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Chapter 14

The Cost of
Capital

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Slide Contents

Learning Objectives
Principles Used in This Chapter
1. The Cost of Capital: An Overview
2. Determining the Firms Capital Structure
Weights
3. Estimating the Costs of Individual Sources of
Capital
4. Summing Up Calculating the Firms WACC
5. Estimating Project Cost of Capital
6. Floatation costs and Project NPV
Key Terms 14-2
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Learning Objectives

1. Understand the concepts underlying the


firms overall cost of capital and the
purpose of its calculation.
2. Evaluate a firms capital structure, and
determine the relative importance
(weight) of each source of financing.
3. Calculate the after-tax cost of debt,
preferred stock, and common equity.

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14-3
Learning Objectives (cont.)

4. Calculate a firms weighted average


cost of capital
5. Discuss the pros and cons of using
multiple, risk-adjusted discount rates.
Describe the divisional cost of capital
as a viable alternative for firms with
multiple divisions.
6. Adjust NPV for the costs of issuing new
securities when analyzing new
investment opportunities.
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14-4
Principles Used in This Chapter

Principle #1: Money Has a Time Value.


Principle #3: Cash Flows Are the Source of
Value.

Estimates of investors required rate of return


extracted from observed market prices are
based on principles #1 and #3.

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14-5
Principles Used in This Chapter
(cont.)

Principle #2: There Is a Risk-Return


Tradeoff.

Investors who purchase a firms common stock


require a higher expected return than investors
who loan money.

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14-6
14.1 The Cost
of Capital:
An Overview

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The Cost of Capital: An Overview

Cost of capital is the weighted average of


the required returns of the securities that
are used to finance the firm. We refer to
this as the firms Weighted Average Cost
of Capital, or WACC.

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14-8
The Cost of Capital: An Overview
(cont.)

Most firms raise capital with a combination


of debt, equity, and hybrid securities.

WACC incorporates the required rates of


return of the firms lenders and investors
and the particular mix of financing sources
that the firm uses.

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14-9
The Cost of Capital: An Overview
(cont.)

How does riskiness of firm affect WACC?

Required rate of return on securities will be


higher if the firm is riskier.

Risk will influence how the firm chooses to


finance i.e. proportion of debt and equity.

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14-10
The Cost of Capital: An Overview
(cont.)

WACC is useful in a number of settings:


WACC is used to value the firm.
WACC is used as a starting point for
determining the discount rate for investment
projects the firm might undertake.
WACC is the appropriate rate to use when
evaluating performance, specifically whether
or not the firm has created value for its
shareholders.

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14-11
WACC equation

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14-12
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14-13
Three Step Procedure for Estimating
Firm WACC

1. Define the firms capital structure by


determining the weight of each source of
capital. (see column 2, figure 14-2)
2. Estimate the opportunity cost of each
source of financing. We will use the
current market value of each source of
capital based on its current, not historical,
costs. (see column 3, figure 14-2)

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14-14
Three Step Procedure for Estimating
Firm WACC (cont.)

3. Calculate a weighted average of the costs


of each source of financing. (see column
4, figure 14-2)

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14-15
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14-16
14.2 Determining
the Firms Capital
Structure Weights

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Determining the Firms Capital
Structure Weights

The weights are based on the following


sources of capital: debt (short-term and
long-term), preferred stock and common
equity.

Liabilities such as accounts payable and


accrued expenses are not included in
capital structure.

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14-18
Determining the Firms Capital
Structure Weights (cont.)

Ideally, the weights should be based on


observed market values. However, not all
market values may be readily available.
Hence, we generally use book values for
debt and market values for equity.

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14-19
Checkpoint 14.1
Calculating the WACC for Templeton Extended Care
Facilities, Inc.
In the spring of 2010, Templeton was considering the acquisition of a chain of
extended care facilities and wanted to estimate its own WACC as a guide to
the cost of capital for the acquisition. Templetons capital structure consists of
the following:

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14-20
Checkpoint 14.1
Calculating the WACC for Templeton Extended Care
Facilities, Inc. (Cont.)
Templeton contacted the firms investment banker to get estimates of the
firms current cost of financing and was told that if the firm were to borrow
the same amount of money today, it would have to pay lenders 8%; however,
given the firms 25% tax rate, the after-tax cost of borrowing would only be
6% 8%(1.25). Preferred stockholders currently demand a 10% rate of
return, and common stockholders demand 15%. Templetons CFO knew that
the WACC would be somewhere between 6% and 15% since the firms capital
structure is a blend of the three sources of capital whose costs are bounded
by this range.

