Cost of capital (Part II) – Practical applications

2. Capital budgeting

Firms constantly face decisions about investments and other projects that carry a certain degree of risk. Managers can use weighted-average cost of capital as a target rate of return for any major investment. Consider this simplified example – would you charge $1,000 to your credit card in order to receive $1,200 next year if the interest rate on the card is 12%? Hopefully not! In the same way, companies have to weigh the future benefits of an investment against the cost of the capital required for the venture.

The most common way to use cost of capital for capital budgeting purposes is to discount estimated cash flows from an investment using a rate that is at least as high as WACC. For more information about discounting and an example of the net present value method, a specific capital budgeting technique, take a look at this article about discounted cash flow information and application.

If a corporation undertakes a project that provides a lower percentage return than its WACC, the company will lose shareholder value even though it might be making more than the interest rate on its debt. Individual owners may become frustrated and sell their stock, which leads to a reduction in share price. On the other hand, if the corporation consistently invests in projects with a higher return than its WACC, shareholder value will be increased. Current investors will be happy with the company’s leadership, and the stock price will steadily climb because more investors want to buy shares instead of sell shares.

3. Financial leverage

You might be tempted to think that a corporation should rely almost entirely on debt financing because of its low cost. Keep in mind, though, that debt financing tends to carry more restrictions than equity financing. In addition, interest payments must be made throughout the life of the loan whether the corporation makes money or not. That fact leads us to our final point about capital financing in this article -- the concept of financial leverage.

A company that relies heavily on debt financing has a high degree of financial leverage. This is similar to operating leverage - it measures how much earnings per share (EPS) change when earnings before income and taxes (EBIT) change. The formula for financial leverage is as follows:

Degree of Financial Leverage =

Percent Change in EPS

Percent Change in EBIT

The big difference between companies at opposite ends of the leverage spectrum is the proportional number of shares outstanding. More debt financing means greater gains when performance improves, but more equity financing means more shares available to dilute negative EPS when performance suffers. Highly leveraged firms, therefore, can experience large swings in earnings per share results.

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