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 cost Min Req’d return needed
of raising $ on Project
Risk Reflects blended costs of
Financing costs raising capital
Discount Rate
Relevant “i ”
Discount rate used to
determine Project’s NPV
or to disct FCFs by
Hurdle rate
3
Determinants of Intrinsic Value:
The Weighted Average Cost of Capital
Weighted average
cost of capital
(WACC)
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 worth asset/business/company
today?
Value of: For Firm:
Enterprise Determine cost of
Entity attracting investors &
Company/Firm 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
14
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
16
Current vs. Historical Cost of
Debt
For cost of debt, don’t 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. What’s rd?
0 1 2 30
rd = ?
...
1,250.00 -66.25 -66.25 <66.25 + 1,000>
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 Debt - Practice
The Heuser Company’s currently
outstanding bonds have a 10 percent
coupon and a 12 percent yield to
maturity. Heuser believes it could issue
new bonds at par that would provide a
similar yield to maturity. If its marginal
tax rate is 35 percent, what is Heuser’s
after-tax cost of debt?
20
Cost of Debt - Practice
rd(1 – T) = 0.12(0.65)
= 7.80%.
21
Component cost of preferred
stock
WACC = wdkd(1-T) + wpkp + wcks
kp = Dp / Pp
= $10 / $111.10
= 9%
Component cost of preferred
stock
Preferred dividends are not tax-
deductible, so no tax adjustments
necessary. Just use kp.
Nominal kp is used.
Our calculation ignores possible
flotation costs.
Cost of preferred stock: Pps = $125;
10.26% Div; Par = $100; F = 8.8%
Use :
Dps
rps = =
Pps (1 – F)
25
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 = 9.0%
$114.
26
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.
27
Cost of Preferred Stock -
Practice
Tunney Industries can issue
perpetual preferred stock at a price
of $47.50 a share. The stock would
pay a constant annual dividend of
$3.80 a share.
What is the company’s cost of
preferred stock, rp?
28
Cost of Preferred Stock -
Practice
Pp = $47.50; Dp = $3.80; rp = ?
Dp $3.80
rp = = = 8%.
Pp $47.50
29
Cost of Preferred Stock -
Practice
Trivoli Industries plans to issue
perpetual preferred stock with an
$11.00 dividend. The stock is
currently selling for $97.00; but
flotation costs will be 5% of the
market price, so the net price will
be $92.15 per share. What is the
cost of the preferred stock,
including flotation? 30
Cost of Preferred Stock -
Practice
$11
rp = = 11.94%.
$92.15
31
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.
32
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.
33
Example:
rps = 9%, rd = 10%, T = 40%
34
Example:
rps = 9%, rd = 10%, T = 40%
35
Example:
rps = 9%, rd = 10%, T = 40%
36
Component cost of equity
WACC = wdkd(1-T) + wpkp + wcks
38
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.
39
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.
40
Three ways to determine
the cost of equity, rs:
41
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
42
CAPM Cost of Equity: rRF = 5.6%,
RPM = 6%, b = 1.2
rs = rRF + (RPM )b
43
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…)
44
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).
45
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
=
46
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%
47
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.
48
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, what’s
the expected future g?
49
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%.
50
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.
51
The Own-Bond-Yield-Plus-Judgmental-Risk-
Premium Method: rd = 10%, RP = 3.2%
This over-own-bond-judgmental-risk
premium CAPM equity risk premium,
RPM.
Produces ballpark estimate of rs.
Useful check.
52
Final estimate of rs?
Method Estimate
CAPM 12.8%
DCF 12.4%
Bond Yld + risk prem 13.2%
Average 12.8%
53
Why is the cost of retained earnings
cheaper than the cost 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 the stock price.
If D0 = $4.19, P0 = $50, and g = 5%,
what’s the cost of common equity based
upon the DCF approach?
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.3995
ks = D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%
If issuing new common stock incurs a
flotation cost of 15% of the proceeds,
what is ke?
D0 (1 g)
ke g
P0 (1 - F)
$4.19(1.05)
5.0%
$50(1 - 0.15)
$4.3995
5.0%
$42.50
15.4%
Flotation costs
Flotation costs depend on the risk of the firm
and the type of capital being raised.
The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
We will frequently ignore flotation costs when
calculating the WACC.
Cost of Common Equity -
Practice
The future earnings, dividends, and common stock price of
Carpetto Technologies Inc. are expected to grow 7% per year.
