Cost of Capital and WACC Notes

The Cost of Capital

• Understanding the cost of capital is crucial for financial managers as it influences firm investment decisions.

Sources of Capital

• Corporations can raise capital as needed.
• Cost of Equity:
  • Expected rate of return for stocks.
  • Higher than the Cost of Debt because:
  • Debt investors have first claims on assets during bankruptcy, thus they accept lower returns.
  • Equity investors take more risk and expect higher returns.
• Issue: Why not only issue debt if it's cheaper?
  • Capital is not unlimited; the price of debt rises with each use.

The Capital Structure of a Corporation

• Capital structure: amount of debt and equity used to fund operations and finance assets.
• Expressed as a debt-to-equity ratio.

Capital Structure Considerations

• Investment Dynamics:
  • Debt: low risk, no ownership rights, lower returns.
  • Equity: high risk, ownership rights including voting and dividend rights, generally higher returns.

Optimal Capital Structure

• Defined as the proportion of debt and equity that minimizes WACC.
• Business Risk:
  • Inability to generate sufficient cash flow to cover operating expenditures leads to favoring equity over debt.
  • High business risk means investors favor less debt.
• Financial Risk:
  • Inability to generate cash flow to pay bond holders increases as debt rises, leading to higher expected returns (interest rates) from bondholders.

Allocating Raised Capital

• Operating Expenditures (OpEx):
  • Ongoing costs for business operations, accounted within the current period.
  • Deducted in the current tax year.
• Capital Expenditures (CapEx):
  • Costs of assets providing future benefits (lifetime > 1 year), accounted for through depreciation.
  • Assets listed as Property, Plant & Equipment (PPE).

Cost of Capital

• After-Tax Cost of Debt:
  • Lower due to tax-deductibility of interest:
  • Formula: After−Tax Cost of Debt = Pre−Tax Cost of Debt × (1 – income tax rate).
• Cost of Equity:
  • Expected return for equity investors considering risk.
  • Formula:
  • Cost of equity = (Dividend Year 1 / Current stock price) + Growth rate.

Weighted Average Cost of Capital (WACC)

• Minimum required rate of return for a firm to cover costs of obtaining funding.
• Example Calculation:
  • For 45% equity at 8%, 20% preferred shares at 5.5%, 35% debt at 6.5% (after tax).
  • WACC example result: 6.406%.

Calculating WACC (No Tax)

• ReeCorp Example:
  • 55% common equity (return 9%), 10% preferred shares (yield 6%), 35% debt (yield 6.5%).
  • WACC = 0.55 * 9% + 0.10 * 6% + 0.35 * 6.5% = 7.825%.

Calculating WACC (With Tax)

• ReeCorp with 40% income tax:
  • Same structure with tax implications.
  • WACC Calculation adjusts for tax:
  • Result: WACC = 6.915%.