Weighted Average Cost of Capital

1
Weighted Average Cost of Capital

• Chapter Fourteen
• Ross, Westerfield, Jordan, Roberts

2
Capital Budgeting

• Cost of project
• Pro forma income statements estimate cash flows
• Source of financing for the project
• Current capital structure?
• Target capital structure?
• Probably source of financing
• Function of risk of the project

3
Optimal leverage

• Optimal proportions of debt and equity financing
  exist
• Dividend payments are not tax deductible
• Optimal leverage, cost benefits of debt
• Tax deductibility reduces the real cost of
  borrowing
• Costs of financial distress increase the cost of
  borrowing
• Capital structure weights
• Favor debt financing for less risky asset
  structures
• Mature firms, utilities
• Favor equity financing for more risky assets
• Dotcoms, junior mining, junior energy firms

4
Capital structure weights

• Proportions of financing of capital budget
• Value of financing arranged through retained
  earnings
• New issues
• Equity
• Prefered stock

5
Debt Financing

• Current liabilities
• Payables
• accruals
• Bank borrowing
• Lines of credit
• Mortgage loans
• Bankers acceptances
• Corporate Bills
• Zero-coupon bills
• Corporate Bonds
• Coupon bonds
• Mortgage bonds

6
Floatation costs

• Retained earnings are lower cost
• Bank loans have lower cost
• New equity include floatation costs
• Up to 10 includes
• Costs of pricing the issue
• Risk factors
• Costs of placing issue
• Return to the investment bank
• New debt also include floatation costs
• Up to 5
• Any adjustment for floatation costs calculated in
  NPV

7
Adjustment for floatation

• Assume 100,000,000 investment
• 20 financing through Retained Earnings
• 30 financing through New Equity
• 8 floatation cost
• 50 financing through New Debt
• 5 floatation cost

8
Cost of Equity

• Compensates investors for use of capital
• Risk sensitive
• Depends on use of funds
• Same level of risk
• Increasing production facilities
• Different level of risk
• Changing the technology
• Going into a new market
• Sensitive to financial leverage of the firm
• Mix of investors - debt/equity

9
Dividend Growth Model

• Dividend yield capital appreciation
• Assumes dividend is paid
• Growth rate (capital appreciation)
• Calculate a historical growth rate
• Forecast
• Can microsoft maintain historical growth??
• Demand factors in the market
• Potential retained earnings

10
Dividend Growth Model cont

• Alternative method
• Disadvantages of the dividend growth model
• Firms must pay dividends
• If not
• Cost of equity very sensitive to growth
• Risk not considered

11
Dividend Growth Model Example

• Dividend paid last year 0.94
• Yesterdays closing price 21.46
• Growth rate
• Historical average last five years 7.69

12
Security Market Line approach

• Advantages
• Adjusts for risk
• Independent of dividend policy
• Disadvantages
• Proxy for risk-free rate, historical T-bill rate
• Proxy for market rate, historical TSE index
• Estimate Beta, historical

13
Security Market Line Approach

• Risk-free rate of return 3.5
• Return to market 10.45
• Beta for the project 1.43597

14
Cost of Debt

• Market yield
• Current bond rating
• approximation
• Historical market rate for firm
• Approximation
• Disadvantages
• Does not price risk of the project to the market

15
Cost of Preferred Stock

• Return to preferred stock
• Fixed dividend
• Stock price varies to adjust for change in risk

16
Calculation of WACC

• Financing from all sources sums to one
• Interest payments are tax deductible
• wacc

17
Example

• Snappy corp
• Capital budget (105,152,471)
• NCFs for seven years (in millions)
• 20.4, 19.5, 21.9, 24.7, 22.8, 21.9, 20.3
• Financing proportions
• E 50, D 50
• Financing costs
• Rates E 13.48, D 8.6
• Tax rate 40

18
Solution

• Floatation costs already included
• True cost included
• 15 floatation for equity
• 8 floatation for debt
• Split of equity
• Retained earnings
• New equity

19
Net Present Value of Project
20
Issues

• Divisional cost of capital
• Different parts of the firm may have different
  costs of capital
• Hotels
• Airlines
• New ventures
• Estimate new wacc
• Subjective estimates
• Put on risk premia for types of investments