Financial Management :

Theory & Practice

Professor Dr. Hussein Seoudy

October 2018

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 Chapter 9
The Cost of Capital

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 Topics in Chapter

Overview of the Cost of Capital

 Cost of Debt
 Cost of Preferred Stock
 Cost of Common Equity

The Weighted Average Cost of Capital

Factors that affect WACC
Adjusting cost of capital for risk
Four Mistakes to Avoid
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 Overview of the Cost of
Capital

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 The Cost of Capital:
Key Definitions and Concepts

Financial Structure:
It refers to the balance between all of the company's
liabilities and its equities. It thus concerns the entire
sources of financing “the right side of the balance sheet" .

Capital Structure:
The specific mixture of long–term debt and equity
that a company uses to finance its operations. This
capital structure is a mixture that directly affects
the risk and value of the business.
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 The Cost of Capital:
Key Definitions and Concepts
The cost of capital represents the firm’s cost of
financing, and is the minimum rate of return that a
project must earn to increase firm value.

Most firms attempt to maintain an optimal mix of

debt and equity financing.

To capture all of the relevant financing costs,

assuming some desired mix of financing, we need to
look at the overall cost of capital rather than just the
cost of any single source of financing.
The firm’s cost of capital is also referred
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to as the firm’s opportunity cost of capital.
 Capital Components

Capital components are sources of funding that come

from investors ( long-term sources of financing ).

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 cost of
capital.

We do adjust for these items when calculating the

cash flows of a project, but not when calculating the
cost of capital.

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 Capital Components

Capital
Components

Long-Term Preferred Common Stock

Debt Stock

Retained New Common

Earnings Stock
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 Capital Components

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.

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 Capital Components

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, we should focus on marginal costs.

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 The Weighted Average
Cost of Capital (WACC) :
Capital Components
Calculation

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 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.

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 Capital Components - Cost of
Preferred Stock
Preferred stock gives preferred stockholders the
right to receive their stated dividends before the
firm can distribute any earnings to common
stockholders.
 Preferred stock dividends may be stated as a
dollar amount.
 Sometimes preferred stock dividends are
stated as an annual percentage rate, which
represents the percentage of the stock’s par, or
face, value that equals the annual dividend.
The cost of preferred stock, rps, is the ratio of
the preferred stock dividend to the firm’s net
9 - 13 proceeds from the sale of preferred stock.
 Capital Components - Cost of
Preferred Stock

If flotation costs are incurred, preferred

stockholder’s required rate of return will be
less than the cost of preferred capital to the
firm.
Thus, in order to determine the cost of
preferred stock, we adjust the price of
preferred stock for flotation cost to give us
the net proceeds.
Net proceeds = issue price – flotation cost
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 Capital Components - Cost of
Preferred Stock

What’s the cost of preferred stock?

PP = $113.10; 10%Q; Par = $100; F = $2.

0.1 $100

D ps $113.10  $2.00
rps 
Pn
$10
  0.090  9.0%.
$111.10

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 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.

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 Capital Components - Cost of
Common Equity

Cost of equity is more challenging to

estimate than the cost of debt or the cost of
preferred stock because common
stockholder’s rate of return is not fixed as
there is no stated coupon rate or dividend.

Furthermore, the costs will vary for two

sources of equity (i.e., retained earnings
and new issue).

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 Capital Components - Cost of
Common Equity

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).

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 Capital Components - Cost of
Common Equity

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.

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 Capital Components - Cost of
Common Equity

Why is there a cost for reinvested earnings?

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.
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 Capital Components - Cost of
Common Equity

Cost of equity is more challenging to

estimate than the cost of debt or the cost of
preferred stock because common
stockholder’s rate of return is not fixed as
there is no stated coupon rate or dividend.

Furthermore, the costs will vary for two

sources of equity (i.e., retained earnings
and new issue).

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 Capital Components - Cost of
Common Equity

There are no flotation costs on retained

earnings but the firm incurs costs when it
sells new common stock.

Note that retained earnings are not a free

source of capital. There is an opportunity
cost.

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 Capital Components - Cost of
Common Equity

Three commonly used methods for

estimating common stockholder’s
required rate of return rs

The Capital Asset Pricing Model

The Dividend Growth Model

The Own-Bond-Yield-Plus-
Judgmental-Risk-Premium
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 Capital Components - Cost of
Common Equity

1. The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) describes

the relationship between the required return, rs, and
the non diversifiable risk of the firm as measured by
the beta coefficient, b.
rs = rRF + (rM - rRF )b.
where
rRF = risk-free rate of return
rM = market return; return on the market
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portfolio of assets
 Capital Components - Cost of
Common Equity

What’s the cost of equity

based on the CAPM?
r RF = %5.6%, RPM = 6%, b = 1.2.

rs = rRF + (rM - rRF )b.

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

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 Capital Components - Cost of
Common Equity

1. The Capital Asset Pricing Model (CAPM)

Issues in Using CAPM

CAPM is easy to apply. Also, the estimates for model

variables are generally available from public sources.

Risk-Free Rate: Wide range of U.S. government

securities on which to base risk-free rate.
 Most analysts use the rate on a long-term
(10 to 20 years) government bond as an

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estimate of rRF.
 Capital Components - Cost of
Common Equity

1. The Capital Asset Pricing Model (CAPM)

Issues in Using CAPM

Market Risk Premium It can be estimated by

looking at history of stock returns and premium
earned over risk-free rate.

 Most analysts use a rate of 3.5% to 6% for the

market risk premium (RPM)

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 Capital Components - Cost of
Common Equity

1. The Capital Asset Pricing Model (CAPM)

Issues in Using CAPM

Beta: Estimates of beta are available from a wide range

of services, or can be estimated using regression
analysis of historical data.
 Estimates of beta vary, and estimates are
“noisy” (they have a wide confidence
interval).

