The Cost of Capital
Group 1
Team Member :
Charlenee Mischa Chandra (2307521102) (10) Agnes Florenza Surjadidjaja (2307521115) (13)
Natasya Eveline (2307521119) (15)
I Komang Mahadi Gautama Saputra (2307521177) (20) Gilbert Maxwell Pasau Tandipayuk (2307521112) (33)
Faculty of Economics and Business Udayana University
2024
I. An Overview of the Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) is a tool to figure out how much it costs a company to get money. It considers the cost of different ways a company gets money, like loans and selling shares, and how much of each type it uses. This helps understand the overall cost of money for the company. WACC is important because it helps decide how valuable a company is when looking at its future earnings.
Table 10.1 in Allied Food Products' report gives extra details about their money situation:
1. It tells us the actual money put in by investors, like banks and stockholders, based on accounting.
2. It also shows how much that money is worth now in the market.
3. Plus, it tells us the plan for where future money will come from, like loans and stocks.
When we calculate WACC (weighted average cost of capital), we focus on the money that investors put in, like loans and stocks. We don't count things like bills or sudden debts during projects because they're not directly from investors.
In the first column, it says that according to regular accounting, 47.8% of Allied's money is from loans, and 52.2% is from stocks.
But investors care more about how much their money is worth now. That's what's in the second column. We assume the worth of Allied's loans is the same as what's on paper.
The value of their stocks is figured by how many shares they have multiplied by the current stock price. Allied has 75 million shares of common stock outstanding, and each share trades at $23.06, making the market value of its equity $1.73 billion. Because this market value of equity is higher than the book value, Allied's market-based capital structure has more equity (66.8%) than what was calculated using accounting (52.2%).
These market-based numbers are a good starting point, but the important thing is the target capital structure. This structure is the mix of debt, preferred stock, and common equity that Allied plans to use for future projects. It's like the ideal balance that maximizes the company's value. In the third column, Allied has decided its target capital structure should be 33% debt, 2% preferred stock, and 65% common equity, and they plan to raise money in those proportions in the future. We use these target weights when we calculate Allied's WACC. So, Allied's overall cost of capital is an average of the costs of the different types of capital it uses, with the weights based on its target capital structure.
II. Basic Definitions
Investor-supplied stuff like loans, preferred stock, and regular stock are called capital components. Firms use these to get money. When a company needs more assets, it has to get more of these capital components. The cost of each type is called its component cost. For example, if Allied can borrow at 8%, then its component cost of debt is 8%.
These costs are all added up to make the WACC (weighted average cost of capital).
This WACC is used by companies when they're figuring out how to get money for their projects. Here are the symbols that show the cost and how much each type counts:
The target proportions of debt (wd), preferred stock (wp), and common equity (wc), along with the costs of those components, are used to calculate the firm's weighted average cost of capital, WACC(weighted average cost of capital). WACC is the average cost of debt,
preferred stock, and regular stock for the company. We assume that any new regular stock is paid from profits kept by the company, which is the case for most companies. So, the cost of
regular stock is called rs.
Only debt gets a tax adjustment factor (1 - T). This is because companies can deduct interest on debt from their taxes, but they can't do the same for preferred dividends or returns on regular stock (like dividends and profits from selling stock).
III. Cost of Debt
Before-tax cost of debt is the interest rate a firm must pay on its new debt. Before-tax cost of debt is symbolized by 𝑟 . We can estimate Before-tax cost of debt by asking their
𝑑
bankers what will cost to borrow of finding the yield to maturity on their currently outstanding debts. However, After-tax cost of debt is the relevant cost of new debt, taking into account the tax deductibility of interest. After-tax cost of debt is symbolized by After-tax cost of debt used to calculate WACC because we interested about 𝑟𝑑(1 − 𝑇).
maximizing company stock value, which depends on after-tax cash flow Example :
If Allied can borrow at an interest rate of 8%, and its marginal federal-plus-state tax rate is 25%, its after-tax cost of debt will be 6%
IV. Cost of Preferred Stock
Cost of preferred stock is the rate of return investors require on the firm’s preferred stock. Cost of preferred stock is symbolized by𝑟 .Preferred dividend, Dp, divided by the current
𝑝
price of the preferred stock, Pp:
The formula
Example :
Allied would sell this stock to a few large hedge funds, the stock would have a $10.00 dividend per share, and it would be priced at $97.50 a share.
