CFA Level I - Reading 45

A company increases its value and creates wealth for its shareholders by earning more on its investment in assets than is required by those who provide the capital for the firm. A firm’s WACC may increase as larger amounts of capital are raised. Thus, its marginal cost of capital, the cost of raising additional capital, can increase as larger amounts are invested in new projects. This results in an upward-sloping marginal cost of capital curve. Given the expected returns (IRRs) on potential projects, we can order the expenditures on additional projects from highest to lowest IRR. This will allow us to construct a downward sloping investment opportunity schedule.
The intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the amount of the optimal capital budget. The intuition here is that the firm should undertake all those projects with IRRs greater than the cost of funds, the same criterion developed in the capital budgeting topic review. This will maximize the value created. At the same time, no projects with IRRs less than the marginal cost of the additional capital required to fund them should be undertaken, as they will erode the value created by the firm.

An additional issue to consider when using a firm’s WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project.

The cost of common equity (k_ce) is the rate of return stockholders require on the equity capital the firm retains from earnings.

1. The CAPM approach:
   k_ce = RFR + Beta[E(R_MKT − RFR)]
   
2. The bond-yield plus risk-premium approach:
   k_ce = bond yield + risk premium
   
3. The discounted cash flow or dividend yield plus growth rate approach:
   k_ce = (D₁ / P₀) + g 

In the weighted average cost of capital calculation, the cost of preferred stock must be adjusted for the cost to issue new preferred stock.

To reflect the increased risk associated with investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.
The general risk of the developing country is reflected in its sovereign yield spread. This is the difference in yields between the developing country’s government bonds (denominated in a developed market currency) and Treasury bonds of a similar maturity. To estimate an equity risk premium for the country, adjust the sovereign yield spread by the ratio of volatility between the country’s equity market and its government bond market (for bonds denominated in the developed market’s currency). A more volatile equity market increases the country risk premium, other things equal.