Carpetto’s common stock currently sells for $23.00 per share;
its last dividend was $2.00; and it will pay a $2.14 dividend at
the end of the current year.
a) Using the DCF approach, what is its cost of common equity?
b) If the firm’s beta is 1.6, the risk-free rate is 9%, and the
average return on the market is 13%, what will be the firm’s
cost of common equity using the CAPM approach?
c) If the firm’s bonds earn a return of 12%, based on the bond-
yield-plus-risk-premium approach, what will be rs? Use the
midpoint of the risk premium range
d) If you have equal confidence in the inputs used for the three
approaches, what is your estimate of Carpetto’s cost of
common equity?
58
Cost of Common Equity -
Practice
D1 $2.14
rs = +g= + 7% = 9.3% + 7% = 16.3%.
P0 $23
60
Cost of Common Equity -
Practice
D1
a. rs = +g
P0
$3.18
= + 0.06
$36
= 14.83%.
61
Cost of Common Equity -
Practice
F = ($36.00 – $32.40)/$36.00
= $3.60/$36.00
= 10%.
62
Cost of Common Equity -
Practice
re = D1/[P0(1 – F)] + g
= $3.18/$32.40 + 6%
= 9.81% + 6%
= 15.81%.
63
Cost of Common Equity -
Practice
Ballack Co.’s common stock currently sells for
$46.75 per share. The growth rate is a constant
12%, and the company has an expected dividend
yield of 5%. The expected long-run dividend
payout ratio is 25%, and the expected return on
equity (ROE) is 16%. New stock can be sold to the
public at the current price, but a flotation cost of
5% would be incurred. What would be the cost of
new equity?
64
Cost of Common Equity -
Practice
If the firm's dividend yield is 5% and its stock price is
$46.75, the next expected annual dividend can be
calculated.
Dividend yield = D1/P0
5% = D1/$46.75
D1 = $2.3375.
Next, the firm's cost of new common stock can be
determined from the DCF approach for the cost of equity.
re = D1/[P0(1 – F)] + g
= $2.3375/[$46.75(1 – 0.05)] + 0.12
= 17.26%
65
Cost of Common Equity -
Practice
The Bouchard Company’s EPS was $6.50 in 2008, up
from $4.42 in 2003. The company pays out 40% of its
earnings as dividends, and its common stock sells for
$36.00.
a) Calculate the past growth rate in earnings. (Hint:
This is a 5-year growth period.)
b) The last dividend was D0 = 0.4($6.50) = $2.60.
Calculate the next expected dividend, D1, assuming
that the past growth rate continues.
c) cWhat is Bouchard’s cost of retained earnings, rs?
66
Cost of Common Equity -
Practice
a)With financial calculator, Inputs:
N = 5,
PV = -4.42,
PMT = 0,
FV = 6.50,
and then solve for
I/YR = g
= 8.02% 8%. 67
Cost of Common Equity -
Practice
b. D1 = D0(1 + g)
= $2.60(1.08)
= $2.81.
c. rs = (D1/P0 ) + g
= ($2.81/$36.00) + 8%
= 15.81%.
68
Cost of Common Equity -
Practice
Sidman Products’ common stock currently sells
for $60.00 a share. The firm is expected to
earn $5.40 per share this year and to pay a
year-end dividend of $3.60, and it finances
only with common equity.
a) If investors require a 9% return, what is the
expected growth rate?
b) If Sidman reinvests retained earnings in
projects whose average return is equal to the
stock’s expected rate of return, what will be
next years’ EPS?
69
Cost of Common Equity -
Practice
D1
a. rs= +g
P0
$3.60
0.09 = +g
$60.00
0.09 = 0.06 + g
g = 3%.
70
Cost of Common Equity -
Practice
EPS1
= EPS0(1 + g)
= $5.40(1.03)
= $5.562.
71
Determining Weights for WACC
72
Estimating Weights for the
Capital Structure
If don’t know targets, better to estimate
wts using current market values than
current book values.
If don’t know MV of debt, then
reasonable to use BV of debt, especially
if S/T debt.
(More…)
73
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…)
74
Estimating Weights
(Continued)
Vs = $50(3 million) = $150 million.
Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75
= $250 million.
75
Estimating Weights
(Continued)
ws = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3
76
What’s the WACC using the
target weights?
WACC = 10.38%
77
WACC - Practice
Patton Paints Corporation has a target capital
structure of 40% debt and 60% common
equity, with no preferred stock. Its before-tax
cost of debt is 12%, and its marginal tax rate
is 40%. The current stock price is P0 = $22.50.
