1

The Cost of Capital

The Cost of Capital is the capital budgeting
projects required return.
It is the opportunity cost of investing those funds in the
project.
It is the rate of return at which investors are willing to
provide financing for the project today. It is based on
current market conditions.
It reflects the risk of the project.
The Cost of Capital is NOT the historical cost of
funds.
2
Corporate Valuation
The market value of the firm (or simply, firm
value) can be viewed in two ways:
Firm value equals the sum of the market values of the
claims on the firms assets.
Firm value equals the sum of the market values of its
assets.
These two views are simply the balance-sheet
accounting identity, but in current market values:

Assets = Liabs + O.E.
3
The Market Line for Capital
Budgeting Projects
The Capital Asset Pricing Model (CAPM) can be
used to obtain the cost of capital for a capital
budgeting project.
r
j
= r
f
+ b
j
(r
m
r
f
)
where
r
j
= cost of capital for project j,
r
f
= riskless return
r
m
= required return on the market portfolio
b
j
= beta of project j
4
Using the Project Market Line
A capital budgeting project costs $2,300, and
expects to return $410 per year in perpetuity. If
r
f
= 7%, r
m
= 14%, and b
j
= 1.3, what is the
projects NPV?

r
j
= r
f
+ b
j
(r
m
- r
f
) = 7 + 1.3(14 7) = 16.1%

NPV = 410/0.161 2,300 = $246.58
5
Leverage
According to the CAPM, the required return
depends only on the non-diversifiable risk.
The non-diversifiable risk borne by shareholders
can be split into two parts:
Operating (business) Risk
Financial Risk
Operating risk results in operating leverage.
Financial risk results in financial leverage.
Financial leverage is moving along the CMLlending
or borrowing.
6
Operating Leverage
Operating leverage arises from the mix of fixed
versus variable costs of production.
High fixed costs (and correspondingly lower
variable costs per unit) results in high operating
leverage.
The firms profits are more sensitive to changes in
sales.
Conversely, low fixed costs (and correspondingly
higher variable costs per unit) result in low
operating leverage.
7
Operating Leverage
Jewel Plastics, Inc., plans to make plastic jewel cases
for CD-ROM disks. Each packet of 10 cases can be
sold for $5.00. Two alternative manufacturing
technologies are available.
Ignoring taxes, compute the profits under each plan.
Plan A Plan B
Annual Fixed Costs
Variable Cost (per unit)
60,000
$2.00
$100,000
$1.00
8
Operating Leverage
Profit = Sales Costs
(Unit Sales) (Selling Price Variable Costs) Fixed Costs
At a sales level of 50,000 units, the profits
under plan A are:
50,000 ($5.00 $2.00) $60,000 = $90,000.
Under Plan B, profits at a sales level of
50,000 units are $100,000.
9
Financial Leverage
The presence of fixed costs associated with
debt financing results in financial leverage.
As financial leverage increases, the
variability of shareholder returns increases.
This increases shareholders risk.
Weve seen financial leverage before,
Borrowing to move up the CML.
10
The Weighted Average Cost of
Capital
The Weighted Average Cost of Capital,
WACC, is the weighted average rate of
return required by the suppliers of capital
for the firms investment project.
The suppliers of capital will demand a rate
of return that compensates them for the
proportional risk they bear by investing in
the project.
11
Components of a Financing
Package
Consider the case where a project will be
financed with 40% debt and 60% equity.
Suppose the project requires an initial
investment of $8,000 and has a NPV of
$2,000.
The TOTAL value of the project is thus
$10,000.
How much debt should the firm use?
(0.40) 10,000 = $4,000.
12
Components of a Financing
Package
Since the project requires an initial
investment of $8,000, the firm will raise
the remaining $4,000 by selling stock.
Since the total value of the project is
$10,000, the stock will be worth $6,000.
In perfect markets, ALL of the benefits from a
project (the projects NPV) goes to the
shareholders.
13
WACC Calculation
Let L = the ratio of debt financing to total
financing,
r
e
= required return for equity,
r
d
= required return on debt, and
T = marginal corporate tax rate on income from
the project.
Then,

