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The Cost of Capital

What is the Cost of Capital?


When we talk about the cost of capital, we are talking about the required rate of return on invested funds It is also referred to as a hurdle rate because this is the minimum acceptable rate of return Any investment which does not cover the firms cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth)

The Appropriate Hurdle Rate: An Example


The managers of Rocky Mountain Motors are considering the purchase of a new tract of land which will be held for one year. The purchase price of the land is $10,000. RMMs capital structure is currently made up of 40% debt, 10% preferred stock, and 50% common equity. This capital structure is considered to be optimal, so any new funds will need to be raised in the same proportions. Before making the decision, RMMs managers must determine the appropriate require rate of return. What minimum rate of return will simultaneously satisfy all of the firms capital providers?

RMM Example (cont.)


Because the current capital structure is optimal, the firm will raise funds as follows:

Source of Funds
Debt Preferred Common Total

Amount
$4,000 $1,000 $5,000 $10,000

Dollar Cost
$280 $100 $600 $980

After-tax Cost
7% 10% 12% 9.8%

RMM Example (Cont.)


The following table shows three possible scenarios:

Rate of Return
Total Funds Available Less: Debt Costs Less: Preferred Costs = Remainder to Common

8%
$10,800 $4,280 $1,100 $5,420

9.8%
$10,980 $4,280 $1,100 $5,600

11%
$11,100 $4,280 $1,100 $5,720

Obviously, the firm must earn at least 9.8%. Any less, and the common shareholders will not be satisfied.
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The Weighted Average Cost of Capital


We now need a general way to determine the minimum required return Recall that 40% of funds were from debt. Therefore, 40% of the required return must go to satisfy the debtholders. Similarly, 10% should go to preferred shareholders, and 50% to common shareholders This is a weighted-average, which can be calculated as:

WACC = w d k d + w p k p + w cs k cs
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Calculating RMMs WACC


Using the numbers from the RMM example, we can calculate RMMs Weighted-Average Cost of Capital (WACC) as follows:
WACC = 0.40( 0.07 ) + 0.10( 0.10) + 0.50( 0.12 ) = 0.098

Note that this is the same as we found earlier

Finding the Weights


The weights that we use to calculate the WACC will obviously affect the result Therefore, the obvious question is: where do the weights come from? There are two possibilities:
Book-value weights Market-value weights

BookBook-value Weights
One potential source of these weights is the firms balance sheet, since it lists the total amount of longterm debt, preferred equity, and common equity We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

BookBook-value Weights (cont.)


The following table shows the calculation of the book-value weights for RMM:
Source Long-term Debt Preferred Equity Common Equity Grand Totals Total Book Value $400,000 $100,000 $500,000 $1,000,000 % of Total 40% 10% 50% 100%

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MarketMarket-value Weights
The problem with book-value weights is that the book values are historical, not current, values The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate Calculation of market-value weights is very similar to the calculation of the book-value weights The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital
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Calculating the Market-value Weights MarketThe following table shows the current market prices:
Source Debt Preferred Common Totals Price per Units Total Market % of Unit Value Total $ 905 400 $362,000 31.15% $ 100 1,000 $100,000 8.61% $ 70 10,000 $700,000 60.24% $1,162,000 100.00%

WACC = 0.3115(0.07 ) + 0.0861(0.10) + 0.6024 (0.12 ) = 0.1027 = 10.27%

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Market vs Book Values


It is important to note that market-values is always preferred over book-value The reason is that book-values represent the historical amount of securities sold, whereas marketvalues represent the current amount of securities outstanding For some companies, the difference can be much more dramatic than for RMM Finally, note that RMM should use the 10.27 WACC in its decision making process
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Cost of Capital?
When we say a firm has a cost of capital of, for example, 12%, we are saying:
The firm can only have a positive NPV on a project if return exceeds 12% The firm must earn 12% just to compensate investors for the use of their capital in a project The use of capital in a project must earn 12% or more, not that it will necessarily cost 12% to borrow funds for the project

Thus cost of capital depends primarily on the USE of funds, not the SOURCE of funds
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Weighted Average Cost of Capital (overview)


A firms overall cost of capital must reflect the required return on the firms assets as a whole If a firm uses both debt and equity financing, the cost of capital must include the cost of each, weighted to proportion of each (debt and equity) in the firms capital structure This is called the Weighted Average Cost of Capital (WACC)
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Cost of Debt
The cost of debt is generally easier to calculate
Equals the current interest cost to borrow new funds Current interest rates are determined from the going rate in the financial markets The market adjusts fixed debt interest rates to the going rate through setting debt prices at a discount (current rate > than face rate) or premium (current rate < than face rate)

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Weighted Average Cost of Capital (WACC)


WACC weights the cost of equity and the cost of debt by the percentage of each used in a firms capital structure WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
(E/V)= Equity % of total value (D/V)=Debt % of total value (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible RE = Rist free rate +(risk premium * )
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WACC Illustration
ABC Corp has 1.4 million shares common valued at $20 per share Debt has face value of $5 million and trades at 93% of face in the market. Risk free rate is 4%, risk premium=7% and ABCs =.74. Current yield on market debt is 11% and tax rate is 40%
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ABC Corp has 1.4 million shares common valued at $20 per share =$28 million. Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the market. Total market value of both equity + debt thus =$32.65 million. Equity % = .8576 and Debt % = .1424 Risk free rate is 4%, risk premium=7% and ABCs =.74 Return on equity per SML : RE = 4% + (7% x .74)=9.18% Tax rate is 40% Current yield on market debt is 11% WACC = (E/V) x RE + (D/V) x RD x (1-Tc) = .8576 x .0918 + (.1424 x .11 x .60) = .088126 or 8.81%

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Final notes on WACC


WACC should be based on market rates and valuation, not on book values of debt or equity. Book values may not reflect the current marketplace WACC will reflect what a firm needs to earn on a new investment. But the new investment should also reflect a risk level similar to the firms Beta used to calculate the firms RE.

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