The last dividend was D0 = $2.00, and it is
expected to grow at a 7% constant rate. What
is its cost of common equity and its WACC?
78
WACC - Practice
Debt = 40%, Common equity = 60%.
D1 $2.14
rs = +g= + 7% = 16.51%.
P0 $22.50
81
WACC Practice
Kahn Inc. has a target capital structure of 60%
common equity and 40% debt to fund its $10
billion in operating assets. Furthermore, Kahn Inc.
has a WACC of 13%, a before-tax cost of debt of
10%, and a tax rate of 40%. The company’s
retained earnings are adequate to provide the
common equity portion of its capital budget. Its
expected dividend next year (D1) is $3, and the
current stock price is $35.
a. What is the company’s expected growth rate?
b. If the firm’s net income is expected to be $1.1
billion, what portion of its net income is the firm
expected to pay out as dividends? 82
WACC Practice
Step 1: Determine WACC
83
WACC Practice
Step 2: Determine Growth rate
rs = D1/P0 + g
0.17667 = $3/$35 + g
g = 0.090952 9.10%.
84
WACC Practice
b. From the formula for the long-run growth
rate:
g = (1 – Div. payout ratio) ROE
= (1 – Div. payout ratio) (NI/Equity)
0.090952 = (1 – Div. payout ratio)
($1,100
million/$6,000 million)
0.090952 = (1 – Div. payout ratio)
0.1833333
0.496104 = (1 – Div. payout ratio) 85
What factors influence a
company’s 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.
86
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. Division’s WACC should be
adjusted to reflect division’s risk and
cap structure.
87
The Risk-Adjusted Divisional
Cost of Capital
Estimate cost of capital division
would have if it were a stand-alone
firm.
This requires estimating division’s
beta, cost of debt, and capital
structure.
88
Pure Play Method for Estimating
Beta for a Division or a Project
Find several publicly traded companies
exclusively in project’s business.
Use average of their betas as proxy for
project’s beta.
Hard to find such companies.
89
Accounting Beta Method for
Estimating Beta
Run regression between project’s
ROA and S&P Index ROA.
Accounting betas correlated (0.5 –
0.6) with market betas.
But normally can’t get data on new
projects’ ROAs before capital
budgeting decision made.
90
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%.
91
Divisional Cost of Capital
Using CAPM (Continued)
92
Division’s WACC vs. Firm’s Overall
WACC?
93
What are the three types of
project risk?
Stand-alone risk
Corporate risk
Market risk
94
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.
95
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.
96
Finding a divisional cost of capital:
Using similar stand-alone firms to
estimate a project’s cost of capital
Comparison firms have the following
characteristics:
Target capital structure consists of 40%
debt and 60% equity.
kd = 12%
kRF = 7%
RPM = 6%
βDIV = 1.7
Tax rate = 40%
Calculating a divisional cost of capital
99
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(1.058) + 5.8%
=
$50(1 – 0.15)
101
WACC Practice
Midwest Electric Company (MEC) uses only debt and
common equity. It can borrow unlimited amounts at an
interest rate of Rd = 10% as long as it finances at its
target capital structure, which calls for 45% debt and 55%
common equity. Its last dividend was $2, its expected
constant growth rate is 4%, and its common stock sells
for $20. MEC’s tax rate is 40%. Two projects are available:
Project A has a rate of return of 13%, while Project B’s
return is 10%. These two projects are equally risky and
about as risky as the firm’s existing assets.
a. What is its cost of common equity?
b. What is the WACC?
c. Which projects should Midwest accept? 102
WACC Practice
rs = $2(1.04)/$20 + 4% = 14.40%.
103
WACC Practice
105
WACC Practice
rs = (D1/P0 )+ g
= [$2(1.07)/$24.75] + 7%
= 8.65% + 7%
= 15.65%.
106
WACC Practice
107
WACC Practice
109
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…)
110
Current vs. Historical Cost of
Debt
When estimating the cost of debt, don’t
use the coupon rate on existing debt,
which represents the cost of past debt.
Use the current interest rate on new
debt.
(More…)
111
Estimating the Market Risk
Premium
When estimating the risk premium for the
CAPM approach, don’t 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…)
112
Estimating Weights
Use target cap structure to determine wts.
If don’t know target wts, use MV of equity.
If don’t know MV of debt, then use BV of
debt.
(More…)
113
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.
114