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14-21
Checkpoint 14.1

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14-22
Checkpoint 14.1

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14-23
Checkpoint 14.1

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14-24
Checkpoint 14.1: Check Yourself

After completing her estimate of Templetons WACC, the CFO


decided to explore the possibility of adding more low-cost
debt to the capital structure. With the help of the firms
investment banker, the CFO learned that Templeton could
probably push its use of debt to 37.5% of the firms capital
structure by issuing more debt and retiring (purchasing) the
firms preferred shares. This could be done without
increasing the firms costs of borrowing or the required rate
of return demanded by the firms common stockholders.
What is your estimate of the WACC for Templeton under this
new capital structure proposal?

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14-25
Step 1: Picture the Problem
16%

14%

12%

10%

8%

6%

4%

2%

0%
Debt Prefered Stock Common Stock

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14-26
Step 1: Picture the Problem (cont.)

Capital Structure Weights

37.5%
Debt

62.5%,
Common stock

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14-27
Step 2: Decide on a Solution
Strategy

We need to determine the WACC based on


the given information:

Weight of debt = 37.5%; Cost of debt = 6%

Weight of common stock = 62.5%; Cost of


common stock =15%

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14-28
Step 2: Decide on a Solution
Strategy (cont.)

We can compute the WACC based on the


following equation:

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14-29
Step 3: Solve

The WACC is equal to 11.625% as


calculated below.

Weights Cost Product


Debt 0.375 0.06 0.0225
Common Stock 0.625 0.15 0.09375
Preferred Stock 0 0.1 0
1 WACC 0.11625

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14-30
Step 4: Analyze

We observe that as Templeton chose to


increase the level of debt to 37.5% and
retire the preferred stock, the WACC
decreased marginally from 12.125% to
11.625%.

Thus altering the weights will change the


WACC.

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14-31
14.3 Estimating
the Cost of
Individual
Sources of Capital

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The Cost of Debt
The cost of debt is the rate of return the
firms lenders demand when they loan
money to the firm.
Note, the rate of return is not the same as
coupon rate, which is the rate contractually
set at the time of issue.
We can estimate the markets required rate
of return by examining the yield to
maturity on the firms debt.

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14-33
The Cost of Debt (cont.)

After-tax cost of debt = Yield (1-tax rate)

Example 14.1 What will be the yield to


maturity on a debt that has par value of
$1,000, a coupon interest rate of 5%,
time to maturity of 10 years and is
currently trading at $900? What will be the
cost of debt if the tax rate is 30%?

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14-34
The Cost of Debt (cont.)

Enter:
N = 10; PV = -900; PMT = 50; FV =1000
I/Y = 6.38%

After-tax cost of Debt = Yield (1-tax rate)


= 6.38 (1-.3)
= 4.47%

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14-35
The Cost of Debt (cont.)

It is not easy to find the market price of a


specific bond as most bonds do not trade
in the public market.
Because of this, it is a standard practice to
estimate the cost of debt using yield to
maturity on a portfolio of bonds with
similar credit rating and maturity as the
firms outstanding debt.

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14-36
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14-37
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14-38
The Cost of Preferred Equity

The cost of preferred equity is the rate of


return investors require of the firm when
they purchase its preferred stock. The
cost is not adjusted for taxes since
dividends are paid to preferred
stockholders out of after-tax income.

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14-39
The Cost of Preferred Equity (cont.)

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14-40
The Cost of Preferred Equity (cont.)

Example 14.2 Consider the preferred


shares of Relay Company that are trading
at $25 per share. What will be the cost of
preferred equity if these stocks have a par
value of $35 and pay annual dividend of
4%?

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14-41
The Cost of Preferred Equity (cont.)

kps = $1.40 $25 = .056 or 5.6%

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14-42
The Cost of Common Equity

The cost of common equity is the rate of


return investors expect to receive from
investing in firms stock. This return comes
in the form of cash distributions of
dividends and cash proceeds from the sale
of the stock.

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14-43
The Cost of Common Equity (cont.)

