click the Instructions tab, and read the instructions.Calculate cost of debt and equity as well as weighted average cost of capital (WACC).Apply the capital asset pricing model (CAPM).Develop a capital budget.
INSTRUCTIONS
Complete the Cost of Capital tab
o Find the cost of Equity using the Capital Asset Pricing Model (CAPM)
o Find the Weighted Average Cost of Capital (WACC)
Complete the Payback tab
o Complete the After-tax Cash Flow re-evaluation table
o Complete the DCF Payback timeline
o Complete the questions on the tab
Complete the Budget Projections tab
o Revenue increases 4% annually
o Expense increases 2¾% annually
Model (CAPM)
Instructions:
1 Find the cost of Equity using the Capital Asset Pricing Model (CAPM)
2 Find the Weighted Average Cost of Equity (WACC)
1
CAPM Information from Largo Global Cost of Equity
RF
Risk-free rate of return = 2.20 percent1
??
Beta = 1.12.
RM
Expected Return of the Market = 7.05 percent2
RP
Market premium = RM – RF
____
1 current U.S. 10-yr Treasury Yield. Source: U.S.Treasury.gov. Mar, 2022
2 The S&P 500 long-term average when holding the S&P 500 index.
Source: https://ycharts.com/indicators/sp_500_1_year_return Jan, 2022
CAPM = Risk Free Rate + Beta x Market Premium
???????? =
RF
?
————————————–
RM
????
+
( ?? × (????? ? ???? ))
= CAPM
2 WACC Information from Largo Global
a. As of today, Largo Global market capitalization (E) is $6,373,341,000.1
b. Largo Global’s Market value of debt is $761,000,000.
c. Cost of Equity = CAPM from question 1
d. Cost of Debt = Last Fiscal Year End Interest Expense2 / Market Value of Debt (D).
e. Use the tax rates given in Project 4 Tab 3.
_________
1 Market value of equity (E), also known as market cap, is calculated using the following equation:
Market Cap = Share Price x Shares Outstanding from Project 1
2 From Project 1. Note that the Cost of Debt formula expressed at here is different from the cost of debt formula
introduced in most textbooks. Most textbooks only consider the long-term debt (i.e., bond) as the debt and use the
bond valuation formula when calculating the cost of debt and WACC.
E
D
Total Capital (V)
Last Fiscal Year End
Interest Expense
Tax Rate (TC)
$
–
??
??
1. Find the weight of equity = E / (E + D).
??
??
2. Find the weight of debt = D / (E + D).
Re
3. Find the cost of equity using CAPM.
Rd
4. Find the cost of debt.
WACC
5. Find the weighted average cost of capital.
After-Tax Cash Flow Re-evlauation and Payback Timelines Instructions
Technologically advanced distribution equipment proposal re-evaluation
The CFO has asked you to re-evaluate the cash flow projections associated with the equipment purchase proposal due to the proposed loan agreement, and
recommend whether the purchase should go forward. Table 1 shows the data and Table 2 shows projections of the cash inflows and outflows that would occur
during the first eight years using the new equipment.
Keep the following in mind: Row 34 has a suggested Excel function to use. Complete all the blank cells within the tables.
I. In the Data Table:
A. Use the WACC calulated on the Cost of Capital tab
B. Calulate the loan amount with a 10% down payment
II. In the After-tax Cash Flow:
C. Complete the Depreciation Expense from Project 4 (straight line, $0 Salvage)
D. Complete the interest expense using the loan interest rate.
E. Complete the After-tax Cash Flow Table including the interest expense
F. Compute the PV, NPV1, IRR, and adjusted NPV2
III. In the Payback Timeline View:
G. Complete the discounted cash flow Payback Timeline View of Discounted Cash Flows
i) complete the timeline amounts based on the DCF (DCF is the same as PV)
