Chapter 17—Cost of Capital
One of the most significant concepts in the management of a potential investment is the establishment of the weighted average cost of capital (WACC).WACC determines the return a project must earn to cover the cost of the funds used in the investment.Generally, a firm will accept a project that produces a return greater than the cost of capital.However, an important concept that we must be aware of is that the cost of capital depends primarily on the use of the funds, not the source of the funds.
The raising of funds for investment in a firm can be divided into two categories: debt, and to a lesser extent, preference shares and equity.The cost of equity can be defined as the return that equity investors require on their investment in the firm.The return is not easily measured.However, a firm can use the dividend growth model and the security market line (SML) to estimate the required return and thus the cost of equity.The downfall with both these approaches is that they focus on historical information, which does not always hold true.
The cost of debt can be defined as the return that lenders require on the firm’s debt. The cost of debt is basically the current interest rate in the market.The cost of preference shares, which are not as popular, is based on the fixed dividend yield paid every period to the preference shareholders.The cost of debt and preference shares is easier to establish as they are generally set at fixed rates.
WACC, which can be defined as the weighted average of the costs of debt and equity, can be looked at in two ways: unadjusted WACC, which does not take taxes into account, and adjusted WACC, which examines the cost of capital taking into consideration taxes on funds.The most important measure for a firm is the adjusted WACC as this gives a true costing of capital funds.
The fundamental idea of WACC is straightforward: it is the overall return that the firm must earn on its existing assets to maintain the value of its shares.However, while WACC is an important measure, it still has its drawbacks.On pages 623-625 of the text, Bernie Wilson (Group Finance Manager of Queensland Rail) sheds some light on the practical problems of correctly calculating WACC.
Furthermore, WACC can only be used when the proposed investment is similar to the current operations of the firm.WACC does not take into account the level of risk of the proposed investment.This element in the real world could a have a great impact on the profitability of the firm.WACC also ignores that firms may have more than one line of business (the divisional cost of capital).
There are, however, two strategies that can be used to overcome the above problems: the pure play approach and the subjective approach.
If a firm chooses to raise funds through issuing primary securities in the market, we must remember that the flotation costs need to be taken into account when working out the cost of capital.
The case article, ‘BOQ acts to reduce cost of capital with debt issue’ in Australian Banking and Finance[*] on 1 September 2000 discusses the Bank of Queensland’s (BOQ) attempt to maximise shareholder value throughproactive management of the capital base.
Considering the above information and the article from Australian Banking and Finance, complete the following eight questions.
Question 1
What is the weighted average cost of capital (WACC), and why is it of such importance to a firm?
Question 2
How is the cost of equity determined?Discuss the methods that can be used.
Question 3
How is the cost of debt determined?
Question 4
What is the difference between unadjusted WACC and adjusted WACC?Which measure is more accurate?
Question 5
Using the article from Australian Banking and Finance, discuss how the Bank of Queensland has changed its financing strategies based on the capital costs of such financing.
Question 6
Discuss why establishing the cost of capital is important when considering a firm’s profitability.
Question 7
We know the formula and the variables used in calculating WACC, so what are some of the practical problems in deriving the correct measure?
Question 8
Imagine calculating the WACC to evaluate an investment in a large BrisbaneGourmet PizzaKitchen.Are there unique problems in calculating this WACC?
1
Online case studies Fundamentals of Corporate Finance 4e by Ross et al.
[*] See file‘C17_article’.