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FINS1613S2Yr2013KyungHwanShim 1
Topic:CostofCapital
Lecture9:Objectives
Definethecostofcapital
Definetheprojectscostofcapital,theminimumrequiredreturnon
theproject.
WACC,thecompanysoverallcostofcapital(WeightedAverageCost
ofCapital).
Determinewhenthecompanysoverallcostofcapitalcanorcannot
beusedinprojectanalysis.
Determinetheprojectscostofcapital using
thePurePlayApproach
andtheSubjectiveApproach
Consideradividendpayingstock(Chapter7)
Givenexpectationsoffuturedividends,P
t
isdeterminedbythemarket.
Considernowacouponpayingbond(Chapter6)
Giventhecouponrate,B
t
isdeterminedbythemarket.
Q)Whodeterminesthethediscountrates forstocksandbonds?
A)Themarket!
FINS1613S2Yr2013KyungHwanShim
2
1 2 3
2 3
...
1 (1 ) (1 )
t t t
t
D D D
P E
r r r
+ + +
(
= + + +
(
+ + +

2 3
...
1 (1 ) (1 ) (1 )
t T t
C C C F C
B E
ytm ytm ytm ytm

( +
= + + + +
(
+ + + +

DefiningtheCostofCapital
Nowconsideradifferentviewofthediscountrate.
Q)Whatisthediscountrater?
A)r istherequiredrateofreturnonthestock!(Chapter11)
Alternatively,
r isthestocksInternalRateofReturn(Chapter8).Thediscountratethatmakes
thestockspriceequaltoitsvalue.
Conclusion:StockshavezeroNPVs.InvestinginfinancialmarketsisazeroNPV
proposition!
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1 2 3
2 3
1 1
...
1 (1 ) (1 )
0
1
t t t
t
t t
t
D D D
P E
r r r
D P
P E
r
+ + +
+ +
(
= + + +
(
+ + +

+ (
= +
(
+
1 2 3 1 1
2 3
1 1 1 1
...
1 (1 ) (1 ) 1
[1 ] [ ]
t t t t t
t
t t t t t
t t
D D D D P
P E E
r r r r
D P P D P
E r E E r E
P P
+ + + + +
+ + + +
( + (
= + + + =
( (
+ + + +
( ( + +
+ = =
( (

DefiningtheCostofCapital
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Considernowanontradableasset,suchasaproject(Chapter8)
J isthediscountratethatvaluestheproject.
Q)Projectsarenontradableassets.Whodeterminesd then?The
manager?
A) NO.
ArgumentbasedontheCAPM:Therequiredrateofreturnonthe
projectmustbethesameastherequiredrateofreturnonstocks
withthesamemarketriskastheproject.Themarketdetermines
d!
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1 2
0 2
...
1 (1 ) (1 )
T
T
C C C
NPV C
d d d
= + + + +
+ + +
DefiningtheCostofCapital
AprojectwillhaveapositiveNPVonlyifitsreturns
exceedwhatfinancialmarketsofferinreturnson
stockswithsimilarrisk.Inotherwords,
Alternatively,tI IRR > d (Chapter8).
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1 2
0 2
... 0
1 (1 ) (1 )
T
T
C C C
NPV C
d d d
= + + + + >
+ + +
DefiningtheCostofCapital
Q)Whatisthedifferencebetweentradableassets(suchasstocksandbond)and
nontradableassets(suchasprojects).
A)
Prices(andreturns)oftradableassetsaredeterminedbythemarket.Recallfrom
SML:
E(r