V. Cost of Retained Earnings, rs
The rate of return required by stockholders on a firm’s common stock.
Cost of Debt and Preferred Stocks
The cost of debt and preferred stock are based on the returns that investors require on these securities, the cost of common equity is based on the rate of return that investors require on the company’s common stock.
new common equity is raised in two ways:
(1) by retaining some of the current year’s earnings and (2) by issuing new common stock
Cost of common Equity
The cost of common equity is based on the rate of return that investors require on the company’s common stock. This cost is divided into 2 components :
- Retained Earnings (rs) - New common stocks (re)
Retained earnings are considered “free” because they don’t have direct costs, but they still have an opportunity cost, as they could be invested elsewhere.
Opportunity Cost of Retained Earnings
The firm needs to earn at least as much money on any earnings retained as the stockholders could earn on alternative investments of comparable risk. This rate of return is represented by rs ,which is the expected rate of return that stockholders expect to earn on their money.
Estimating the Cost of Equity from Retained Earnings
The cost of equity from retained earnings (rs) can be estimated using various techniques, including the expected rate of return, risk free-rate, risk premium, expected dividend yield, and expected.
CAPM Approach
CAPM approach for estimating the cost of common equity involves four steps : 1. Estimate the risk-free rate (rRF)
This is typically done using the 10-year Treasury bond rate or the short-term treasury bill rate.
2. Estimate the Stock’s Beta Coefficient (bi)
This measures the stock’s risk relative to the market. A higher beta indicates higher risk.
3. Estimate the Market Risk Premium (rpm)
This is the difference between the return that investors require on an average stock and the risk-free rate.
4. Substitute the Values in the CAPM Equation
This involves using the risk-free rate, the stock’s beta and the market risk premium to estimate the required rate of return on the stock.
The CAPM estimate of the cost of equity (rs) is calculated as:
Rs= rRF + Rpm * bi
Using the example provided, if the risk-free rate is 4.5%, the market risk premium is 5.0%, and Allied’s beta is 1.50, the estimated cost of equity is :
Rs = 4.5% +5.0% * 1.50 = 12.0%
However, the CAPM approach has several potential problems : 1. Underestimation of Stand-Alone Risks
If a firm’s stockholders are not well diverse, they may be concerned with stand-alone risk rather than just market risk. This could lead to an underestimation of the correct value of rs
2. Difficulty in Estimating Required Inputs
Estimating the beta that investors expect the company to have in the future and determining the proper market risk.
The Bond-Yield-Plus-Risk-premium Approach
This method is used to estimate the cost of equity when reliable inputs for the Capital Asset Pricing Model (CAPM) are not available. This approach involves adding a judgemental risk premium to the interest rate on the firm’s own long-term debt to estimate the cost of equity.
The risk premium is typically estimated to be between 3% to 5% based on empirical studies.
This means that if a company's bonds yield 8%, for example, its cost of equity might be estimated as 11% (8% + 3%). If the company's bonds yield 12%, its cost of equity would be 16% (12% + 4%).
This approach is subjective and does not produce a precise cost of equity. However, it can provide a reasonable estimate within a range. For instance, if the risk premium is estimated to be between 3% to 5%, the estimated cost of equity for Allied could be between 11% to 13%.
This method is useful because it utilizes the logic that firms with risky, low-rated and high-interest-rate debt also have risky, high-cost equity. By basing the cost of equity on the firm's own readily observable debt cost, this approach provides a more realistic estimate of the cost of equity compared to the CAPM approach.
