The Cost of Capital (Chapter 15)

OVU-ADVANCE
Managerial Finance
D.B. Hamm, rev. Jan 2006
“Cost of Capital?”
 When we say a firm has a “cost of capital” of,
for example, 12%, we are saying:
– The firm can only have a positive NPV on a project
if return exceeds 12%
– The firm must earn 12% just to compensate
investors for the use of their capital in a project
– The use of capital in a project must earn 12% or
more, not that it will necessarily cost 12% to
borrow funds for the project
 Thus cost of capital depends primarily on the
USE of funds, not the SOURCE of funds
Weighted Average Cost of Capital
(overview)
 A firm’s overall cost of capital must reflect the
required return on the firm’s assets as a
whole
 If a firm uses both debt and equity financing,
the cost of capital must include the cost of
each, weighted to proportion of each (debt
and equity) in the firm’s capital structure
 This is called the Weighted Average Cost of
Capital (WACC)
Cost of Equity
The Cost of Equity may be derived from the dividend
growth model as follows:
P = D / RE – g
Where the price of a security equals its dividend (D)
divided by its return on equity (RE) less its rate of growth
(g). We can invert the variables to find RE as follows:
RE = D / P + g
But this model has drawbacks when considering that some
firms concentrate on growth and do not pay dividends at
all, or only irregularly. Growth rates may also be hard to
estimate. Also this model doesn’t adjust for market risk.
Cost of Equity (2):
Therefore many financial managers prefer the security
market line/capital asset pricing model (SML or
CAPM) for estimating the cost of equity:

RE = Rf + βE x (RM – Rf)
or Return on Equity = Risk free rate + (risk factor x
risk premium)
Advantages of SML: Evaluates risk, applicable to
firms that don’t pay dividends
Disadvantages of SML: Need to estimate both Beta
and risk premium (will usually base on past data, not
future projections.)
Cost of Debt
 The cost of debt is generally easier to
calculate
– Equals the current interest cost to borrow new
funds
– Current interest rates are determined from the
going rate in the financial markets
– The market adjusts fixed debt interest rates to the
going rate through setting debt prices at a discount
(current rate > than face rate) or premium (current
rate < than face rate)
Weighted Average Cost of Capital
(WACC)
 WACC weights the cost of equity and the cost
of debt by the percentage of each used in a
firm’s capital structure
 WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
– (E/V)= Equity % of total value
– (D/V)=Debt % of total value
– (1-Tc)=After-tax % or reciprocal of corp tax rate
Tc. The after-tax rate must be considered
because interest on corporate debt is deductible
WACC Illustration
ABC Corp has 1.4 million shares common valued at $20
per share =$28 million. Debt has face value of $5 million
and trades at 93% of face ($4.65 million) in the market.
Total market value of both equity + debt thus =$32.65
million. Equity % = .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18%
Tax rate is 40% Current yield on market debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
Final notes on WACC
 WACC should be based on market rates and
valuation, not on book values of debt or
equity. Book values may not reflect the
current marketplace
 WACC will reflect what a firm needs to earn
on a new investment. But the new investment
should also reflect a risk level similar to the
firm’s Beta used to calculate the firm’s RE.
– In the case of ABC Co., the relatively low WACC
of 8.81% reflects ABC’s β=.74. A riskier
investment should reflect a higher interest rate.
Cartoon
Pause for Class Case
Financial Leverage (Chapter 17)

OVU-ADVANCE
Managerial Finance
D.B. Hamm, Jan. 2006
Equity vs Debt Financing (1)

 Since the WACC is the weighted average of

cost of equity + cost of debt, we can vary the
WACC by changing the mix of debt + equity
– If cost of debt < cost of equity, we can reduce
WACC by increasing the % of debt in the mix and
vice versa
 The value of the firm (its earning’s potential)
is maximized when its WACC is minimized.
– A firm with a lower cost of capital can more easily
return profits to its owners
Debt vs Equity Financing (2):
 The optimal, or target capital structure is the
structure with the lowest possible WACC
 The Interest Tax Shield (deductibility of corp.
interest) is critical here, because it effectively
lowers the cost of debt.
 Therefore for many firms, the use of financial
leverage (debt financing) can lower WACC
and increase profitability
Debt vs. Equity Financing (3):
 Warning: choice between debt & equity can
not be based on interest rates, etc. alone.
Risk must be considered as well
 Systematic risk (see ch. 13) consists of two
factors which must be considered
– Business risk—risk inherent in firm’s operations
– Financial risk—risk inherent in using debt
financing
 Remember debt is a multiplier:
– it can multiply returns if returns > cost of debt; but
– it can also multiply losses, or returns < cost of
debt.
Pause for class case
illustrating Financial
Leverage
Financial Leverage Considerations:
 If profits are down, dividends (the key cost of
equity financing) can often be deferred.
 Interest (cost of debt) must always be paid for
a firm to remain solvent
 Financial distress costs: costs incurred with
going bankrupt or costs that must be paid to
avoid bankruptcy
 According to the static theory of capital
structure, gains from the tax shield are offset
by the greater potential of financial distress
costs.
Optimal Capital Structure:
 Optimal capital structure is achieved by
finding the point at which the tax benefit of an
extra dollar of debt = potential cost of
financial distress. This is the point of:
– Optimal amount of debt
– Maximum value of the firm
– Optimal debt to equity ratio
– Minimal cost of WACC
 This will obviously vary from firm to firm and
takes some effort to evaluate. No single
equation can guarantee profitability or even
survival
Critical considerations:
 Firms with greater risk of financial distress must
borrow less
 The greater volatility in EBIT, the less a firm should
borrow (magnify risk of losses)
 Costs of financial distress can be minimized the more
easily firm assets can be liquidated to cover
obligations
 A firm with more liquid assets may therefore have
less financial risk in borrowing
 A firm with more proprietary assets (unique to the
firm, hard to liquidate) should minimize borrowing
Congratulations!
You are now all
financial wizards!
End of module!