Chapter 14 – Cost of Capital
Video Note: “Economic Value Added (EVA)” can be used to reinforce the concepts.
1. Divisional and Project Costs of Capital
A. The SML and the WACC
The WACC is the appropriate discount rate only if the proposed
investment is of similar risk as the firm’s existing assets.
Lecture Tip: Ask the class to consider a situation in which a
company maintains a large portfolio of marketable securities. Now
ask them to consider the impact this large security balance would
have on a company’s current and quick ratios and how this might
impact the company’s ability to meet short-term obligations. The
students should easily remember that a larger liquidity ratio
implies less risk (and less potential profit). Although the revenue
realized from the marketable securities would be less than the
interest expense on the company’s comparable debt issues, these
holdings would result in lowering the firm’s beta and WACC. This
example allows students to recognize that the expected return and
beta of an investment in marketable securities would be below the
company’s WACC, and justification for such investments must be
considered relative to a benchmark other than the company’s
overall WACC.
B. Divisional Cost of Capital
When a firm has different operating divisions with different risks,
its WACC is an average of the divisional required returns. In such
cases, the cost of capital for projects of average risk in each
division needs to be established.
If you do use the firm’s WACC across divisions, then riskier
divisions will receive the bulk of the funding and less risky
divisions will have to forgo what would be good projects if the
appropriate discount rate were used. This will lead to an increase in
risk for the overall firm.
Lecture Tip: It may help students to distinguish between the
average cost of capital to the firm and the required return on a
given investment if the idea is turned around from the firm’s point
of view to the investor’s point of view. Consider an investor who is
holding a portfolio of T-bills, corporate bonds and common stocks.
Suppose there is an equal amount invested in each. The T-bills
have paid 5% on average, the corporate bonds 10%, and the
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common stocks 15%. Thus, the average portfolio return is 10%.
Now suppose that the investor has some additional money to invest
and they can choose between T-bills that are currently paying 7%
and common stock that is expected to pay 13%. What choice will
the investor make if he uses the 10% average portfolio return as
his cut-off rate? (Invest in common stock 13%>10%, but not in T–
bills 7%<10%.) What if he uses the average return for each
security as the cut-off rate? (Invest in T-bills 7% > 5%, but not
common stock 13%<15%.)
Lecture Tip: You may wish to point out here that the divisional
concept is no more than a firm-level application of the portfolio
concept introduced in the section on risk and return. And, not
surprisingly, the overall firm beta is therefore the weighted
average of the betas of the firm’s divisions.
C. The Pure Play Approach
Pure play – a company that has a single line of business. The idea
is to find the required return on a near substitute investment.
D. The Subjective Approach
Assigns investment to “risk” categories that have higher or lower
risk premiums than the firm as a whole.
International Note: The difficulty in arriving at an appropriate
estimate of the cost of capital for project analysis is magnified for
firms engaged in multinational investing. In Financial
Management for the Multinational Firm, Faud Abdullah
suggests that adjustments to foreign project hurdle rates should
reflect the effects of the following:
-foreign exchange risk
-political risk
-capital market segmentation
-international diversification effects
Making these adjustments requires a great deal of judgment and
expertise, as well as an understanding of the underlying financial
theory. Most multinational firms find it expeditious to adjust the
hurdle rates subjectively, rather than attempting to quantify
precisely the effects of these factors for each foreign project.
Lecture Tip: What an individual firm considers a risky investment
and what the financial market considers a risky investment may
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not be the same. Recall that the market is concerned with
systematic risk, or non-diversifiable risk. If a firm is considering
an investment’s total risk in assigning it to a risk category, the risk
categories may not line up with the SML.
2. Company Valuation With the WACC
A. Cash flow calculations for the firm
Treating a company like one big project, we can calculate the firm
value using the same project analysis techniques. First, calculate
the expected CFFA for the firm. To separate financing costs, we
must use the taxes that would have been paid if the firm had not
used debt financing. To do that, we just take earnings before
interest and taxes (EBIT) and multiply it by the firm’s tax rate (TC)
to get the firm’s “would-have-been” tax bill, which we will call the
“adjusted” taxes and label Taxes*:
Taxes* = EBIT × TC
Then we calculate “adjusted” cash flow from assets, ACFA, as:
ACFA = EBIT + Depreciation – Taxes* – Change in NWC
– Capital spending
= EBIT + Depreciation – EBIT × TC – Change in NWC
– Capital spending
= EBIT × (1 – TC) + Depreciation – Change in NWC
– Capital spending
The term EBIT × (1 – TC) is just what net income would have been
if the firm had used no debt.
B. Constant firm growth case
If the firm is growing steadily at growth rate g, we can value it
using our growing perpetuity formula. The value of the firm
today (V0) is:
Firm value today = V0 = ACFA1 / (WACC – g)
where ACFA1 is the “adjusted” CFFA projected for next year.
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C. Non-constant growth case
If the firm’s cash flows are not growing at a constant growth rate, a
more general model could be used. ACFA must be projected for the
near term years. The terminal value may be projected for the
period when growth stabilizes. In that case, we can write the value
of the firm today as:
V0 = ACFA1 / (1+WACC) + ACFA2 / (1+WACC)2
+ ACFA3 / (1+WACC)3 + …
+ (ACFAt + Vt)/ (1+WACC)t
where, Vt is value of the firm at Time t, which we again calculate
using the growing perpetuity formula:
Vt = ACFAt+1 / (WACC – g)
Vt, is often referred to as the “terminal value.”
3. Flotation Costs and the Weighted Average Cost of Capital
A. The Basic Approach
Weighted average flotation cost (fA) – sum of all flotation costs as a
percent of the amount of the security issued, multiplied by the
target structure weights. The multiplier 1 / (1 – fA) is used to
determine the gross amount of capital to be raised so that the after-
flotation cost amount is sufficient to fund the investment.
B. Flotation Costs and NPV
If a project requires an investment of $I before flotation costs, then
compute the gross capital requirement as I/(1 – fA) and use this
figure as the investment cost in calculating NPV.
Example:
Suppose ABC Company is considering opening another office. The
expansion will cost $50,000 and is expected to generate after-tax
cash flows of $10,000 per year in perpetuity. The firm has a target
debt/equity ratio of .5. New equity has a flotation cost of
10% and a required return of 15%, while new debt has a flotation
cost of 5% and a required return of 10%. The tax rate is 34%.
Cost of capital = (1/1.5)(15) + (.5/1.5)(10)(1-.34) = 12.2%
Flotation cost = (1/1.5)(10) + (.5/1.5)(5) = 8.33%
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Initial investment = 50,000/(1-.0833) = 54,543
NPV = 10,000/.122 – 54,543 = 27,424
C. Internal Equity and Flotation Costs
While new debt and equity issues would be subject to flotation
costs, the retained earnings component of equity would not. The
key point to make is that whenever external financing is used, there
is an additional cost associated with that financing. That cost is a
relevant cash flow for capital budgeting purposes.
4. Summary and Conclusions
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