Cost of common equity is harder to


estimate since common stockholders do
not have a contractually defined return
(similar to interest on bonds or dividends
on preferred stock). There are two
approaches to estimating the cost of
common equity:
Dividend growth model (introduced in chapter
10)
CAPM (introduced in chapter 8)

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14-44
The Dividend Growth Model
Discounted Cash Flow Approach

Using this approach, we estimate the


expected stream of dividends as the
source of future estimated cash flows.
We use the estimated dividends and
current stock price to calculate the internal
rate of return on the stock investment.
This return is used as an estimate of cost
of equity.

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14-45
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14-46
Checkpoint 14.2
Estimating the Cost of Common Equity for Pearson plc
Using the Dividend Growth Model
Pearson plc (PSO) is an international media company that
operates three business groups: Pearson Education, the
Financial Times, and Penguin. In the spring of 2009, Pearsons
CFO called for an update of the firms cost of capital. The first
phase of the estimation focused on the firms cost of common
equity. How would the CFO determine the cost of the
companys equity, using the dividend growth model?

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14-47
Checkpoint 14.2

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14-48
Checkpoint 14.2

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14-49
Checkpoint 14.2: Check Yourself

Prepare two additional estimates of


Pearsons cost of common equity using the
dividend growth model where you use
growth rates in dividends that are 25%
lower than the estimated 6.25% (i.e., for g
equal to 5% and 7.81%)

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14-50
Step 1: Picture the Problem

We are given the following:

Price of common stock (Pcs ) = $10.09


Growth rate of dividends (g) = 5% and 7.81%
Dividend (D0) = $0.47 per share

Cost of equity is given by dividend yield +


growth rate.

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14-51
Step 1: Picture the Problem (cont.)

Dividend Yield Growth Cost of


=D1 P0 Rate (g) Equity (kcs )

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14-52
Step 2: Decide on a Solution
Strategy

We can determine the cost of equity using


equation 14-3a

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14-53
Step 3: Solve

At growth rate of 5%

kcs = {$0.47(1.05)/$10.09} + .05


= .0989 or 9.89%

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14-54
Step 3: Solve (cont.)

At growth rate of 7.81%

kcs = {$0.47(1.0781)/$10.09} + .0781


= .1283 or 12.83 %

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14-55
Step 4: Analyze

Pearsons cost of equity is estimated at


9.89% and 12.83% based on the different
assumptions for growth rate.

Thus growth rate is an important variable


in determining the cost of equity. However,
estimating the growth rate is not easy.

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14-56
Estimating the Rate of Growth, g

The growth rate can be obtained from


various websites that post analysts
forecasts of growth rates.

We can also estimate the growth rate


using the historical data and computing
the arithmetic average or geometric
average.

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14-57
Estimating the Rate of Growth, g
(cont.)

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14-58
Pros and Cons of the Dividend
Growth Model Approach

While dividend growth model is easy to


use, it is severely dependent upon the
quality of growth rate estimates.
Furthermore, not all firms pay dividends.

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14-59
The Capital Asset Pricing Model

CAPM was used in chapter 8 to determine


the expected or required rate of return for
risky investments.

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14-60
The Capital Asset Pricing Model
(cont.)

Equation 14-4 illustrates that the expected


return on common stock is determined by
three key ingredients:
The risk-free rate of interest,
The beta or systematic risk of the common
stock returns, and
The market risk premium.

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14-61
Advantages of the CAPM approach

1. The model is simple to understand and


use.

2. The model does not depend on dividends


or growth rate so it can be applied to
companies that do not currently pay
dividends or are not expected to
experience a constant rate of growth in
dividends.

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14-62
Disadvantages of the CAPM
Approach
1. CAPM does not offer any guidance on the
appropriate choice for the risk-free rate.
Risk-free rate may vary widely depending
on the Treasury security chosen.
2. Estimates of beta can vary widely
depending upon the market index and
time period chosen.
3. Estimates of market risk premium will also
vary depending on the time period and
security chosen.
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14-63
Checkpoint 14.3
Estimating the Cost of Common Equity for Pearson plc
using the CAPM
A review of current market conditions at the end of March 2009
reveals that the 10-year U.S. Treasury Bond yield that we will
use to measure the risk-free rate was 2.81%, the estimated
market risk premium is 6.5%, and the beta for Pearsons
common stock is 1.20.
Determine Pearsons cost of common equity using the CAPM, as
of March 2009.