ii) complete the timeline amountss for the Cummulative DCF
iii) calulate the payback period in years and months
IV. Answer the following questions:
1. What is the total depreciation for tax purposes?
2. What is the total PV of the Cash Flows using the WACC rate?
3. What is the NPV using the WACC rate?
4. What is the NPV using the alternative rate?
5. What is the IRR?
6. What is the payback period using the DCF?
7. Should the project be accepted? Why?
Payback Table View
Table 1 – Data
191.10 million
26.0%
8.0%
Cost of new equipment (at year 0)
Corporate income tax rate – Federal
Corporate income tax rate – State of Maryland
Discount rate for the project using WACC
Loan Amount
Loan Interest rate (Prime + 2)
million
5.25%
Table 2 – After-tax Cash Flow Table
(all figures in $ millions)
Year
Projected Cash Projected Cash
Depreciation
Inflows from Outflows from
Expense
Operations
Operations
Excel function to use :
0
1
2
3
4
5
6
7
8
$850.0
$900.0
$990.0
$1,005.0
$1,200.0
$1,300.0
$1,350.0
$1,320.0
$840.0
$810.0
$870.0
$900.0
$1,100.0
$1,150.0
$1,300.0
$1,300.0
SLN
Interest
Expense
Projected
Taxable
Income
Projected Projected Projected
Federal
State
After-tax
Income
Income
Cash
Taxes
Taxes
Flows
IPMT
$23.89
$0.00
PV
PV
($13.89)
($3.61)
($1.11)
$14.72
PV
NPV
NPV1 – calculated NPV including interest expense
NPV2 – calculated NPV at the lower discount rate of 5.02%
IRR
Payback Timeline View Example of Actual Cash Flows
0
1
2
3
4
5
6
7
|
|
|
|
|
|
|
|
Cash Flow
($191.10)
$8.76
$62.18
$82.63
$73.42
$70.84
$104.60
$39.40
Cummulative Cash
Flow
($191.10)
($182.34)
($120.16)
($37.53)
$35.89
$106.73
$211.33
$250.73
Payback Period
3 years
6
0
1
2
3
4
5
6
7
|
|
|
|
|
|
|
|
Discounted Cash
Flow (DCF)
Cummulative DCF
Payback Period
ANSWER THESE QUESTIONS:
1. What is the total depreciation for tax purposes?
2. What is the total PV of the Cash Flows using the WACC rate?
3. What is the NPV using the WACC rate?
4. What is the NPV using the alternative rate?
5. What is the IRR?
6. What is the payback period using the DCF?
years
7. Should the project be accepted? Why?
n agreement, and
ws that would occur
NPV1
IRR
NPV2
NPV
IRR
NPV
IRR
8
|
$20.44
$271.17
$271.17
months
8
PV
|
$0.00
$0.00
$0.00
months
INSTRUCTIONS:
1). Complete the budget projections for years 2023-2026 using the following information
Revenue increases 4% annually
Expense increases 2¾% annually
For Depreciation and Interest expenses assume the Acutal 2022 figure as the base for the budget and
and forecast then add the amount calculated in the Payback tab for both budget and forecast.
2). Answer the question below the forecast.
1).
Largo Global Income Statement of December 31, 2022 (millions)
Sales (net sales)
Cost of goods sold
Gross profit
Selling, general, and administrative
expenses
Earnings before Interest, taxes,
depreciation, and amortization
(EBITDA)
Depreciation and amortization
Earning before interest and taxes
(EBIT) Operating income (loss)
Interest expense
Earnings before taxes (EBT)
Taxes (34%)
Net earnings (loss)/Net Income
ACTUAL BUDGET
2022
2023
$2,013
1400
613
0
FORECAST
2025
2024
0
0
0
0
0
0
0
0
0
0
0
0
0
0
125
488
174
314
$
141
173
59
114
2). Based on the changes suggested throughout the 5 projects, is Largo Global in a better financial position?
base for the budget and
et and forecast.
illions)
FORECAST
2026
0
0
0
0
0
etter financial position?
13
The Cost of Capital
Jeff Greenberg/Alamy
Learning Objectives
Explain what the weighted average cost of capital for a firm is and why it is
often used as a discount rate to evaluate projects.
Calculate the cost of debt for a firm.
Calculate the cost of common stock and the cost of preferred stock for a firm.
