COST OF CAPITAL

2
Cost of Capital
Definition: the minimum required rate of return
on a project
Discount rate to be used in NPV calculations
Project specific:
business risk of the project
Long run: companys cost of capital changes with
the types of projects the company takes (Enron:
from pipeline operator to energy trader to)
3
Cost Of Capital: Practical Points
Higher discount rates for investments involving new
products
Lower rates for ones that expand an existing
business
Problem: this is justified only if the betas of the
projects differ substantially
Incorporate impact of difficulties/uncertainties
during new product launch in expected cash flow
estimate (NOT in discount rate)
4
Weighted Average Cost of Capital
WACC: weighted average of the costs of different
financing sources
Weights reflect relative importance of each
financing source in firms capital structure
( )
V
P
P
D E
V
E
r
V
D
t r WACC
P
P
E C D
+ + = ) 1 (
After tax cost of debt
Proportion of debt
Cost of
equity
Proportion of equity
Cost of
preferred
stock
Proportion
of preferred
stock
5
WACC
( )
V
P
P
D E
V
E
r
V
D
t r WACC
P
P
E C D
+ + = ) 1 (
P E D V

V
P
,
V
E
,
V
D
P
) E(D
r
t
r
WACC
P
P
E
C
D
+ + = =
=
=
=
=
=
=
=
Value Firm
stucture capital s company' the in
stock preferred and stock common debt, for ratios target
stock preferred of price
stock preferred on dividend expected
stock common on return expected
rate tax corporate
debt of cost tax - pre
capital of cost
6
WACC The Cost of Equity
The hardest part of calculating WACC
Two main methods to obtain expected
return on common stock (r
E
)
Discounted cash flow method (Gordon Growth
Model)
Comparable companies (CAPM)
7
Discounted Cash Flow Method
Problems
Must estimate g
What if g not constant or g > r
E
?
What about companies that pay no dividends?
g r
DIV
P
E

=
1
0
g
P
DIV
r
E
+ =
0
1
dividends annual of rate growth constant the
next year share per dividend
price stock
=
=
=
g
DIV
P
1
0
8
Using Comparable Companies
Main steps
Select comparable firm(s): firms in same industry
Calculate (levered) equity beta for comparable(s)
Unlever equity beta using capital structure of
comparable(s)
Lever up the unlevered beta using the relevant
firm's target capital structure
Use CAPM
to get r
E
:

( )
f m E f E
r r E r r + = ] [ |
9
Getting the Inputs for CAPM
Find
E
form comparable firm (or industry)
Regress common stock returns on the return of a
market index. Issues:
Daily, weekly, monthly or annual returns?
What time period?
Are dividends included?
Which is the correct market index?
Reduce noise in estimates by using industry betas
Or, use estimates from Value Line, Bloomberg,
Barra or Prof. Damodaran (check methodology!):
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html
Industry Name
Number
of Firms
Average
Beta
Market
D/E Ratio Tax Rate
Unlevered
Beta
Cash/Firm
Value
Unlevered
Beta
corrected for
Advertising 32 1.54 27.53% 16.27% 1.25 8.39% 1.36
Aerospace/Defense 67 0.78 33.46% 19.04% 0.61 3.17% 0.63
Air Transport 43 1.15 122.96% 17.65% 0.57 14.94% 0.67
Apparel 55 0.82 16.52% 22.22% 0.73 3.21% 0.75
Auto & Truck 21 0.97 188.17% 18.43% 0.38 9.80% 0.42
Auto Parts 67 0.83 70.88% 19.78% 0.53 5.44% 0.56
Bank 449 0.66 38.15% 28.52% 0.52 9.43% 0.57
Bank (Canadian) 8 0.92 11.24% 19.32% 0.84 3.33% 0.87
Bank (Foreign) 5 1.03 86.73% 16.29% 0.59 16.90% 0.71
Bank (Midwest) 34 0.75 28.92% 30.15% 0.62 8.69% 0.68
Beverage (Alcoholic) 21 0.59 15.21% 23.92% 0.52 2.33% 0.54
Beverage (Soft Drink) 21 0.67 12.15% 20.82% 0.61 1.93% 0.63
Biotechnology 78 1.12 3.13% 7.11% 1.08 16.27% 1.3
Building Materials 54 0.82 29.44% 22.34% 0.67 6.03% 0.71
Cable TV 28 1.36 108.29% 3.28% 0.66 7.34% 0.72
Canadian Energy 12 0.74 28.63% 34.38% 0.62 3.37% 0.65
Cement & Aggregates 16 0.73 38.63% 23.11% 0.56 2.37% 0.57
Chemical (Basic) 23 0.86 40.55% 15.60% 0.64 4.14% 0.67
Chemical (Diversified) 33 0.77 24.83% 29.44% 0.66 3.65% 0.68
Chemical (Specialty) 91 0.79 46.81% 20.08% 0.58 2.74% 0.59
Industry Name

