COST OF CAPITAL

Cost of Capital
Definition: the minimum required rate of
return on a project
Discount rate to be used in NPV calculations
Project specific:
business risk of the project

Long run: companys cost of capital

changes with the types of projects the
company takes (Enron: from pipeline
operator to energy trader to)
2

Cost Of Capital: Practical Points

Higher discount rates for investments
involving new products
Lower rates for ones that expand an existing
business
Problem: this is justified only if the betas of
the projects differ substantially
Incorporate impact of
difficulties/uncertainties during new product
launch in expected cash flow estimate (NOT
in discount rate)
3

Weighted Average Cost of Capital

WACC: weighted average of the costs of
different financing sources
Weights reflect relative importance of each
financing source in firms capital structure
Proportion of
equity

D
E E DP P
WACC rD (1 tC ) rE

V
V
PP
V
After tax cost of
debt
Proportion of
debt

Cost
of
equity

Cost of
preferre
d stock

Proportion
of
preferred
stock

WACC
D
E E DP P
WACC rD (1 tC ) rE

V
V
PP V
WACC cost of capital
rD pre - tax cost of debt
tC corporate tax rate
rE expected return on common stock
E(DP ) expected dividend on preferred stock
PP price of preferred stock
D E P
, , target ratios for debt, common stock and preferred stock
V V V
in the company' s capital stucture
V Firm Value D E P

WACC The Cost of Equity

The hardest part of calculating WACC
Two main methods to obtain
expected return on common stock (rE)
Discounted cash flow method (Gordon
Growth Model)
Comparable companies (CAPM)

Discounted Cash Flow Method

DIV1
P0
rE g

DIV1
rE
g
P0

P0 stockprice
DIV1 dividendper sharenext year
g the constantgrowthrateof annualdividends

Problems
Must estimate g
What if g not constant or g > rE ?
What about companies that pay no dividends?
7

Using Comparable Companies

Main steps
Select comparable firm(s): firms in same
industry
Calculate (levered) equity beta for
comparable(s)
Unlever equity beta using capital structure of
comparable(s)
Lever up the unlevered beta using the
relevant firm's target capital structure
Use CAPM
rE rf E E[rm ] rf
to get rE:

Getting the Inputs for CAPM

Find E form comparable firm (or industry)
Regress common stock returns on the return of a
market index. Issues:

Daily, weekly, monthly or annual returns?

What time period?
Are dividends included?
Which is the correct market index?

Reduce noise in estimates by using industry

betas
Or, use estimates from Value Line, Bloomberg,
Barra or Prof. Damodaran (check methodology!):

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.htm
l
9

Unlevered
Number Average Market
Unlevered Cash/Firm
Beta
Industry Name
of Firms
Beta
D/E Ratio Tax Rate
Beta
Value
corrected for
Advertising
32
1.54
27.53%
16.27%
1.25
8.39%
1.36
Aerospace/Defense
67
0.78
33.46%
19.04%
0.61
3.17%
0.63
Air Transport
43
1.15
122.96% 17.65%
0.57
14.94%
0.67
Apparel
55
0.82
16.52%
22.22%
0.73
3.21%
0.75
Unlevered
Auto & Truck
21
0.97
188.17% 18.43%
0.38
9.80%
0.42
Market
Beta
Auto Parts
67
0.83
70.88%
19.78%
0.53
5.44%
0.56
Number449
Average
Cash/Firm
corrected
Bank
0.66 D/E
38.15%
28.52% Unlevered
0.52
9.43%
0.57
Bank (Canadian)
11.24%Tax19.32%
0.84
3.33%
0.87cash
Industry
Name of Firms 8 Beta 0.92 Ratio
Rate
Value
for
Beta
Bank (Foreign)
5
1.03
86.73%
16.29%
0.59
16.90%
0.71
Bank (Midwest)
34
0.75
28.92%
30.15%
0.62
8.69%
0.68
Beverage (Alcoholic)
21
0.59
15.21%
23.92%
0.52
2.33%
0.54
0.8
Publishing
45 21 0.95 0.67 23.18%
4.81%
0.84
Beverage (Soft Drink)
12.15% 20.38%
20.82%
0.61
1.93%
0.63
Biotechnology
78
1.12
3.13%
7.11%
1.08
16.27%
1.3
Building Materials
54
0.82
29.44%
22.34%
0.67
6.03%
0.71
Cable TV
28
1.36
108.29%
3.28%
0.66
7.34%
0.72
Canadian Energy
12
0.74
28.63%
34.38%
0.62
3.37%
0.65
Cement & Aggregates
16
0.73
38.63%
23.11%
0.56
2.37%
0.57
Chemical (Basic)
23
0.86
40.55%
15.60%
0.64
4.14%
0.67
Chemical (Diversified)
33
0.77
24.83%
29.44%
0.66
3.65%
0.68
Chemical (Specialty)
91
0.79
46.81%
20.08%
0.58
2.74%
0.59

