cost of capital 7

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CHAPTER 7

Cost of Capital


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The Short Story of WACCPurposes/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.

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The Short Story of WACCWhat Costs are Measured?

Costs associated with financing the firms

invested capital including:

Debt Costs: Bank loans

Long-term debtbonds

Equity Costs:

Preferred equity costs

Common equity costs

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The Short Story of WACCWhy the Marginal Cost?

What capital cost the firm 5 months, 5 years

or 5 decades ago is irrelevant. What is relevant is what the next dollar of

capital will cost in todays economic

environment for this particular firm.

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The Short Story of WACCSteps in Solving for the WACC

1. Identify the relevant sources of capital (debt and

equity).

2. Estimate the market values for the sources ofcapital 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.

CHAPTER 20 Cost of Capital 20 - 5


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The Short Story of WACCThe 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.

)1(

V

DTK

V

SKKWACC

dea

The cost of equity

times the market

value weight of

equity

The cost of debt

after tax times the

market value weight

of debt


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The Short Story of WACCThe Spreadsheet Approach

(1) (2) (3) (4) = (2)*(3)

Type of

Capital

Specific

Marginal Cost

after tax andfloatation

costs

MarketValue

Weights

Weighted

SpecificMarginal

Cost

Long-Term Debt 5.5% 43.0% 0.02365

Preferred Stock 11.4% 11.0% 0.01254

Common Stock 12.9% 46.0% 0.05934

WACC = 9.55%


WACC is the sum of the weightedspecific marginal costs of each source ofcapital.


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Important Terms

Financial Structure

Includes both short-term and long-term sources of financing (debt andequity)

Capital Structure

How the firm finances its invested capital Includes long-term sources of financing

Includes:

Bank Loans

Long-term debt

Common stock and retained earnings

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Financing SourcesCapital Structure

$50 Accruals $100

200 Accounts payable 200

250 Short-term debt 50

0 Total current liabilities 350

Total current assets 500 Long-term debt 650

1,500 Shareholders' equity 1,000

Total assets $2,000 Total liabilities and shareholders' equity $2,000

Prepaid expenses

Net fixed assets

Table 20-2 A "Simplified" Balance Sheet

Cash and marketable securities

Accounts receivable

Inventory


Financial Structure = $2,000Capital Structure = $1,700


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Financing SourcesInterpreting Balance Sheets

Balance sheets are prepared in accordance with GAAP:

Represent historical costs which may not be relevant for currentdecision-making purposes.

Analysis of reported data should include ratios such as:

DebttoEquity: Interest bearing debt to shareholders equity plus minority interest

Convert book values to market values

This is done by multiplying the market-to-book ratio times the book value.

Interpret the ratios again.

(Table 20 2 will be used to illustrate the adjustment process from book values tomarket values)



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cost of capital 7

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