Question

Up to this point we have been analyzing what the price of a stock or bond should be for an investor. In this chapter, we flip the tables and see what the actual cost is to the issuing entity (company). As you have now seen, just because a bond has a 10% coupon and yield, the cost to the issuing or selling entity (company) is actually less than 10%. Conversely, if a preferred stock or common stock pays a 10% annual dividend (a stock with a market value of $100, that pays an annual dividend of $10) actually costs the issuing entity (company) more than 10%. Discuss why the bond, debt, is actually cheaper, and the stocks are more expensive?
Discuss why we MUST use the Weighted Average Cost of Capital (WACC) and not the specific means of financing when evaluating a project? For example, if a company sells bonds with an after tax cost of 6% to fund a project, and that project has an 8% profit (return) and the WACC is 10%, why we we reject this project?

Answer 1

1). Debt funding is cheaper for a company compared to preferred or common stock because debt receives an interest tax shield as a result of which the actual cost of debt is less than the interest rate of the debt. There is no such tax advantage given to preferred/common stock.

2). Firms prefer to use WACC for evaluating a project because the firm has to look at firm-level profits and not the profit from a single project. A firm can earn profits only when a project is viable at firm level. For this, a project has to be evaluated on the basis of the firm's hurdle rate (i.e. the return required by the firm's investors) and not on the basis of specific financing used for a particular project.