A FINANCING PACKAGE

Consider a project that is going to be financed with 40%
debt and 60% equity.
The projects initial investment is $8,000 and the NPV is

$2,000.
NPV = Value cost, so the projects TOTAL value is $10,000.
How much debt should the firm use?

(0.40) 10,000 = $4,000.
23
COMPONENTS OF A FINANCING PACKAGE

The project requires an initial investment of $8,000, so the firm will
raise the remaining $4,000 by selling stock.
Because equity gets the NPV, the stock will be worth 4,000 + 2,000 =
$6,000.
This makes the projects financing 40% debt and 60% equity.
24
WACC CALCULATION
Let L = the ratio of debt financing to total financing,
ke
= required return for equity,
kd = required return on debt, and

T = marginal corporate tax rate on
income from the project.
Then,
WACC (1 L)ke L(1 T )k d
25
WACC CALCULATION
Compute the WACC for the Nikko Co. given the following
information:
Nikko has 9 million common shares outstanding priced at
$13.00 each. Next years 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. Nikkos marginal corporate income
tax rate is 34%.
26
WACC CALCULATION
Market value of Nikkos equity =
9 million $13.00 per share = $117 million.
Market value of Nikkos 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 M / $180
L = 35%
27
WACC CALCULATION
To compute the rate of return required by Nikkos
stockholders, we use the constant growth model of
stock valuation.
D1
$1.33
+g =
+ 0.05 = 15. 25%
re =
P0
$13. 00
28
WACC CALCULATION
Because we are interested in measuring the firms current cost of
capital, we use the bond yield currently demanded by the bondholders.
Thus, rd = 10%.
Also, the tax rate, T, is 34%.
W
A
C
(
1
L
)
r
(
1
T
)
r
e
d
W
A
C(0.65)W
2A
0C2.35%
%
0.34)(1%
29
WACC CALCULATION
30
A POTENTIAL MISUSE OF THE WACC

Assume new projects being considered have the same risk as the
average risk of the firms existing operations.
If the firm uses its current WACC, it will accept projects with above
average risk and reject projects with below average risk.
Over time, the risk of the firm would then increase.
31
FINANCIAL LEVERAGE AND BETA

Using the CAPM, we get
WACC = rf + A(rm rf)
Thus, we can see that WACC is independent of the capital
structure since A is unaffected by capital structure.
32

How does financial leverage affect the stocks beta?
Let d denote the beta of the debt and
denote the beta of the
stock.
rd= r + d(r
f
rf) and
re=
rf +
(r
rf)
33

Recall that
WACC = (1 L) re +L (1 T) rd
WACC = rf + A (rm rf)
Plugging in the CAPM specifications for re and rd and rearranging the

terms, we get:
(1 LT) A = L(1 T)d + (1 L)
34
(
)AT
1
(1 LT) A = L(1 T)d + (1 L)
Suppose that debt is risk-free. Then d = 0, and:
35
PRACTICAL PRESCRIPTION FOR ESTIMATING A

WACC
The Evergreen Sprinkler Corp. (ESC) is considering
expanding its current operations, and you are asked to
estimate the WACC to be used for this project. ESCs
outstanding stock is valued at $16.8 million, while its debt
has a market value of $7.2 million. ESCs stock has a beta
of 1.80 and its debt is risk free. ESCs marginal tax rate is
37%. The risk-free rate is 5% and the required return on
the market portfolio is 13%.
(A1L
)T(10.37)1801.473
36
WACC FOR A CAPITAL BUDGETING PROJECT IN

THE SAME BUSINESS
Since ESCs debt is worth $7.2 million and its equity
is worth $16.8 million, the value of L is $7.2/($7.2 +
$16.8) or 0.30.
Further, = 1.80 and T = 0.37.

Thus, the beta of the assets of ESC is:
37
WACC FOR A CAPITAL BUDGETING PROJECT IN

THE SAME BUSINESS
WACC = rf + A (rm rf)
=5% + 1.42(13% 5%)
= 16.36%

Cost of Capital

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COST OF CAPITAL

DR. RICARDO H ARCHBOLD

Source: Emery Finnerty Stowe

THE COST OF CAPITAL

The Cost of Capital is often misinterpreted.

The relevant cost is the opportunity cost.

Source: Emery Finnerty Stowe

THE COST OF CAPITAL

The Cost of Capital is the required return for a capital budget.

It reflects the risk of the project.

It is the opportunity cost of funds tied up in the project.

Source: Emery Finnerty Stowe

Source: Emery Finnerty Stowe

FINANCING DECISIONS AND FIRM VALUE

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

In imperfect capital markets, capital structure can affect the value of

INVESTMENT DECISIONS AND FIRM

Source: Emery Finnerty Stowe

The value of the firm does depend on:

firms assets, and

An asset will add value if its expected return (the

Source: Emery Finnerty Stowe

THE MARKET LINE FOR CAPITAL BUDGETING

obtain the cost of capital for a capital budgeting project.

rj = cost of capital for project j,

Source: Emery Finnerty Stowe

GRAPHICAL REPRESENTATION OF THE

Risk Premium for a

Source: Emery Finnerty Stowe

USING THE PROJECT MARKET LINE

A capital budgeting project costs $2,300, and

Source: Emery Finnerty Stowe

VALUE AND THE RISK-RETURN TRADE-OFF

the expected future cash flows

financing interest rate, you can have the same

An offset like this is simply a risk-return

Source: Emery Finnerty Stowe

depends only on the non-diversifiable risk.

Source: Emery Finnerty Stowe

variable costs of production.

Source: Emery Finnerty Stowe

Annual Fixed Costs

Variable Cost (per unit)

Ignoring taxes, compute the profits under each plan.

Source: Emery Finnerty Stowe

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

Under Plan B, profits at a sales level of 50,000 units are

Source: Emery Finnerty Stowe

investments, and is unique for each investment.

Source: Emery Finnerty Stowe

As financial leverage increases, the variability of shareholder returns

This increases shareholders risk.

Weve seen financial leverage before, Borrowing to move up the CML.

Source: Emery Finnerty Stowe

LEVERAGE AND RISK BEARING

Source: Emery Finnerty Stowe

With $1,000 in debt at 10%, Clubs annual

Issuing $1,000 of debt and paying the

Source: Emery Finnerty Stowe

As the firms returns vary, the returns to shareholders

will vary more with debt financing than without.

Source: Emery Finnerty Stowe

Source: Emery Finnerty Stowe

THE WEIGHTED AVERAGE COST OF CAPITAL