Unlevering Beta
The formula to unlever beta is:
D
EL 1 tC D
E
EU
D
1 1 t C
E
Sometimes people assume D=0
This is equivalent to saying that the
cost of debt is the risk free rate!
11

Levering up the Unlevered Beta

Here we use the firms target capital
structure (i.e. the firms D and E)

EL EU 1 tC EU D

D
E

Notice that we have simply

rearranged the previous formula
12

Lack of Data
What if the firm is unlisted and you cant
find any similar companies?
Remember the intuition behind beta!
Beta reflects how closely the companys profits
fluctuate with the economy
If the company is cyclical and has high
operating leverage (ratio of fixed costs to
variable costs), its beta is probably high
On the other hand if the company is noncyclical and has low fixed costs, its beta is
probably low

Risk Free Rate

Long-term or short term rate?
Discount rate should reflect duration of project
Use a long term (10-year) government bond
rate as the risk free rate
Emerging markets (with no 10-year govt bond):
Use recent issues of the largest firms in that country
and subtract a rough estimate of the risk premium
Interest Rate Parity: derive risk free rate from spot
and forward exchange rate and US risk free rate

14

Market Risk Premium: E(rm) rf

This is the expected risk premium
The average risk premium is a good estimate if:
On average, expectations are realized over the long-run
The risk premium is constant

Depending on the stock market in question the

historical risk premium has varied between 4%
and 7%
For the US: Ibbotson Associates data from 1926
The longer the period, the lower the estimation
error common choice: start from 1926!

15

The Cost of Debt

Firms credit rating is known
rD can be estimated from yield-to-maturity
(YTM) of bonds issued by companies with
similar credit rating
NOT THE COUPON RATE!

Difference between Investment and NonInvestment Grade Bonds:

BBB or better for investment grade
Investment: calculate yield-to-maturity
Non-Investment: use expected (not promised)
cash flows (estimated probability of default)
Otherwise use BBB YTM
16

Credit Ratings and Bond Spreads

ForLargeManufacturingFirms

Ifinterestcoverageratiois
>
100000
0.2
0.65
0.8
1.25
1.5
1.75
2
2.5
3
4.25
5.5
6.5
8.50

to
Ratingis
0.199999
D
0.649999
C
0.799999
CC
1.249999
CCC
1.499999
B
1.749999
B
1.999999
B+
2.499999
BB
2.999999
BBB
4.249999
A
5.499999
A
6.499999
A+
8.499999
AA
100000
AAA

Source: http://www.stern.nyu.edu/~adamodar/pc/ratings.xls

Spreadis
14.00%
12.70%
11.50%
10.00%
8.00%
6.50%
4.75%
3.50%
2.25%
2.00%
1.80%
1.50%
1.00%
0.75%

Example 1: Columbia Power

Capital structure:
Debt: 4,000 10-year, 8% semi-annual coupon
bonds priced at par (face value = $1,000)
Common stock: 50,000 shares outstanding, price =
$62 and = 1.1
Preferred stock: 9,000 shares of 4% preferred stock
outstanding, price = $60 (face value = $100)
Market risk premium: 5%
Risk-free rate: 6%
Tax rate: 35%
What is the WACC?