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14-64
Checkpoint 14.3

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14-65
Checkpoint 14.3

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14-66
Checkpoint 14.3: Check Yourself

Prepare two additional estimates of Pearsons cost


of common equity using the CAPM where you use
the most extreme values of each of the three
factors that drive the CAPM.

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14-67
Step 1: Picture the Problem

CAPM describes the relationship between


the expected rates of return on risky
assets in terms of their systematic risk. Its
value depends on:
The risk-free rate of interest,
The beta or systematic risk of the common
stock returns, and
The market risk premium.

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14-68
Step 1: Picture the Problem

However, there can be wide variation in


the estimates for each one of these
variables.
Here we are given the following estimates:
The risk-free rate of interest (.03% or 3.73%)
The beta or systematic risk of the common
stock returns (1 or 1.5)
The market risk premium (4% or 8%)

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14-69
Step 1: Picture the Problem (cont.)

The cost of equity can be estimated using


the CAPM equation:

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14-70
Step 1: Picture the Problem (cont.)
The cost of equity is given by Risk-free rate +
(Risk premium Beta) :

Risk-Free Risk Premium Cost of


Rate Equity
Beta

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14-71
Step 2: Decide on a Solution
Strategy

Since we have been given the estimates


for market factors (risk-free rate and risk
premium) and firm-specific factor (beta),
we can determine the cost of equity using
CAPM.

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14-72
Step 3: Solve

kcs = 0.03 + 1(4) = 4.03%

kcs = 3.73 + 1.5(8) = 15.73%

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14-73
Step 4: Analyze

Pearsons cost of equity is shown to be


sensitive to the estimates used for risk-
free rate of interest, beta and market risk
premium.

Based on the estimates used, the cost of


common equity ranges from 4.03% to
15.73%.

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14-74
14.4 Summing
Up Calculating
the Firms WACC

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Summing Up Calculating the
Firms WACC

The final step is to calculate the firms


overall cost of capital by taking the
weighted average of the firms financing
mix that we evaluated in Steps One and
Two.

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14-76
Summing Up Calculating the
Firms WACC (cont.)

When estimating the firms WACC,


following issues should be kept in mind:
Determine weights based on market value
rather than book value.
Use market based opportunity costs rather
than historical rates (such as coupon rates).
Use forward looking weights and opportunity
costs.

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14-77
14.5 Estimating
Project Cost of
Capital

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Estimating Project Cost of Capital

Should the firms WACC be used to


evaluate all new investments?

In theory, it is appropriate only if the risk of


the new project is equal to the overall risk of
the firm. This may generally not be the case
necessitating the need for a unique cost of
capital for each project.

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14-79
Estimating Project Cost of Capital
(cont.)

However, a recent survey found that more


than 50% of the firms tend to use single,
company-wide discount rate to evaluate all
of their investment proposals.

There are advantages and costs associated


with estimating a unique discount rate for
each project.

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14-80
The Rationale for Using Multiple
Discount Rates

Multiple discount rates is consistent with


finance theory that suggests that unique
discount rate will reflect the unique risk of
the investment.

Figure 14-6 illustrates the problems that


arise when a single discount rate is used to
evaluate investment projects with different
levels of risk.

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14-81
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14-82
Why Dont Firms Typically Use
Project Cost of Capital?

1. It may be difficult to trace the source of


financing for individual project since most
firms raise money in bulk for all the
projects.

2. It adds to the time and cost in getting


approval for new projects.

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14-83
Estimating Divisional WACCs

If a firm undertakes investment with very


different risk characteristics, it will try to
estimate divisional WACCs.

The divisions are generally defined by


geographical regions (e.g., Asian region
versus European region) or industry.

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14-84
Estimating Divisional WACCs (cont.)

Advantages of a divisional WACC:


The discount rate reflects the risk of projects
evaluated by different divisions.
It requires estimating only one cost of capital
estimate for the entire division (rather than
one for each project).
It limits managerial latitude and the attendant
influence costs.

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14-85
Using Pure Play Firms to Estimate
Divisional WACCs

Here a firm with multiple divisions may


identify a comparable firm with only one
division (called a pure play firm).

The estimate of pure play firms cost of


capital can then be used as a proxy for
that particular divisions cost of capital.

