McGraw-Hill/Irwin

Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Know how to determine:
A firms cost of equity capital
A firms cost of debt
A firms overall cost of capital

Understand pitfalls of overall

cost of capital and how to
manage them
12-2

Chapter Outline
12.1 The Cost of Capital: Some
Preliminaries
12.2 The Cost of Equity
12.3 The Costs of Debt and Preferred Stock
12.4 The Weighted Average Cost of Capital
12.5 Divisional and Project Costs of Capital

12-3

Cost of Capital Basics

The cost to a firm for capital funding
= the return to the providers of those
funds
The return earned on assets depends on
the risk of those assets
A firms cost of capital indicates how the
market views the risk of the firms assets
A firm must earn at least the required
return to compensate investors for the
financing they have provided
The required return is the same as the
appropriate discount rate
12-4

Cost of Equity
The cost of equity is the return
required by equity investors given
the risk of the cash flows from the
firm
Two major methods for
determining the cost of equity
- Dividend growth model
- SML or CAPM
Return to
Quick Quiz

12-5

The Dividend Growth Model

Approach
Start with the dividend growth
model formula and rearrange to
solve for RE

D1
P0
RE g
RE

D1

g
P0
12-6

Example: Dividend Growth

Model
Your company is expected to pay a
dividend of $4.40 per share next year.
(D1)
Dividends have grown at a steady rate
of 5.1% per year and the market expects
that to continue. (g)
The current stock price is $50. (P0)
What is the cost of equity?

4.40
RE
.051 .139
50

12-7

Example: Estimating the

Dividend Growth Rate
One method for estimating the
growth rate is to use the historical
average
Year
Dividend
Percent
(1.30
1.23)Change
/ 1.23 = 5.7%
2009 1.23
(1.36 1.30) / 1.30 = 4.6%
2010 1.30
(1.43 1.36) / 1.36 = 5.1%
2011 1.36
(1.50 1.43) / 1.43 = 4.9%
2012 1.43
2013 =1.50
Average
(5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
12-8

Advantages and
Disadvantages of Dividend
Growth Model

Advantage easy to understand and use

Disadvantages
Only applicable to companies currently
paying dividends
Not applicable if dividends arent growing
at a reasonably constant rate
Extremely sensitive to the estimated
growth rate
Does not explicitly consider risk
12-9

The SML Approach

Use the following information to
compute the cost of equity
Risk-free rate, Rf
Market risk premium, E(RM) Rf
Systematic risk of asset,

RE Rf E ( E ( R M ) Rf )

12-10

Example: SML
Companys equity beta = 1.2
Current risk-free rate = 7%
Expected market risk premium = 6%
What is the cost of equity capital?

R E 7 1.2 ( 6 ) 14.2%

12-11

Advantages and
Disadvantages of SML

Advantages

Explicitly adjusts for systematic risk

Applicable to all companies, as long as beta is
available

Disadvantages
Must estimate the expected market risk
premium, which does vary over time
Must estimate beta, which also varies over
time
Relies on the past to predict the future, which
is not always reliable
12-12

Example: Cost of Equity

Data:

Beta = 1.5
Market risk premium = 9%
Current risk-free rate = 6%.
Analysts estimates of growth = 6% per
year
Last dividend = $2.
Currently stock price =$15.65

Using SML: RE = 6% + 1.5(9%) = 19.5%

Using DGM: RE = [2(1.06) / 15.65] + .06
= 19.55%
12-13

Cost of Debt
The cost of debt = the required
return on a companys debt
Method 1 = Compute the yield to
maturity on existing debt
Method 2 = Use estimates of
current rates based on the bond
rating expected on new debt
The cost of debt is NOT the coupon
rate
12-14

Example: Cost of Debt

Current bond issue:

30
N
-1253.72
PV
1000
FV
60
PMT
CPT I/Y4.45%

15 years to maturity
Coupon rate = 12% YTM = 4.45%*2 = 8.9%
Coupons paid
semiannually
Currently bond price =
$1,253.72
12-15

Component Cost of Debt

Use the YTM on the firms debt
Interest is tax deductible, so the
after-tax (AT) cost of debt is:
R D , AT R D ,BT ( 1 TC )

If the corporate tax rate = 40%:

R D , AT 8.9%(1 .40 ) 5.34%
Return to
Quick Quiz

12-16

Cost of Preferred Stock

Preferred pays a constant dividend
every period
Dividends expected to be paid forever
Preferred stock is a perpetuity
D
RP
Example:
P0
Preferred annual dividend = $10
Current stock price = $111.10
RP = 10 / 111.10 = 9%
12-17

Weighted Average Cost of

Capital
Use the individual costs of capital
to compute a weighted average
cost of capital for the firm
This average = the required
return on the firms assets, based
on the markets perception of the
risk of those assets
The weights are determined by
how
much of each type of
financing is used
Return to
Quick Quiz

12-18

Determining the Weights

for the WACC
Weights = percentages of the
firm that will be financed by
each component
Always use the target weights,
if possible
If not available, use market
values
12-19

Capital Structure Weights

Notation
E = market value of equity
= # outstanding shares times price per
share
D = market value of debt
= # outstanding bonds times bond price
V = market value of the firm = D + E

Weights
E/V = percent financed with equity
D/V = percent financed with debt

Return to
Quick Quiz

12-20

WACC
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)

Where:
(E/V) = % of common equity in capital structure

Weights

(P/V) = % of preferred stock in capital structure

(D/V) = % of debt in capital structure

Component
costs

RE = firms cost of equity

RP = firms cost of preferred stock
RD = firms cost of debt
TC = firms corporate tax rate
12-21

Estimating Weights
Given:

Stock price = $50; 3m shares common stock

$25m preferred stock
$75m debt
40% Tax rate
RE = 14%; RP = 9%; RD = 10%

Component Values:
VE = $50 x (3 m) = $150m

Weights:

VP = $25m

P/V = $25/$250 = 0.1 (10%)

D/V = $75/$250 = 0.3 (30%)

VD = $75m

E/V = $150/$250 = 0.6 (60%)

VF = $150+$25+$75=$250m

12-22

WACC
Component
Debt (before tax)
Preferred Stock
Common equity

W
0.30
0.10
0.60

R
10%
9%
14%

WACC = E/V x RE + P/V x RP + D/V x RD (1 - TC)

WACC = 0.6(14%) + 0.1(9%) + 0.3(10%)
(1-.40)
WACC = 8.4% + 0.9% + 1.8% = 11.1%
12-23

Table 12.1

12-24

Factors that Influence a

Companys WACC
Market conditions, especially
interest rates, tax rates and the
market risk premium
The firms capital structure and
dividend policy
The firms investment policy
Firms with riskier projects generally
have a higher WACC
12-25

Eastman Chemical 1
Equity Data

Source: http://finance.yahoo.com
12-26

Eastman Chemical 2
Dividend Growth

Source: http://finance.yahoo.com
12-27

Eastman
Chemica
l-3
Beta and
Shares
Outstandin
g

Source: http://finance.yahoo.com

12-28

Eastman
Chemica
l-4
Dividends

Source: http://finance.yahoo.com

12-29

Eastman Chemical - 5
Cost of Equity - SML
Beta:

Yahoo Finance
Value Line

2.31
1.25

(1.25 is a more reasonable value)

T-Bill rate = 0.05% (Yahoo Finance bonds

section)

Market Risk Premium = 7% (assumed)

Cost of Equity (SML) = 0.05% + (7%)(1.25)
= 8.80%
RE Rf E ( E ( RM ) Rf )

12-30

Eastman Chemical - 6
Cost of Equity - DGM
Growth rate
Last dividend
Stock price
Cost of Equity
RE

7.67%
$1.04
$53.74
D1
g
(DGM)R=
E
P0

D1
g
P0

$1.04(1.0767)
RE
.0767
53.74
RE 9.75%

$1.04(1.0767)
.0767
53.74
RE 9.75%
RE

12-31

Eastman Chemical - 7
Cost of Equity
Cost of Equity Method

Estimated Value

SML

8.80%

DCF
Average

9.75%
9.28%

12-32

Eastman Chemical - 8
Bond Data

Source: http://www.sec.gov
12-33

Eastman Chemical - 9
Cost of Debt

For Eastman, the cost of debt is similar when using either

book values or market values.

12-34

Eastman Chemical - 10
WACC
Capital structure weights (market values):
E = 136.92 million x $53.74 = $7.358 billion
D = 1.661 billion
V = $7.358 + 1.661 = 9.019 billion
E/V = 7.358 / 9.019 = .82
D/V = 1.661 / 9.019 = .18
Tax rate (assumed) = 35%
Re = 9.28%; Rd = 3.81%

WACC = .82(9.28%) + .18(3.81%)(1-.35)

= 8.02%
12-35

Risk-Adjusted WACC
A firms WACC reflects the risk of an
average project undertaken by the firm
Average risk = the firms current
operations

Different divisions/projects may have

different risks
The divisions or projects WACC should be
adjusted to reflect the appropriate risk and
capital structure
Return to
Quick Quiz

12-36

Using WACC for All Projects

What would happen if we use the
WACC for all projects regardless of
risk?
Assume the WACC = 15%

12-37

Using WACC for All Projects

Assume the WACC = 15%
A projects required return is
calculated using the SML and the
projects Beta
Adjusting for risk changes the
decisions

12-38

Divisional Risk & the Cost of

Capital

12-39

Pure Play Approach

Find one or more companies that
specialize in the product or service
being considered
Compute the beta for each company
Take an average
Use that beta along with the CAPM
to find the appropriate return for a
project of that risk
Pure play companies can be difficult
to find
Return to
Quick Quiz

12-40

Subjective Approach
Consider the projects risk
relative to the firm overall
If the project is riskier than the
firm, use a discount rate greater
than the WACC
If the project is less risky than the
firm, use a discount rate less
than the WACC
Return to
Quick Quiz 12-41

Subjective Approach Example

Risk Level
Very Low Risk

Discount Rate
WACC 8%
6%

Low Risk

WACC 4%

10%

Same Risk as Firm

WACC

14%

High Risk
Very High Risk

WACC + 6%
WACC + 10%

20%
24%

12-42

Quick Quiz
What are the two approaches for computing
the cost of equity? (Slide 12.5)
How do you compute the cost of debt and
the after tax cost of debt? (Slide 12.16)
How do you compute the capital structure
weights required for the WACC? (Slide 12.20)
What is the WACC? (Slide 12.18)
What happens if we use the WACC as the
discount rate for all projects? (Slide 12.36)
What are two methods that can be used to
compute the appropriate discount rate when
WACC isnt appropriate? (Slide 12.40 and Slide
12.41)

12-43

Chapter 12
END

12-44