10/13/2016

Chapter
14

Cost of Capital

Chapter Outline

The Cost of Capital Overview

The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of Capital
(WACC)
Divisional and Project Costs of Capital
Floatation Costs relative to WACC
13-2

1
 10/13/2016

Why the Cost of Capital

Is Important
1. We know that the return earned on assets
depends on the risk of those assets
2. The return to an investor is the same as
the cost to the company

13-3

Why the Cost of Capital

Is Important
3. Our cost of capital provides us with an
indication of how the market views the
risk of our assets

4. Knowing our cost of capital can also help

us determine our required return for
capital budgeting projects

13-4

2
 10/13/2016

The Cost of Equity

The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm:

Business risk
Financial risk

13-5

The Cost of Equity

There are two major methods for
determining the cost of equity:

1. Dividend growth model

(aka: the Gordon
Model)

13-6
2. SML, or the CAPM

3
 10/13/2016

The Dividend Growth Model

(The Gordon Model)
Start with the dividend growth model formula
and rearrange to solve for RE

D1
P0
RE g
D1
RE g
P0
13-7

Dividend Growth Model

Example
Suppose that your company is expected to pay a
dividend of $1.50 per share next year.

There has been a steady growth in dividends of

5.1% per year and the market expects that to
continue. The current price is $25.

What is the cost of equity?

1.50
RE .051 .111 11.1%
13-8 25

4
 10/13/2016

Example: Estimating the

Dividend Growth Rate
One method for estimating the growth rate is
to use the historical average:

Year Dividend Percent Change

2005 1.23 (1.30 1.23) / 1.23 = 5.7%
2006 1.30
(1.36 1.30) / 1.30 = 4.6%
2007 1.36
2008 1.43 (1.43 1.36) / 1.36 = 5.1%
2009 1.50 (1.50 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

13-9

Advantages and Disadvantages

of the Dividend Growth Model
Advantage:
Easy to understand and
use

13-10

5
 10/13/2016

Advantages and Disadvantages

of the Dividend Growth Model
Disadvantages:
Only applicable to
companies currently
paying dividends

Not applicable if dividends

arent growing at a
reasonably constant rate

13-11

Advantages and Disadvantages

of the Dividend Growth Model
Disadvantages :
Extremely sensitive to
the estimated growth
rate an increase in g
of 1% increases the cost
of equity by 1%

Does not explicitly

consider risk
13-12

6
 10/13/2016

The SML Approach

Use the following information to
compute our cost of equity:

Risk-free rate, Rf

Market risk premium, E(RM) Rf

Systematic risk of asset,

RE R f E ( E ( RM ) R f )
13-13

Example - SML
Suppose your company has:
an equity beta of .58
the current risk-free rate is 6.1%
the expected market risk premium is
8.6%
What is the cost of equity using the SML
valuation technique?

RE = 6.1 + .58(8.6) = 11.1%

13-14

7
 10/13/2016

How Did We Do?

Since we came up with
similar numbers using
both the dividend growth
model (11.1%) and the
SML approach (11.1%),
we should feel good about
our estimate!

13-15

Advantages and
Disadvantages of SML
Advantages:

Explicitly adjusts for systematic risk

Applicable to all companies, as long as

we can estimate beta

13-16

8
 10/13/2016

Advantages and
Disadvantages of SML
Disadvantages:
Have to estimate the expected market risk
premium, which does vary over time
Have to estimate beta, which also varies
over time
We are using the past to predict the future,
which is not always reliable

13-17

Example Cost of Equity

Our company has a beta of 1.5.

The market risk premium is expected to be 9%, and the

current risk-free rate is 6%.

We have used analysts estimates to determine that the

market believes our dividends will grow at 6% per year
and our last dividend was $2.

Our stock is currently selling for $15.65.

What is our cost of equity using the SML?

RE = 6% + 1.5(9%) = 19.5%
13-18

9
 10/13/2016

Example Cost of Equity

Our company has a beta of 1.5.

The market risk premium is expected to be 9%, and the

current risk-free rate is 6%.

We have used analysts estimates to determine that the

market believes our dividends will grow at 6% per year
and our last dividend was $2.

Our stock is currently selling for $15.65.

What is our cost of equity using the DGM?

RE= [2(1.06) / 15.65] + .06 = 19.55%

13-19

Cost of Debt
The cost of debt is the required return
on our companys debt

We usually focus on the cost of long-

term debt or bonds (as opposed to
short-term debt like notes payable)

13-20

10
 10/13/2016

Cost of Debt
The required return is best estimated
by computing the yield-to-maturity
on the existing long-term debt (the
YTM).

The computation of the YTM was

presented in the chapter on Bond
Valuation
13-21

Example: Cost of Debt:

computing the YTM
Suppose we have a corporate bond issue currently
outstanding that has 25 years left to maturity.

The coupon rate is 9%, and coupons are paid

semiannually.

The bond is currently selling for $908.72 per

$1,000 bond.

What is the cost of debt?

13-22

11
 10/13/2016

Cost of Preferred Stock

Preferred stock is a
perpetuity, so we take the
perpetuity formula:
and then rearrange the terms
to solve for RP
P0 = D_ Rps = D_
Rps P0
13-23

Example: Cost of
Preferred Stock
Your company has preferred
stock that has an annual
dividend of $3.00

The current price is $25

What is the cost of preferred stock?

RP = 3 / 25 = 12%
13-24

12
 10/13/2016

Capital Structure Weights

To compute the WACC,
we first need the weights
of each source of funds:
namely debt, preferred
stock and equity

13-25

Capital Structure Weights

Lets simplify with an
example of just debt and
equity.

We often use the market

value of both debt and
equity

13-26

13
 10/13/2016

Capital Structure
Valuation
Debts Market Value = (# of outstanding
bonds ) x (the market price of one bond)

Equitys Market Value = (# shares of

outstanding common stock) x (the market
price of one share of common stock)

13-27

Capital Structure
Valuation
A firms market value is simply the
added value of both the debt and the
equity:

V=D + E

13-28

14
 10/13/2016

Capital Structure Weights

WD = D/V
This is the % financed
with debt
WE = E/V
This is the % financed
with equity

13-29

Student Alert!
The capital structure
weights must always add
up to 100%

WD + WE = 100%
or
WD + WPS + WE = 100%

13-30

15
 10/13/2016

Example: Capital
Structure Weights
Suppose you have a market value of equity
equal to $500 million and a market value of
debt equal to $475 million.
What are the capital structure weights?
V = $500 million + $475 million = $975 million
wD = D/V = 475 / 975 = .4872 = 48.72%
wE = E/V = 500 / 975 = .5128 = 51.28%
13-31

Taxes and the WACC

Wait a minute!
Debt and Equity are
not equal in the eyes
of the firm.

Debt gets a tax

advantage and Equity
does not.
13-32

16
 10/13/2016

Taxes and the WACC

Interest expense reduces our tax
liability
This reduction in taxes reduces
our cost of debt
Thus, our real cost of debt is
actually the AFTER-TAX cost of
debt or
After-tax cost of debt = RD(1-TC)
13-33

Taxes and the WACC

Our new equation for the WACC
is:

WACC = WDRD(1-TC) + WE RE

This is one of the most

powerful relationships in
finance.
13-34

17
 10/13/2016

Putting All the Pieces

Together WACC
Example
Equity Information: Debt Information:

50 million shares $1 billion in outstanding

debt (face value)
$80 per share
Current quote = 110
Beta = 1.15
Coupon rate = 9%,
Market risk premium semiannual coupons
= 9%
15 years to maturity
Risk-free rate = 5%

13-35 The firms tax rate is 40%

WACC Example
1. What is the cost of debt?

N = 30; PV = -1,100; PMT = 45;

FV = 1,000; CPT I/Y = 3.9268
RD = 3.927(2)
= 7.854%
2. What is the cost of equity
(using the CAPM)?
RE = 5 + 1.15(9) = 15.35%
13-36

18
 10/13/2016

WACC Example
3. What is the AFTER-TAX
cost of debt?

RD (1 TC) = 7.854 (1 - .40)

= 4.712%

13-37

WACC Example
4. What are the capital structure weights?

Debt = 1 billion ($1.10) = $1.1 billion

Equity = 50 million ($80) = $4 billion
Value of the Firm = 4 + 1.1 = $5.1 billion

13-38

19
 10/13/2016

WACC Example (Plug and

Chug)
5. Compute the Weighted Average
Cost of Capital (the WACC)

WACC = WDRD(1-TC) + WE RE

WACC = .2157 (4.712%) + .7843 (15.35%)

= 13.06%
13-39

Eastman Chemical I
Click on the web surfer to go to Yahoo
Finance to get information on Eastman
Chemical (EMN)
Under Profile and Key Statistics, you
can find the following information:
# of shares outstanding
Book value per share
Price per share
Beta
13-40

20
 10/13/2016

Eastman Chemical IV
Find the weighted average cost of the
debt
Use market values if you were able to
get the information

Use the book values if market

information was not available

They are often very close

Compute the WACC

13-41 Use market value weights if available

Divisional and Project

Costs of Capital
Using the WACC as our discount rate is only
appropriate for projects that have the same risk
as the firms current operations

If we are looking at a project that does NOT

have the same risk as the firm, then we need to
determine the appropriate discount rate for that
project

13-42

21
 10/13/2016

Divisional and Project

Costs of Capital
Divisions also often require separate
discount rates

13-43

Project Risk An
Example
What would happen if we use the WACC for
all projects regardless of risk?
Assume the WACC = 15%
Project Required Return IRR
A 20% 17%
B 15% 18%
C 10% 12%
13-44

22
 10/13/2016

Project Risk
Differentiation
We have two tools in finance to help us here:

1. The Pure Play Approach

2. The Subjective Approach

13-45

Project Risk
Differentiation
We have two tools in finance to help us
here:

1. The Pure Play Approach

2. The Subjective Approach

13-46

23
 10/13/2016

The Pure Play Approach

1.Find one or more companies that
specialize in the product or service
that we are considering

2.Compute (or research) the beta for

each company

3.Take an average of the betas

13-47

The Pure Play Approach

4. Use that beta along with the

CAPM to find the appropriate
return for a project of that
identical risk

5. Use this computed cost of capital

for capital budgeting computations

13-48

24
 10/13/2016

Project Risk
Differentiation
We have two tools in finance to help us
here:

1. The Pure Play Approach

2. The Subjective Approach

13-49

Subjective Approach
Consider the projects risk relative to the firm
overall:

If the project has more risk than the firm, use

a discount rate greater than the WACC
If the projects risk > firms risk,
increase the WACC number
If the project has less risk than the firm, use a
discount rate less than the WACC
If the projects risk < firms risk,
Decrease the WACC number
13-50

25
 10/13/2016

Subjective Approach
You may still accept
projects that you
shouldnt and reject
projects you should
accept, but your error
rate should be lower
than not considering
differential risk at all.

13-51

Subjective Approach:
An Example
Risk Level Discount Rate

Very Low Risk WACC 8%

Low Risk WACC 3%

Same Risk as Firm WACC

High Risk WACC + 5%

Very High Risk WACC + 10%

13-52

26
 10/13/2016

Flotation Costs
Flotation costs are the fees paid to
issue stocks or bonds
While the required return for a
project depends on the risk, it
should not depend upon how the
money is raised
However, the cost of issuing new
securities should not just be ignored
13-53
either

Flotation Costs
However, the cost of issuing new
securities should not just be
ignored either.
The Basic Approach:
1. Compute the weighted average
flotation cost

2. Use the target weights because the

firm will issue securities in these
percentages over the long term
13-54

27
 10/13/2016

Flotation Costs: An NPV

Example
Your company is considering a project that
will cost $1 million.

The project will generate after-tax cash flows

of $250,000 per year for 7 years.

The WACC is 15%, and the firms target D/E

ratio is .6

The flotation cost for equity is 5%, and the

flotation cost for debt is 3%.
13-55

Flotation Costs: An NPV

Example
What is the NPV for the project before
adjusting for flotation costs?

WACC = 15%

PV of future cash flows = $1,040,105

NPV = 1,040,105 - 1,000,000

= $ 40,105
13-56

28
 10/13/2016

Flotation Costs: An NPV

Example
What is the NPV for the project after
adjusting for flotation costs?

fA = (.375)(3%) + (.625)(5%) = 4.25%

PV of future cash flows = 1,040,105

NPV = 1,040,105 - 1,000,000/(1-.0425)

= $ -4,281
13-57

Flotation Costs: An NPV

Example
The project would have a positive
NPV of $40,105 without considering
flotation costs
Once we consider the cost of issuing
new securities, the NPV becomes a
negative $4,281!

13-58

29
10/13/2016

30