Averaging the Alternative Estimates
Allied’s management has chosen to use the Capital Asset Pricing Model (CAPM) method, which estimates the cost of equity as 12.0%. This method is widely used and accepted, and it provides a straightforward way to calculate the expected return based on the risk-free rate, the market risk premium, and the beta of the company or project. The CAPM method is easy to apply and widely accepted, but it also has some limitations, such as relying on historical data, ignoring company-specific risks, and being sensitive to changes in beta
The CAPM method is recommended if you have reliable data on beta and market risk premium, and if you want to capture the systematic risk of the company or project. The method is also easy to use and provides a straightforward way to calculate the expected return, making it a reliable choice for estimating the cost of equity
VI. Cost of New Common Stock
Companies often enlist investment bankers for issuing new common stock, and sometimes for preferred stock or bonds. In exchange for a fee, investment bankers assist in structuring terms, setting prices, and selling the issue to investors. These fees, known as flotation costs, add to the total capital raised, comprising the investors' required return plus flotation costs.
While equity flotation costs are typically insignificant for most firms due to retained earnings, they can be substantial when issuing new stock. Thus, when planning to issue new stock, these costs should not be disregarded. Two approaches are commonly used to account for flotation costs when firms engage investment bankers for capital raising, which we'll discuss in the following sections.
1. Add flotation cost to a project cost
One approach to handling flotation costs, found as the sum of the flotation costs for the debt, preferred, and common stock used to finance the project, is to add this sum to the initial investment cost. Because the investment cost is increased, the project’s expected rate of return is reduced.
example : Consider a 1-year project with an initial cost (not including flotation costs) of $100 million. After 1 year, the project is expected to produce an inflow of $115 million. Therefore, its expected rate of return is $115⁄$100 - 1 5= 0.15 = 15.0%.
However, if the project requires the company to raise $100 million of new capital and incur $2 million of flotation costs, the total upfront cost will rise to $102 million, which will lower the expected rate of return to $115 ⁄ $102 - 1 = 0.1275 = 12.75%.
2. Increase the cost of capital
The second approach involves adjusting the cost of capital rather than increasing the project’s investment cost. If the firm plans to continue using the capital in the future, as is generally true for equity, this second approach theoretically will be better. The adjustment process is based on the following logic.
If there are flotation costs, the issuing firm receives only a portion of the capital provided by investors, with the remainder going to the underwriter. To provide investors with their required rate of return on the capital they contributed, each dollar the firm actually receives must “work harder”; that is, each dollar must earn a higher rate of return than the investors’ required rate of return.
example : suppose investors require a 10.7% return on their investment, but flotation costs represent 10% of the funds raised. Therefore, the firm actually keeps and invests only 90% of the amount that investors supplied. In that case, the firm must earn about 11.3% on the available funds in order to provide investors with a 10.7% return on their investment. This higher rate of return is the flotation-adjusted cost of equity.
The DCF approach can be used to estimate the effects of flotation costs. Here is the equation for thecost of new common stock,re:
F (Flotation Cost) The percentage cost of issuing new common stock. (1 - F) is the𝑃
0
net price per share received by the company.
Assuming that Allied has a flotation cost of 10%, its cost of new common equity, ,𝑟
𝑒
would be calculated as follows:
this is higher than previously estimated which is 10.7%. DCF cost of equity, so the flotation cost adjustment is 0.6%
The 0.6% flotation cost adjustment can be added to the previously estimated 𝑟
𝑠 = 12.0% (Allied management’s estimate of its cost of equity considering the CAPM approach), resulting in a cost of equity from new common stock, or external equity, of 12.6%:
If Allied earns 12.6% on funds obtained from selling new stock, the investors who purchased that stock will end up earning 12.0%, their required rate of return, on the money they invested. If Allied earns more than 12.6%, its stock price should rise, but the price should fall if Allied earns less than 12.6%.
