9-1 Company and Project Costs of Capital

Whenever a company wants to make an investement a discount rate has to be choosen. The company cost of capital is used as that discount rate for investements with the same risk as a the company as a whole.

Company cost of capital

Defined as the expected return on a portfolio of all the company’s outstanding debt and equity securities

Often CAPM is used to estimate the company cost of capital. The company cost of capital is not the correct discount rate if the new projects are more or less risky than the firm’s existing business. That would be silly as discounting riskier or less risky projects at the same rate wouldn't be appropiate. If we measure the risk of a project by its beta then a company would accept any project lying above the upward-sloping security market line that links expected return to risk in the image below. This way riskier projects require greater expected returns while safer project require less.

The cost of capital is estimated as a blend of the cost of debt (the interest rate on the firm’s debt) and the cost of equity (the expected rate of return demanded by investors in the firm’s common stock).

Weighted-average cost of capital (WACC)

$$\text{ Company cost of capital }=r_{D}D/V+r_{E}E/V$$

$r_D=\text{cost of debt}$$r_e=\text{cost of equity}$$\text{E = market value total equity}$$\text{V = total market value of the company’s combined debt and equity or E + D}$$\text{E/V = equity portion of total financing}$$\text{D/V = debt portion of total financing}$

Interest is tax deductable so:

After-tax WACC

$$\text{ After-tax WACC }=(1-T_c)r_{D}D/V+r_{E}E/V$$

$T_c\text{ = income tax rate}$