Weighted Average Cost Of Capital

The ÐŽ§Hurdle RateЎЁ or the ÐŽ§Discount RateЎЁ represented by the ÐŽ§Weighted Average Cost of CapitalЎЁ (WACC) plays an important role in deciding the Net Present Value (NPV) of a project. Calculating the NPV is an important task since it allows the decision maker to make sound investment decisions; if the NPV of a project is positive, then the project is profitable and should be taken, but if the project has a negative NPV, then the project should not be considered. When evaluating a project, the decision maker is making an investment decision with the goal of maximizing shareholdersÐŽ¦ wealth. But the investment money does not come from one source, or to put it in another way, the financial manager might have money to invest, but this money could be available from sale of stock, sale of bonds, suppliersÐŽ¦ accounts payable, the firmÐŽ¦s retained earnings, as well as bank loans. Each of such sources has its own cost, and this cost is the return required by each stakeholder. Since the aim is maximizing the general worth of the firm, the financial manager should base his analysis on the weighted average of all such costs.

To sum up, the firmÐŽ¦s overall cost of capital will reflect the required return on the firmÐŽ¦s assets as a whole. Given that the firm uses debt and equity capital, the overall cost of capital will be a mixture of the returns needed to compensate its creditors and its stockholders. In other words, a firmÐŽ¦s cost of capital will reflect both its cost of debt capital and its cost of equity capital.

First: The Cost of Equity:

This is the hardest type of cost to calculate; the reason behind that is the fact that there is no way of directly observing the return that the firmÐŽ¦s equity investors required on their investment. Instead such a return must be estimated. There are two approaches to determining the cost of equity: the Dividend Growth Model Approach and the Security Market Line (SML) Approach.

The easiest way to estimate the cost of equity capital is to use the dividend growth model. In such a model, it is assumed that the firmÐŽ¦s dividends will grow at a constant rate g, the current price per share of stock P0 can be written as:

P0 = D0 ЎС (1+ g) = D1

RE ÐŽV g RE ÐŽV g

Where D0 is the dividend just paid, and D1 is the next periodÐŽ¦s projected dividend, and RE is the Required Rate of Return on Equity. This formula can be re-arranged to calculate RE as follows:

RE = D1

P0+g

The primary advantage of such a model is its simplicity, although it also has some disadvantages. First and foremost, the dividend growth model is obviously only applicable to companies that pay dividends. This means that this approach is useless in many cases. Furthermore, even for companies that do pay dividends, the key underlying assumption is that the dividend grows at a constant rate, and this will never be exactly the case. A second problem is that the estimated cost of equity is very sensitive to the estimated growth rate. For a given stock price, an upward revision of g by just one percentage point, for example, increases the estimated cost of equity by at least a full percentage point. Since D1 will probably be revised upward as well, the increase will actually be somewhat larger than that.

Finally, this approach does not explicitly consider risk. Unlike the SML approach, this one has no direct adjustment of the riskiness of the investment. For example, there is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate in dividends. As a result, it is difficult to say whether or not the estimated return is commensurate with the level of risk.

The SML Approach:

The Required or Expected Return on a risky investment depends on three main factors:

1) The Risk Free Rate, Rf

2) The Market Risk Premium ( RM-Rf)

3) The Systematic Risk of the Asset relative to average, which is called the Beta CoefficientÑ"Т.

Note: A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.

Using SML, we can write the estimated return on the companyÐŽ¦s equity, E (RE), as:

E(RE) = Rf + Ñ"ТE (RM ÐŽV Rf)

Expected Return is the same as the Required Return for as far as we are concerned, so we can rewrite the formula as:

RE = Rf + Ñ"ТE (RM ÐŽV Rf)

We saw that one estimate of the Risk Premium (based on large common stocks) is 8.8%. U.S. Treasury Bills are paying about 1.5%...so we will use that as the Risk Free Rate of Return.

The SML approach has two advantages, First: It explicitly adjusts for risk. Second: It is applicable to companies other than just those with steady dividend growth.

There are drawbacks, of course. The SML approach requires that two things be estimated, the market risk premium