The weighted cost of capital is an extremely important input in the capital budgeting decision process. The weighted cost of capital is the discount rate used when computing the net present value (NPV) of a project of average risk. Similarly, the weighted cost of capital is the hurdle rate used in conjunction with the internal rate of return (IRR) approach to project evaluation (for a project of average risk).
Thus, the appropriate after -tax cost of capital figure to be used in capital budgeting not only is based on the next (marginal) capital to be raised, but also is weighted by the proportions of the capital components in the firm’s long-range target capital structure. Therefore, this figure is called the weighted, or overall, cost of capital.
The general expression for calculating the weighted cost of capital, ka, follows:
where B is debt, Pf is preferred stock, E is common equity in the target capital structure, ke is the marginal cost of equity capital, kd is the marginal pretax cost of debt capital, and kp is the marginal cost of preferred stock capital.
Market Value Versus Book Value Weights
When computing the weighted cost of capital for a company, a decision must be made whether to use the proportions of debt, preferred stock, and common equity based on balance sheet values for each of these capital sources, or to use weightings based on market values of debt, preferred stock, and common equity. Although the book value of debt and preferred stock are normally close to their book value, the market value of common equity frequently diverges greatly from the book value of equity.Which weightings are more consistent with the goal of maximizing shareholder value?
It is generally agreed that the preferred weighting to use is the market value weights.Consider the marginal common stock investor. Assume this investor has paid $20 per share for common stock that was purchased and that the investor’s expected rate of return is 12.5 percent (e.g., the cost of equity computed using the constant growth dividend valuation model).Assume also that the book value of that share of common stock is currently $7.When market value weights are used in computing the weighted cost of capital, it is assumed that the marginal investor will be satisfied with a 12.5 percent rate of return on their investment.However, if book values are used, we are assuming that the marginal common stock investor is satisfied with a 12.5 percent return on a book value of $7. This is clearly incorrect since the appropriate value of the marginal investor’s investment is the market price per share of $20, not the book value of $7.
Consequently, it is recommended that market value weights be used for the various component costs in the calculation of the weighted cost of capital, especially when there is a significant divergence between book values and market values. First, some firms prefer to use book value weights because market values change daily and it is not practical to calculate a new cost of capital on a daily basis. Second, in the case of privately held firms, book value may have to be used because market prices of the various sources of capital to the private firm are not available.Many practitioners blend both approaches by combining book values of debt and preferred stock with the market value of common equity. This is done because most firms have several different issues of debt and preferred stock, not all of which are publicly held or traded; consequently, market prices are often unavailable for these securities and book values have to be substituted.
Kinder Morgan, Inc.’s Weighted Cost of Capital
Kinder Morgan, Inc. (KMI), a Denver-based natural gas company, has a target capital structure consisting of 47 percent common equity, 51 percent debt, and 2 percent preferred stock. The company plans to finance future capital investments in these proportions. All common equity is expected to be derived internally from additions to retained earnings.
The marginal cost of internal common equity has been estimated to be 10.4 percent using the dividend valuation approach. The marginal cost of preferred stock is 8.1 percent and the pretax marginal cost of debt is 8 percent. The marginal tax rate is 40 percent. Using these figures, the weighted cost of capital for KMI can be computed using Equation 12.1 as follows:ka = 0.47 * 10.4% + 0.51*8.0%(1 – 0.4) + 0.02 *8.1% = 7.5%
This is the rate that KMI should use to evaluate investment projects of average risk over the coming year. Table illustrates the weighted cost of capital calculation for KMI.
In the following sections, the techniques used to compute each of the component capital costs are presented and illustrated. Then more complex weighted cost of capital schedule calculations are presented.
The Problem of “Lumpy” Capital
Firms usually raise funds in “lumpy” amounts; for example, a firm may sell $50 million in bonds to finance capital expenditures at one point in time, and it may use retained earnings or proceeds from the sale of stock to finance capital expenditures later on. In spite of this tendency to raise funds in lumpy amounts from various sources at different points in time, the weighted (or composite) cost of funds, not the cost of any particular component of funds, is the cost we are interested in for capital budgeting purposes.Another way of saying this is that it is generally incorrect to associate any particular source of financing with a particular project; that is, the investment and the financing decisions should be separate.
Consider, for example, the case of a firm that is financed 50 percent with debt and 50 percent with equity. The after-tax cost of equity is 16 percent, and the after-tax cost of debt is 10 percent. The firm has two plants, A and B, which are identical in every respect. The manager of Plant A proposes to acquire a new automated packaging machine costing $10 million. A bank has offered to loan the firm the needed $10 million at a rate that will give the firm a 10 percent after-tax cost. The internal rate of return for this project has been estimated to be 12 percent. Because the rate of return exceeds the cost of funds (debt) used to finance the machine, the manager of Plant A argues that the investment should be made.
The manager of Plant B now argues that she, too, should be allowed to make a similar investment. Unfortunately, she is reminded that the firm has a target capital structure of 50 percent debt and 50 percent equity and that her investment will have to be financed with equity in order for the firm to maintain its target capital structure. Because the cost of equity is 16 percent and the project only offers a 12 percent return, the investment is denied for Plant B.
The point of this illustration is that two economically identical projects were treated very differently, simply because the method of financing the projects was tied to the acceptreject decision. To avoid problems of this type, the capital expenditure decision is usually based on a composite capital cost—that is, each project is assumed to be financed with debt and equity in the proportion in which it appears in the target capital structure. In this example, the composite cost of capital is 13 percent, computed as follows:
Weighted Cost of Capital for Kinder Morgan, Inc.
In this example, neither project should be accepted, because the company’s weighted cost of capital exceeds the projects’ expected rates of return.
Accordingly, as a firm evaluates proposed capital expenditure projects, it normally does not specify the proportions of debt, preferred stock, and common equity financing for each individual project. Instead, each project is presumed to be financed with the same proportion of debt, preferred stock, and equity contained in the company’s target capital structure.
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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