Chapter 12

Cost of Capital

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• The Cost of Capital: Some Preliminaries
• The Cost of Equity
• The Costs of Debt and Preferred Stock
• The Weighted Average Cost of Capital
• Divisional and Project Costs of Capital

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Why Cost of Capital Is Important?

• Capital budgeting
• r = interest rate, discount rate, required return,
cost of capital, opportunity cost
• The required return on asset depends on the risk
of the asset
• How much return required by investor = cost to
the company
• How to calculate the cost of capital (r)?
– Where the capital being raised
– Return required by capital suppliers

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Capital Components

3 sources of capital:
1) Common stock (Equity) - RE
2) Debts - RD
3) Preferred stock - RP

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1) Cost of Equity (RE)

• The cost of equity is the return required by
equity investors
• There are two major methods for
determining the cost of equity
– Dividend growth model
– SML or CAPM

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The Dividend Growth Model

Approach
• Start with the dividend growth model
formula and rearrange to solve for RE
D1
P0 =
RE −g
D1
RE = +g
P0
Cost of equity = Dividend Yield + Capital gains Yield

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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?

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Example: Estimating the
Dividend Growth Rate
• One method for estimating the growth rate is to use the
historical average
Year Dividend Percent Change
– 2000 1.23
– 2001 1.30
– 2002 1.36
– 2003 1.43
– 2004 1.50

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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 aren’t growing at a
reasonably constant rate
– 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
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The CAPM Approach (SML)

• Derived from Capital Asset Pricing Model

R E = R f + β E [E(R M ) − R f ]

– Rf = Risk-free rate
– E(RM)= Market return
– E(RM) – Rf = Market risk premium,
β = beta = Systematic risk of asset,

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Example - SML

• Suppose your company has an equity

beta of .58 and the current risk-free rate is
6.1%. If the expected market risk premium
is 8.6%, what is your cost of equity
capital?

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Advantages and Disadvantages of

SML
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as we can
compute beta
• 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 relying on the past to predict the future, which
is not always reliable

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Example – Cost of Equity

• Suppose 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?

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2) Cost of Debt (RD)

• The cost of debt is the investors’ required return

on company’s debt
• The cost of long-term debt or bonds
• The cost of debt is NOT the coupon rate
• Best estimated by using the Yield to maturity
(YTM) on the existing debt
• YTM is the rate implied by the current bond price
• The rate that equals the PV of bond’s cash flows
with bond price.

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Cost of Debt Example

• Suppose we have a 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 $1000 bond. What is the cost of debt?

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3) Cost of Preferred Stock (Rp)

• Preferred generally pays a constant dividend
every period
• Dividends are expected to be paid every period
forever
• Preferred stock is an perpetuity, so we take the
perpetuity formula, rearrange and solve for RP
• PV = C/r ==> P = D/Rp
• RP = D / P0

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Cost of Preferred Stock -

Example
• Your company has preferred stock that has an
annual dividend of $3. If the current price is $25,
what is the cost of preferred stock?

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Capital Structure Weights

• We can use the individual costs of capital that we
have computed to get our “average” cost of capital
for the firm.
• Weights according to:
– Target capital structure
– Current market value of capital structure
– Book values of capital structure

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Capital Structure Weights
• Suppose you have a market value of equity equal to
$500mil, market value of debt = $475mil and
preferred market value = 25mil:

• Suppose a company has a target debt equity ratio of

0.6:

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Taxes and WACC

• After-tax cash flows After-tax cost of capital
• Interest expense for debt is tax deductible:
– Reduces cost of debt
– After-tax cost of debt = RD(1-TC)
– TC = corporate tax rate
• Dividends for common equity and preferred
equity are not tax deductible.

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Weighted Average Cost of
Capital (WACC)
E D P
WACC = R E + R D (1 − Tc) + R P
V V V
where: E/V = Weight for Equity
RE = Cost of Equity
D/V = Weight for Debt
RD = Cost of Debt
Tc = Corporate tax rate
P/V = Weight for Preferred
Rp = Cost of Preferred
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Example – WACC
• Equity Capital: • Debt Capital:
– 50,000 shares – $1 million in outstanding
– $80 per share debt (at face value)
– Beta = 1.15 – Current quote = 118.39%
– Market risk premium = 9% – Coupon rate = 9%,
– Risk-free rate = 5% semiannual coupons
– 15 years to maturity
• Preferred Capital: – Tax rate = 40%
– 10,000 shares
– $110 per share
– Dividend rate of 5.5%

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Example – WACC

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Example – WACC

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Divisional and Project Costs of

Capital
• Using the WACC as our discount rate is only
appropriate for projects that are the same risk as
the firm’s current operations
• If we are looking at a project that is NOT the
same risk as the firm, then we need to determine
the appropriate discount rate for that project
• Divisions also often require separate
discount rates

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Pure Play Approach

• Find one or more companies that specialize in
the product or service that we are considering
• 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
• Often difficult to find pure play companies

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Subjective Approach
• Consider the project’s risk relative to the firm
overall
• Assume WACC=15% for average risk class
• If the project is more risky than the firm, use a
discount rate greater than the WACC (r>15%)
• If the project is less risky than the firm, use a
discount rate less than the WACC (r<15%)

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Subjective Approach - Example

Risk Level Discount Rate

Very Low Risk WACC – 8% =12%

Low Risk WACC – 3% = 17%

Same Risk as Firm WACC = 20%

High Risk WACC + 5% = 25%

Very High Risk WACC + 10% = 30%

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Quick Quiz
• What are the two approaches for computing the cost
of equity?
• How do you compute the cost of debt and the after-
tax cost of debt?
• How do you compute the capital structure weights
required for the WACC?
• What is the WACC?
• What happens if we use the WACC for the discount
rate for all projects?

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Tutorial
• Problem 4, 10 & 18 from page 397

• Problem 18:
- under Debt:
“…a quoted price of 108.” change to
“…a quoted price of 105.34.”

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