- r
]
)
[

=
E(r
]
- r
]
)
[
]
= E(r
m
-r
]
)
Investorsareindifferentbetweenholdingstocki,orj,oranyotherstock.Theyare
allfairlypriced.Lookedanotherway,allinvestmentsinthecapitalmarketshave
zeroNPV(efficientmarkets).
Projects,ontheotherhand,arenottraded.Projectvaluesdonotadjustto
reflecttheirrisk.Thereisabnormalprofitstobemade!!!
ApositiveNPVprojectisanassetthatoffersareturngreaterthanwhatis
deemedappropriateforitsmarketrisk.
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DefiningtheCostofCapital
3
ProjectDiscountRate:
CAPM:J = r
po]cct
= r
]
+[
po]cct
E(r
m
-r
]
)
r
]
: Capitalprovidersmustearncompensationforthetimevalue
ofmoney.
[
po]cct
E(r
m
-r
]
): Capitalprovidersmustearncompensation
forbearingprojectrisk.
Question:Howtofindoutprojectrisk
pruject
?
Ans:(1)PurePlayApproach,(2)SubjectiveApproach.
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TheRiskandRewardTradeoffandtheRequiredRateof
ReturnonProjects
Firm
OperatingSide
OperatingCash
Flows
Operating(Business)
Risk
RequiredRateof
ReturnonFirms
OperatingAssets
Operations Overall
Cost of Capital
FinancingSide
Dividendsand
Interest Payments
Financial (Stocks,
Bond) Risks
RequiredRateof
ReturnonFirms
Financial Securities
Overall Cost of
Capital onFirms
Financial Securities
Afirmcanbeviewedasa:
PortfolioofOperatingAssets(projects),
orasa
PortfolioofFinancialAssets(Stocks,andBonds).
Theweightedaverageoftherequiredrateof
returnonthefirmsoperatingassets=the
weightedaverageoftherequiredrateofreturnon
thefirmsfinancialsecurities.
Assessingthemarketriskofthecompanys
operatingassetisveryhardtodo.
Assessingthemarketriskofthefirmsfinancial
securitiesismucheasierbecausebondandstock
pricesareobservable.
Conclusion:Theoverallcostofcapitalforthe
firmsoperations=theWeighedAverageofthe
CostofCapital(WACC) ofthefirmsfinancial
assets.
TheOperatingandFinancingSidesoftheFirm:
TwoSides oftheSameCoin
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TheOverallCostofCapitalforAllEquity
FinancedFirms
Foranallequityfinanced firm:
Owningthebusiness=Owningthestock
Valueofbusiness=Valueofstock
Riskofbusiness=Riskofstock
Requiredrateofreturnfrombusiness=RequiredRate
ofreturnonstock
Companycostofcapital=investorsrequiredrateof
returnonthecompanysstocks
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Thecapitalstructureofafirmreferstothemixoffinancialassetssoldto
investorstofinancethefirmsoperations.Forexample,1/3Debtand2/3
Equitymeansthatthefirmsvalueis1/3composedofDebtValueand
2/3composedofEquityValue(ie.V=E+D).
Onceweknowthefirmscapitalstructure,wecancomputethebetaof
thefirmsoperationsandexpectedreturns.
DefineV=D+E+P tobethecombinedmarketvalueofdebt,common
equityandpreferredequity
TheOverallCostofCapitalforDebtandEquity
FinancedFirms

D E
P
D E
P
V D E P
V D R E R P R
D E P
WAC
R R R
V V V
C
WACC
+
+ =
= + +
= +
| | | | | |
+
| | |
\ . \ . \ .
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CorporateTaxesandWACC
Recallthatinterestpaymentsaretaxdeductible,whiledividendsarenot.
Therefore,theactualcostofdebtislowerifthecompanypaystaxeson
profits.
Aftertaxcostofdebt
WACCwithtaxesinClassicalTaxSystem
WACCwithtaxesinImputationTaxSystem
(1 )
D
C E
P
D E P
WACC R T R R
V V V
+
| | | | | |
= +
| | |
\ . \ . \ .
(1 )
D C
R T =
! !
(1 ) (1 ) (1 ) +
| | | | | |
= +
| | |
\ . \ . \ .
D
E
C C P C
D E P
WACC R T R T R T
V V V
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EstimatingTheCostofEquityR
E
Thecostofequity isthereturnthatequityholdersrequireontheir
investmentinthefirm
TheDividendGrowthModelApproach (PVofagrowing
perpetuity):
P
0
: Pricepershareofthestock
D
1
: Thenextperiodprojecteddividend
g: Theconstantgrowthrateofdividends
R
E
: Therequiredreturnonthestock
Thisapproachonlyworksfordividendpayingfirms
1 1
0
0
, rearranging weget
E
E
D D
P R g
R g P
= = +