Calculate the weighted average cost of capital for a firm, explain the limitations of using a firm’s weighted average cost of capital as the discount rate when
evaluating a project, and discuss the alternatives to the firm’s weighted average
cost of capital that are available.
The Walt Disney Company announced in May 2010 that it would build a
new hotel at Walt Disney World, its first new hotel at that theme park in
seven years. The hotel, which is to be opened in several phases beginning
in 2012, has been named “Disney’s Art of Animation Resort.” It will be
built on a 65-acre parcel of land across the lake from Disney’s Pop
Century Resort and will have 1,120 suites and 864 traditional hotel rooms.
Disney executives anticipate that the rooms in the Art of Animation
Resort will be priced comparably to those at the Pop Century Resort,
which begin at less than $100 per night.
As you can imagine, the cost of financing a project like this is substantial.
Disney is a highly sophisticated and successful hotel and theme park developer and operator. Before the company announced the construction of
the Art of Animation Resort, you can be sure that the managers at Disney
carefully considered the financial aspects of the project. They evaluated
the required investment, what revenues the new hotel was likely to generate, and how much it would cost to operate and maintain. They also estimated what it would cost to finance the project—how much they would
pay for the debt and the returns equity investors would require for an investment with this level of risk. This “cost of capital” would be incorporated into their NPV analysis through the discounting process.
Doing a good job of estimating the cost of capital is especially important
for a capitalintensive project such as a hotel. The cost of financing a hotel
like the one that Disney is building can easily total $50 or more per room
rental. In other words, if an average room rents for $100, the cost of financing the project can consume 50 percent or more of the revenue the
hotel receives from renting a room!
From this example, you can see how important it is to get the cost of capital right. If Disney managers had estimated the cost of capital to be 7 percent when it was really 9 percent, they might have ended up investing in
a project with a large negative NPV. How did they approach this important task? In this chapter we discuss how managers estimate the cost of
capital they use to evaluate projects.
CHAPTER PREVIEW
Chapter 7 discussed the general concept of risk and described what financial analysts mean when they talk about the risk associated with a project’s cash flows.
It also explained how this risk is related to expected returns. With this background, we are ready to discuss the methods that financial managers use to estimate discount rates, the reasons they use these methods, and the shortcomings
of each method.
We start this chapter by introducing the weighted average cost of capital and explaining how this concept is related to the discount rates that many financial
managers use to evaluate projects. Then we describe various methods that are
used to estimate the three broad types of financing that firms use to acquire assets—debt, common stock, and preferred stock—as well as the overall weighted
average cost of capital for the firm.
We next discuss the circumstances under which it is appropriate to use the
weighted average cost of capital for a firm as the discount rate for a project and
outline the types of problems that can arise when the weighted average cost of
capital is used inappropriately. Finally, we examine alternatives to using the
weighted average cost of capital as a discount rate.
13.1 THE FIRM’s OVERALL COST OF CAPITAL
Our discussions of investment analysis up to this point have focused on
evaluating individual projects. We have assumed that the rate used to discount the cash flows for a project reflects the risks associated with the incremental after-tax free cash flows from that project. In Chapter 7, we
saw that unsystematic risk can be eliminated by holding a diversified
portfolio. Therefore, systematic risk is the only risk that investors require
compensation for bearing. With this insight, we concluded that we could
use Equation 7.10, to estimate the expected rate of return for a particular
investment:
where E (Ri) is the expected return on project i, Rrf is the risk-free rate of
return, bi is the beta for project i, and E (Rm) is the expected return on the
market. Recall that the difference between the expected return on the
market and the risk-free rate [E (Rm) ? Rrf] is known as the market risk
premium.
Although these ideas help us better understand the discount rate on a
conceptual level, they can be difficult to implement in practice. Firms do
not issue publicly traded shares for individual projects. This means that
analysts do not have the stock returns necessary to use a regression
analysis like that illustrated in Exhibit 7.10 to estimate the beta (?) for an
individual project. As a result, they have no way to directly estimate the
discount rate that reflects the systematic risk of the incremental cash
flows from a particular project.
