CHAPTER 10

The Cost of Capital

Topics

Cost of Capital Components

Debt
Preferred
Common Equity

WACC

Composite
Risk Adjustments
WACC with Flotation Costs
2

Sources of Long-term Capital

rd

rs

rps

rce

re
3

10-3

WACC
Weighted Average Cost of Capital

WACC = wdrd(1-T) + wpsrps + wcers(10.10)

Where:

Weights

Component
costs

w d = % of debt in capital structure

w ps = % of preferred stock in capital structure
w ce = % of common equity in capital structure
rd = firms cost of debt
rps= firms cost of preferred stock
rs = firms cost of equity
T = firms corporate tax rate

Capital Components

Capital components = sources of

funding from investors
Accounts payable, accruals, and
deferred taxes sources of
funding from investors

Not included in calculation of the

cost of capital
Adjustments made when calculating
project cash flows
5

Cost of Debt

Method 1: Ask an investment

banker
what the coupon rate
would be on
new debt
Method 2: Find the bond rating for
the
company and use the yield
on other
bonds with a similar
rating
Method 3: Find the yield on the
companys outstanding debt
6

NCCs Cost of Debt (rd)

Calculator Solution
A 22-year, 9%
44

semiannual coupon
835.42
bond sells for
45

1000

$835.42
= 5.50%
Bond pays a
semiannual coupon:
rd = 5.5% x 2 = 11%

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

= 11%(1 - 0.40) = 6.6%

Use nominal rate

Flotation Costs on New

Debt

Flotation costs on debt usually low

Frequently ignored
Project Financing

Adjusts projects cash flows for

flotation costs of debt
Debt has specific claim on the
projects cash flows
9

Adjusting the Cost of Debt

for Flotation Costs
INT ( 1 T )
M
M(1 F )

t
N
[
1

r
(
1

T
)]
[
1

r
(
1

T
)]
t 1
d
d
N

(10 - 2)

Where:
M = Bonds par value (face value)
F = Flotation cost as a %
N = Number of coupon payments
T = Corporate tax rate
INT = Dollars of interest per period
rd(1-T) = after tax cost of debt adjusted for inflation

10

NCCs Cost of Debt (rd)

with Flotation Costs

NCC can issue 30-year

bonds

11% annual coupon rate

Coupons paid semiannually

PMT = [(.11 x 1000)/2]*(1-.40)
PMT = $33

Flotation cost = 1%

N = 60

PV = -1000(1-.01) = -990

Face value = M = 1000

Calculator Solution
60

990

33

1000

= 3.34%

Nominal after-tax cost of

debt with flotation costs =
6.68%
11

Preferred Stock

Flotation costs for preferred are

significant

Preferred dividends are not

deductible

Use net price

No tax adjustment
Use rps

Nominal rps is used

12

NCCs Cost of preferred

stock:
PP = $100
2.5%

r ps

$10
Dividend
D
ps

Pps ( 1 F )

F=

(10 - 3)

Where:
Dps = Preferred dividend
PPS = Preferred stock price
F = Flotation cost %

r ps

$10

10.3%
$100 ( 1 .025 )
13

Cost of Common Equity

Two Ways to raise equity financing:
Directly

Issue new shares of common stock

Indirectly

Reinvesting earnings not paid out as

dividends
Use retained earnings
14

Funding with New Common

Equity

Mature firms rarely issue new

equity
High flotation costs
Negative signal to the market
Downward pressure on stock
price

15

Cost of Retained Earnings

Earnings can be reinvested or paid

out as dividends
Investors could buy other
securities, earn a return
Thus, there is an opportunity cost
if earnings are reinvested

16

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

rs = the cost of reinvested

earnings
= the cost of equity
17

Three ways to determine

the cost of equity, rs:
1. CAPM:

rs

= rRF + (RM - rRF)

= rRF + (RPM)

2. DCF:

rs

= D1/P0 + g

3. Own-Bond-Yield-Plus-Risk Premium:
rs
= rd + Bond RP
18

Three ways to determine

the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)
= rRF + (RPM)
2. DCF:

rs = D1/P0 + g

3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
19

CAPM Cost of Equity Steps

1.
2.

3.
4.

Estimate risk-free rate (rRF)

Estimate market risk premium
(RPM) or expected return on the
market (RM)
Estimate beta ()
Substitute into CAPM
20

Estimating rRF

Common stock = long-term

security

T-Bills more volatile than T-Bonds

Most analysts use the rate on a

long-term (10 to 30 years)
government bond as an estimate
of rRF
21

Estimating RPM or RM

Historical - Ibbotson & Associates

1926-most recent year

6.5% arithmetic mean - if constant risk
aversion
4.9 % geometric mean best future
estimate

Ex Ante = Forward-Looking

Expected Return
rM
If market
Value Line
or Reuters

D1

g rRF RPM R M Required Return

in
equilibrium:
P0
Historical or analysts
estimates

22

RPM Estimate #1
RPM = 11.73%

rM Estimate

Forward-looking RPM:

(Reuters, Spring 2008)

D (1 g )
Dividend yield on S&P500 = 2.61%
rM 0
g
P0
Dividend growth rate = 13.20%
rM=[0.0261(1+.132)]+0.132=16.15%
Long-term T-Bond rate = 4.42%
16.15% - 4.42% = 11.73%

Problems:

Past = future?
Growth rates sensitive to period
measured

23

RPM Estimate #2
RPM = 17.79%

rM Estimate

Forward-looking RPM:

(Spring 2008)
Reuters S&P500 dividend yield = 2.61%
Yahoo Earnings growth rate = 19.1%
rM=[0.0261(1+.191)]+0.191=22.21%
22.21% - 4.42% = 17.79%

rM

D0 ( 1 g )
g
P0

Problems:

Earnings growth dividend growth

1-year growth rate long-term growth
Analysts accuracy
Differing analysts opinions

24

Estimating RPM (or RM)

RPM = Equity risk premium

RM

Most analysts use a rate of 5% to

6.5% for the market risk premium
S&P500 index return =proxy for the
market return

RPM=RM- rRF
Brigham-Daves RPM = [3.5, 6.5]
25

Estimating Beta -

Beta estimates vary

Beta estimates are noisy

Historical Beta

Wide confidence interval

4-5 years/monthly or 1-2 years/weekly
Adjusted Beta
Fundamental Beta

Multinational issues
26

NCCs CAPM Cost of Equity

rRF = 8%

RPM = 6%

= 1.1

rs = rRF + (RM - rRF )

= 8.0% + (6.0%)1.1
= 14.6%
27

Three ways to determine

the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)
= rRF + (RPM)
2. DCF:

rs = D1/P0 + g

3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
28

DCF Approach: Inputs

P0

D1
rs g

(10 - 5)

D1
rs r s
expected g
Po
1.

Current stock price (P0)

2.

Current dividend (D0)

3.

Growth rate (g)

29

Estimating the Growth

Rate
The historical growth rate

If you believe future = past

The earnings retention model

Analysts estimates:

Value Line, Zacks, Yahoo.Finance

30

Earnings Retention
Model

NCC Data:

Retention ratio = 100% - dividend payout

ROE = 14.5%
Dividend payout ratio = 52%
Retention rate = 100% - 52% = 48%

Retention growth rate:

g = ROE x (Retention rate)

g = (14.5%) x 0.48 = 7%

31

Earnings Retention
Assumptions
1.
2.
3.
4.

Retention rate is constant

ROE on new investments is
constant
No new common stock will be
issued
The risk of future projects is very
close to the risk of the overall firm
32

Using Analysts Forecasts

Analysts estimate earnings growth

= proxy for dividend growth

Sometimes involve non-constant growth

Analysts Estimates for NCC:

Develop a proxy constant rate

10.4% annual growth for 5 years

6.5% growth after 5 years

Analysts estimates usually best

source

g = 6.9%

33

NCCs DCF Cost of Equity, rs

D1 = $2.40
rs =
=

D1
P0

P0 = $32
+g=

$2.40

D0(1+g)
P0

g = 7%
+g

+ 0.07

$32
= 0.075 + 0.07
= 14.5%

34

Three ways to determine

the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)
= rRF + (RPM)
2. DCF:

rs = D1/P0 + g

3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
35

The Own-Bond-Yield-Plus-RiskPremium Method: rd = 11%, RP =

3.7%

rs = rd + RP

rs = 11.0% + 3.7% = 14.7%

This RP CAPM RPM

Produces ballpark estimate of rs

Useful check
36

Final Estimate of rs
Method
CAPM

Estimat Used by
e
14.6%
74% - 85%

DCF

14.5%

16%

rd + RP

14.7%

Non-public

Average

14.6%
37

Flotation Costs for Equity

re = Cost of New Equity
D1
re re
g
P0 ( 1 F )

NCC: D1 = $2.40

P0 = $32

(10 - 9)

F = 12.5%

$2.40
re re
.07 15.6%
$32 ( 1 .125 )
38

Topics

Cost of Capital Components

Debt
Preferred
Common Equity

WACC

Composite
Risk Adjusted
WACC with Flotation Costs
39

WACC
Weighted Average Cost of Capital

WACC = wdrd(1-T) + wpsrps + wcers(10.10)

Where:

Weights

Component
costs

w d = % of debt in capital structure

w ps= % of preferred stock in capital structure
w ce= % of common equity in capital structure
rd = firms cost of debt
rps= firms cost of preferred stock
rs= firms cost of equity
T = firms corporate tax rate