18

Cost of Capital
First, we have to calculate relative weights of
different sources of capital
D 4,000 1,000 $4,000,000
Debt
:
Preferred Stock : P 9,000 $60 $540,000
Common Stock : E 50,000 $62 $3,100,000
Firm value
: V D P E $7,640,000

19

After-Tax Cost of Debt: Columbia Power

Bond price = Par value YTM = Coupon rate =
8%
YTM cost of debt! YTM = semi-annually
compounded APR must calculate
EAR!
2

0.08
RD EAR 1
1 8.16%
2

After- tax costof debt:

RD (1- TC ) 0.0816 0.65 5.30%
20

Cost of Preferred Stock

Preferred stock is assumed to be a
perpetuity (zero growth)
Dividend = Face value Dividend rate
= $100 4% = $4
Market price=$60

DP
$4
RP

6.67%
PP $60

21

Cost of Common Stock

Apply CAMP (Capital Asset Pricing Model):

RE Rf (Marketriskpremium)
Rf E RM Rf
0.06 1.1 0.05
0.115
Cost of common stock: RE = 11.5%
22

WACC of Columbia Power

D
E
P
WACC RD (1 Tc) RE RP
V
V
V
0.5236 5.30% 0.405811.5% 0.0707 6.67%
7.91%

If this is a typical project for the firm, then

the WACC is the appropriate discount rate for
the capital budgeting problem.
23

Unipress Example
Unipress, a publishing company

Market capitalization:
$2 billion
Market value of debt (rated AAA):
$300m
Corporate tax rate:
34 %
Risk free rate (10-year treasuries): 5.12%
Market risk premium
(Ibbotson): 6.47%

Unipress is planning to launch a new

magazine dealing with soap operas
Cost of the new project: $500m
% of debt financing for project:

100% (AAA)

What is the relevant discount rate for project?

24

Unipress Example Continued

Cost of debt (from table above)
rD = 0. 75 + 5.12 = 5.87% (10 years)

Target debt-to-equity ratio after

project has been financed
D = $300m + $500m = $800m
E = $2,000m + $500m x 0.34 =
$2,170m
Hence, D/E = 36.8 %
25

Unipress Example: Cost of Equity

Beta table gives us unlevered equity beta
for publishing industry (0.8)
Need to lever it up using formula:
D
EL EU 1 tC EU D
E
What is Unipress' debt beta? Use CAPM!

rD rf D E[rM ] rf

5.87% 5.12% D 6.47%

Therefore D =0.116
26

Unipress Example: Cost of Equity 2

EL 0.8 1 0.34 0.8 0.116 0.368
0.966
Finally, using the CAPM again:

rE rf EL E [ rM ] rf

rE 5.12% 0.966 6.47%

rE 11.37%
27

Unipress Example: WACC

D
E
WACC rD (1 tC ) rE
V
V
800
2170
5.87(1 0.34)
11.37
800 2170
800 2170
9.35%

28

Appendix: Levering/Unlevering Betas

Value of Levered Firm = Value of Unlevered
Firm + Tax Shields = Equity + Debt

VL = V U + D T C = E + D
Remember: portfolio beta is weighted average
of the betas of the assets in the portfolio
Beta of levered firms assets:

E
D
A
EL
D
ED
ED
E
D

EL
D
VL
VL
29

Appendix: Levering/Unlevering Betas

(Continued)
Alternatively: beta of levered firms assets using
beta of Unlevered Firm and beta of Tax Shields

VU
tC D
A
EU
D
VU tC D
VU tC D
VU
tC D

EU
D
VL
VL

Combining the two expressions for A:

VU
tC D
E
D
EL
D
EU
D
VL
VL
VL
VL
30

Appendix: Levering/Unlevering Betas

(Continued)
Multiply both sides by VL and replace VU with E + D tCD :

E EL D D E D tC D EU tC D D

Deduct DD from both sides and then divide by E:

D
EL EU 1 tC ( EU D )
E
Rearrange for EU to obtain formula to un-lever beta:
EU

D
D
E
D
1 1 t C
E

EL 1 tC

31