d e
r T L r L ) 1 ( ) 1 ( WACC
14
WACC Calculation
Compute the WACC for the Nikko Co. given the
following information:
Nikko has 9 million common shares outstanding
priced at $13.00 each. Next years dividend on these
shares is expected to be $1.33, and will grow at 5%
per year forever. Nikko has 60,000 bonds
outstanding, each with a coupon rate of 11% and are
priced at $1,050 each to yield 10% to bondholders.
Nikkos marginal corporate income tax rate is 34%.
15
WACC Calculation
Market value of Nikkos equity =
9 million $13.00 per share = $117 million.
Market value of Nikkos debt =
60,000 $1,050 per bond = $63 million.
Total market value of Nikko =
$117 million + $63 million = $180 million.
Proportion of debt financing used by Nikko =
L = $63 M / $180
L = 35%
16
WACC Calculation
To compute the rate of return required by
Nikkos stockholders, we use the constant
growth model of stock valuation.
r
D
P
g
e
= + = + =
1
0
33
00
0 05 15 25%
$1 .
$13 .
. .
17
WACC Calculation
Because we are interested in measuring the
firms current cost of capital, we use the
bond yield currently demanded by the
bondholders.
Thus, r
d
= 10%.
Also, the tax rate, T, is 34%.
18
WACC Calculation
d e
r T L r L ) 1 ( ) 1 ( WACC
%) 10 )( 34 . 0 1 ( 35 . 0 %) 25 . 15 )( 65 . 0 ( WACC
% 22 . 12 WACC
19
Perfect Market View of Capital
Structure
Unleveraged Firm
Leveraged Firm
V
U
= $2,000
V
L
= $2,000
$1,000
Equity
$1,000
Debt
$2,000
Equity
20
Shareholders Required Return in
Perfect Markets
At 10%, MFIs annual interest expense is $100.
The annual expected cash flow to its
shareholders is $300 $100 or $200.
Since the equity is worth $1,000, the rate of
return required by the shareholders is 20%:
$1,000 = $200/0.20
With leverage, equity is riskier and the
shareholders required rate of return increases.
21
Leverage Ratio
The leverage ratio, (L) is:
= =
$1 ,
$2 ,
.
000
000
0 50 50% or
value firm total
debt of ue Market val
L
22
WACC and Capital Structure in
Perfect Markets
The weighted average cost of capital is 15%:

WACC = (1 L)r
e
+ L r
d


= (1 0.5)(0.20) + 0.50.10

=15%
23
Dividend Policy in Practice
Preference for paying common dividends
Smaller and younger firms
Mature firms
Stability of Dividends
Dividends are more stable from year to year
than are earnings.
They follow the trend in cash flow more
closely.
24
Dividend Policy in Practice
Regular decisions
Review dividend policy at least annually, and
at about the same time each year.
Regular payments
Quarterly payments most common.
Annual, semi-annual, and monthly payments
are less common.
25
Dividend Policy in Practice
Reluctance to cut dividends
Dividend cut is interpreted as a negative
signal.
Extra or special dividends
Paid during periods of temporarily high
earnings.
Generally occur at the end of the fiscal year.
26
Industry Differences in Dividend
Policy
Investment opportunities are comparable
within an industry, but vary across industries.
Firm-specific information must be taken into
account.
27
Dividend Payment Mechanics
Dividends are declared by the board of
directors:
amount of dividend
record date
payment date
The ex-dividend date is two business days
prior to the record date.
28
Dividend Payment Mechanics
On Tuesday, October 15, 2002, General
Supply Co. announced a dividend of $0.36 per
share payable to shareholders of record as of
Thursday, November 7, 2002. The dividend
would be paid on Monday, December 9,
2002.
What is the ex-dividend day?
What happens to the stock price on this day?
29
Dividend Payment Mechanics
The ex-dividend day is 2 business days
prior to the ex-dividend day.
Tuesday, November 5, 2002.
Suppose General Supplys stock closed at
$20 on Monday, November 4, 2002.
The stock would open ex-dividend on
Tuesday, November 5, 2002 at about
$19.64 = $20 $0.36
30
Dividend Payment Mechanics
Declaration
Date
Ex-Dividend
Date
Record
Date
Payment
Date
December 9, 2002 November 5, 2002 October 15, 2002 November 7, 2002

31
Dividend Policy Guidelines
Project future residual funds.
Earnings and cash flow projections for the next few
years.
Include depreciation generated funds.
Deduct capital expenditures.
Determine an appropriate target payout ratio.
Range of payout ratios.
Set the quarterly dividend.
Evaluate alternative dividend policies.
32
Stock Dividends
A stock dividend proportionately increases
the number of shares each shareholder
owns.
A 10% stock dividend:
Increases total number of shares outstanding
by 10%.
Increases each shareholders holdings by 10%.
If a shareholder own 50 shares before the dividend,
she owns 55 shares after the stock dividend is paid.
33
Stock Splits
A stock split alters the par value of the
shares but there is no transfer of balances
between the equity accounts.
The total number of shares outstanding
increases.
In a 3-for-2 stock split, 3 new shares are
issued for every 2 pre-split shares outstanding.
Thus, there is a 50% increase in the number of
shares outstanding.