Cost of capital
The cost of capital is the return investors require for providing funds. It sets the hurdle every investment must clear.
What the cost of capital is
A firm's cost of capital is the minimum return it must earn on investments to satisfy its lenders and shareholders. It reflects the opportunity cost of investors' money: what they could earn on other investments of similar risk. Projects earning less than the cost of capital destroy value.
Cost of debt
The cost of debt is the yield lenders require, such as the yield to maturity on the firm's bonds. Because interest is tax-deductible, the after-tax cost of debt = pre-tax cost x (1 - tax rate). With a 6% yield and a 21% tax rate, the after-tax cost of debt is about 4.74%.
Cost of equity
The cost of equity is the return shareholders require. It can be estimated using CAPM (risk-free rate + beta x market risk premium) or the dividend growth model (D1 / P0 + g). Equity is riskier than debt for investors, so the cost of equity is higher than the cost of debt.
Cost of preferred stock
The cost of preferred stock is its annual dividend divided by its price: a preferred share paying 5 dollars a year and priced at 80 dollars has a cost of 6.25%. Preferred dividends are not tax-deductible for the issuer.
The weighted average cost of capital
The weighted average cost of capital (WACC) weights each source by its share of total financing at market values: \(WACC = \frac{E}{V}R_E + \frac{D}{V}R_D(1 - T)\), where E and D are the market values of equity and debt, V = E + D, and T is the tax rate. WACC is the discount rate for projects of average risk.
WACC = \tfrac{E}{V}R_E + \tfrac{D}{V}R_D(1-T)Using WACC correctly
WACC applies to projects with the same risk as the firm's existing business. Riskier projects need higher discount rates; safer ones lower rates. Divisions in different industries should use divisional costs of capital, often estimated from pure-play comparable firms in those industries.
Flotation costs
Raising new capital involves costs such as underwriting fees, legal costs, and the discount often needed to sell new shares. These flotation costs can be included by treating them as an extra initial cost of the project, increasing the investment required.
Worked example
A firm has equity worth 60 million dollars and debt worth 40 million. Cost of equity is 11%, pre-tax cost of debt 6%, tax rate 25%. WACC = 0.6 x 11% + 0.4 x 6% x (1 - 0.25) = 6.6% + 1.8% = 8.4%. Average-risk projects must earn at least 8.4% to create value.
Key takeaways
The cost of capital is the minimum return required by investors and the hurdle rate for projects. The after-tax cost of debt = pre-tax yield x (1 - tax rate). The cost of equity uses CAPM or the dividend growth model and exceeds the cost of debt. Preferred stock cost = dividend / price. WACC weights components by market value. Use WACC only for average-risk projects; adjust for different risk. Flotation costs add to project costs.
Flashcard
Minimum return investors require
Check your understanding
A firm's pre-tax cost of debt is 8% and its tax rate is 25%. What is its after-tax cost of debt?