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 Capital Components - Cost of
Common Equity

2. The Dividend Growth Model

The cost of equity capital, rs, is the discount

rate that equates the present value of all
expected future dividends with the current
market price of the stock.

ˆP  D D D D
1
 2
 3
 . . .  
0
1  rs  1  rs  1  rs 
1 2 3
1  rs 

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 Capital Components - Cost of
Common Equity

2. The Dividend Growth Model

The constant dividend growth assumption
reduces the model .
Investors’ required rate of return
(For issuing new shares):
D1 D0 1  g 
rs  g g
P0 P0
 D1 = Dividends expected one year hence
 P0 = Price of common stock
9 - 30  g = growth rate
 Capital Components - Cost of
Common Equity

2. The Dividend Growth Model

Investors’ required rate of return

(For Retained Earnings):

D1 D0 1  g 
rs  g g
NP0 NP0

 D1 = Dividends expected one year hence

 NP0 = Net proceeds per share
 g = growth rate
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 Capital Components - Cost of
Common Equity

2. The Dividend Growth Model

Dividend growth model is simple to use

but suffers from the following drawbacks:

 It assumes a constant growth rate

 It is not easy to forecast the growth rate

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 Capital Components - Cost of
Common Equity

2. The Dividend Growth Model

What’s the DCF cost of equity, rs?
Given: D0 = $3.26 ; 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%
9 - 33 = 12.4%
 Capital Components - Cost of
Common Equity

2. The Dividend Growth Model

Estimating the Growth Rate

Use the earnings retention model

Suppose the company has been earning 15%
on equity (ROE = 15%) and retaining 35%
(dividend payout = 65%), and this situation
is expected to continue.
g = ROE(Retention rate)
9 - 34 g = 0.35(15%) = 5.25%.
 Capital Components - Cost of
Common Equity

3. The Own-Bond-Yield-Plus-Judgmental-
Risk Premium

rs = rd + Judgmental risk premium

rs = 10.0% + 3.2% = 13.2%

This judgmental-risk premium  CAPM equity risk

premium, RPM.
Produces ballpark estimate of rs. Useful check.

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 Capital Components - Cost of
Common Equity

What’s a reasonable final estimate of rs?

Method Estimate
CAPM 12.8%
DCF 12.4%
rd + judgment 13.2%
Average 12.8%

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 The Weighted Average
Cost of Capital (WACC) :
Estimating the Weights

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Estimating Weights for the Capital Structure

The weights are the percentages of the firm

that will be financed by each component.

If possible, always use the target weights

for the percentages of the firm that will be
financed with the various types of capital.

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Estimating Weights for the Capital Structure

If you don’t know the targets, it is better to

estimate the weights using current market
values than current book values.

If you don’t know the market value of debt,

then it is usually reasonable to use the book
values of debt, especially if the debt is
short-term.

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Estimating Weights for the Capital Structure

Suppose the stock price is $50, there are 3

million shares of stock, the firm has $25
million of preferred stock, and $75 million
of debt.

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Estimating Weights for the Capital Structure

Vs = $50(3 million) = $150 million.

Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75
= $250 million

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Estimating Weights for the Capital Structure

ws = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3

The target weights for this company are the

same as these market value weights, but
often market weights temporarily deviate
from targets due to changes in stock prices.
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 What’s 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% ≈ 10.4%

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 Factors Affecting
Company’s WACC

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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

9 - 45 generally have a higher cost of equity.

 Is the Firm’s WACC Correct for Each of its
Divisions?

NO! The composite WACC reflects the risk

of an average project undertaken by the
firm.
Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk and
capital structure.
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 The Risk-Adjusted Divisional
Cost of Capital

Estimate the cost of capital that the division

would have if it were a stand-alone firm.

This requires estimating the division’s beta,

cost of debt, and capital structure.

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 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.

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Accounting Beta Method for Estimating Beta

Run regression between project’s ROA and

S&P Index ROA.
Accounting betas are correlated (0.5 – 0.6)
with market betas.
But normally can’t get data on new
projects’ ROAs before the capital budgeting
decision has been made.
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 Divisional Cost of Capital Using CAPM

Target debt ratio = 10%.

rd = 12%.
rRF = 5.6%.
Tax rate = 40%.
Beta Division = 1.7.
Market risk premium = 6%.

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 Divisional Cost of Capital Using CAPM

Division’s 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%

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Division’s WACC vs. Firm’s Overall WACC?

Division WACC = 14.9% versus company

WACC = 10.4%.

“Typical” projects within this division

would be accepted if their returns are
above 14.9%.

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 Adjusting Cost of Capital
for Risk

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 What are the Three Types of Project Risk?

Stand-alone risk
Corporate risk
Market risk

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 How is Each Type of Risk used?

Stand-alone risk is easiest to calculate.

Market risk is theoretically best in most
situations.
However, creditors, customers, suppliers,
and employees are more affected by
corporate risk.
Therefore, corporate risk is also relevant.
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 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.

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 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.

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 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)

= $3.30 + 5.8% = 13.6%

$42.50
9 - 58
 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.

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 Four Mistakes to Avoid
When Estimating The Cost
of Capital

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 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

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 Four Mistakes to Avoid

1. 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.

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 Four Mistakes to Avoid

2. 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

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current market risk premium is not 12.2% – 10% = 2.2%!
 Four Mistakes to Avoid

3. Estimating Weights

Use the target capital structure to determine the

weights.
If you don’t know the target weights, then use the
current market value of equity.
If you don’t know the market value of debt, then the
book value of debt often is a reasonable approximation,
especially for short-term debt.
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 Four Mistakes to Avoid

4. 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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 Chapter 9

The Cost of Capital

The End

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