CHAPTER 9

Cost of Capital

1
Topics in Chapter
Cost of capital components
Debt
Preferred stock
Common equity
WACC
Factors that affect WACC
Adjusting cost of capital for risk

2
 COST OF CAPITAL
Why? Business Application
Key to understanding Min Reqd return

cost of raising $ needed on Project

Risk Reflects blended costs
Financing costs of raising capital
Discount Rate Relevant i

Discount rate used to

determine Projects
NPV or to disct FCFs by
Hurdle rate

3
 Determinants of Intrinsic Value:
The Weighted Average Cost of Capital

Net operating Required investments

profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF

Value = + + +
(1 + WACC)1 (1 + WACC)2 (1 +
WACC)

Weighted
Weightedaverage
average
cost
costof
ofcapital
capital
(WACC
(WACC) )

Market interest rates Firms debt/equity mix

Cost
Costof
ofdebt
debt
Market risk aversion Cost
Costof
ofequity
equity Firms business risk
What types of long-term
capital do firms use?
Long-term debt
Preferred stock
Common equity

5
Capital Components
Cap. components are sources of funding
that come from investors.
A/P, accruals, and deferred taxes are not
sources of funding that come from
investors, & not included in the
calculation of the cost of capital.
These items are adjusted for when
calculating project cash flows, not when
calculating the cost of capital.
6
Before-tax vs. After-tax
Capital Costs
Tax effects associated with
financing can be incorporated
either in capital budgeting cash
flows or in cost of capital.
Most firms incorporate tax effects
in the cost of capital. Therefore,
focus on after-tax costs.
Only cost of debt is affected.

7
Historical (Embedded)
Costs vs. New (Marginal)
Costs
The cost of capital is used
primarily to make decisions which
involve raising and investing new
capital. So, focus on marginal
(incremental) costs.

8
 COST of CAPITAL
Raising $ & its Costs
Debt Equity
Cost of Borrowing Internal
Interest Rate RE

External
Common Stock
Prfd Stock

9
 Cost of Capital
Raising $ & its Costs
Debt & Equity

Cost Return
Int. pd. Int. recd.
Divids pd. Divids Recd

10
 EQUITIES
Why? Business Application
Key to understanding For Investor:
valuations Determine value of
What is investment asset/business/compan
worth today? y
Value of:
Enterprise For Firm:
Entity Determine cost of
Company/Firm attracting investors &
raising equity capital
Selling ownership stake
to raise $

11
Weighted Average Cost of
Capital (WACC)
WACC: Blended cost or raising
capital considering mix of debt &
equity
WACC = (Wt of Debt)(After-tax cost
of Debt) + Wt of Eqty)(Cost of
Eqty) + (Wt of Prfd)(Cost of Prfd)

12
Cost of Equity
Know: = P0 = D1/ (rs g)

So then: rs = D1/P0 + g

13
Cost of Equity
Cost of External Equity: Function of
Dvids, growth, & net proceeds after
adjusting for flotation costs

Cost of Internal Equity: Function of

opp. Costs of divids not pd out but
retained in firm to grow internally (no
flot. reqd)

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Cost of Preferred Stock
r = D1/P0 + g
g= 0, so cost of prfd = function of
divids pd. & flot cost to issue

15
Determining Cost of Debt

Method 1: Ask an investment

banker what coupon rate would be
on new debt.
Method 2: Find bond rating for the
company and use yield on similarly
rated bonds.
Method 3: Find yield on the
companys existing debt.

16
Current vs. Historical Cost
of Debt
For cost of debt, dont use coupon
rate on existing debt, which
represents cost of past debt.
Use the current interest rate on
new debt (think YTM).

(More)
17
 A 15-year, 13.25% semiannual bond
sells for $1,250. Tax = 40%. 60,000
Bonds o/s. Whats rd?

0 1 2 30
rd = ?
...
1,250.00 -66.25 -66.25 <66.25 + 1,000>

INPUTS 30 1250 -66.25 -1000

N I/YR PV PMT FV
OUTPUT 5.0% x 2 = rd = 10%

18
Component Cost of Debt
Interest is tax deductible, so the
after tax (AT) cost of debt is:
rd AT = rd BT(1 T)
rd AT = 10%(1 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.

19
 Cost of preferred stock: Pps = $125;
10.26% Div; Par = $100; F = 8.8%

Use :
Dps .0126($100)
rps = =
Pps (1 F) $125.00(1 0.088)
$10.26
= = 0.090 =
$114. 9.0%
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 Time Line of Preferred

0 1 2
rps = ?
...
-114. 10.26 10.26 10.26

DQ $10.2
$114.00 = =
rPer 6rPer
$10.2
rPer = = 9%
6
$114.00
21
Note:
Flotation costs for preferred are
significant, so are reflected. Use
net price.
Preferred dividends are not
deductible, so no tax adjustment.
Just rps.
Nominal rps is used.

