COST OF CAPITAL Pe tector ner cee Cnc ies’ The candidate should be able to: 2 Mastery ‘a caleuste and interpret the weighted average cost of capital WACC) «= of acomgany: 'B. describe how taxes affect the cost 6 capil o sources, i ‘c. deseribe alternative methods of caculating the weights Used in the o ‘weighted average cost of capita, including the use of the company’s target capital structure a.” lain how this marginal cost of capital and the invesiment epporunity: schedule ate used to determine the optimal capital budget; explain the marginal cost of capital role in determining the net present) value of 2 project §. "calculate and interpret the cost of fixed rete debt capital using the a viele-to-meturity eperaach and the debt-rating approach; “g. calculate and interpret the cost of noncallable, nonconvertbie preferred?” C1™™ stock: i ‘hy calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dvdene discount model approach, end ‘he bond yield ps ck sxemium approach: i ‘leuate and niet the bee and cost of capita ora project o j explain the country equity risk premium in the estimation of the cost of . equity for a cornpay located ina developing market ie. describe the marginat cost of capital schedule, explain why it may be o upward-sloping with respect to additional capital, and calculete and interpret its breok-points “ Gapiain and demonstrate the Coredt treatment of flotation costs. opi © 2 be CH tite Repried i 35 ‘yrvon.cfalnsttute org/toolkit— Your online preparation resource36 Reading 45 + Cost of Capital INTRODUCTION company grows by making investments that are expected to increase revenues and profits. The company acquires the capital or funds necessary to make such investments by borrowing or using funds from owners. By applying this capital to investments with fong-tere benefits, the company is producing value today, But, how much value? The answer depends not anly on the investments’ expected future cash flows but also on the cost of the funds. Borrowing is not costless. Neither is using owners’ funds. ‘The cast of this cepital is an important ingredient in both investment decision aking by the company’s management and the valuation of the company by investors Ifa company invests in projects that produce a return in excess of the cost of capital, the company has created value; in contrast, i the company invests in projects whose returns are less than the cost of capital, the company has actually destroyed vaiue. Therefore, the estimation of the cost of capital sa central isue in corporate financial management. For the analyst seaking to evaluate a company's investment program end its competitive position, en accurate estimate of a company’s cost of capital is important as well Cost of capital estimation is a challenging task. As we have already implied, ‘the cost of capital is not observable but, ratiner, must be estimated, Arriving at 3 cost of capital estimate requires a host of assumptions and estimates. Another challenge is that the cost of capital that is appropriately epplied t6 a specific investment depends on the characterstcs of that investment: The riskier the investments cash flows, the greater its cost of capital. In reality, a company must estimate project-specific costs ef capital. What is often done, however, is 10 estimate the cost of capital for the company as 2 whole and then adjust this ‘overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project. ‘This reading is organized 2s follows: In the next section, we introduce the cost Of capita and its basic computation. Section 3 presents a selection of methods for estimating the costs of the various sources of capital. Section 4 discusses issues an analyst faces in using the cost of capital. A summary concludes the reading, COST OF CAPITAL ‘The cost of capital is the rate of return that the suppliers of capi and owners—requive as compensation for their contibution of capital. Another sway of looking at the cost of capital is that itis the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in ‘a company unless its remrn meets or exceeds what the supplier could earn else- where in an investment of comparable 1isk. -wuweefainstitute-orgitoolkit—Your online preparation resourceCost of Capital A company typically has several alternatives for raising capital, including issue ing equity, debt, and instruments that share characteristics of debt and equity. Each source selected becomes. a component of the company’s funding and has a cost (required rate of return) that may be called a component cost of capital, Because we are using the cost of capital inthe evaluation of investment opporty- nities, we are dealing with a marginal cost—what it would cost to raise additional Fonds for the potential investment project. Therefore, the cost of capital that the investment analyst is concerned with isa marginal cost. Let us focus on the cost of capital for the entire company (later we will address how to adjust that for specific projects). The cost of capital ofa company is the required vate of return that investors demand for the averagerrisk invest- meat of a company. The most common way to estimate this required rate of return is to calculate the marginal cost of each of the various sources of capital and then calculate a weighted average of these costs. This weighted average is referred to as the weighted average cost of capital (WACC), The WACC is also referred to as the marginal cost of capital (MCC) because itis che cost that a company incurs for additional capital. The weights in this weighted average are the proportions of the various sources of capital chat the company uses to stip- port its investment program. Therefore, the WACC, in its most general terms, is WACG = ayy (19 + yy, + 0, as) where ‘ag is the proportion of@Byhat the company uses when it raises new funds ris the before-a mdegina) cost of debt sis the company Kwargisaf tax rate 1, isthe propos ferved stock the company uses when ic raises new finds 1,19 the argind cost of preferred stock 4, is th proportion of equity thar the company uses when it raises new Rings ns "gr of equity Computing the Weighted Average Cost of Capital Assume that ABC Corporation has the following capital structure: 30 percent debt, 10 percent preferred stock, and 60 percent equity, ABC Corporation wishes to maintain these proportions as it raises new funds. Its before-ax cost of debt is 8 percent, its Cost of preferred stock 10 percent, and its cost of equity is 15 percent. JE the company’s marginal tax rate is 40 percent, what is ABC's weighted average cost of capital? Solution: The weighed average cost of capital is WACC = (0.8) (0.08){1 — 0.40) + (0.1) (0.1) + (0.6) (0.15) 1.44 percent. itute.orgftoolkit—Your online preparation resource 37