ipptch011 finance

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Finance 3rd Edition

Cornett, Adair, and Nofsinger

11

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Calculating the

Cost of Capital


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The WACC Formula

Weighted Average Cost of Capital (WACC) Average cost per dollar of capital raised

Weights based on market values, not book

values

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved


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WACC


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Component Cost of Equity

Two ways to calculate Capital Asset Pricing Model (CAPM)

Constant-growth model


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Component Cost of Equity and CAPM

Not appropriate when historical datainsufficient or not good indicator of future

CAPM generally more accurate


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Component Cost of Equity and Constant-growth Model

Use when constant dividend growthexpected on limited number of stocks


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Component Cost of Preferred Stock

Calculate with constant-growth model


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Component Cost of Debt

Debt is tax deductible Two-part calculation adjusts to after-tax rate

of return


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Tax Rates

Firms marginal tax rate affects benefit ofdebt-interest deductibility

WACC tax rate

Weighted average of marginal tax rates onincome shielded by interest deduction


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Calculating WACC Weights

Percentages of funding that come from

Equity

Preferred stock

Debt


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Firm vs. Project WACC

Firm WACC Use for evaluating typical projects

Project WACC

Use with atypical projects, i.e. high- or low-

risk


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Divisional WACC

Less time-consuming, uses fewerresources

Divides firms existing projects into

divisions WACC based on each divisions average

project risk


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Risk-Appropriate WACC

Sloped line represents return rates andrisk


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Inappropriate Use of Firm-wide WACC

Incorrect

Decisions


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Divisional WACC

Use of divisional WACC reduces errors


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Subjective vs. Objective

Subjective approach to assessing riskresults in arbitrary adjustments

Created only for current project


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Flotation Costs

Externally-generated capital Stock issues

Bond issues

Issuing securities generates underwritingcosts such as commissions


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Flotation Costs

Two ways to account for flotation costs1) Increase costs as percentage of WACC

2) Adjust initial project investment upwards

ipptch011 finance

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