In many firms, senior financial managers deal with this problem by estimating the cost of capital for the firm as a whole and then requiring analysts within the firm to use this cost of capital to discount the cash flows
for all projects.1 A problem with this approach is that it ignores the fact
that a firm is really a collection of projects with different levels of risk. A
firm’s overall cost of capital is actually a weighted average of the costs of
capital for these projects, where the weights reflect the relative values of
the projects.
To see why a firm is a collection of projects, consider The Boeing
Company. Boeing manufactures a number of different models of civilian
and military aircraft. If you have ever flown on a commercial airline,
chances are that you have been on a Boeing 737, 747, 757, 767, or 777 aircraft. Boeing manufactures several versions of each of these aircraft models to meet the needs of its customers. These versions have different
ranges, seat configurations, numbers of seats, and so on. Some are designed exclusively to haul freight for companies such as UPS and FedEx.
Every version of every model of aircraft at Boeing was, at some point in
time, a new project. The assets owned by Boeing today and its expected
cash flows are just the sum of the assets and cash flows from all of these
individual projects plus the other projects at the firm, such as those involving military aircraft.2 This means that the overall systematic risk associated with Boeing’s cash flows and the company’s cost of capital are
weighted averages of the systematic risks and the costs of capital for its
individual projects.
If the risk of an individual project differs from the average risk of the
firm, the firm’s overall cost of capital is not the ideal discount rate to use
when evaluating that project. Nevertheless, since this is the discount rate
that is commonly used, we begin by discussing how a firm’s overall cost
of capital is estimated. We then discuss alternatives to using the firm’s
cost of capital as the discount rate in evaluating a project.
The Finance Balance Sheet
To understand how financial analysts estimate their firms’ costs of capital, you must be familiar with a concept that we call the finance balance
sheet. The finance balance sheet is like the accounting balance sheet
from Chapter 3. The main difference is that it is based on market values
rather than book values. Recall that the total book value of the assets reported on an accounting balance sheet does not necessarily reflect the total market value of those assets. This is because the book value is largely
based on historical costs, while the total market value of the assets equals
the present value of the total cash flows that those assets are expected to
generate in the future. The market value can be greater than or less than
the book value but is rarely the same.
finance balance sheet
a balance sheet that is based on market values of expected cash flows
While the left-hand side of the accounting balance sheet reports the book
values of a firm’s assets, the right-hand side reports how those assets
were financed. Firms finance the purchase of their assets using debt and
equity.3 Since the cost of the assets must equal the total value of the debt
and equity that was used to purchase them, the book value of the assets
must equal the book value of the liabilities plus the book value of the equity on the accounting balance sheet. In Chapter 3 we called this equality
the balance sheet identity.
Just as the total book value of the assets at a firm does not generally equal
the total market value of those assets, the book value of total liabilities
plus stockholders’ equity does not usually equal the market value of these
claims. In fact, the total market value of the debt and equity claims differ
from their book values by exactly the same amount that the market values of a firm’s assets differ from their book values. This is because the total market value of the debt and the equity at a firm equals the present
value of the cash flows that the debt holders and the stockholders have
the right to receive. These cash flows are the cash flows that the assets in
the firm are expected to generate. In other words, the people who have
lent money to a firm and the people who have purchased the firm’s stock
have the right to receive all of the cash flows that the firm is expected to
generate in the future. The value of the claims they hold must equal the
value of the cash flows that they have a right to receive.
The fact that the market value of the assets must equal the value of the
cash flows that these assets are expected to generate, combined with the
fact that the value of the expected cash flows also equals the total market
value of the firm’s total liabilities and equity, means that we can write the
market value (MV) of assets as follows:
EXHIBIT 13.1 The Finance Balance Sheet
The market value of a firm’s assets, which equals the present value of the
cash flows those assets are expected to generate in the future, must equal
the market value of the claims on those cash flows—the firm’s liabilities
and equity.
Equation 13.1 is just like the accounting balance sheet identity. The only
difference is that Equation 13.1 is based on market values. This relation is
illustrated in Exhibit 13.1.
