Transcript The Weighted Cost of Capital

The Weighted Cost of Capital
Objectives
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Define the concept of cost of capital.
Use the concept of cost of capital to link the
investment decisions with financing decisions.
Examine the key factors that affect a firm’s
weighted cost of capital.
Consider the assumptions of the weighted cost of
capital model.
Study the procedure to estimate a firm’s weighted
average cost of capital.
Concept of Cost of Capital
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The cost of capital is the rate that the firm must
earn on its investment in order to satisfy the
required rate of return of the firm’s investors.
The weighted cost of capital (WCC) for a firm is
equal to the cost of each source of financing (debt,
preferred stock, common stock) multiplied by the
percentage of the financing provided by that
source.
Linkage
Financing Decisions
affects
Cost of Capital
affects
Investment Decisions
affects
Using WCC for Investment
Decisions
IRR
Weighted Cost of Capital
IRR
IRR
IRR
Percent
A
Optimal decision: Invest a total of
17 million in projects A, B, and C.
B
C
D
5
12
17
20
Financing (millions)
Factors Determining WCC
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General Economic Conditions
• An increase in riskless rate increases the WCC. The riskless rate
is determined by:
– the demand and supply of capital within the economy.
– the expected level of inflation.
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Market Conditions
• The WCC increases due to an increase in the market risk as
investors demand a higher risk premium.
• The market risk could increase due to decrease in the liquidity
of the security.
Factors Determining WCC
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Firm’s Operating and Financing Decisions
• Risk also results from the decisions made within the
company. The risk can be divided into two classes:
– Business Risk: Refers to the variability in returns on
assets and is affected by the company’s investment
decisions.
– Financial Risk: Refers to the increased variability in
returns to the common stockholders as a result of
using debt and preferred stock.
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Amount of Financing
• An increase in the amount of financing increases the
WCC as a result of increase in flotation costs.
• The risk premium may be a non-linear function of
amount of funds.
Assumptions of WCC Model
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Constant Business Risk: The model assumes that
any investment being considered will not
significantly change the firm’s business risk.
Constant Financial Risk: Management is assumed
to use the same financial mix as it used in the past.
Constant Dividend Policy: The model assumes that
the firm’s dividends are growing at a constant rate
and that the dividend payout ratio is constant.
Computing the WCC
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Determine the cost of capital for individual source
of financing (debt, preferred stock, and common
stock).
Determine the percentage of debt, preferred stock,
and common stock to be used for financing future
investment.
Use the individual costs and the capital structure
percentage in the first two steps to compute the
WCC.
Level of Financing and WCC
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Effect of additional financing on the cost of capital
• Issuing new common stock will increase the firm’s
weighted cost of capital because external equity capital
has a higher cost than internally generated common
equity.
• As we use additional debt and preferred stock, their cost
may increase, which will result in an increase in WCC.