Chapter 9: Weighted Average Cost of Capital (WACC) and Capital Structure

Definitions and Concepts

The Weighted Average Cost of Capital (WACC) is a key financial metric that represents the average rate a firm expects to pay to finance its assets, weighted by the proportion of each capital source. The capital structure refers to the mix of debt, equity, and other financing sources a firm uses, which directly influences the WACC and the firm's risk and return profile.

• WACC: Combines the cost of debt, preferred stock, and common equity.

• Capital Structure: The proportion of debt and equity; affects cash flows and the variability of net operating income.

Impact of Taxes and Flotation Costs

• Taxes: Interest on debt is tax-deductible, reducing the effective cost of debt. The after-tax cost of debt is calculated as:

• Flotation Costs: Costs incurred when issuing new securities (e.g., underwriting, legal fees). These increase the cost of capital by reducing net proceeds from issuance. Example: If a share sells for \text{Required Return} = \frac{\text{Investor's Rate} \times \text{Share Price}}{\text{Net Proceeds}} $

Calculating Costs of Capital Components

• After-tax Cost of Debt: See formula above.

• Cost of Preferred Stock: where is the preferred dividend, is the price, and is flotation cost.

• Cost of Common Stock (External Equity): where is the expected dividend, is the price, is flotation cost, and is growth rate.

• Cost of Retained Earnings (Internal Equity):

Internal vs. External Equity

• Internal Equity (Retained Earnings): Lower cost, no flotation costs, sourced from reinvested earnings.

• External Equity (New Common Stock): Higher cost due to flotation costs, sourced from new share issuance, may alter capital structure.

Weighted Average Cost of Capital (WACC) Calculation

The WACC is calculated as the weighted sum of the costs of each capital component:

• : weights of debt, preferred stock, and common equity

• : respective costs

• : tax rate

Divisional Cost of Capital

The divisional cost of capital (divisional WACC) is the cost of capital assigned to a specific business unit or division, reflecting its unique risk profile. It provides a consistent discount rate for evaluating divisional projects, simplifying analysis and limiting managerial discretion.

WACC Table (Summary)

Additional info: Table structure inferred from summary references.

Chapter 10: Capital Budgeting

Definition and Concept

Capital budgeting is the process of evaluating and selecting long-term investments in fixed assets that are expected to generate future cash flows. It is essential for maximizing shareholder value.

Key Capital Budgeting Methods

• Payback Period: Time required to recover the initial investment from cash inflows.

  • Formula (Even Cash Flows):

  • Advantages: Simple, measures liquidity risk.

  • Disadvantages: Ignores time value of money and cash flows after payback.

  • Accept/Reject: Accept if payback period is less than a set benchmark.

• Profitability Index (PI): Ratio of present value of future cash flows to initial investment.

  • Formula:

  • Advantages: Considers time value of money, useful for capital rationing.

  • Disadvantages: May conflict with NPV for mutually exclusive projects.

  • Accept/Reject: Accept if PI > 1.

• Net Present Value (NPV): Present value of cash inflows minus initial investment.

  • Formula:

  • Advantages: Measures absolute value added, considers time value of money.

  • Disadvantages: Requires estimate of cost of capital.

  • Accept/Reject: Accept if NPV > 0.

• Internal Rate of Return (IRR): Discount rate that makes NPV = 0.

  • Formula:

  • Advantages: Considers time value of money, easy to interpret as a rate.

  • Disadvantages: May have multiple IRRs, assumes reinvestment at IRR.

  • Accept/Reject: Accept if IRR > required return.

Additional info: Discounted Payback Period and MIRR are not required for this course.

Net Present Value Profile and IRR

• NPV Profile: A graph showing how a project's NPV changes as the discount rate changes.

• IRR: The discount rate where the NPV profile crosses the x-axis (NPV = 0).

Capital Rationing Constraints

When a firm imposes a fixed limit on its capital budget, it must select the combination of projects that maximizes total NPV within the budget constraint.

• List all projects with required investment and NPV.

• Recognize the budget constraint.

• Choose the combination of projects with the highest total NPV that fits within the budget.

• If projects are indivisible, compare discrete combinations.

Mutually Exclusive Projects and Ranking Conflicts

• Mutually Exclusive Projects: Projects that serve the same purpose; accepting one excludes the others.

• Ranking Conflicts: Occur when different methods (e.g., IRR vs. NPV) suggest different choices.

• Resolution: NPV is preferred as it measures actual dollar increase in shareholder wealth.

• Problems:

  • Size Disparity: Projects of unequal size may conflict; choose higher NPV.

  • Unequal Lives: Projects with different lifespans; use NPV profile to find crossover rate, but NPV remains the final criterion.

Chapter 11: Cash Flow Analysis in Capital Budgeting

Relevant Cash Flows

Relevant cash flows are those that will change as a direct result of the investment decision. Only incremental cash flows—those that occur if and only if the project is accepted—should be included in capital budgeting analysis.

• Include: Additional revenues, cost savings, incremental expenses, changes in working capital, and terminal cash flows.

• Exclude: Sunk costs, allocated overheads not affected by the project, and financing costs (handled in WACC).

Initial Outlay, Free Cash Flows, and Terminal Cash Flows

• Initial Outlay: The net cash outflow required to start a project, including purchase price, installation, and changes in working capital.

• Free Cash Flows (FCF): Cash flows available from the project each period, calculated as:

• Terminal Cash Flows: Cash flows at the end of the project, including salvage value and recovery of working capital.

Capital Budgeting Options

• Options may include the ability to expand, abandon, or delay a project, which can add value by providing managerial flexibility in response to future uncertainties.

Types of Risk in Capital Budgeting

• Stand-alone Risk: The project's risk as if it were the firm's only asset.

• Corporate (Within-firm) Risk: The project's risk considering its effect on the firm's overall risk.

• Market (Systematic) Risk: The risk of the project in relation to the market as a whole; most relevant for diversified shareholders.

• Most Relevant: Market (systematic) risk is generally considered most relevant for capital budgeting decisions.

Risk-Adjusted Discount Rate

A risk-adjusted discount rate is a discount rate that has been increased to account for the riskiness of a project. Higher-risk projects are evaluated using higher discount rates to reflect their greater uncertainty.