To see why the market value of the assets must equal the total market
value of the liabilities and equity, consider a firm whose only business is
to own and manage an apartment building that was purchased 20 years
ago for $1,000,000. Suppose that there is currently a mortgage on the
building that is worth $300,000, the firm has no other liabilities, and the
current market value of the building, based on the expected cash flows
from future rents, is $4,000,000. What is the market value of all of the equity (stock) in this firm?
The fact that you paid $1,000,000 20 years ago is not relevant to this question. What matters in finance is the value of the expected cash flows from
future rents, the $4,000,000. This is the market value of the firm’s assets—
the left-hand side of the balance sheet in Exhibit 13.1. Since we know
that the firm owes $300,000, we can substitute into Equation 13.1 and
solve for the market value of the equity:
If the cash flows that the apartment building is expected to produce are
worth $4,000,000, then investors would be willing to pay $3,700,000 for
the equity in the firm. This is the value of the cash flows that they would
expect to receive after making the interest and principal payments on the
mortgage. Furthermore, since, by definition, the mortgage is worth
$300,000, the value of the debt plus the value of the equity is $300,000 +
$3,700,000 = $4,000,000—which is exactly equal to the market value of the
firm’s assets.
If the concept of a balance sheet based on market values seems familiar
to you, it is because the idea of preparing an actual balance sheet based
on market values was discussed in Chapter 3. In that chapter we pointed
out that such a balance sheet would be more useful to financial decision
makers than the ordinary accounting balance sheet. Financial managers
are much more concerned about the future than the past when they
make decisions. You might revisit the discussion of sunk costs in Chapter
11 to remind yourself of why this is true.
BUILDING INTUITION THE MARKET VALUE OF A FIRM’s ASSETS EQUALS THE
MARKET VALUE OF THE CLAIMS ON THOSE ASSETS
The market value of the debt and equity claims against the cash flows of a firm
must equal the present value of the cash flows that the firm’s assets are expected
to generate. This is because, between them, the debt holders and the stockholders have the legal right to receive all of those cash flows.
How Firms Estimate Their Cost of Capital
Now that we have discussed the basic idea of the finance balance sheet,
consider the challenge that financial analysts face when they want to estimate the cost of capital for a firm. If analysts at a firm could estimate the
betas for each of the firm’s individual projects, they could estimate the
beta for the entire firm as a weighted average of the betas for the individual projects. They could do this because, as we discussed earlier, the firm
is simply a collection (portfolio) of projects. This calculation would just be
an application of Equation 7.11:
where ?i is the beta for project i and xi is the fraction of the total firm
value represented by project i.
The analysts could then use the beta for the firm in Equation 7.10:
to estimate the expected return on the firm’s assets, which is also the
firm’s cost of capital. Unfortunately, because analysts are not typically
able to estimate betas for individual projects, they generally cannot use
this approach.
Instead, analysts must use their knowledge of the finance balance sheet,
along with the concept of market efficiency, which we discussed in
Chapter 2, to estimate the cost of capital for the firm. Rather than using
Equations 7.11 and 7.10 to perform the calculations for the individual
projects represented on the left-hand side of the finance balance sheet,
analysts perform a similar set of calculations for the different types of financing (debt and equity) on the right-hand side of the finance balance
sheet. They can do this because, as we said earlier, the people who finance the firm have the right to receive all of the cash flows on the lefthand side. This means that the systematic risk associated with the total
assets on the left-hand side is the same as the systematic risk associated
with the total financing on the right-hand side. In other words, the
weighted average of the betas for the different claims on the assets must
equal a weighted average of the betas for the individual assets (projects).
Analysts do not need to estimate betas for each type of financing that the
firm has. As long as they can estimate the cost of each type of financing—
either directly, by observing that cost in the capital markets, or by using
Equation 7.10—they can compute the cost of capital for the firm using the
following equation:
In Equation 13.2, kFirm is the cost of capital for the firm, ki is the cost of financing type i, and xi is the fraction of the total market value of the financing (or of the assets) of the firm represented by financing type i. This
formula simply says that the overall cost of capital for the firm is a
weighted average of the cost of each different type of financing used by
the firm.4 Note that since we are specifically talking about the cost of capital, we use the symbol ki to represent this cost, rather than the more general notation E (Ri) that we used in Chapter 7.
