The Cost of Capital

1
Topics in Chapter
Cost of Capital Components
Debt
Preferred
Common Equity
WACC

2
What types of long-term
capital do firms use?
Long-term debt
Preferred stock
Common equity

3
Capital Components
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 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.
4
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.

5
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.

6
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 debt, if it has any.

7
 A 15-year, 12% semiannual bond
sells for $1,153.72. Whats rd?

0 1 2 30
i=? ...
-1,153.72 60 60 60 + 1,000

INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5.0% x 2 = rd = 10%

8
Component Cost of Debt
Interest is tax deductible, so the after
tax (AT) cost of debt is:
rdAT = rdBT(1 - T)
rdAT = 10%(1 - 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.

9
 Cost of preferred stock
To illustrate the calculation, lets Use this formula for
assume company NCC has preferred new issue of preferred:
stock that pays an $8 dividend Dps
per share and sells for $100 per rps =
share. Pps (1-F)

Lets also assume if NCC issued new preferred stock then it

would incur an underwriting (or flotation) cost of 2.5%, or
$2.50 per share, so
it would net $97.50 per share. Therefore, NCCs cost of
preferred stock is 8.2%:
rps = $8/$97.50 = 8.2%
10
 Time Line of Preferred

0
rps=?
1 2
...
-111.1 10 10 10

D
$111.10= = $10
rps rps

$10
rps(Nom) = = 9%
$111.10
11
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.

12
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.

13
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).

14
Why is there a cost for
reinvested 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.

15
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 the cost of
reinvested earnings and it is the cost of
equity.
16
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.
17
CAPM Cost of Equity: rRF = 7%, RPM
= 6%, b = 1.2.

rs = rRF + (rM - rRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

18
Issues in Using CAPM
Most analysts use the rate on a long-
term (10 to 20 years) government bond
as an estimate of rRF
Most analysts use a rate of 5% to 6.5%
for the market risk premium (RPM)
Estimates of beta vary, and estimates
are noisy (they have a wide
confidence interval).
19
DCF Cost of Equity, rs: D0 =
$4.19; P0 = $50; g = 5%.

D1 D0(1+g)
rs = +g= +g
P0 P0

= $4.19(1.05) + 0.05
$50
= 0.088 + 0.05
= 13.8%
20
Estimating the Growth Rate
Use the historical growth rate if you
believe the future will be like the past.
Obtain analysts estimates: Value Line,
Zacks, Yahoo.Finance.
Use the earnings retention model,
illustrated on next slide.

21
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.

Whats the expected future g?

22
Earnings Retention Model
(Continued)
Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 - payout rate)(ROE)
g = (1 0.65)(15%) = 5.25%.

This is close to g = 5% given earlier. Think

of bank account paying 15% with retention
ratio = 0. What is g of account balance? If
retention ratio is 100%, what is g?
23
The Own-Bond-Yield-Plus-Risk-Premium
Method: rd = 10%, RP = 4%.

rs = rd + RP
rs = 10.0% + 4.0% = 14.0%

This RP CAPM RPM.

Produces ballpark estimate of rs. Useful
check.

24
Whats a reasonable final
estimate of rs?
Method Estimate

CAPM 14.2%

DCF 13.8%

rd + RP 14.0%

Average 14.0%

25
Determining the Weights for
the WACC
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.

26
Estimating Weights for the
Capital Structure
If you dont know the targets, it is
better to estimate the weights using
current market values than current
book values.
If you dont 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.
(More...)
27
Estimating Weights
(Continued)
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.

(More...)
28
Estimating Weights
(Continued)
Vce = $50 (3 million) = $150 million.
Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75 =
$250 million.

29
Estimating Weights
(Continued)
wce = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3

30
 Weighted Average Cost of
Capital (WACC)
WACC = wdrd (1 t) + wprp + were
where
wd is the proportion of debt that the company uses when it raises
new funds
rd is the before-tax marginal cost of debt
t is the companys marginal tax rate
wp is the proportion of preferred stock the company uses when it
raises new funds
rp is the marginal cost of preferred stock
we is the proportion of equity that the company uses when it raises
new funds
re is the marginal cost of equity
31
Whats the WACC?
WACC = wdrd(1 - T) + wpsrps + wcers

WACC = 0.3(10%)(0.6) + 0.1(9%) +

0.6(14%)

WACC = 1.8% + 0.9% + 8.4% = 11.1%.

32
What factors influence a
companys WACC?
Market conditions, especially interest
rates and tax rates.
The firms capital structure and dividend
policy.
The firms investment policy. Firms
with riskier projects generally have a
higher WACC.

33
Is the firms 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 divisions WACC should be
adjusted to reflect the divisions risk
and capital structure.

34
Divisional Cost of Capital
Using CAPM
Target debt ratio = 10%.
rd = 12%.
rRF = 7%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.

35
Divisional Cost of Capital
Using CAPM (Continued)

Divisions required return on equity:

rs = rRF + (rM rRF)bDiv.
rs = 7% + (6%)1.7 = 17.2%.
WACCDiv. = wd rd(1 T) + wc rs
= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.

36
Divisions WACC vs. Firms Overall
WACC?

Division WACC = 16.2% versus

company WACC = 11.1%.
Typical projects within this division
would be accepted if their returns are
above 16.2%.

37
What are the three types of
project risk?
Stand-alone risk
Corporate risk
Market risk

38
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.

39
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.

40
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.

41
Cost of New Common Equity: P0=$50,
D0=$4.19, g=5%, and F=15%.

D0(1 + g)
re = +g
P0(1 - F)
$4.19(1.05) + 5.0%
=
$50(1 0.15)

= $4.40 + 5.0% = 15.4%

$42.50
42
 Comments about flotation
costs:
A flotation cost is the investment banking fee associated with
issuing securities.
There are two treatments for flotation costs:
1. Adjust the price of the security in the return calculation by the
flotation cost, (shown in earlier slides) or
2. Adjust the NPV of the project for the monetary cost of flotation.

Adjusting the NPV is preferred because the flotation costs

occur immediately rather than affect the company throughout
the life of the project.

Problem: Suppose a company has a project with an NPV of $100

million. If the company issues $1 billion of equity to finance this project
and the flotation costs are 1.2%, what is the NPV after adjusting for
flotation costs?
Solution: NPV = $100 million $12 million = $88 million
43
Comments about 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.

44