Number
of Firms

Average
Beta

Market
D/E
Ratio

Tax Rate

Unlevered
Beta

Cash/Firm
Value

Unlevered
Beta
corrected
for cash

Publishing

45

0.95

23.18%

20.38%

0.8

4.81%

0.84

11
Unlevering Beta
The formula to unlever beta is:
( )
( )
E
D
t
E
D
t
C
D C EL
EU
+
+
=
1 1
1 | |
|
Sometimes people assume
D
=0
This is equivalent to saying that the cost of
debt is the risk free rate!
12
Levering up the Unlevered Beta
Here we use the firms target capital
structure (i.e. the firms D and E)
( )( )
E
D
t
D EU C EU EL
| | | | + = 1
Notice that we have simply rearranged the
previous formula
Lack of Data
What if the firm is unlisted and you cant find any
similar companies?
Remember the intuition behind beta!
Beta reflects how closely the companys profits
fluctuate with the economy
If the company is cyclical and has high operating
leverage (ratio of fixed costs to variable costs), its
beta is probably high
On the other hand if the company is non-cyclical and
has low fixed costs, its beta is probably low
14
Risk Free Rate
Long-term or short term rate?
Discount rate should reflect duration of project
Use a long term (10-year) government bond rate
as the risk free rate
Emerging markets (with no 10-year govt bond):
Use recent issues of the largest firms in that country
and subtract a rough estimate of the risk premium
Interest Rate Parity: derive risk free rate from spot
and forward exchange rate and US risk free rate
15
Market Risk Premium: E(r
m
) r
f
This is the expected risk premium
The average risk premium is a good estimate if:
On average, expectations are realized over the long-run
The risk premium is constant
Depending on the stock market in question the
historical risk premium has varied between 4%
and 7%
For the US: Ibbotson Associates data from 1926
The longer the period, the lower the estimation
error common choice: start from 1926!
16
The Cost of Debt
Firms credit rating is known
r
D
can be estimated from yield-to-maturity (YTM) of
bonds issued by companies with similar credit rating
NOT THE COUPON RATE!
Difference between Investment and Non-
Investment Grade Bonds:
BBB or better for investment grade
Investment: calculate yield-to-maturity
Non-Investment: use expected (not promised) cash
flows (estimated probability of default)
Otherwise use BBB YTM
Source: http://www.stern.nyu.edu/~adamodar/pc/ratings.xls
Credit Ratings and Bond Spreads
For Large Manufacturing Firms
If interest coverage ratio is

> to Rating is Spread is
-100000 0.199999 D 14.00%
0.2 0.649999 C 12.70%
0.65 0.799999 CC 11.50%
0.8 1.249999 CCC 10.00%
1.25 1.499999 B- 8.00%
1.5 1.749999 B 6.50%
1.75 1.999999 B+ 4.75%
2 2.499999 BB 3.50%
2.5 2.999999 BBB 2.25%
3 4.249999 A- 2.00%
4.25 5.499999 A 1.80%
5.5 6.499999 A+ 1.50%
6.5 8.499999 AA 1.00%
8.50 100000 AAA 0.75%
18
Example 1: Columbia Power
Capital structure:
Debt: 4,000 10-year, 8% semi-annual coupon bonds
priced at par (face value = $1,000)
Common stock: 50,000 shares outstanding, price = $62
and = 1.1
Preferred stock: 9,000 shares of 4% preferred stock
outstanding, price = $60 (face value = $100)
Market risk premium: 5%
Risk-free rate: 6%
Tax rate: 35%

What is the WACC?
19
Cost of Capital
First, we have to calculate relative weights of different
sources of capital
Debt :
Preferred Stock :
Common Stock :
Firm value :
$7,640,000 E P D V = + + =
$4,000,000 1,000 4,000 D = =
$540,000 $60 9,000 P = =
$3,100,000 $62 50,000 E = =
Proportions Market Value Weights
Debt (V) 4,000,000 D/V = 52.36%
Preferred stock (P) 540,000 P/V = 7.07%
Common stock (E) 3,100,000 E/V = 40.57%
Firm Value (V) 7,640,000 100.00%
20
After-Tax Cost of Debt: Columbia Power
8.16% 1
2
0.08
1 EAR R
2
D
=
|
.
|