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14-86
Divisional WACC Estimation Issues
and Limitations

While divisional WACC is an improvement


over a single, company-wide WACC, it has
a number of limitations:
1. The sample of firms in a given industry may
include firms that are not good matches for
the firm or one of its divisions.
2. The division being analyzed may not have a
capital structure that is similar to the sample
of firms in the industry data.

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14-87
Divisional WACC Estimation Issues
and Limitations (cont.)
3. The firms in the chosen industry that are
used to proxy for divisional risk may not be
good reflections of project risk.
4. Good comparison firms for a particular
division may be difficult to find.

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14-88
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14-89
14.6 Floatation
Costs and Project
NPV

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WACC, Floatation Costs and Project
NPV

Floatation costs are costs incurred by a


firm when it raises money to finance new
investments by selling bonds and stocks.

For example, these costs may include fees


paid to an investment banker, and costs
incurred when securities are sold at a
discount to the current market price.

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14-91
WACC, Floatation Costs and Project
NPV (cont.)

Because of floatation costs, the firm will


have to raise more than the amount it
needs.

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14-92
WACC, Floatation Costs and Project
NPV (cont.)

Example 14.3 If a firm needs $100 million


to finance its new project and the
floatation cost is expected to be 5.5%,
how much should the firm raise by selling
securities?

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14-93
WACC, Floatation Costs and Project
NPV (cont.)

= $100 million (1-.055) = $105.82 million

Thus the firm will raise $105.82 million,


which includes floatation cost of $5.82
million.

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14-94
Checkpoint 14.4
Incorporating Flotation Costs into the
Calculation of NPV
The Tricon Telecom Company is considering a $100 million
investment that would allow it to develop fiber optic high-speed
Internet connectivity to its 2 million subscribers. The investment will
be financed using the firms desired mix of debt and equity with 40%
debt financing and 60% common equity financing. The firms
investment banker advised the firms CFO that the issue costs
associated with debt would be 2% while the equity issue costs would
be 10%.
Tricon uses a 10% cost of capital to evaluate its telecom investments
and has estimated that the new fiber optic project will yield future
cash flows valued at $115 million. However, to this point no
consideration has been given to the effect of the costs of raising the
financing for the project or flotation costs. Should the firm go forward
with the investment in light of the flotation costs?

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14-95
Checkpoint 14.4

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14-96
Checkpoint 14.4

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14-97
Checkpoint 14.4

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14-98
Checkpoint 14.4: Check Yourself

Before Tricon could finalize the financing


for the new project, stock market
conditions changed such that new stock
became more expensive to issue. In fact,
floatation costs rose to 15% of new
equity issued and the cost of debt rose to
3%. Is the project still viable (assuming
the present value of future cash flows
remain unchanged)?

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14-99
Step 1: Picture the Problem

The NPV will be equal to the present value


of the future cash flows less the initial
outlay and floatation costs.

NPV
= PV(inflows) Initial outlay Floatation costs

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14-100
Step 1: Picture the Problem (cont.)
PV of Cash INflows

Initial Outlay

NPV
Floatation costs

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14-101
Step 2: Decide on a Solution
Strategy

We need to first estimate the average


floatation costs that Tricon will incur when
raising the funds. This can be done using
equation 14-5.

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14-102
Step 2: Decide on a Solution
Strategy (cont.)

Next, the grossed-up investment outlay


can be estimated using equation 14-6 and
subtracted from the present value of the
expected future cash flows to determine
whether the project has a positive NPV.

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14-103
Step 3: Solve

We can use equation 14-5 to estimate the


weighted average floatation cost as
follows:

= .40 .03 + .60 .15 = .102 or 10.2%

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14-104
Step 3: Solve (cont.)
The grossed up initial outlay for $100 million
project can be estimated using equation 14-6:

= $100 million (1- 0.102) = $111.36 million


Thus, floatation costs is equal to $11.36 million.

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14-105
Step 3: Solve (cont.)

NPV = $115 million - $111.36 million


= $3.64 million

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14-106
Step 4: Analyze

The project is feasible even after


consideration of higher floatation costs as
the NPV is positive at $3.64 million.

However, the problem illustrates that


floatation costs can be significant and
cannot be ignored while evaluating
projects.

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14-107
Key Terms

Cost of capital
Cost of debt
Cost of preferred equity
Cost of common equity
Divisional WACC
Floatation costs
Weighted Average Cost of Capital

Copyright 2011 Pearson Prentice Hall. All rights reserved.


14-108