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It all comes down to fundamentals ...

19. Cost of Capital

The basic idea is this: The rm owns some assets. These assets generate cash ows

The cost of capital is used to discount expected cash ows in making capital budgeting decisions. In this chapter, we go into more detail on how to estimate the rms cost of capital. Issues include: Does it make any dierence if the project is nanced out of retained earnings, by issuing new equity, or by issuing debt? How should we evaluate the cost of capital for projects with risk proles that dier from that of the overall rm? What is the eect of operating leverage on a projects cost of capital?

The return that investors require to compensate them for holding these assets depends on the size timing riskiness of these cash ows. The return required by investors determines the cost to the rm of obtaining nancing for new investments. This cost of capital is the appropriate rate to use when discounting cash ows to evaluate

The key lesson is that the cost of capital depends upon the use of funds, not the source.

potential projects.

Modigliani-Miller
In this chapter, we are interested in the overall rate of return the rm must earn on its total assets. Recall that: The cash ows (and associated risk) can be apportioned to dierent groups of investors (e.g., shareholders and creditors) in various ways. The return that each group will require in compensation for holding these assets depends upon their share of the risk. But the overall return the rm must earn depends fundamentally on the characteristics of the cash ows, not on how the pie is divided up.

Estimating the rms cost of capital

The return that the rm must earn to compensate investors depends upon the risk prole of its cash ows. Ideally, one would estimate the appropriate discount rate (required return) directly from these cash ows. But this is usually hard (impossible!) to do. Instead, it is common to use the market prices of the rms various asset categories (debt, equity, etc) to estimate this rate indirectly.

Note: In practice, this is not entirely true due to the eects of taxes bankruptcy risk possibly other (minor) factors

WACC
Estimating the cost of capital: The rm can be thought of as a portfolio of assets: debt, common stock, preferred stock, ... (As with any other portfolio) we can estimate the required return for the rm as a whole by taking a weighted average of the component required returns: D E RE + RD RA = A A But, it is often more useful (e.g., when evaluating projects) to look at the after tax cost to the rm, WACC = E D RE + RD (1 T ) A A

Cost of debt
The cost of debt can be observed (more or less) directly. Just look at yields on the rms bonds. In practice, the cost of debt is most commonly estimated as a weighted average of the yields on outstanding debt. Weight by market value!!

Note: In practice, there are some complications since a rm may have many dierent bond issues outstanding with dierent features (and thus dierent yields to maturity): dierent times to maturity dierent coupon payments

Notes: A third term for preferred stock can be added if applicable. It is best to use the market values of debt and equity. But, some analysts will use book values.

convertible? callable? etc

Example cost of debt

Boing Corp. has three debt issues outstanding: assume book value equals face value assume annual coupon payments

Cost of preferred stock

Recall that preferred stock should pay a xed dividend every period forever. Thus, a share of preferred stock should be valued as a perpetuity. R= D P0

Time to maturity 5 years 10 years 25 years Total

Coupon rate 8% 7.5% 8.25%

Yield 10% 10.5% 11.5%

Book value 10 million 15 million 18 million 43 million

Market value

If there is more than one issue of preferred stock outstanding, compute the cost of preferred stock as a weighted average (using weights proportional to market value of each issue).

Note: As with bonds, there are some additional complications in practice... What is the market-weighted cost of debt?

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Cost of equity
There is no way of directly observing the return required by investors for owning equity. But we have discussed several ways that one might estimate it. Dividend growth model CAPM Historical returns

In practice ...
There can be a lot of variation possible in the exact details of how the costs of debt and equity and the WACC area computed. If using a value computed by someone else, it is essential to look at exactly what they did.

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Example warehouse renovation

Suppose we are considering a decision on whether to renovate our companys warehouse distribution system. The project will cost $50 million and is expected to save $12 million per year (after tax) over the next 6 years. Suppose that the cost of equity is 20% the cost of debt is 10%

Debt or equity nancing Does it matter?

The WACC is typically used to determine required returns for proposed projects. But, we know that debt can usually be issued at a rate lower than the WACC. On the other hand, investors require higher expected returns to be willing to purchase new equity. How does the choice of debt or equity nancing aect a proposed projects cost of capital (or required return)?

the debt-equity ratio is 1/3 the tax rate is 34% What discount rate should we use when evaluating this project?

Should we accept this project?

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Example debt or equity

Suppose I am evaluating a new project which has an estimated rate of return that is lower than the rms WACC. But, my CFO suggests that we could nance the project by issuing debt.

Discussion
Using debt to nance the project looks at rst glance like a source of cheap funds. But changing the capital structure aects the cost of both debt (if we include default

If the cash ows are discounted at the cost of debt, the project has a positive NPV. The CFO argues that taking on the project and using debt to nance it would be a good strategy. How should I respond?

risk) and equity. The project needs to earn a high enough return to cover not only the interest on the debt, but also to compensate investors for the additional risk they take on by increasing leverage. If the project does not have a positive NPV when discounted at the WACC, adopting it will decrease the value of the rm. Using debt to nance the project does not change this.

Note: The discussion above assumes that changing the capital structure does not change the rms WACC. As we have seen previously, there could be an eect on the WACC. But, if the rm is already at its optimal capital structure, any change in leverage will increase WACC, making the project even less attractive.

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Discussion continued
What if the project could be nanced entirely using retained earnings? What would be the appropriate cost of capital to use in this case? Zero?

