12 3 In earlier examples, we found the costs of the various types of capital for Duchess Corporation to be as follows:

Example 9.12 3 In earlier examples, we found the costs of the various types of capital for Duchess Corporation to be as follows:

Cost of debt, r i = 5.6% Cost of preferred stock, r p = 10.6% Cost of retained earnings, r r = 13.0% Cost of new common stock, r n = 14.0%

The company uses the following weights in calculating its weighted average cost of capital:

Source of capital

Weight

Long-term debt

Preferred stock

Common stock equity

Total

Because the firm expects to have a sizable amount of retained earnings avail- able ($300,000), it plans to use its cost of retained earnings, r r , as the cost of common stock equity. Duchess Corporation’s weighted average cost of capital is calculated in Table 9.1. The resulting weighted average cost of capital for Duchess is 9.8%. Assuming an unchanged risk level, the firm should accept all projects that will earn a return greater than 9.8%.

CHAPTER 9 The Cost of Capital

Calculation of the Weighted Average Cost of Capital for Duchess Corporation

Weighted cost Weight

Cost [(1) (2)]

Source of capital

Long-term debt

Preferred stock

Common stock equity

focus on PRACTICE Uncertain Times Make for an Uncertain Weighted Average

Cost of Capital

on those projects that have immediate returns,” Mr. Domanico is quoted saying. a

Part of Caraustar’s motivation for implementing this two-pronged approach was to account for the exces- sively large spread between short- and long-term debt rates that emerged dur- ing the financial market crisis. Mr. Domanico reported that during the cri- sis Caraustar could borrow short-term funds at the lower of Prime plus 4 per- cent or LIBOR plus 5 percent—where either rate was reasonable for making short-term investment decisions. Alternatively, long-term investment deci- sions were being required to clear Caraustar’s long-term cost-of-capital cal- culation accounting for borrowing rates in excess of 12 percent.

3 Why don’t firms generally use both short- and long-run weighted

average costs of capital?

inaccessible, and the great recession saw Treasury bond yields fall to historic lows, making cost of equity projections appear unreasonably low. With these key components in flux, it is exceedingly difficult, if not impossible, for firms to get a handle on a cost of long-term capital.

According to CFO Magazine, at least one firm resorted to a two- pronged approach for determining its cost of capital during the uncertain times. Ron Domanico is the chief finan- cial officer (CFO) at Caraustar Industries, Inc., and he reported that his company dealt with the cost-of-capital uncertainty by abandoning the conven- tional one-size-fits-all approach. “In the past, we had one cost of capital that we applied to all our investment deci- sions . . . today that’s not the case. We have a short-term cost of capital we apply to short-term opportunities, and a longer-term cost of capital we apply to longer-term opportunities . . . and the reality is that the longer-term cost is so high that it has forced us to focus only

As U.S. financial mar- kets experienced and

recovered from the 2008 financial crisis and 2009 “great recession,” firms struggled to keep track of their weighted average cost of capital. The individual component costs were moving rapidly in response to the financial market turmoil. Volatile finan- cial markets can make otherwise man- ageable cost-of-capital calculations exceedingly complex and inherently error prone—possibly wreaking havoc with investment decisions. If a firm underestimates its cost of capital it risks making investments that are not economically justified, and if a firm overestimates its financing costs it risks foregoing value-maximizing investments.

Although the WACC computation does not change when markets become unstable, the uncertainty sur- rounding the components that comprise the WACC increases dramatically. The financial crisis pushed credit costs to a point where long-term debt was largely

in practice

a Randy Myers, “A Losing Formula” (May 2009), www.cfo.com/article.cfm/13522582/c_13526469 .

PART 4

Risk and the Required Rate of Return

WEIGHTING SCHEMES Firms can calculate weights on the basis of either book value or market value

using either historical or target proportions.

book value weights Weights that use accounting

Book Value versus Market Value

values to measure the proportion of each type of

Book value weights use accounting values to measure the proportion of each type of

capital in the firm’s financial

capital in the firm’s financial structure. Market value weights measure the propor-

structure.

tion of each type of capital at its market value. Market value weights are appealing market value weights

because the market values of securities closely approximate the actual dollars to be

Weights that use market values

received from their sale. Moreover, because firms calculate the costs of the various

to measure the proportion of

types of capital by using prevailing market prices, it seems reasonable to use market

each type of capital in the

value weights. In addition, the long-term investment cash flows to which the cost of

firm’s financial structure.

capital is applied are estimated in terms of current as well as future market values. historical weights

Market value weights are clearly preferred over book value weights.

Either book or market value weights based on actual

Historical versus Target

capital structure proportions.

Historical weights can be either book or market value weights based on actual target weights

capital structure proportions. For example, past or current book value propor-

Either book or market value

tions would constitute a form of historical weighting, as would past or current

weights based on desired

market value proportions. Such a weighting scheme would therefore be based on

capital structure proportions.

real—rather than desired—proportions.

Target weights, which can also be based on either book or market values,

In more depth

reflect the firm’s desired capital structure proportions. Firms using target weights establish such proportions on the basis of the “optimal” capital structure they

To read about Changes wish to achieve. (The development of these proportions and the optimal structure in the Weighted Average

are discussed in detail in Chapter 13.)

Cost of Capital, go to When one considers the somewhat approximate nature of the calculation of www.myfinancelab.com

weighted average cost of capital, the choice of weights may not be critical. However, from a strictly theoretical point of view, the preferred weighting scheme is target market value proportions, and we assume these throughout this chapter.

Personal Finance Example 9.13 3 Chuck Solis currently has three loans outstanding, all of which mature in exactly 6 years and can be repaid without penalty

any time prior to maturity. The outstanding balances and annual interest rates on these loans are noted in the following table.

interest rate

After a thorough search, Chuck found a lender who would loan him $80,000 for

6 years at an annual interest rate of 9.2% on the condition that the loan proceeds

be used to fully repay the three outstanding loans, which combined have an out- standing balance of $80,000 ($26,000 + $9,000 + $45,000) . Chuck wishes to choose the least costly alternative: (1) to do nothing or (2)

CHAPTER 9

The Cost of Capital

average cost of his current debt by weighting each debt’s annual interest cost by the proportion of the $80,000 total it represents and then summing the three weighted values as follows:

Weighted average cost of current debt = 3($26,000 , $80,000) * 9.6%4 + 3($9,000 , $80,000)

* 10.6% 4 + 3($45,000 , $80,000) * 7.4%4 = (.3250 * 9.6%) + (.1125 * 10.6%) + (.5625 * 7.4%) = 3.12% + 1.19% + 4.16% = 8.47% L 8.5%

Given that the weighted average cost of the $80,000 of current debt of 8.5% is below the 9.2% cost of the new $80,000 loan, Chuck should do nothing, and just continue to pay off the three loans as originally scheduled.