Cost of Equity and Debt

Week 7 Case Study

Question 1: WACC (Weighted Average Cost of Capital)

· On the most basic level, if a firm’s WACC is 12 percent, what does this mean?

WACC is the average rate of return a company needs to pay to finance its assets. If a firm's WACC is 12%, it means that the company has to have a 12% return on its investments to be able to maintain its payments to stakeholders and on loans (Menifield, 2020).

Question 2: Cost of Capital

· (a) The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, “It will cost us $5 per share to use the stockholders’ money this year, so the cost of equity is equal to 10 percent (= $5/$50).” What’s wrong with this conclusion?

It is a totally accurate conclusion—that is why it is wrong. First, it only considers the dividend yield ($5/$50 = 10%). That is not the whole cost of equity, though. Tom also needs to think about the expected growth rate of the dividends. It can be estimated using models like the Gordon Growth Model. If he ignores the growth component then he underestimates the true cost of equity (Menifield, 2020).

· (b) Based on the most recent financial statements, Bedlam Products’ total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Tom therefore reasons, “We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/ $8 million = .125, or 12.5%.” What’s wrong with this conclusion?

Tom only calculates the cost of debt based on the interest payment alone. He ignores the tax shield that interest gives (Menifield, 2020). Interest payments are tax-deductible, which means the after-tax cost of debt should be less.

· (c) Based on his own analysis, Tom is recommending that the company increase its use of equity financing, because “Debt costs 12.5 percent, but equity only costs 10 percent; thus equity is cheaper.” Ignoring all the other issues, what do you think about the conclusion that the cost of equity is less than the cost of debt?

It is not a good conclusion. Even though the nominal cost of equity looks like it would be lower than the cost of debt, there are other things to consider. For example, equity is riskier because shareholders expect higher returns due to the risk they bear compared to debt holders. The cost of equity tends to show the higher risk with a higher return over time. This could be missed if one is only looking at the current dividend yield (Menifield, 2020).

Question 3: Divisional Cost of Capital

· (a) Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions?

It would be appropriate when those divisions are in different industries or if they have different risk profiles. For example, a technology division would be in a different industry and have a different risk profile (likely be riskier) than a utility division. It would make sense, then, for the technology division to have a higher cost of capital so as to reflect its higher risk (Menifield, 2020).

· (b) If the overall firm WACC was used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why?

The riskier divisions would likely get most of the investment projects because their return would be higher than the hurdle. However, there would need to be a risk-adjusted basis established to properly consider where the projects go.