The similarity between Equation 13.2 and Equation 7.11 is not an accident. Both are applications of the basic idea that the systematic risk of a
portfolio of assets is a weighted average of the systematic risks of the individual assets. Because Rrf and E (Rm) in Equation 7.10 are the same for
all assets, when we substitute Equation 7.10 into Equation 13.2 (remember that E (Ri) in Equation 7.10 is the same as ki in Equation 13.2) and cancel out Rrf and E(Rm), we get Equation 7.11. We will not prove this here,
but you might do so to convince yourself that what we are saying is true.
To see how Equation 13.2 is applied, let’s return to the example of the
firm whose only business is to manage an apartment building. Recall that
the total value of this firm is $4,000,000 and that it has $300,000 in debt. If
the firm has only one loan and one type of stock, then the fractions of the
total value represented by those two types of financing are as follows:
This tells us that the value of the debt claims equals 7.5 percent of the
value of the firm and that the value of the equity claims equals the remaining 92.5 percent of the value of the firm. If the cost of the debt for
this business is 6 percent and the cost of the equity is 10 percent, the cost
of capital for the firm can be calculated as a weighted average of the costs
of the debt and equity:5
Notice that we have used Equation 13.2 to calculate a weighted average
cost of capital (WACC) for the firm in this example. In fact, this is what
people typically call the firm’s cost of capital, kFirm. From this point on,
we will use the abbreviation WACC to represent the firm’s overall cost of
capital.
weighted average cost of capital (WACC)
the weighted average of the costs of the different types of capital (debt
and equity) that have been used to finance a firm; the cost of each type of
capital is weighted by the proportion of the total capital that it represents
BUILDING INTUITION A FIRM’s COST OF CAPITAL IS A WEIGHTED AVERAGE
OF ALL OF ITS FINANCING COSTS
The cost of capital for a firm is a weighted average of the costs of the different
types of financing used by a firm. The weights are the proportions of the total
firm value represented by the different types of financing. By weighting the costs
of the individual financing types in this way, we obtain the overall average opportunity cost of each dollar invested in the firm.
APPLICATION 13.1 LEARNING BY DOING
Calculating the Cost of Capital for a Firm
PROBLEM: You are considering purchasing a rug cleaning company that will
cost $2,000,000. You plan to finance the purchase with a $1,500,000 loan from
Bank of America (BofA) that has a 6.5 percent interest rate, a $300,000 loan from
the seller of the company that has an 8 percent interest rate, and $200,000 of
your own money. You will own all of the equity (stock) in the firm. You estimate
that the opportunity cost of your $200,000 investment—that is, what you could
earn on an investment of similar risk in the capital market—is 12 percent with
that much debt. What is the cost of capital for this investment?
APPROACH: You can use Equation 13.2 to calculate the WACC for this firm. Since
you are planning to finance the purchase using capital from three different
sources—two loans and your own equity investment—the right-hand side of
Equation 13.2 will have three terms.
SOLUTION:
We begin by calculating the weights for the different types of financing:
We can then calculate the WACC using Equation 13.2:
On average, you would be paying 7.3 percent per year on every dollar you invested in the firm. This is the opportunity cost of capital for the firm. It is the rate
that you would use to discount the cash flows associated with the rug cleaning
business in an NPV analysis.
> BEFORE YOU GO ON
1. Why does the market value of the claims on the assets of a firm equal the
market value of the assets?
2. How is the WACC for a firm calculated?
3. What does the WACC for a firm tell us?
13.2 THE COST OF DEBT
In our discussion of how the WACC for a firm is calculated, we assumed
that the costs of the different types of financing were known. This assumption allowed us to simply plug those costs into Equation 13.2 once
we had calculated the weight for each type of financing. Unfortunately,
life is not that simple. In the real world, analysts have to estimate each of
the individual costs. In other words, the discussion in the preceding section glossed over a number of concepts and issues that you should be familiar with. This section and Section 13.3 discuss those concepts and issues and show how the costs of the different types of financing can be
estimated.
