Weighted Average Costing

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Lecture 9
Cost of Capital
 Cost of capital is the weighted average of the required returns of
the securities that are used to finance the firm. We refer to this as
the firm’s Weighted Average Cost of Capital, or WACC.
 Most firms raise capital with a combination of debt, equity, and
hybrid securities.
 WACC incorporates the required rates of return of the firm’s
lenders and investors and the particular mix of financing sources
that the firm uses.

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How does riskiness of firm affect
WACC?
 Required rate of return on securities will be higher if
the firm is riskier.
 Risk will influence how the firm chooses to finance,
i.e., the proportion of debt and equity.
 WACC is useful in a number of settings:
 WACC is used to value the firm.
 WACC is used as a starting point for determining
the discount rate for investment projects the firm
might undertake.
 WACC is the appropriate rate to use when
evaluating performance, specifically whether or
not the firm has created value for its
shareholders.

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Why Cost of Capital Is Important
 We know that the return earned on
assets depends on the risk of those
assets
 The return to an investor is the same
as the cost to the company
 Our cost of capital provides us with an
indication of how the market views the
risk of our assets
 Knowing our cost of capital can also
help us determine our required return
for capital budgeting projects 14-3

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Required Return
 The required return is the same as the
appropriate discount rate and is based on
the risk of the cash flows
 We need to know the required return for
an investment before we can compute the
NPV and make a decision about whether
or not to take the investment
 We need to earn at least the required
return to compensate our investors for the
financing they have provided
14-4

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“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

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What sources of long-term capital do
firms use?
Long-Term Capital
Long-Term Debt Preferred Stock Common Stock
Retained Earnings New Common Stock

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Capital components are sources of
funding that come from investors.
Accounts payable, accruals, and
deferred taxes are not sources of
funding that come from investors, so
they are not included in the
calculation of the cost of capital.
We do adjust for these items when
calculating the cash flows of a
project, but not when calculating the
cost of capital.

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Should we focus on before-tax or
after-tax capital costs?
Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
Most firms incorporate tax effects in
the cost of capital. Therefore, focus
on after-tax costs.
Only cost of debt is affected.

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Should we focus on historical
(embedded) costs or new (marginal)
costs?
The cost of capital is used primarily
to make decisions which involve
raising and investing new capital.
So, we should focus on marginal
costs.

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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)

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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.

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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.)

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The Dividend Growth Model Approach
Start with the dividend growth model
formula and rearrange to solve for RE
g
P
D
R
g
R
D
P
E
E




0
1
1
0
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Advantages and Disadvantages of
Dividend Growth Model
 Advantage – easy to understand and use
 Disadvantages
 Only applicable to companies currently
paying dividends
 Not applicable if dividends aren’t growing at
a reasonably constant rate
 Extremely sensitive to the estimated growth
rate – an increase in g of 1% increases the
cost of equity by 1%
 Does not explicitly consider risk
14-14

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The SML Approach
 Use the following information to compute
our cost of equity
 Risk-free rate, Rf
 Market risk premium, E(RM) – Rf
 Systematic risk of asset, 
)
)
(
( f
M
E
f
E R
R
E
R
R 

 
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Advantages and Disadvantages of SML
 Advantages
 Explicitly adjusts for systematic risk
 Applicable to all companies, as long as we can
estimate beta
 Disadvantages
 Have to estimate the expected market risk
premium, which does vary over time
 Have to estimate beta, which also varies over
time
 We are using the past to predict the future,
which is not always reliable 14-16

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Example – Cost of Equity
 Suppose our company has a beta of 1.5. The
market risk premium is expected to be 9%, and
the current risk-free rate is 6%. We have used
analysts’ estimates to determine that the market
believes our dividends will grow at 6% per year
and our last dividend was $2. Our stock is
currently selling for $15.65. What is our cost of
equity?
Using SML: RE = 6% + 1.5(9%) = 19.5%
Using DGM: RE = [2(1.06) / 15.65] + .06 =
19.55%
When possible average the two methods
14-17

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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)

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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