22
Is preferred stock more or
less risky to investors than
debt?
More risky; company not required
to pay preferred dividend.
However, firms want to pay
preferred dividend. Otherwise, (1)
cannot pay common dividend, (2)
difficult to raise additional funds,
and (3) preferred stockholders may
gain control of firm.
23
Why is yield on preferred
lower than rd?
Corporations own most preferred stock,
because 70% of prfd divids nontaxable
to corps.
T/4, prfd often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost to
the issuer are higher on prfd than on
debt, which is consistent w/ higher risk
of prfd.
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 Example:
rps = 9%, rd = 10%, T =
40%
rps, AT = rps rps(1 0.7)(T)
= 9% 9%(0.3)(0.4) = 7.92%
rd, AT = 10% 10%(0.4) = 6.00%
A-T Risk Premium on Preferred = 1.92%

25
What are the two ways that
companies can raise common
equity?
Directly, by issuing new shares of
common stock.
Indirectly, by reinvesting earnings
that are not paid out as dividends
(i.e., retaining earnings).

26
Why is there a cost for
reinvested earnings?
Earnings can be reinvested or paid
out as dividends.
Investors could buy other
securities, earning a return.
Thus, there is an opportunity cost
if earnings are reinvested.

27
Cost for Reinvested
Earnings (Continued)
Opportunity cost: The return
stockholders could earn on
alternative investments of equal risk.
They could buy similar stocks and
earn rs, or company could repurchase
its own stock and earn rs. So, rs, is
cost of reinvested earnings and is
cost of common equity.

28
Three ways to determine
the cost of equity, rs:
1. CAPM: rs = rRF + (rM rRF)b
= rRF + (RPM)b.

2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-
Judgmental-Risk Premium: rs = rd
+ Bond RP.
29
Equity Cost Components
Risk free = 5.6%
Mrkt Risk Prem = 6%
Beta = 1.2
Div today = $3.12
Price today = $50
Growth = 5.8%
Cost of Debt = 10%
Risk prem = 3.2%
3,000,000 shs outstanding
30
CAPM Cost of Equity: rRF = 5.6%,

RPM = 6%, b = 1.2

rs = rRF + (RPM )b

= 5.6% + (6.0%)1.2 = 12.8%.

31
Issues in Using CAPM
Most analysts use the rate on
a long-term (10 to 20 years)
government bond as an
estimate of rRF.
Can use Bloomberg.com to
obtain US Treasuries Quotes

(More)
32
Issues in Using CAPM
(Continued)
Most analysts use a rate of 3.5%
to 6% for the market risk
premium (RPM)
Estimates of beta vary, and
estimates are noisy (they
have a wide confidence
interval).

33
DCF Cost of Equity, rs:
D0 = $3.12; P0 = $50; g =
5.8%
D1 D0(1 + g)
rs +g= +g
P0 P0
=
= $3.12(1.058+ 0.058
) $50

= 6.6% + 5.8%
= 12.4%
34
Estimating the Growth
Rate
Use historical growth rate if believe
future be like past.
Obtain analysts estimates: Value
Line, Zacks, Yahoo!Finance.
Use earnings retention model.

35
Earnings Retention Model
Suppose company has been
earning 15% on equity (ROE =
15%) and been paying out 62%
of its earnings.
If expected to continue as is,
whats the expected future g?

36
Earnings Retention Model
(Continued)
Growth from earnings retention
model:
g = (Retention rate)(ROE)
g = (1 Payout rate)(ROE)
g = (1 0.62)(15%) = 5.7%.

Close to g = 5.8% given earlier.

37
Could DCF methodology
be applied if g is not
constant?
YES, nonconstant g stocks are
expected to have constant g at
some point, generally in 5 to 10
years.

38
The Own-Bond-Yield-Plus-Judgmental-Risk-
Premium Method: rd = 10%, RP = 3.2%

rs = rd + Judgmental risk premium

rs = 10.0% + 3.2% = 13.2%

This over-own-bond-judgmental-risk
premium CAPM equity risk
premium, RPM.
Produces ballpark estimate of r s.
Useful check.
39
Final estimate of rs?
Method Estimate
CAPM 12.8%
DCF 12.4%
Bond Yld + risk 13.2%
prem
Average 12.8%

40
Determining Weights for
WACC
Wts are % of firms capital to be
financed by each component.
If possible, always use the target
wts for % financed by each type
of capital.

41
Estimating Weights for the
Capital Structure
If dont know targets, better to
estimate wts using current market
values than current book values.
If dont know MV of debt, then
reasonable to use BV of debt,
especially if S/T debt.

(More)
42
Estimating Weights
(Continued)
Suppose the common stock price is
$50 with 3 million shares
outstanding; the firm has 200,000
shs of preferred stock trading at
$125; and 60,000 bonds
outstanding trading at quoted
price of 125% of par.
(More)
43
Estimating Weights
(Continued)
Vs = $50(3 million) = $150
million.
Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75
= $250 million.

