Page 149 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes 9.5.1 Concept of Average Cost of Capital

A company’s cost of capital is the weighted average cost of various sources of finance used by it,
viz. equity, preference, and debt.
Suppose that a company uses equity, preference, and debt in the following proportions: 50, 10,
and 40. If the component costs of equity, preference, and debt are 16 percent, 12 percent, and 8
percent respectively, the Weighted Average Cost of Capital (WACC) will be: WACC = (Proportion
of equity) (Cost of equity).
(Proportion of preference) (Cost of preference)

(Proportion of debt) (Cost of debt) = (0.5)(16) + (0.10)(12) + (0.4)(8) = 12.4 percent
Bear in mind the following in applying the preceding formula:
For the sake of simplicity, we have considered only three types of capital (equity; non-convertible,
non-callable preference; and non-convertible, non-callable debt). We have ignored other forms
of capital like convertible or callable preference, convertible or callable debt, bonds with payments
linked to stock market index, bonds that are puttable or extendable, warrants, so on and so forth.
Calculating the cost of these forms of capital is somewhat complicated. Fortunately, more often
than not, they are a minor source of capital. Hence, excluding them may not make a material
difference.
Debt includes long term debt as well as short term debt (such as working capital loans and
commercial paper). Some companies leave out the cost of short term debt while calculating the
weighted average cost of capital. In principle, this is not correct. Investors who provide short
term debt also have a claim on the earnings of the firm. If a company ignores this claim, it will
misstate the rate of return required on its investments.

Non-interest bearing liabilities, such as trade creditors, are not included in the calculation of the
weighted average cost of capital. This is done to ensure consistency and simplify valuation.
True, non-interest bearing liabilities have a cost. However, this cost is implicitly reflected in the
price paid by the firm to acquire goods and services. Hence, it is already taken care of before the
free cash flow is determined. While it is possible to separate the implicit financing costs of
non-interest bearing liabilities from the cash flow, it will make the analysis needlessly more
complex, without contributing to the quality thereof.

Rationale
The rationale for using the WACC as the hurdle rate in capital budgeting is fairly straightforward.
If a firm’s rate of return on its investment exceeds its cost of capital, equity shareholders benefit.
To illustrate this point, consider a firm which employs equity and debt in equal proportions and
whose cost of equity and debt are 14 percent and 6 percent respectively. The cost of capital, which
is the weighted average cost of capital, works out to 10 percent (0.5 × 14 + 0.5 × 6). If the firm
invests 100 million, say, on a project which earns a rate of return of 12 percent, the return equity
funds employed in the project will be:
Total return on the project – Interest on debt 100(0.12)– 50(.006)
  18 percent
Equity funds 50
Since 18 percent exceeds the cost of equity (14 percent), equity shareholders benefit.

Company Cost of Capital and Project Cost of Capital

At the outset we must distinguish between the company cost of capital and the project cost of
capital.

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