Topic 9 - Cost of Capital

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This article is a topic within the subject Business Finance.

Contents

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 368-397.

The Cost of Capital: Depends Primarily On The Use of the Funds, Not The Source

[1] FINS161391.jpg

Non-tradeable asset discount rates (e.g. projects) are determined by the required rate of return on stocks with the same market risk as the project. A project will only generate a NPV > 0 if its returns exceed those of stocks with similar risk.

Unlike projects, the prices/returns of tradeable assets are determined by the market (SML) FINS161392.jpg so all stocks are fairly priced & have 0 NPV (if markets are assumed to be efficient). Projects, don’t adjust to reflect risk & abnormal profits can be made. Thus, financial markets are useful as they are places that allow capital users to meet with providers, determine the price of capital (risk & return) & offer a useful benchmark to determine the value of real assets/projects. The manager must earn a return for investors at least as large as returns on stocks with similar risks. This hurdle rate is the project’s cost of capital.

Required Rate Of Return On Projects

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The Overall Cost Of Capital For A Firm

[2] A firm can be divided into its operating side (portfolio of assets) & its financing side (portfolio of securities). The weighted average required return on the firms operating assets = weighted average return on the firm’s financial securities. Assessing market risk embedded in a firm’s securities is much easier than operating assets. To determine the weighted average return on a firm’s securities we must know its capital structure (for weighting).

Equity Only Firms

Company cost of capital = Investors required return on the stock

Equity & Debt Firms

The firm’s cost of capital is the weighted average debt & equity returns.

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Taxes And WACC

Since interest payments are tax deductible, the after tax cost of debt is lowered. FINS161395.jpg if there is an imputation system dividends would also be lowered by the tax rate.

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Estimating The Cost of Equity

[3] Cost of equity is the return that equity holders require on their investment in the firm.

Dividend Growth Model Approach

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  • Advantages: Simple to understand & easy to use
  • Disadvantages: Too Simple, Applicable to only dividend paying firms, based on historical’s, Sensitive to ‘g’ – large margin for error, does not explicitly consider risk like the CAPM,

SML Approach

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  • Advantages: Explicitly accounts for risk, Applicable to all companies even without steady dividend growth, Applicable as long as stock prices observed, can also be applied to individual projects
  • Disadvantages: Estimates of market risk premium & beta can be inaccurate making cost of equity inaccurate, historicals

The Cost of Debt And Preferred Stock

[4] Cost of debt is the return required by lenders on new borrowings. It can be determined via the SML approach if we know the beta or we can use the yield to maturity(the coupon rate is not the cost of debt). Preferred stocks pay a fixed dividend rate & are perpetuities. FINS161398.jpg

WACC Example

[5] ABC has a 20 year debt issue, Face Value of 1.2M & an annual coupon rate of 15%, priced today in the market to yield 8%. ABC has preferred shares priced at $56, with a 10% dividend on $100 face value. The Stock has a beta of 1.4, market premium of 12% & the risk free rate is 5%. 10,000 preferred shares, 3,000,000 common stock & NPV of debt = 2,006,702.33.Total Market Capitalisation = 13,066,702

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Measuring Capital Structure

[6] Market Capitalisation (MV) of equity = # of shares * market price, MV of debt = # of bonds * market price. If the bonds are not publically traded, we need to find a similar traded bond & use the yield to discount the bond’s payments to present value.

Interpreting WACC

[7] WACC is the weighted average required rates of return by all the stakeholders of the firm. It is the overall return that a firm must earn on existing assets to maintain the value of the shares. We can use the WACC for a project if it has the same business risk as the firm to find the project NPV e.g. an expansion of existing operations. Positive NPVs increase shareholder wealth.

Company vs. Project Risk

[8] Company cost of capital is the expected rate of return demanded by investors in a company, determined by the average risk of the company’s assets & operations computed by WACC. Project cost of capital is the minimum expected rate of return on a project, given its risk.

Estimating A Project Specific Discount Rate

[9]

Pure Play Approach

A pure player is a company that focuses on a single line of business e.g. iron ore mining or grocery retailing.

  1. Find a public firm that invests exclusively in the type of project under valuation (estimate equivalent risk) – same risk class
  2. Compute average WACC of these firms (using beta)

Subjective Approach

This approach estimates the project specific discount rate by making subjective adjustments to overall firm WACC

  1. Create different risk categories relative to overall business risk – high, moderate, low risk
  2. Subjectively assign a risk adjustment factor to the benchmark WACC to each risk category
  3. Use the adjusted discount rate for the project based on the risk category

Project Discount Rate = WACC +/- Adjustment Factor

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End

This is the end of this topic. Click Business Finance to go back to the main subject page for Business Finance

References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.

  1. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 369-370
  2. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 375-382
  3. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 370-372
  4. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 374-375
  5. ASB, UNSW
  6. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 375-382
  7. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 375-382
  8. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 386-388
  9. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 387-388
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