(33) Cost of Capital

Question 1

LOS 36. a: Calculate and interpret the weighted average cost of capital (WACC) of a company. What is the WACC equation?

Answer 1

WACC = (w_d)(k_d)(1 – t) + (w_ps)(k_ps) + (w_ce)(k_ce)

Question 2

LOS 36. a: Calculate and interpret the weighted average cost of capital (WACC) of a company. Define what the WACC is.

Answer 2

The weighted average cost of capital, or WACC, is calculated using weights based on the market values of each component of a firm’s capital structure and is the correct discount rate to use to discount the cash flows of projects with risk equal to the average risk of a firm’s projects.

Question 3

LOS 36. b: Describe how taxes affect the cost of capital from different capital sources.

Answer 3

Interest expense on a firm’s debt is tax deductible, so the pre-tax cost of debt must be reduced by the firm’s marginal tax rate to get an after-tax cost of debt capital:

After-tax cost of debt = k_d(1 – firm’s marginal tax rate)

The pre-tax and after-tax capital costs are equal for both preferred stock and common equity because dividends paid by the firm are not tax deductible.

Question 4

LOS 36. c: Describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined.

Answer 4

WACC should be calculated based on a firm’s target capital structure weights.

If information on a firm’s target capital structure is not available, an analyst can use the firm’s current capital structure, based on market values, or the average capital structure in the firm’s industry as estimates of the target capital structure.

Question 5

LOS 36. d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget.

Answer 5

A firm’s marginal cost of capital (WACC at each level of capital investment) increases as it needs to raise larger amounts of capital. This is shown by an upward-sloping marginal cost of capital curve.

An investment opportunity schedule shows the IRRs of (in decreasing order), and the initial investment amounts for, a firm’s potential projects.

The intersection of a firm’s investment opportunity schedule with its marginal cost of capital curve indicates the optimal amount of capital expenditure, the amount investment required to undertake all positive NPV projects.

Question 6

LOS 36. e: Explain the marginal cost of capital’s role in determining the present value of a project.

Answer 6

The marginal cost of capital (the WACC for additional units of capital) should be used as the discount rate when calculating project NPVs for capital budgeting decisions.

Adjustments to the cost of capital are necessary when a project differs in risk from the average risk of a firm’s existing projects. The discount rate should be adjusted upward for higher-risk projects and downward for lower-risk projects

Question 7

LOS 36. f: Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach.

Answer 7

The before-tax cost of fixed-rate debt capital, k_d, is the rate at which the firm can issue new debt.

• The yield-to-maturity approach assumes the before-tax cost of debt capital is the YTM on the firm’s existing publicly traded debt.
• If a YTM is not available, the analyst can use the debt rating approach, estimating the before-tax cost of debt capital based on market yields for debt with the same rating and average maturity as the firm’s existing debt.

Question 8

LOS 36. f: Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach. What is important to realize on “what is the cost of debt?”

Answer 8

Professor’s Note: It is important that you realize that the cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm’s existing debt. CFA Institute may provide you with both rate, and you need to select the current market rate.

Question 9

LOS 36. g: Calculate and interpret the cost of noncallable, nonconvertible preferred stock.

Answer 9

The cost (and yield) of noncallable, nonconvertible preferred stock is simply the annual dividend divided by the market price of preferred shares.

Question 10

LOS 36. h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yield-plus risk-premium approach.

Answer 10

The cost of equity capital, k_ce, is the required rate of return on the firm’s common stock.

There are three approaches to estimate k_ce:

1. CAPM approach: k_ce = R_f + β[E(R_mkt) – R_f]
2. Dividend discount model approach: k_ce = (D₁/P₀) + g
3. Bond yield plus risk premium approach: add a risk premium of 3% to 5% to the market yield on the firm’s long-term debt.

Question 11

LOS 36. h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yield-plus risk-premium approach. In the CAPM Approach, what is the marginal risk premium?

Answer 11

CAPM approach: k_ce = R_f + β[E(R_mkt) – R_f] (… [E(R_mkt) – R_f] = marginal risk premium)

Question 12

LOS 36. h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yield-plus risk-premium approach. In the dividend discount approach, what is essential to remember?

Answer 12

That we use the expected dividend, not the current one. D₀ is the current dividend, to get D₁ we need to multiply D₀ by the expected growth rate (g).

Dividend discount model approach: k_ce = (D₁/P₀) + g

D₁ = D₀ x g

Question 13

LOS 36. Cost of Capital: What happens to a company’s weighted average cost of capital (WACC) if the firm’s corporate tax rate increases and if the Federal Reserve causes an increase in the risk-free rate, respectively? (Consider the events independently and assume a beta of less than one)

Answer 13

An increase in the corporate tax rate will reduce the after-tax cost of debt, causing the WACC to fall. More specifically, because the after-tax cost of debt = (k_d)(1 – t), the term (1 – t) decreases, decreasing the after-tax cost of debt. If the risk-free rate were to increase, the cost of debt and equity would both increase, thus causing the firm’s cost of capital to increase.

Question 14

LOS 36. i: Calculate and interpret the beta and cost of capital for a project.

Answer 14

When a project’s risk differs from that of a firm’s average project, we can use the beta of a company or group of companies that are exclusively in the same business as the project to calculate the project’s required return. This pure-play method involves the following steps:

1) Estimate the beta for the comparable company or companies.
2) Unlever the beta to get the asset beta using the marginal tax rate and debt-to-equity ratio for the comparable company:
3) Re-lever the beta using the marginal tax rate and debt-to-equity ratio for the firm considering the project:
4) Use the CAPM to estimate the required return on equity to use when evaluating the project. (CAPM approach: k_ce = R_f + β[E(R_mkt) – R_f])
5) Calculate the WACC for the firm using the project’s required return on equity. (WACC = (w_d)(k_d)(1 – t) + (w_ps)(k_ps) + (w_ce)(k_ce))

Question 15

LOS 36. j: Describe the uses of country risk premiums in estimating the cost of equity.

Answer 15

A country risk premium should be added to the market risk premium in the Capital Asset Pricing Model (CAPM) to reflect the added risk associated with investing in a developing country.

k_ce = R_f + β[E(R_mkt) – R_f + CRP]

Question 16

LOS 36. Cost of Capital: Jay company has a debt-to-equity ratio of 2.0. Jay is evaluating the cost of equity for a project in the same line of business as Cass Company and will use the pure-play method in the same line of business as Cass as the comparable firm. Cass as a beta of 1.2 and debt-to-equity ratio of 1.6. The project beta most likely will be?

Answer 16

Could be greater than or less than Jay Company’s beta. The project beta calculated using the pure-play method is not necessarily related in a predictable way to the beta of the firm that is performing the project.

Question 17

LOS 36. k: Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points.

Answer 17

The marginal cost of capital schedule shows the WACC for successively greater amounts of new capital investment for a period, such as the coming year.

Question 18

LOS 36. k: Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points.

Answer 18

The MCC schedule is typically upward-sloping because raising greater amounts of capital increases the cost of equity and debt financing. Break points (increases) in the marginal cost of capital schedule occur at amounts of total capital raised equal to the amount of each source of capital at which the component cost of capital increases, divided by the target weight for that source of capital.