Chapter 14, Cost of Capital

security market line, or SML. Our primary conclusion was that the required or expected return on a risky investment depends on three things:

1) The risk-free rate, Rf . 2) The market risk premium, E(RM) − Rf . 3) The systematic risk of the asset relative to average, which we called its beta coefficient, β.

The WACC for a firm reflects the risk and the target capital structure of the firm's existing assets as a whole.

As a result, strictly speaking, the firm's WACC is the appropriate discount rate only if the proposed investment is a replica of the firm's existing operating activities

The Cost of Debt, RD

For a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. The coupon rate is irrelevant.

The primary advantage of the dividend growth model approach is its simplicity. .

It is both easy to understand and easy to use. There are a number of associated practical problems and disadvantages

INTERNAL EQUITY AND FLOTATION COSTS

Notice that whether equity is generated internally or externally makes a big difference because external equity has a relatively high flotation cost. We now assign a value of zero to the flotation cost of equity because there is no such cost

This section discusses two approaches to determining the cost of equity

The dividend growth model approach and the security market line (SML) approach.

Problems with the subjective approach

The effect of this crude partitioning is to assume that all projects either fall into one of three risk classes or else are mandatory. Within each risk class, some projects will presumably have more risk than others, and the danger of making incorrect decisions still exists.

The firm should use the target weights, even if it can finance the entire cost of the project with either debt or equity. The fact that a firm can finance a specific project with debt or equity is not directly relevant.

To take this into account, the firm should always use the target weights in calculating the flotation cost.

Finally, we will use the symbol V (for value) to stand for the combined market value of the debt and equity:

V = E + D

WACC equation

WACC = (E/V) × RE + (D/V) × RD × (1 − TC) if there is preferred stock, add (P/V) times the rate of the preferred

if it is risky, is greater than the risk-free rate, and the appropriate discount rate would exceed the risk-free rate.

We will henceforth use the terms required return, appropriate discount rate, and cost of capital more or less interchangeably because, as the discussion in this section suggests, Page 460they all mean essentially the same thing. The key fact to grasp is that the cost of capital associated with an investment depends on the risk of that investment

THE SML AND THE WACC

When we are evaluating investments with risks that are substantially different from those of the overall firm, use of the WACC will potentially lead to poor decisions. Figure 14.1 illustrates why. (WACC if flat, SML is up-word sloping)

REQUIRED RETURN VERSUS COST OF CAPITAL

When we say that the required return on an investment is, say, 10 percent, we usually mean that the investment will have a positive NPV only if its return exceeds 10 percent. Another way of interpreting the required return is to observe that the firm must earn 10 percent on the investment to compensate its investors for the use of the capital needed to finance the project. This is why we could also say that 10 percent is the cost of capital associated with the investment.

the weighted average flotation cost, fA

fA=(E/V)×fE+(D/V)×fD

Economic Value added

he basic idea behind EVA and similar strategies is straightforward. Suppose we have $100 million in capital (debt and equity) tied up in our firm, and our overall WACC is 12 percent. If we multiply these together, we get $12 million. f our cash flow from assets is less than this, we are, on an overall basis, destroying value; if cash flow from assets exceeds $12 million, we are creating value.

The primary disadvantages of the dividend growth model

only to companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate. As our previous example illustrates, this will never be exactly the case. More generally, the model is really applicable only to cases in which reasonably steady growth is likely to occur. Finally, this approach really does not explicitly consider risk, very sensitive to the estimated growth rate

We emphasize here that the correct way to proceed is to use the market values of the debt and equity.

read the first part

DRAWBACKS of The SML approach

requires that two things be estimated, To the extent that our estimates are poor, the resulting cost of equity will be inaccurate. we essentially rely on the past to predict the future when we use the SML approach. Economic conditions can change quickly; so as always, the past may not be a good guide to the future.

Floatation costs

the costs associated with issuing new stocks or bonds. I.E, wants to raise 100 but the cost is .1. 100 = (1-.1)x Amount raised

Cost of Equity

the return that equity investors require on their investment in the firm

Cost of Debt

the return that lenders require on the firm's debt

pure play approach

the use of a WACC that is unique to a particular project, based on companies in similar lines of business

The cost of capital depends primarily on .

the use of the funds, not the source

Weighted Average Cost of Capital (WACC)

the weighted average of the cost of equity and the aftertax cost of debt

The subjective approach to project analysis:

Assigned a category (ex: high, moderate, and low risk, or mandatory), and an adjustment factor (ex: high has a +6% discount rate factor, 0% for Moderate, and -4% for low risk.

The SML approach has two primary advantages.

First, it explicitly adjusts for risk. Second, it is applicable to companies other than just those with steady dividend growth. It may be useful in a wider variety of circumstances.

this overall cost of capital will be a mixture of the returns needed to compensate its creditors and those needed to compensate its stockholders.

In other words, a firm's cost of capital will reflect both its cost of debt capital and its cost of equity capital.

Dividend growth model

RE = D1/P0 + g

Using SMl, we get

RE = Rf + βE × (RM − Rf)

The cost of preferred stock, RP, is thus:

RP = D/P0

In this case, the firm's overall cost of capital is really a mixture of two different costs of capital, one for each division. If the two divisions were competing for resources, and the firm used a single WACC as a cutoff, which division would tend to be awarded greater funds for investment?

The answer is that the riskier division would tend to have greater returns (ignoring the greater risk), so it would tend to be the "winner." The less glamorous operation might have great profit potential that would end up being ignored.

Unlike a firm's cost of equity, its cost of debt can normally be observed either directly or indirectly:

The cost of debt is the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets.