Chapter 12 – Determining the Cost of Capital

Introduction

Capital is a firm's sources of financing, which includes debt, equity, and other securities that it may have outstanding. Typical firms raise money by selling shares of stock and borrowing from lenders such as banks, etc. The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. As financial managers, we must take into account each component of the firm's capital structure when deciding the firm's overall cost of capital. Usually, a firm's overall cost of capital should be a blend of different sources. We calculate the firm's overall cost of capital as a weighted average of its equity and debt costs of capital, also known as the weighted average cost of capital. It is useful to think about the market-value balance sheet where assets, debt, and equity are all listed in terms of their market values, instead of their book values. Also, we can calculate the WACC a couple of different ways. First, we begin with the simple case where a firm does not issue debt. We call this an unlevered firm that pays out all of the free cash flows generated by its assets to its equity holders. On the other hand, a levered firm is a firm that has debt outstanding. Leverage, therefore, is the relative amount of debt on a firm's balance sheet.
Weighted Average Cost of Capital (before tax)
r = [(Fraction of Firm Value Financed by Equity) x (Equity Cost of Capital)] + [(Fraction of Firm Value Financed by Debt) x (Debt Cost of Capital)]

The Firm's Costs of Debt and Equity Capital

One of the tools we will utilize will be the Yield to Maturity, which we an use to estimate the firm's current cost of debt. It is the yield that the investors demand to hold the firm's debt. In such a case, the return paid to the debt holder is not the same as the cost to the firm because interest paid on debt is a tax-deductible expense. Tax deductibles lower the effective cost of the debt, or a firm's net cost of interest on its debt after accounting for the interest tax deduction.
Firms may also chose to raise capital by issuing preferred stock, where it promises the stockholder a fixed dividend that must be paid before any other dividends are issued to common stockholders. If preferred dividend is known and fixed, we can use the following equation to calculate the cost of capital for preferred stock:

r = (Div1/Po) + gwhere g represents the growth rate.Assuming growth rate is 0, Cost of Preferred Stock
Preferred Dividend / Preferred Stock PriceFor the common stock, we can use the Capital Asset Pricing Model, which is discussed in Chapter 11. We can also use constant dividend growth model as well discussed in previous chapters. Because of difficulties with the constant dividend growth model, the CAPM is a more popular approach for estimating cost of equity. Also, the weighted average cost of capital can be utilized. The equation for this would be:Cost of Equity rE
Cost of Equity Preferred = rPREFCost of Equity Debt Capital = rD Corporate Tax Rate = TcWeighted Average Cost of CapitalrWAAC = rE(% of firm's value financed by equity) + rPREF(% of firms value financed by preferred stock) + rD(1 - Tc)(% of firms value financed by debt) The WAAC is driven by the risk of a company's line of business and its leverage. An issue that arises when estimating WAAC is net debt. This is defined as the tottal debt outstanding minus any cash balances. You must adjust for this by subtracting company's cash since assets on a firm's balance sheet include any holdings of cash or risk-free securities.We can use the WACC to value projects because the WACC incorporates the tax savings form debt, allowing us to compute the value of an investment including the benefit of the interest tax deduction given the firm's leverage policy or leverage value. With the WACC method, we discount future icremental cash flows using the firms WACC, producing a levered value of a project. This works with a couple key assumptions:
  • Market risk of the project is equal to average market risk of the firm's investment.
  • Firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity, also called debt-equity ratio.
  • Main effect of leverage on valuation follows from the interest tax deduction.

Project-Based Costs of Capital

It is often the case where specific projects differ from average investments made by the firm. If a company that focuses business on producing basketballs decides to acquire a chocolate factory, we must calculate the WACC of the chocolate business in order to analyze the differing risks. Now, assume that same company wants to start producing soccer balls, that would be considered a divisional cost of capital and is calculated also with a differing WACC. Firms with multiple divisions rarely use a single WACC company-wide.


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