40

WACC Weights

Weights =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

NCC: 30% debt, 10% Preferred, 60% Equity

41

NCCs WACC
Weighted Average Cost of
Capital
Component
Debt (before
tax)
Preferred Stock
Common equity

w
r
0.30 11.0%
0.10 10.3%
0.60 14.6%

WACC = wDrD (1- T)+ wPsrPs + wcrs

WACC =0.3(11%)(1-.40)+0.1(10.3%)
+0.6(14.6%)
WACC = 11.77%

42

Cost of Capital Issues

Before-tax vs. After-tax Capital Costs

Long- and short-term debt affected

Historical Costs vs. Marginal Costs

Target Weights vs. Annual Financing
Choices
Target Weights vs. Book Values

43

Estimating Weights for the

Capital Structure

Estimate the weights using

current market values rather
than current book values
If market value of debt is not
known:

Usually reasonable to use the book

values of debt, especially if the
debt is short-term
44

Estimating Weights

Given:
The stock price is $50
There are 3 million shares of
stock
$25 million of preferred stock
$75 million of debt

45

Estimating Weights

Vce = $50 x (3 million) = $150

million
Vps = $25 million

Vd = $75 million

Total value = $150 + $25 + $75 =

$250 million
46

Estimating Weights

47

WACC

48

Factors that influence a

companys WACC

Market conditions

Interest rates
The market risk premium
Tax rates

Firms capital structure

Firms dividend policy
Firms investment policy

Firms with riskier projects generally

have a higher WACC

49

Topics

Cost of Capital Components

Debt
Preferred
Common Equity

WACC

Composite
Risk Adjusted
WACC with Flotation Costs
50

Risk-Adjusted WACC

The composite WACC reflects the

risk of an average project
undertaken by the firm
Different divisions/projects may
have different risks
The divisions or projects WACC
should be adjusted to reflect the
appropriate risk and capital
structure
51

Divisional Risk and the

Cost of Capital
Rate of Return
(%)

Acceptance Region
WACC

WACC H

Acceptance Region
Rejection Region

WACC F
Rejection Region

WACC L

Risk L

Risk H

Risk

52

Using WACC for All Projects Example

What would happen if we use the

WACC for all projects regardless of
risk?
Assume the WACC = 15%

53

The Risk-Adjusted
Divisional Cost of Capital

Estimate the cost of capital that

the division would have if it were a
stand-alone firm
Requires estimating the divisions
beta, cost of debt, and capital
structure

CAPM frequently used

54

Pure Play Method for

Estimating Beta for a
Division or a Project

Find several publicly traded

companies exclusively in projects
business
Use average of their betas as
proxy for projects beta
Hard to find such companies

55

Huron Steel Example

56

Subjective Approach

Consider the projects risk

relative to the firm overall

If project risk > firm risk

Project discount rate > WACC

If project risk < firm risk

Project discount rate < WACC

57

Subjective Approach Example

Risk Level
Very Low Risk

Discount Rate
WACC 8%
7%

Low Risk

WACC 3%

Same Risk as Firm

WACC

High Risk
Very High Risk

WACC + 5%
WACC + 10%

12%
15%
20%
25%

58

Topics

Cost of Capital Components

Debt
Preferred
Common Equity

WACC

Composite
Risk Adjusted
WACC with Flotation Costs
59

Flotation Costs

Flotation costs depend on the risk

of the firm and the type of capital
being raised
Flotation costs:

Highest for common equity

Most firms issue equity infrequently

Flotation costs frequently ignored

when calculating WACC
60

NCCs WACC
With New Debt
Component
w
New Debt (afterd 0.30
tax)
Preferred Stock
ps 0.10
New Common
c
0.60
WACC = wdrATd + wpsrps + wcre
equity

r
6.68%
10.3%
14.6%

WACC = 0.3(6.68%)+0.1(10.3%) +0.6(14.6%)

WACC = 2.004% + 1.03% + 9.36% = 11.794%

61

NCCs WACC
With New Debt & New Equity
Component
w
New Debt (afterd 0.30
tax)
Preferred Stock
ps 0.10
New Common
c
0.60
WACC = wdrATd + wpsrps + wcre
equity

r
6.68%
10.3%
15.6%

WACC = 0.3(6.68%)+0.1(10.3%) +0.6(15.6%)

WACC = 2.004% + 1.03% + 9.36% = 12.394%

62

NCCs WACC
WACC Description
No New Issues
With New Debt
With New Debt & New
Equity

WACC
11.770
%
11.794
%
12.394
%
63

Increasing Marginal Cost of

Capital

Externally raised capital flotation costs

Investors often perceive large capital

budgets as being risky

Increases the cost of capital

Drives up the cost of capital

If external funds will be raised, then the

NPV of all projects should be estimated
using this higher marginal cost of capital

64

Increasing Marginal Cost of

Capital
% 16
15
14

WACC2 = 12.394%

13
12

WACC1 = 11.77%

External debt
& equity

10
9

No external funds

500

700 Capital Required

61

Four Mistakes to Avoid

Current (YTM) vs. historical (Coupon rate) cost

of debt
Mixing current and historical measures to
estimate the market risk premium
Book weights vs. Market Weights

Use Target weights

Use market value of equity
Book value of debt is a reasonable proxy for market
value

Incorrect cost of capital components

Only investor provided funding

66

CHAPTER 10
The Cost of Capital

67