Cost of Capital

1
Session 6

• Cost of Capital

2
COST OF CAPITAL

• WEIGHTED AVG COST OF CAPITAL (WACC)
• r wdrd were
• wd proportion of assets funded by debt
• rd After-tax cost of debt
• we proportion of assets funded by equity
• re cost of equity

3
COST OF CAPITAL

• rd 10 rp 15 re 18
• wd 40 wp 10 we 50
• Proof Firm raises 100 -- Buys an Asset
• Asset earns 14.50
• Debt 40 _at_ 10 4.00
• Prefs 10 _at_ 15 1.50
• Equity 50 _at_ 18 9.00
• Total 14.50

WACC 40(.10)10(.15)50(.18) 4 1.50 9
14.50
4
COST OF CAPITAL

• WEIGHTS
• BOOK VALUE
• MARKET VALUE
• TARGET
• COSTS
• HISTORIC
• CURRENT (MARGINAL)

5
Cost Of Debt

• ESTIMATING COSTS
• DEBT BANK RATE
• YIELD TO MATURITY ON BONDS
• Example 10 year 8 coupon bond is trading at
  951
• Yield to maturity is 8.75
• N20 PV-951 Pmt40 FV1000

6
Cost Of Equity

• Capital Asset Pricing Model
• rf Risk Free Rate
• ? Relative Risk of Firm
• Mkt Prem Risk Premium Paid on Average Company
• rmkt - rf

re rf ? (Mkt Premium)
7
Cost of Equity Components

• Risk Free Rate
• 10-year Treasury Bond Rate
• 3-Month Treasury Bill Rate
• Market Premium
• Historic Average of 7 to 8
• Growth in economy plus inflation 5 to 6

8
Example Boeing

• Book Value .
• Debt 17,032 61
• Equity 10,825 39
• 27,857 100
• Mkt Value .
• Debt 17,032 30
• Equity 40,205 70
• (837.648) 57,237 100

9
COST OF CAPITAL

• Debt Bond Rate 9.73
• rd 9.73 (1-0.34) 6.42
• CAPM re rf ?(Mkt Premium)
• 5.50 0.935(5.00)
• 5.50 4.68
• 10.18

10
BOEINGS WACC

• BV Weights
• WACC .616.42 .3910.18
• 3.92 3.97
• 7.89
• MV Weights
• WACC .306.42 .7010.18
• 01.93 7.13
• 9.05

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Boeing Case Changing Debt

• Target Cap Structure 60 Debt, 40 Equity
• WACC .66.42) .4(10.18)
• 3.85 4.07
• 7.92

12
Effect of Debt on the WACC
13
FINANCIAL STRUCTURE
14
LEVERAGE
15
Effect of Leverage on Beta

• ?asset ?unlevered WE ?equity
• ?tgt ?asset / WEtgt
• ?port w1?1 w2?2 w3?3

16
Boeing Case Beta Effect

• Target Cap Structure 60 Debt, 40 Equity
• ?asset ?unlevered (WE) ?equity
• .70.935
• .655
• ?tgt ?asset / (WE)tgt
• .655/.40
• 1.64

17
BA Case Beta Effect (contd.)

• re rf ?(Mkt Premium)
• 5.5 1.64(5)
• 5.5 8.2
• 13.7
• WACC .60(6.42) .40(13.7)
• 3.85 5.48
• 9.33

18
BA Case Debt Cost Effect

• re rf ?(Mkt Premium)
• 5.5 1.64(5)
• 13.7
• rd 13.5 (1-.34) 8.91
• WACC .60(8.91) .40(13.7)
• 5.35 5.48
• 10.83

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EFFECT OF FIN STRUCTURE ON WACC
20
Plot of Boeings WACC
21
Boeings WACC
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Notes on WACC Computations

• 1) Equity versus entity approach
• 2) Peer group analysis industry versus company
  betas.
• 3) Leveraged and unleveraged betas.
• 4) F Flexibility
• R Risk
• I Income
• C Control
• T Taxes

23
Observations on Financial Structure

• 1)You can make a lot more money by smart
  investment decisions (real assets) than by smart
  financing decisions.
• 2)It is very hard to guess direction of the
  markets.
• 3)Exotic securities of value only if you are
  first in the queue. And then you better know
  what you are doing!

24
Observations on Financial Structure

• 4)Think about distress costs. These are less
  important (i.e. you can have more debt) if
• Tangible assets
• Lower growth
• Lower R D
• Less Reliance advertising

25
Observations on Financial Structure

• 5)Consider impact on firm of
• Employee losses
• Customer defections
• Lost opportunities (NPV 0 projects foregone)
• Slower investment
• R D
• Advertising
• Refurbishment/Replacement
• Technology