I n Chapters 8 through 10, we discussed and practiced techniques for

I n Chapters 8 through 10, we discussed and practiced techniques for

valuing assets and weighing risk and return. These are all topics we will apply in Part Three of this book, when we turn to the methods and techniques used in making decisions about actual projects: capital bud- geting. In this chapter, we focus on a crucial element in both valuation and capital budgeting: the cost of capital.

The cost of capital is the return that must be provided for the use of an investor’s funds. If the funds are borrowed, the cost is related to the interest that must be paid on the loan. If the funds are equity, the cost is the return that investors expect, both from the stock’s price appreciation and dividends. From the investor’s point of view, the cost of capital is the same as the required rate of return, which we discussed in Chapter 10.

The required rate of return on an investment and its value are inter- twined. If you buy a bond, you expect to receive interest and the repay- ment of the principal in the future. The price you pay reflects your required rate of return. What determines your required rate? Your opportunity cost—the return you could have received on an investment with similar risk. Suppose that after you buy this bond, market interest rates increase. Your own required rate of return also rises. When your required rate of return increases, the value of your bond’s future interest and principal fall since the discount rate—the rate you use to translate future cash flows into today’s value—increases. The discount rate increases because its is a reflection of market interest rates.

The cost of capital and the required rate of return are marginal con- cepts. That is, the cost of capital is the cost associated with raising one more dollar of capital, whereas the required rate of return is the return expected on one more dollar invested. For example, suppose I have already borrowed $10,000, promising to pay 5% interest per year. And suppose

THE FUNDAMENTALS OF VALUATION

that if I need to borrow any more, I would have to pay 6% per year of the amount I borrow above $10,000. Six percent is the marginal cost. The cost of what we have already borrowed is history, sort of. How much we have already borrowed and what we committed ourselves to pay will influence what we will have to pay to borrow further. That’s because the more you are already paying for your borrowings, the greater the rate lenders will require to lend you more. That’s why when we analyze the cost of a new investment, we should be thinking about the marginal costs of capital.

To make investment decisions of any kind, we need to know the cost of capital. In economics, you learned that a firm should produce goods to the point where the firm’s marginal benefit from producing them equals the marginal cost to produce them. At that level of production, profit is maximized.

It’s the same in investment and financing decisions: Invest in a project until the marginal cost of funds to invest is equal to the marginal benefit the project provides. The benefit from an investment is its return, which we refer to as its internal rate of return (from the investor’s perspective) or the marginal efficiency of capital (from the firm’s perspective). This means that managers keep on raising funds to invest in projects until the marginal cost of these funds is equal to the marginal benefit (which decreases as we take on more and more projects). Therefore, you need to know the marginal cost of funds before you can determine how much to invest in projects in your attempt to maximize shareholder wealth.

When we refer to the cost of capital for a firm, we are usually refer- ring to the cost of financing its assets. In other words, we mean the cost of capital for all the firm’s projects taken together and, hence, the cost of capital for the average project risk of the firm.

When we refer to the cost of capital of a project, we are referring to the cost of capital that reflects the risk of that project. So why determine the cost of capital for the firm as a whole? For two reasons.

First, the cost of capital for the firm is often used as a starting point (a benchmark) for determining the cost of capital for a specific project. The firm’s cost of capital is adjusted upward or downward depending on whether the project’s risk is more than or less than the firm’s typical project.

Second, many of a firm’s projects have risk similar to the risk of the firm as a whole. So the cost of capital of the firm is a reasonable approx- imation for the cost of capital of one of its projects that are under con- sideration for investment.

A firm’s cost of capital is the cost of its long-term sources of funds: debt, preferred stock, and common stock. And the cost of each source reflects the risk of the assets the firm invests in. A firm that invests in assets having little risk will be able to bear lower costs of capital than a firm that invests in assets having a high risk. For example, a discount

The Cost of Capital

retail store has much less risk than an oil drilling firm. Moreover, the cost of each source of funds reflects the hierarchy of the risk associated with its seniority over the other sources. For a given firm, the cost of funds raised through debt is less than the cost of funds from preferred stock which, in turn, is less than the cost of funds from common stock. Why? Because creditors have seniority over preferred shareholders, who have seniority over common shareholders. If there are difficulties in meeting obligations, the creditors receive their promised interest and principal before the preferred shareholders who, in turn, receive their promised dividends before the common shareholders.

For a given firm, debt is less risky than preferred stock, which is less risky than common stock. Therefore, preferred shareholders require a greater return than the creditors and common shareholders require a greater return than preferred shareholders.

Figuring out the cost of capital requires us to first determine the cost of each source of capital we expect the firm to use, along with the rela- tive amounts of each source of capital we expect the firm to raise. Then we can determine the marginal cost of raising additional capital.

We can do this in three steps: Step 1: Determine the proportions of each source to be raised as capital.

Step 2: Determine the marginal cost of each source. Step 3: Calculate the weighted average cost of capital.

In this chapter, we look at each step. We first discuss how to determine the proportion of each source of capital to be used in our calculations. Then we calculate the cost of each source. The proportions of each source must be determined before calculating the cost of each source since the proportions may affect the costs of the sources of capital.

We then put together the cost and proportions of each source to cal- culate the firm’s marginal cost of capital. We also demonstrate the calcu- lations of the marginal cost of capital for an actual company, showing just how much judgment and how many assumptions go into calculating the cost of capital. That is, we show that it’s an estimate. We will use this information in Part Three when we evaluate capital projects.