44
Estimating Weights
(Continued)
ws = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3

Target wts for this co. are same as these

MV wts, but often MV wts temporarily
deviate from targets due to changes in
stock prices.

45
 Whats the WACC using
the target weights?

WACC = wdrd(1 T) + wpsrps + wsrs

WACC = 0.3(10%)(1 0.4) + 0.1(9%)

+ 0.6(12.8%)

WACC = 10.38%

46
What factors influence a
companys WACC?
Uncontrollable factors:
Market conditions, especially interest rates.
The market risk premium.
Tax rates.
Controllable factors:
Capital structure policy.
Dividend policy.
Investment policy. Firms with riskier projects
generally have higher financing costs.

47
Should firm-wide WACC be
used for each of its
divisions?
NO! Composite WACC reflects risk
of an average project undertaken
by the firm.
Different divisions may have
different risks. Divisions WACC
should be adjusted to reflect
divisions risk and cap structure.

48
The Risk-Adjusted
Divisional Cost of Capital
Estimate cost of capital division
would have if it were a stand-
alone firm.
This requires estimating
divisions beta, cost of debt, and
capital structure.

49
Pure Play Method for
Estimating Beta for a Division
or a Project
Find several publicly traded
companies exclusively in projects
business.
Use average of their betas as
proxy for projects beta.
Hard to find such companies.

50
Accounting Beta Method
for Estimating Beta
Run regression between projects
ROA and S&P Index ROA.
Accounting betas correlated (0.5
0.6) with market betas.
But normally cant get data on
new projects ROAs before capital
budgeting decision made.

51
Divisional Cost of Capital
Using CAPM
Target debt ratio = 10%.
rd = 12%.
rRF = 5.6%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.

52
Divisional Cost of Capital
Using CAPM (Continued)

Divisions required return on equity:

rs = rRF + (rM rRF)bDiv.
rs = 5.6% + (6%)1.7 = 15.8%.
WACCDiv. = wd rd(1 T) + wsrs
= 0.1(12%)(0.6) + 0.9(15.8%)
= 14.94% 14.9%

53
Divisions WACC vs. Firms
Overall WACC?
Division WACC = 14.9% versus
company WACC = 10.4%.
Typical projects within this
division would be accepted if its
returns above 14.9%.

54
What are the three types
of project risk?
Stand-alone risk
Corporate risk
Market risk

55
How is each type of risk
used?
Stand-alone risk easiest to calculate.
Market risk theoretically best in
most situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.

56
A Project-Specific, Risk-
Adjusted
Cost of Capital
Start by calculating a divisional
cost of capital.
Use judgment to scale up or down
the cost of capital for an individual
project relative to the divisional
cost of capital.

57
Costs of Issuing New
Common Stock
When a company issues new
common stock they also have to
pay flotation costs to the
underwriter.
Issuing new common stock may
send a negative signal to the
capital markets, which may
depress stock price.
58
Cost of New Common Equity: P0 =
$50, D0 = $3.12, g = 5.8%, and F =
15%

D0(1 + g)
re = +g
P0(1 F)
$3.12(1.05 + 5.8%
=
8)
$50(1
0.15)
= $3.30 + 5.8% = 13.6%
$42.50
59
Cost of New 30-Year Debt: Par =
$1,000, Coupon = 10% paid annually,
and F = 2%
Using a financial calculator:
N = 30
PV = 1,000(1 0.02) = 980
PMT = -(0.10)(1,000)(1 0.4) = -60
FV = -1,000
Solving for I/YR: 6.15%

60
Comments about flotation
costs:
Flot costs depend on risk of firm & type
of capital being raised.
Flot costs highest for common equity.
However, most firms issue equity
infrequently, the per-project cost is
fairly small.
We will frequently ignore flotation costs
when calculating the WACC.

61
Four Mistakes to Avoid
Current vs. historical cost of debt
Mixing current and historical
measures to estimate the market
risk premium
Book weights vs. Market Weights
Incorrect cost of capital
components
(More)
62
Current vs. Historical Cost
of Debt
When estimating the cost of debt,
dont use the coupon rate on
existing debt, which represents the
cost of past debt.
Use the current interest rate on
new debt.

(More)
63
Estimating the Market Risk
Premium
When estimating the risk premium for the
CAPM approach, dont subtract the current
long-term T-bond rate from the historical
average return on common stocks.
For example, if the historical rM has been
about 12.2% and inflation drives the
current rRF up to 10%, the current market
risk premium is not 12.2% 10% = 2.2%!

(More)
64
Estimating Weights
Use target cap structure to determine
wts.
If dont know target wts, use MV of
equity.
If dont know MV of debt, then use BV of
debt.

(More)
65
Capital components are sources
of funding that come from
investors.
Accounts payable, accruals, and
deferred taxes are not sources of
funding that come from investors, so
they are not included in the calculation
of the WACC.
We do adjust for these items when
calculating project cash flows, but not
when calculating the WACC.

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