3. When must external equity be used?
Flotation costs mean that money raised by selling new stock needs to generate higher returns compared to money from retained earnings. Retained earnings are cheaper as they don't involve flotation costs. So, companies should primarily use retained earnings. But if a company has more investment opportunities than it can fund with retained earnings, plus debt and preferred stock backed by those earnings, it may need to issue new common stock.
The total amount of capital that can be raised before new stock must be issued is defined as theretained earnings breakpoint, and it can be calculated as follows:
example : Allied’s addition to retained earnings in 2022 is expected to be $66 million.
and its target capital structure consists of 33% debt, 2% preferred, and 65% equity.
Therefore, its retained earnings breakpoint for 2022 is as follows:
To prove that this is correct, note that a capital budget of $101.5 million could be financed as 0.33($101.5) = $33.5 million of debt, 0.02($101.5) = $2.0 million of preferred stock, and 0.65($101.5) = $66 million of equity raised from retained earnings.
Up to a total of $101.5 million of new capital raised for the capital budget will not exhaust the addition to retained earnings, so equity would have a cost of 𝑟 12.0%.
𝑠 =
However, if the capital budget exceeded $101.5 million, the addition to retained earnings would be exhausted, and Allied would have to obtain equity by issuing new common stock at a cost of𝑟 12.6%.
𝑠=
VII. Composite, or Weighted Average, Cost of Capital, WACC
Allied’s target capital structure calls for 33% debt, 2% preferred stock, and 65%
common equity. Earlier we saw that its before-tax cost of debt is 8.0%; its after-tax cost of debt is rd(1 - T) = 8%(0.75) = 6.0%; its cost of preferred stock is 10.3%; its cost of common equity from retained earnings is 12.0%; and its marginal tax rate is 25%. Equation 10.1, presented earlier, can be used to calculate its WACC when all of the new common equity comes from retained earnings:
Under these conditions, every dollar of new capital that Allied raises would consist of 33 cents of debt with an after-tax cost of 6%, 2 cents of preferred stock with a cost of 10.3%, and 65 cents of common equity from additions to retained earnings with a cost of 12.0%. The average cost of each whole dollar, or the WACC, would be 10.0%. This estimate of Allied’s WACC assumes that common equity comes exclusively from retained earnings.
If, instead, Allied had to issue new common stock, its WACC would be slightly higher because of the additional flotation costs:
VIII. Factors That Affect the WACC
There is two factors that affect the WACC such as : A. Factors the firm cannot control
The three most important factors that the firm cannot directly control are interest rates in the economy, the general level of stock prices, and tax rates. The cost of capital for a firm can be influenced by factors beyond its control. These include interest rates, stock market conditions, and tax rates. Higher interest rates mean the firm pays more to borrow, while a declining stock market makes issuing new shares more expensive. Taxes also play a role, as changes in tax rates can affect the relative attractiveness of debt and equity financing.
Imagine a company, Let's call it "SunCo" considering expanding its operations. To finance this, they need capital. Here's how the three uncontrollable factors can affect SunCo's cost of capital:
● Interest Rates: If interest rates rise, borrowing money becomes more expensive for SunCo. They'll have to pay a higher interest rate on any loans they take out, increasing the cost of debt financing.
● Stock Market: If the stock market is doing poorly and SunCo's stock price falls, issuing new shares to raise capital becomes less attractive. Investors will be less willing to pay a high price for SunCo's shares, making equity financing more
expensive.
● Tax Rates: Changes in tax laws can impact the cost of capital. For instance, if taxes on corporate debt are lowered, borrowing becomes more appealing for SunCo compared to issuing stock. This can lead to a lower overall cost of capital.
B. Factors the firm can control
A firm can directly affect its cost of capital in three primary ways: (1) by changing its capital structure, (2) by changing its dividend payout ratio, and (3) by altering its capital budgeting decision rules to accept projects with more or less risk than projects previously undertaken.
