The Cost of Capital

ID: ma3n0224 name: Suvdaa

Chapter 11- Concept

Cost of Capital is an extremely important financial concept.

In this chapter we will demonstrate how to calculate the cost of specific sources of capital and combine them to arrive at a weighted average cost of capital that firms can use to evaluate investment opportunities.

A weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a weighted average cost of capital calculation. All else equal, the weighted average cost of capital of a firm increases as the beta and rate of return on equity increases, as an increase in weighted average cost of capital notes a decrease in valuation and a higher risk.

Basic Concept

The cost of capital is the rate of return that a firm must earn on the projects in which it invest to maintain the market value of it’s stock. It can also be thought of as the rate of return required by the market suppliers of capital to attract their funds to the firm. It acts as a major link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the market-place. It is, in effect, the “magic number” that is used to decide whether a proposed corporate investment will increase or decrease the firm’s stock price.

The cost of capital is estimated at a given point in time. It reflect the expected average future cost of funds over the long run. Although firms typically raise money in lumps, the cost of capital should reflect the interrelatedness of financing activities. We need to look at the overall cost of capital rather than the cost of the specific source of funds used to finance a given expenditure.

key assumptions:

Business Risk—the risk to the firm of being unable to cover

operating costs—is assumed to be unchanged. This means that the acceptance of a given project does not

affect the firm’s ability to meet operating costs

Financial Risk

—the risk to the firm of being unable to cover required financial obligations—is assumed to be unchanged. This means that the projects are financed in such a way that the firm’s ability to meet financing costs is unchanged.

After-tax costs are considered relevant.

Cost of Capital formulas

In the wake of the terrorist attacks in September of 2001

United Airlines Hence airlines saw costs rise and passenger volume decline.

United Airlines Corporation- In 2002 sought protection from creditors while attempting to reorganize. After 3 years of complex restructuring, the airline finally emerged from bankruptcy on 2006. The extensive restructuring measures- $7 billion in yearly cost reductions from renegotiated airplane leases, new labor contract, 20,000 job cuts, and the elimination of pension obligations-gave it the needed financial edge to fly on its own again. As part of its restructuring, United Airlines required a $3 bollion financing package, provided through a sydnicate led by JPMorganChase and Citigroup Global Markets. UAL received offers of subscription for more than twice the capital necessary to support the $3 billion it sought. As a results, it was able to reduce its financing costs by 75 basis points(0.75%). The financing consisted of a $2.8 billion term loan and a $200 million revolving credit line.

In 2007, a year after emerging from bankruptcy, UAL was able to restructure its $3 billion dept. Using cash, it paid down $972 million of the original $3 billion loan and refinanced the remaining $2 billion. Once again, it eas able to lower its financing costs because of oversubscription of the refinancing. The new loan was set at 200 basis points (2.00%) over LIBOR, a reduction of 175 basis points (1.75%) from the original financing cost. The lower pricing is expected to result in net pre-tax savings of approximately $70 million per year.Although UAL was able to meet its capital needs primarily from operating activities and the issuance of debt, other corporating rely more heavily on issuance of common stock. Each method of raising capital has its unique costs and benefits. Often companies will strive to meet some desired mix of debt and equity capital financing.

Conclusion So United Airlines must be assess the investment

opportunities. Its arrive cost of capital and weighted average cost of capital associated with refinancing.

United Airlines, It will able to lower its financing costs because oversubscription of the refinancing.

UAL need to calculate the cost of retained earnings and the cost of new issue of common stock.

In this chapter we will demonstrate how to calculate the cost of specific sources of capital and combine them to arrive at a weighted average cost of capital that firms can use to evaluate investment opportunities.

Example: United Airlines

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