\
|
+ = =
5.30% 0.65 0.0816 ) T - (1 R
: debt of cost tax - After
C D
= =
Bond price = Par value YTM = Coupon rate = 8%

YTM = cost of debt! YTM = semi-annually
compounded APR must calculate EAR!
21
Cost of Preferred Stock
6.67%
$60
$4
P
D
R
P
P
P
= = =
Preferred stock is assumed to be a perpetuity
(zero growth)
Dividend = Face value Dividend rate
= $100 4% = $4
Market price=$60
22
Cost of Common Stock
( ) | |
0.115
0.05 1.1 0.06
R R E R
premium) risk (Market R R
f M f
f E
=
+ =
+ =
+ =
Cost of common stock: R
E
= 11.5%
Apply CAMP (Capital Asset Pricing Model):
23
WACC of Columbia Power
7.91%
6.67% 0.0707 11.5% 0.4058 5.30% 0.5236
R
V
P
R
V
E
R
V
D
WACC
P E D
=
+ + =
+ + = Tc) (1
If this is a typical project for the firm, then the
WACC is the appropriate discount rate for the
capital budgeting problem.
24
Unipress Example
Unipress, a publishing company
Market capitalization: $2 billion
Market value of debt (rated AAA): $300m
Corporate tax rate: 34 %
Risk free rate (10-year treasuries): 5.12%
Market risk premium (Ibbotson): 6.47%
Unipress is planning to launch a new magazine
dealing with soap operas
Cost of the new project: $500m
% of debt financing for project: 100% (AAA)
What is the relevant discount rate for project?
25
Unipress Example Continued
Cost of debt (from table above)
r
D
= 0. 75 + 5.12 = 5.87% (10 years)
Target debt-to-equity ratio after project
has been financed
D = $300m + $500m = $800m
E = $2,000m + $500m x 0.34 = $2,170m
Hence, D/E = 36.8 %
26
Unipress Example: Cost of Equity
Beta table gives us unlevered equity beta for
publishing industry (0.8)
Need to lever it up using formula:
( )( )
E
D
t
D EU C EU EL
| | | | + = 1
What is Unipress' debt beta? Use CAPM!
( )
% . % . % .
r r E r r
D
f M D f D
47 6 12 5 87 5
] [
+ =
+ = |
Therefore
D
=0.116
27
Unipress Example: Cost of Equity 2
( )( )
966 0
368 0 116 . 0 8 . 0 34 . 0 1 8 . 0
.
.
EL
=
+ = |
Finally, using the CAPM again:
( )
( )
% . r
r
r r E r r
E
E
f M EL f E
37 11
% 47 . 6 966 . 0 % 12 . 5
] [
=
+ =
+ = |
28
Unipress Example: WACC
9.35%
2170 800
2170
37 . 11
2170 800
800
) 34 . 0 1 ( 87 . 5
) 1 (
=
+
+
+
=
+ =
V
E
r
V
D
t r WACC
E C D
29
Appendix: Levering/Unlevering Betas
Value of Levered Firm = Value of Unlevered Firm
+ Tax Shields = Equity + Debt
V
L
= V
U
+ D T
C
=

E + D
Remember: portfolio beta is weighted average of
the betas of the assets in the portfolio
Beta of levered firms assets:
D
L
EL
L
D EL A

V
D

V
E

D E
D

D E
E

+ =
+
+
+
=
30
Alternatively: beta of levered firms assets using
beta of Unlevered Firm and beta of Tax Shields
D
L
C
EU
L
U
D
C U
C
EU
C U
U
A

V
D t

V
V

D t V
D t

D t V
V

+ =
+
+
+
=
Combining the two expressions for
A
:
D
L
C
EU
L
U
D
L
EL
L

V
D t

V
V

V
D

V
E
+ = +
Appendix: Levering/Unlevering Betas
(Continued)
31
Multiply both sides by V
L
and replace V
U
with E +
D t
C
D :
Deduct D
D
from both sides and then divide by E:
( )
D C EU C D EL
D t D t D E D E + + = +
( )
E
D
t
D EU C EU EL
) ( 1 + =
Rearrange for
EU
to obtain formula to un-lever beta:
( )
( )
E
D
t
E
D
t
C
D C EL
EU
+
+
=
1 1
1 | |
|
Appendix: Levering/Unlevering Betas
(Continued)