Cost of capital for a project

If the projects risk prole diers from that of the rm as a whole, is it appropriate to use the rms overall cost of capital when discounting cash ows?

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Example project choice

ABC Inc. is all equity nanced and has a beta of .625. Expected cash ows earned by ABC are $100 forever. ABC is considering a project with an initial cost of $500 which is expected to generate cash ows of $75 per year forever. The estimated beta of these cash ows is 1.875. If accepted, the project will be nanced by issuing new equity. The risk-free rate is 5% and the market risk premium is 8%. Ignore taxes. Should ABC undertake this project? What is ABCs required return (without the project)?

Example continued
This is starting to look promising, but lets look a little more closely. What does the CAPM say about the projects required return?

Now, consider the rm together with the proposed project (as a portfolio). What is its beta?

What is the value of the rms equity (without the project)?

What is its required return?

What is the rate of return of the proposed project?

What is the market value of the assets?

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Example continued
Taking on the project requires an investment of $500 but only increases the value of the rm by $314...

Discussion
If the rm over-accepts high beta projects, its overall beta will increase. If a project does not earn a high enough return to justify its risk, undertaking it will

Things are starting to look a little sketchy. Suppose the rm originally had 1000 shares worth $1 each and is able to nd some loser willing to buy a new issue of 500 shares at $1 each to nance the project. What happens to the share price if the project is undertaken?

destroy shareholder value. We can think of the rm as a portfolio of projects: Dierent projects have dierent risks and expected returns. The rms project choice problem is similar to the investors portfolio problem. The goal is to maximize risk-adjusted return.

Would it make any dierence if the rm used debt nancing?

Note: This illustrates the idea that if prospects are bad, the rm should try to issue new equity!

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Division cost of capital

A similar situation holds for corporations with multiple divisions. Consider a company that has two divisions. One division is involved with bringing out new products based on cutting-edge technologies. It is very risky and thus has a high beta. The other division provides cable TV services and is very stable (low beta). Projects for each division must be evaluated using a required return commensurate with their risk.

Finding the appropriate cost of capital

If we are evaluating investments in divisions or projects with risk proles that do not mirror that of the rm as a whole, we need to think a little bit more about what discount rate to use. We know that the appropriate discount rate should reect the risk prole of the project. The problem is how to estimate it.

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Appropriate cost of capital continued

Possible approaches include: Accounting beta approach: One could also try to estimate the projects beta by running a regression of the projects accounting returns against the market portfolio. It may be dicult to come up with good forecasts for the degree of correlation in variation of accounting returns and market returns (forecasting expected returns is not sucient).

Example subjective method

Consider a rm that has an overall WACC of 14% and is trying to assess possible investments of dierent types. It might think about evaluating them based on adjustments such as these:
Discount rate

Category

Examples

Adjustment factor +6% +0

High risk

New products Cost savings, expansion of existing lines Replacement of existing equipment

20% 14

Pure-play approach: One alternative is to search for other rms in the same risk class as the investment under consideration. A rm that specializes in a single line of business is often referred to as a pure play. Such rms are useful for analyzing the cost of capital in that business. Subjective approach: Since it may be dicult to nd an objective basis for establishing appropriate discount rates for individual projects, analysis is sometimes based on ad hoc adjustments to the rms overall WACC. This is often the only feasible approach.
Low risk -4 10 Moderate risk

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Example pure play

Suppose that GM notices that it is having trouble competing in the automotive industry and decides to try its hand in the bicycle business. GMs historical cost of capital would provide a poor guide for estimating cost of capital for the new bike business. What companies might it look at to get a better estimate?

Example pure play

KM Inc. is all equity nanced and is looking at getting into the business of manufacturing bicycles. They would like to estimate the cost of capital for this project. They look at Trik, a company specializing in bicycles, as a pure play. Trik has a debt-equity ratio of .50 and an equity beta of 1.2. The risk-free rate is 5% and the market risk premium is 8%. The tax rate is 35%. Ignore default risk. Assuming that KM will use equity to nance the project, what is its cost of capital?

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Operating leverage and beta

Recall that operating leverage measures the sensitivity of EBIT to change in sales. Higher operating leverage means that uctuations in sales due to cyclic business conditions results in more variation in cash ows. Thus, a projects beta is, in part, determined by the choice of operating leverage.

Discussion
A project with a higher operating leverage (and thus beta), must earn a commensurately higher return to be woth adopting. As usual, the expected return must increase suciently to compensate investors for the increased risk.

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Factors aecting beta

Business risk Operating leverage Financial leverage

Conclusions
The cost of capital depends upon the use, not the source of funds. Ultimately, the rate of return a rm must earn to attract new capital depends on the risks associated with the cash ows generated by the rm (but this can be dicult to assess directly...). Alternatively, the rms cost of capital can be estimated by observing the market prices

Note: Business risk and operating leverage aect asset beta (and equity beta), while nancial leverage aects equity beta only.

of its debt and equity and computing the WACC. If the capital structure changes, the costs of debt and equity will also change.

Debt is cheaper than equity but increasing leverage raises the risk and thus cost of both debt and equity. If taxes and default risk are ignored, the WACC is unaected by change in capital structure. Including the eects of taxes and default risk, the eect on WACC is ambiguous. But, if the rm is already at its optimal capital structure, any change in capital structure will increase its WACC. If the proposed project has a dierent risk prole than the company as a whole, the cost of capital should reect the projects risk. A projects riskiness (and beta) can also be aected by choice of operating leverage.