Capital structure impacts a firm’s cost of capital. So far we have assumed that Allied has a given target capital structure, and we used the target weights to calculate its WACC. However, if the firm changes its target capital structure, the weights used to calculate the WACC will change. Other things held constant, an increase in the target debt ratio tends to lower the WACC (and vice versa if the debt ratio is lowered) because the after-tax cost of debt is lower than the cost of equity. However, other things are not likely to remain constant. An increase in the use of debt will increase the riskiness of both the debt and the equity, and these increases in component costs might more than offset the effects of the changes in the weights and raise the WACC.
Dividend policy affects the amount of retained earnings available to the firm and thus the need to sell new stock and incur flotation costs. This suggests that the higher the dividend payout ratio, the smaller the addition to retained earnings, the higher the cost of equity, and therefore the higher the firm’s WACC will be. However, investors may prefer dividends to retained earnings, in which case reducing dividends might lead to an increase in both rs and re.
The firm’s capital budgeting decisions can also affect its cost of capital. When we estimate the firm’s cost of capital, we use as the starting point the required rates of return on its outstanding stock and bonds. These cost rates reflect the riskiness of the firm’s existing assets. Therefore, we have been implicitly assuming that new capital
will be invested in assets that have the same risk as existing assets. This assumption is generally correct, as most firms do invest in assets similar to ones they currently operate. However, if the firm decides to invest in an entirely new and risky line of business, its component costs of debt and equity (and thus its WACC) will increase.
IX. Adjusting the Cost of Capital for risk
The cost of capital is a key element in the capital budgeting process. Projects should be accepted if and only if their estimated returns exceed their costs of capital. Thus, the cost of capital is a “hurdle rate” a project’s expected rate of return must “jump the hurdle” for it to be accepted. Moreover, investors require higher returns on riskier investments. Consequently, companies that are raising capital to take on risky projects will have higher costs of capital than companies that are investing in safer projects.
Figure 10.1 illustrates the trade-off between risk and the cost of capital. Firm L is in a low-risk business and has a WACC of 8%. Firm A is an average-risk business with a WACC of 10%, whereas Firm H’s business is exposed to greater risk and consequently has a WACC of 12%. Thus, Firm L will accept a typical project if its expected return is above 8%. Firm A’s hurdle rate is 10%, whereas the cor- responding hurdle rate for Firm H is 12%.
It’s important to remember that the costs of capital for Firms L, A, and H in Figure 10.1 represent the overall, or composite, WACCs for the three firms and thus apply only to
“typical” projects for each firm. However, different projects often have different risks, even for a given firm. Therefore, each project’s hurdle rate should reflect the risk of the project, not the risk associated with the firm’s average project as reflected in its composite WACC.
Empirical studies do indicate that firms consider the risks of individual projects, but the studies also indicate that most firms regard most projects as having about the same risk as the firm’s average existing assets. Therefore, the WACC is used to evaluate most projects, but if a project has especially high or low risk, the WACC will be adjusted up or down to account for the risk differential.
X. Some Other Problems with Cost of Capital Estimates
1. Depreciation-generated funds : It mentions that depreciation, a major funding source for firms, isn't factored in. The cost of this capital is similar to the WACC of retained earnings and debt, so it can be ignored for practical purposes.
2. Privately owned firms : The discussion focused on publicly traded companies.
Measuring the cost of equity for private firms (not publicly traded) is more complex due to lack of data and tax considerations.
3. Measurement problems : Obtaining accurate data for cost of equity calculations (CAPM model, growth rates, risk premiums) is challenging, leading to uncertainty in the final cost of capital estimate.
4. Cost of capital for projects of differing risk : Different projects have varying risk levels requiring different return rates. However, accurately measuring project risk to adjust the cost of capital for such projects is difficult.
5. Capital structure weight : target capital structure (debt vs equity ratio) for WACC calculation. Determining the optimal capital structure itself is a complex task