Before we move on to the specifics of how to estimate the costs of different types of financing, we must stress an important point: All of these calculations depend in some part on financial markets being efficient. We
suggested this in the last section when we mentioned that analysts have
to rely on the concept of market efficiency to estimate the WACC. The reason is that analysts often cannot directly observe the rate of return that
investors require for a particular type of financing. Instead, analysts must
rely on the security prices they can observe in the financial markets to estimate the required rate.
It makes sense to rely on security prices only if you believe that the financial markets are reasonably efficient at incorporating new information
into these prices. If the markets were not efficient, estimates of expected
returns that were based on market security prices would be unreliable.
Of course, if the returns that are plugged into Equation 13.2 are bad, the
resulting estimate for WACC will also be bad. With this caveat, we can
now discuss how to estimate the costs of the various types of financing.
Key Concepts for Estimating the Cost of Debt
Virtually all firms use some form of debt financing. The financial managers at firms typically arrange for revolving lines of credit to finance
working capital items such as inventories or accounts receivable. These
lines of credit are very much like the lines of credit that come with your
credit cards. Firms also obtain private fixed-term loans, such as bank
loans, or sell bonds to the public to finance ongoing operations or the purchase of long-term assets—just as you would finance your living expenses
while you are in school with a student loan or a car with a car loan. For
example, an electric utility firm, such as FPL Group in Florida, will sell
bonds to finance a new power plant, and a rapidly growing retailer, such
as Target, will use debt to finance new stores and distribution centers. As
mentioned earlier, we will discuss how firms finance themselves in more
detail in Chapters 15 and 16, but for now it is sufficient to recognize that
firms use these three general types of debt financing: lines of credit, private fixed-term loans, and bonds that are sold in the public markets.
There is a cost associated with each type of debt that a firm uses.
However, when we estimate the cost of capital for a firm, we are particularly interested in the cost of the firm’s long-term debt. Firms generally
use long-term debt to finance their long-term assets, and it is the longterm assets that concern us when we think about the value of a firm’s assets. By long-term debt, we usually mean the debt that, when it was borrowed, was set to mature in more than one year. This typically includes
fixed-term bank loans used to finance ongoing operations or long-term
assets, as well as the bonds that a firm sells in the public debt markets.
Although one year is not an especially long time, debt with a maturity of
more than one year is typically viewed as permanent debt. This is because firms often borrow the money to pay off this debt when it matures.
We do not normally worry about revolving lines of credit when calculating the cost of debt because these lines tend to be temporary. Banks typically require that the outstanding balances be periodically paid down to
$0 (just as we are sure you pay your entire credit card balance from time
to time).
When analysts estimate the cost of a firm’s long-term debt, they are estimating the cost on a particular date—the date on which they are doing
the analysis. This is a very important point to keep in mind because the
interest rate that the firm is paying on its outstanding debt does not necessarily reflect its current cost of debt. Interest rates change over time,
and so does the cost of debt for a firm. The rate a firm was charged three
years ago for a five-year loan is unlikely to be the same rate that it would
be charged today for a new five-year loan. For example, suppose that FPL
Group issued bonds five years ago for 7 percent. Since then, interest rates
have fallen, so the same bonds could be sold at par value today for 6 percent. The cost of debt today is 6 percent, not 7 percent, and 6 percent is
the cost of debt that management will use in WACC calculations. If you
looked in the firm’s financial statements, you would see that the firm is
paying an interest rate of 7 percent. This is what the financial managers
of the firm agreed to pay five years ago, not what it would cost to sell the
same bonds today. The accounting statements reflect the cost of debt that
was sold at some time in the past.
BUILDING INTUITION THE CURRENT COST OF LONG-TERM DEBT IS WHAT
MATTERS WHEN CALCULATING WACC
The current cost of long-term debt is the appropriate cost of debt for WACC calculations.
