Cost of Capital - Finance - Lecture Slides, Slides of Finance

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Cost of Capital

Lecture Agenda

1. Financing Sources

2. The Cost of Capital

3. Estimating Non-Equity Costs

4. Effects of Leverage

5. Growth Models and Cost of Equity

Financing Sources Cost of Capital Non-Equity Costs Leverage Effects Growth Models

6. Cost of Capital and Investment

Important Chapter Terms

• Asset turnover ratio
• Beta coefficient
• Capital asset pricing model
• Capital structure
• Cash cow
• Cost of capital
• Debt-to-equity ratio
• Dog
• Earnings yield
• Hurdle rate
• Investment opportunities

schedule (IOS)

• Issuing (or floatation) costs
• Marginal cost of capital (MCC)
• Market-to-book (M/B) ratio
• Market risk premium
• Multi-stage growth DDM
• Operating leverage
• Present value of existing opportunities (PVEO)
• Present value of growth opportunities (PVGO)
• Return on assets (ROA)
• Return on invested capital (ROIC)
• Return on equity (ROE)

Important Chapter Terms…

• Risk-based model
• Risk-free rate of return
• Star
• Turnaround
• Weighted average cost of

capital (WACC)

The Short Story of WACC

Purposes/Use

• The weighted average cost of capital

(WACC) serves three primary purposes:

1. To evaluate capital project proposals before- the-fact.
2. To set performance targets in order for management to sustain or grow market values, and
3. to measure management performance after- the-fact.

The Short Story of WACC

What Costs are Measured?

• Costs associated with financing the

firm’s invested capital including:

– Debt Costs:

• Bank loans
• Long-term debt – bonds/debentures

– Equity Costs:

• Preferred equity costs
• Common equity costs

The Short Story of WACC

Steps in Solving for the WACC

1. Identify the relevant sources of capital

(debt and equity).

2. Estimate the market values for the

sources of capital and determine the

market value weights.

3. Estimate the marginal, after-tax, and

after-floatation cost for each source of

capital.

4. Calculate the weighted average.

The Short Story of WACC

The Formula

Once you have the specific marginal costs of capital (after accounting for taxes and floatation costs) and you have found the appropriate weights to use, the actual calculation of a WACC is a simple matter.

V

D

K T

V

S

WACC Ka Ke d

The cost of equity times the market value weight of equity

The after-tax cost of debt after tax times the market value weight of debt

The Short Story of WACC

Frequently Asked Questions

1. Why don’t we include the cost of accruals and

accounts payable in the cost of capital?

• These are ‘spontaneous’ liabilities that rise and fall with the volume of business activity, and are not subject to formal lending arrangements.
• Accruals (wages and taxes), it can be argued, don’t have an explicit cost.
• For major corporations, spontaneous liabilities are often a very small part of the overall capitalization of the firm (are immaterial for cost of capital purposes).

The Short Story of WACC

Frequently Asked Questions

2. Why is the cost of capital an estimate and does this matter?
   • WACC is calculated based on a current estimate of what it will cost for the next dollar of debt and equity. Since that next dollar hasn’t yet been raised, we are attempting for forecast or estimate that cost.
   • To estimate the cost of debt we often assume it is equal to the required rate of return on existing debt outstanding in the markets (Of course, when a firm actually goes to the market, conditions may have changed, underwriting costs may be greater, etc.)
   • Forecasting WACC also requires estimating the cost of equity. There may different approaches to this task, and will result in a range of estimates.
   • In the end, WACC will still be an estimate. The key thing to ensure is that the NPV of the project be positive over the range of possible WACC’s. (Graph an NPV profile and determine the range of WACCs that will still produce a positive NPV.)

The Short Story of WACC

Summary

• WACC measures the firm’s cost of financing future growth today, based on current capital market conditions, and assuming the firm use a long-term average of financing sources.
• WACC is an estimate.
• WACC is used to make capital investment decisions.
• WACC is used to set performance targets for sales, and ROE.
• WACC is used to assess management’s performance, answering the question, “has management added value?”

Sources of Capital for

Corporations

Cost of Capital

Financing Sources

Capital Structure

Accruals Accounts payable Short-term debt Total current liabilities Total current assets Long-term debt Shareholders' equity Total assets Total liabilities and shareholders' equity

Prepaid expenses

Net fixed assets

Table 20-1 Main Balance Sheet Accounts

Cash and marketable securities Accounts receivable Inventory

The Financial Capital StructureStructure

Important Terms

• Financial Structure
  • The whole right-hand side of the balance sheet
  • Includes both short-term and long-term sources of financing (debt and equity)
• Capital Structure
  • How the firm finances its invested capital
  • Excludes accruals and accounts payable – short-term liabilities that are not strictly debt contracts, that spontaneously change in response to the operations of the business.
  • Includes:
    • Bank Loans
    • Long-term debt
    • Common stock and retained earnings (See Table 20 – 2 for a typical example)