Introduction to Cost of Capital and WACC

Introduction to Cost of Capital

  • Definition of Cost of Capital   - The cost of capital refers to the required return necessary to make an investment worthwhile.   - Also referred to as Weighted Average Cost of Capital (WACC), which combines the costs of equity and debt financing.
  • Importance of Cost of Capital   - Understanding the cost of capital helps businesses determine the feasibility of their investments.

Learning Objectives

  • Examine key concepts related to WACC, cost of capital, and their significance to businesses.

Definition of Capital

  • Capital in a business context refers to the financial resources and assets that a firm uses to fund its expenditures.   - Two perspectives of capital:
        - Assets:       - Represented on the left side of the balance sheet.       - Includes all resources a firm owns that contribute to its operations.     - Liabilities and Equity:       - Represented on the right side of the balance sheet where the firm sources its capital.       - Includes how the capital was obtained:         - Debt (long-term and short-term loans)         - Equity (ownership stakes by business owners)

Main Sources of Capital

  • Major components on the right side of the balance sheet:   - Debt: Total liabilities owed by the firm:     - Costs associated with borrowing money.   - Preferred Stock: A type of equity financing that generally has a fixed dividend.   - Common Equity: Comprising two aspects:     - Common Stock: Shares owned by the founders or investors.     - Retained Earnings: Profits reinvested in the company instead of distributed as dividends.

Calculating Cost of Capital

  • Conceptual Understanding:   - An example with a loan scenario:     - A loan from the bank at 5% interest rates: $100 borrowed will cost $5 per annum.   - Simplified explanation:     - If the cost of capital is less than the company's returns, it adds value to shareholders (e.g., returns > 10% increases business value).     - If the returns are lower than the cost of capital, it devalues the business (e.g., returns < 10%).

Return Rate Required by Investors

  • Rate of Return for Investors:   - Investors require a return rate for the capital injected into the business through purchases of stock or bond investments.   - This rate is essential to evaluate opportunities that exceed their investment thresholds.

Hurdle Rate Concept

  • The cost of capital is often termed as Hurdle Rate:   - Definition: The minimal acceptable return on investment.   - Comparisons to athletics: A hurdle on a track race requires athletes to jump over; similarly, investments must exceed the cost of capital to be worthwhile.

Financial Policy and Capital Mix

  • Financial Policy:   - Refers to the mix of debt and equity financing the company chooses to use effectively.     - Debt to Equity Ratio: A measure of how much a company is financing its operations through debt versus wholly-owned funds.
  • Strategy Options:   - Adjusting capital mix entails:     - Increasing debt to reduce equity or vice versa.

Costs of Capital by Source

  • Each source of capital has a distinct cost associated with it due to various factors:   - Debt typically has a lower required return than equity due to lower risk perceived by lenders.   - Equity Holders typically demand higher returns since they assume greater risks.

Weighted Average Cost of Capital (WACC)

  • WACC Definition:   - The WACC gives an average cost of capital based on the proportion of each source of capital used:     - Formula:       WACC=EVimesre+DVimesrdimes(1−T)WACC = \frac{E}{V} imes r_e + \frac{D}{V} imes r_d imes (1 - T)       - Where:         - EE = Market value of equity         - DD = Market value of debt         - VV = Total market value of the firm (E + D)         - rer_e = Cost of equity         - rdr_d = Cost of debt         - TT = Corporate tax rate
  • Components of WACC:   - Each type of financing (debt, preferred stock, common equity) will have their respective cost contributions weighted by their proportions in the overall capital structure.

Effects of Taxes and Transaction Costs on Cost of Capital

  • Transaction Costs:   - Costs related to issuing new shares (e.g., flotation costs).   - Example: Selling a new stock at $50 with a $5 flotation cost effectively reduces the total received to $45 (leading to an increased cost of capital).

  • Tax Impact on Debt:   - Interest paid on debt is tax-deductible, reducing taxable income and thus overall tax liability.   - If paying 8% interest on debt, the effective cost is lower when accounting for tax reductions.

Summarizing Key Points

  • Capital for a business arises from various sources, impacting costs and investment strategies.
  • Transaction costs escalate the overall cost of capital, while tax benefits from debt lower it.
  • WACC is a critical calculation reflecting the average costs associated with financing the firm's operations.
  • It serves as a threshold for investment decisions, where only projects exceeding WACC will positively affect company value.
  • Motto: "If you don’t know WACC, you don’t know Jack."