Title: Introduction to Cost of Capital
1Introduction to Cost of Capital
- Idea Find the appropriate discount rate for a
firms assets as a whole. - The cost of capital reflects the average cost of
funds for the firm. In other words it is the
return required by investors in the firm. - Cost of capital depends mostly on the assets (use
of funds), not the financing (source of funds).
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2Why is Cost of Capital Important?
- A firms Weighted Average Cost of Capital (WACC)
is the correct r to use in the DCF formulas
when the project is of average risk. - For projects of different risk we need to make
adjustments. - Knowing the cost of capital is critically
important in making investment decisions.
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3Example
- Firm currently has
- 60 equity, cost of 15
- 40 debt, cost of 7, 30 tax rate
- Project is same risk as other assets
- Requires 1 million investment, pays 100,000 in
perpetuity. - If the firm raises the 1 million by issuing
debt, what is the project NPV? - What if the firm issues equity instead?
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4All Equity Firms
- With no debt, the cost of capital is just the
cost of equity. - So where do we get cost of equity?
- Dividend Growth Model
- CAPM
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5Estimating Cost of Equity
- Dividend growth model
- requires estimates of g and the dividend yield.
- Does not work well when these are changing.
- CAPM
- need estimates of beta and E(RM)
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6Dividend Growth Example
- A firm expects dividends to grow 5 per year.
- The next dividend is expected to be 1.
- The current price is 10.
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7CAPM Example
- Suppose rf 6 and E(RM) 13.
- Find rE if the stock has a beta of 1.5.
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8Which Approach?
- Dividend Growth
- Simple
- g constant not reasonable
- Sensitive to assumptions
- no risk adjustment
- based on historical
- CAPM
- Adjusts for risk
- g can vary
- requires estimate of b and E(RM)
- often historically-based
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9Cost of Debt
- Ignore the cost of capital idea for a moment and
focus only on the cost of debt. - Use the bond formulas to find rD
- Alternatively, look at the required return on
debt with similar risks and provisions.
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10Combining Debt and Equity
- Combining the cost of debt and the cost of equity
gives the cost of capital for all the assets
(WACC). - Alternatively, we can find the asset beta
- Portfolio betas are weighted averages
- View a firm as portfolio of debt and equity
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11WACC Calculation
- To calculate the WACC we need
- rE, and wE
- rD, wD, and the tax rate t
- The WACC represents the average cost of financing
the assets. - It adjusts for the tax shield provided by debt.
- Note We are ignoring complications such as
flotation costs.
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12WACC Example
- Consider the firm in the opening example.
- 60 equity, rE 15
- 40 debt, rD 7, 30 tax rate
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13Asset Beta Example
- A firm has debt beta, bD 0.1 and asset beta, bA
1.2. - The market value of the firm is 1 billion, and
the equity has a value of 700 million. - The market return is expected to be 13, with a
6 riskless rate.
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14Note on Asset Betas
- Asset betas apply to all assets, including
equity, entire firms, specific divisions, or
individual projects. - Equity betas are influenced by the financing
choice, but asset betas are not. - To estimate project betas from the betas of peer
firms, convert equity betas to asset betas to
account for differences in financing.
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15Project Cost of Capital
- The WACC idea is appropriate for use in capital
budgeting only when the project is of the same
risk as the entire firm. - If the project is of different risk, we need to
make adjustments. - Pure play approach
- Subjective approach
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