Cost of Capital

USC Graduate Series
Week 2 speaker: Naikaj P. Bhobe
Topic: Cost of Capital
Date: 24 January 2014 
#1 COST OF CAPITAL - NAIKAJ P. BHOBE
How do companies value different projects? – A note related to cost of
capital.
Consider a common scenario. You are the CEO of a company and your manager comes up with
two proposals. The company needs to invest money in 2 activities- Build a new factory or Build a
marketing team by investing in human capital. How do you decide which one to pick assuming
both the projects require the same amount of budget? Following are some metrics one should
consider while gauging such decisions.
Rate of Return/Return on Investment
The first step is always to figure out the Return on Investment. Whenever you are lending money
to some project, you want the output to be higher than the input. ROI is just (Output-Input)/
Input. Thus, if you are lending 1000 bucks and get a product worth 1100, then your ROI =
1100-1000/1000 = 0.10 or 10%. If the benefits come over a period of time, you need to slightly
increase the complexity of the calculation (concepts involving time value of money etc.). But, let us
leave this for now. In our case, the CEO first gets the ROI for both the projects.
Weighted Average Cost of Capital (WACC)
A company gets money from multiple sources - from owners & stock markets (Equity) and from
lenders (Debt). Always realize that the cost of lender's debt will be lower than the cost of equity
(shareholders (owners) will expect a higher return than the lenders). Debt has a fixed rate of
interest while equity actually owns a part of the company.
To compute a company's cost of equity, we just divide the company's dividends by the total
market value of the stock (assuming it is a mature company). You can also compute by finding the
return offered by the main Stock Market Indices (such as S&P 500 or BSE SENSEX) and multiply
that by company's Risk (Beta). To compute cost of debt, you just find the average Interest Rate the
company pays to the bank and other debt holders. WACC = Weighted average of cost of (Stock,
Bonds). For most major corporations, this rate is around 10%.
Hurdle Rate or Minimum Acceptable Rate of Return or Discount Rate
Once you have found out how much it costs you to get a dollar, you can set a "hurdle rate" that is
the minimum rate of return above which all your projects should expect to make. Usually you set
this slightly above the weighted average Cost of Capital (WACC).

Now, that you have the hurdle rate, you just see which of the projects have ROI above the hurdle
rate. If both projects are expected to make above the hurdle rate, you could decide to take both,
subject to operational constraints.


#2 COST OF CAPITAL - NAIKAJ P. BHOBE