Financial Mangement (FIN 306)
The Cost of Capital
Chapter 11
Lecture II
Dr. Muhammad Asim Faheem
Department Of Banking and Finance
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Lecture Outline
• Retained Earnings
• The Debt Component and Taxes
• Weighting the Components:
Book Value or Market Value?
• Adjusted Weighted Average Cost of Capital
• Using the Weighted Average Cost of Capital in a
Budgeting Decision
• Individual Weighted Average Cost of Capital for
Individual Projects
• Selecting Appropriate Betas for Projects
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Retained Earnings
Retained earnings does have a cost, i.e., the
opportunity cost for the shareholders not being able to
invest the money themselves.
A company has the option to pay out earnings to the owners
via dividends or retain the earnings for future investment.
Therefore, all retained earnings are an opportunity cost for
the owners.
The cost of retained earnings can be calculated by
using either of the two equity cost approaches, without
including flotation cost.
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The Debt Component and Taxes
Since interest expenses are tax deductible, the cost of
debt, must be adjusted for taxes, as shown below, prior
to including it in the WACC calculation:
After-tax cost of debt = Rd x (1-Tc)
So if the YTM (with flotation cost) = 7.6%,
and the company’s marginal tax rate is 30%,
the after-tax cost of debt= 7.6% x (1 - 0.30)
= 5.32%
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Weighting the Components:
Book Value or Market Value?
To calculate the WACC of a firm, each component’s
cost is multiplied by its proportion in the capital mix
and then summed up.
There are two ways to determine the proportion or
weights of each capital component:
1. Book value, or
2. Market values.
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Book Value
Book value weights can be determined
by taking the balance sheet values for
debt, preferred stock, and common
stock, adding them up, and dividing
each by the total.
These weights, however, do not indicate
the current proportion of each
component. Why?
These financing components are recorded at
their historical costs, not current costs.
The company’s risk profile changes overtime and
this impacts the cost of borrowing
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Market Value
Market value weights are determined by taking the current market
prices of the firm’s outstanding securities and multiplying them by
the number outstanding to get the total current value. Then dividing
each by the total market value produces the proportion or weight of each
If possible, market value weights should be used since they are a
better representation of a company’s current capital structure and risk,
which would be relevant for raising new capital.
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Book Value Vs. Market Value
Example: Calculating capital component weights
Kellogg’s CFO is in the process of determining the firm’s WACC and needs to figure
out the weights of the various types of capital sources. Accordingly, he starts by
collecting information from the balance sheet and the capital markets, and makes
up the Table shown below:
Balance Sheet Number Current
Component Value outstanding Market Price Market Value
Debt $ 150,000,000 150,000 $1,075 $161,250,000
Preferred Stock $ 45,000,000 1,500,000 $40 $ 60,000,000
Common Stock $ 180,000,000 4,500,000 $45.57 $205,065,000
What should he do next?
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Book or Market Value weights
Calculate the total book value and total market value of the capital components
and then
Divide each component’s book value and market value by their respective totals.
Balance Sheet Number Current
Component Value outstanding Market Price Market Value
Total Book Value = $375,000,000; Debt $ 150,000,000 150,000 $1,075 $161,250,000
Preferred Stock $ 45,000,000 1,500,000 $40 $ 60,000,000
Total Market Value = $426,315,000 Common Stock $ 180,000,000 4,500,000 $45.57 $205,065,000
Book Value Weights: Market Value Weights:
Debt = $150m/$375m= 40%;
40% Debt = $161.25m/$426.32m= 38%
P/ S = $45m/$375m= 12%;
12% P/S = $60m/$426.32= 14%
C/S = $180m/$375m= 48%;
48% C/S= $205.07m/$426.32m= 48%
(Rounded to nearest whole number)
He should use the market value weights as they represent
a more current picture of the firm’s capital structure .
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Adjusted Weighted Average Cost of Capital
(WACCadj)
Combine all the weights and component costs into a
single average cost which can be used as the firm’s
discount or hurdle rate:
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Adjusted Weighted Average Cost of Capital
(WACCadj)
Example : Calculating Adjusted WACC
Using the market value weights and the component costs
determined, calculate Kellogg’s adjusted WACC.
Capital Component Weight After-tax Cost%
Debt 0.38 7.6% x (1- 0.30) = 5.32%
Preferred Stock 0.14 10.53%
Common Stock 0.48 11.36%
WACCadj = 0.48 x 11.36% + 0.14 x 10.53% + 0.38 x 5.32%
= 5.45% + 1.47% + 2.02% = 8.94%
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Using the Weighted Average Cost of Capital in a Budgeting
Decision
Once a firm’s WACC has been determined, it can be used
either as the discount rate to calculate the NPV of the
project’s expected cash flow or as the hurdle rate (WACC)
which must be exceeded by the project’s IRR.
Table below presents the incremental cash flow of a $5 million project
being considered by a firm whose WACC is 12%.
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Using the Weighted Average Cost of Capital in a Budgeting
Decision
Using a discount rate of 12%, the project’s NPV would be determined
as follows:
Since the NPV > 0 this would be an acceptable project.
Alternatively, the IRR could be determined using Excel =
14.85%
Again, since IRR > 12%, this would be an acceptable project.
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Individual Weighted Average Cost of Capital for Individual
Projects
Using the WACC for evaluating projects assumes that the project is of average risk. Here
average risk means that average risk of the company overall, not the average risk of the
market.
If projects have varying risk levels, using the same discount rate (WACC) could lead to
incorrect decisions. In addition, firms will tend to pick risky projects and reject projects
with low risk.
4 projects, whose IRRs are 8% 9% 10% and 11%, but the risk levels also go from low to
moderate to high to very high
Applying a constant WACC of 9.5%, only Projects 3 and 4, with IRRs of 10% and 11%
respectively would be accepted.
However, Projects 1 and 2 could have been profitable lower risk projects that are
being rejected in favor of higher risk projects, merely because the risk levels
have not been adequately adjusted for prior to the decision to accept or reject.
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Individual Weighted Average Cost of Capital for
Individual Projects:
To adjust for risk, we would need to get individual project discount
rates (WACCs) based on each project’s beta.
Using a risk-free rate of 3%; a market risk premium of 9%; a before-
tax debt cost of 10%, a tax rate of 30%; equally-weighted debt and
equity levels, and varying project betas we can compute each
project’s hurdle rate as follows:
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Individual Weighted Average Cost of Capital (with Risk Factor)
for Individual Projects
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Selecting Appropriate Betas for Projects
It is important to adjust the discount rate used when
evaluating projects of varying risk, based on their
individual betas.
However, since project betas are not easily
available, it is more of an art than a science.
There are two approaches generally used:
1. Pure play betas: i.e. matching the project with a
company that has a similar single focus, and
using that company’s beta.
2. Subjective modification of the company’s
average beta: i.e. adjusting the beta up or down to reflect
different levels of risk.
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