Chapter outline. Chapter orientation

CHAPTER 12

Cost of Capital

CHAPTER ORIENTATION

In Chapters 7 and 8 we considered the valuation of debt and equity instruments. The concepts advanced there serve as a foundation for determining the required rate of return for the firm and for specific investment projects. The objective in this chapter is to determine the required rate of return to be used in evaluating investment projects.

CHAPTER OUTLINE

I. The concept of the cost of capital

A. Defining the cost of capital:

1. The rate that must be earned in order to satisfy the required rate of return

2. The rate of return on investments at which the price of a firm's common stock will remain unchanged.

B. Investor’s required rate of return is not the same as the firm’s cost of capital due to

1. Taxes: Interest payments on debt are tax deductible to the firm.

2. Flotation costs: Firms incur expenses when issuing securities that reduce the proceeds to the firm.

C. Financial Policy

1. Each type of capital used by the firm (debt, preferred stock, and common stock) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital.

2. Using the cost of a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems.

II. Computing the weighted cost of capital. A firm's weighted cost of capital is a function of (l) the individual costs of capital, (2) the capital structure mix, and (3) the level of financing necessary to make the investment.

A. Determining individual costs of capital.

1. The before-tax cost of debt is found by trial-and-error by solving for kd in

NP_d = +

where NP_d = the market price of the debt, less flotation costs,

$It = the dollar interest paid to the investor each period,

$M = the maturity value of the debt

k_d = before-tax cost of the debt (before-tax required rate of return on debt)

n = the number of periods to maturity.

The after-tax cost of debt equals: k_d (1 - T)

where T = corporate tax rate

2. Cost of preferred stock (required rate of return on preferred stock), kps, equals the dividend yield based upon the net price (market price less flotation costs), or

kps = =

3. Cost of Common Stock. There are two measurement techniques to obtain the required rate of return on common stock.

a. dividend-growth model

b. capital asset pricing model

4. Dividend growth model

a. Cost of internally generated common equity, kcs

kcs = +

kcs = + g

b. Cost of new common stock, kncs

kncs = + g

where NP_cs = the market price of the common stock less flotation costs incurred in issuing new shares.

5. Capital asset pricing model

kc = krf + b(km- krf)

where kc = the cost of common stock

krf = the risk-free rate

b = beta, measure of the stock's systematic risk

km = the expected rate of return on the market

6. It is important to notice that the major difference between the equations presented here and the equations from Chapters 7 and 8 is that the firm must recognize the flotation costs incurred in issuing the security.

B. Selection of weights. The individual costs of capital will be different for each source of capital in the firm's capital structure. To use the cost of capital in investment analyses, we must compute a weighted, or overall, cost of capital.

1. It will be assumed that the company's current financial mix resulting from the financing of previous investments is relatively stable and that these weights will closely approximate future financing patterns.

2. In computing weights, we could use either the current market values of the firm's securities or the book values as shown in the balance sheet. Since we will be issuing new securities at their current market value, and not at book (historical) values, we should use the market value of the securities in calculating our weights.

III. PepsiCo approach to weighted average cost of capital

A. PepsiCo calculates the divisional cost of capital for its snack, beverage and restaurant organizations by first finding peer-group firms for each division and using their average betas, after adjusting for differences in financial leverage, to compute the division's cost of equity. They also use accounting betas in estimating the cost of equity. They then compute the cost of debt for each division. Finally, they calculate a weighted cost of capital for each division.

B. PepsiCo's WACC basic computation

kwacc = kcs + kd[1-T]

where:

kwacc = the weighted average cost of capital

kcs = the cost of equity capital

kd = the before-tax cost of debt capital

T = the marginal tax rate

E/(D+E)= percentage of financing from equity

D/(D+E)= percentage of financing from debt

C. Calculating the Cost of Equity

Based on capital asset pricing model:

kcs = krf + b(km- krf)

where:

kcs = the cost of common stock

krf = the risk-free rate

b = beta, measure of the stock's systematic risk

km = the expected rate of return on the market

Betas for each division are estimated by calculating an average unlevered beta from a group of divisional peers.

The average beta for each division's peer group is unlevered and then re-levered using that division's target debt-to-equity ratio.

D. Calculating the Cost of Debt

The after-tax cost of debt is equal to:

kd(1 - T)

where:

kd = before-tax cost of debt

T = marginal tax rate

IV. Required rate of return for individual projects

A. Using the weighted cost of capital. Investments with an internal rate of return exceeding the weighted cost of capital should be accepted. Doing so, we must assume that the project has similar business risk as existing assets. Otherwise, the weighted cost of capital does not apply.

B. The weighted cost of capital, k_waccdoes not allow for varying levels of project risk. We need to specify the appropriate required rates of return for investments having different amounts of risk.

C. Risk also results from the decisions made within the company. This risk is generally divided into two classes:

1. Business risk is the variability in returns on assets and is affected by the company’s investment decisions.

2. Financial risk is the increased variability in returns to the common stockholder as a result of using debt and preferred stock.

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