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DividendGrowthModelApproach
Advantages:
Thisapproachisverysimple.
Disadvantages:
Thisapproachmaybetoosimple.
Applicableonlyfordividendpayingfirms(otherwisecanuse
earningsgrowth).
Oftentimespeopleusehistoricaldatatopredictfuturegrowth.
Itisverysensitivetotheestimatedgrowthrate,sothereisa
largemarginforerror.
ItdoesnotexplicitlyconsiderriskliketheCAPMdoes.
EstimatingTheCostofEquityR
E
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VirtuesofTheSMLApproach
TheSMLApproach:
Advantages:
Itexplicitlyaccountsforrisk
Itisapplicabletoallcompanies,notjustforcompanies
withsteadydividendgrowth
Disadvantages
Iftheestimatesofthemarketriskpremiumandbetaare
poor,theresultingcostofequitycanbeinaccurate
Manypeopleusehistoricaldatatopredictfuturereturns.
Applicableonlyifstockpricesareobserved
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TheCostofDebtR
D
andPreferredStockR
P
The cost of debt is the return required by lenders (observable)
The cost of debt can be obtained using the SML approach if we know
the beta for the firms debt. Easier than that, it is the yield to
maturity on the firms bonds.
The coupon rate is not the cost of debt
Preferred stocks are stocks with dividend priority over common
stocks. They pay a fixed dividend rate, every period, for as long as
the firm exists.
The cost of preferred stock, R
P
, is thus the dividend yield on the
preferred stock
0
P 0
P
D D
P R
R P
= =
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Example:ABCscostofcapital
ABCsonlydebtissueisa20yrdebtwithafacevalueof$1.2Mandan
annualcouponrateof15%(thefirstcouponpaymentwasjustmade).
Today,thedebtispricedinthemarkettoyield8%.ABCalsohaspreferred
sharesoutstandingpricedat$56pershareandpaya10%dividendrateon
aparvalueof$100.ABCscommonshareshaveabetaof1.4,themarket
premiumis12%andtheriskfreerateis5%.
Whatistherequiredrateofreturnbypreferredshareholders?
Whatisthebeforetaxcostofdebt?
Whatistherequiredrateofreturnbycommonshareholders?
p
e
)
10% 100
17.86%
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thepre-tax required rateof return on thedebt is theyield to maturity 8%
r [ ] 5% 1.4 12% 21.80%
f m f
Solution
D
r
P
r E r r

= = =
= + = + = |
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Q:MarketValuesorBookValues?
A:alwaysusemarketvalues!
MarketValueofEquity:
E=#ofshares marketpricepershare
MarketValueofDebt:
D=#ofbondsoutstanding marketpriceperbond
Iftherearemultiplebonds,dothesameforeachbondand
add.
Ifdebtisnotpubliclytraded,thenfindasimilarpubliclytraded
bondandusetheyieldtodiscountthebondspaymentsto
PresentValue.
MeasuringCapitalStructure
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ABChas10,000preferredsharesoutstandingvaluedat$56and3M
commonsharesoutstandingpricedat$3.5.ABCscorporatetax
rateis35%.WhatisABCsoverallcostofcapital?
Example:ABCscostofcapitalcontd
e
19
19
1
pref
#of common shares oustanding=$3.5 3M=$10.5
15% $1.2 $1.2
$2.0067
(1.08) (1.08)
#of preferred shares oustanding=$56 10,000 $.56
$2.0067 $10.5 $.56 $13.0667M
t
t
E p M
M M
D M
P p M
V D E P M M M
D
WACC
V
=
=

= + =
= =
= + + = + + =
=

(1 )
2.0067 10.5 .56
8% (1 .35) 21.80% 17.86%
13.0667 13.0667 13.0667
19.08%
D
C E
P
E P
R T R R
V V
+
| | | | | |
+
| | |
\ . \ . \ .
= + +
=
7
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WACCisaweightedaverageoftherequireratesofreturnbyallthe
stakeholdersofthefirm.
WecanuseWACCasthediscountratetofindtheNPVofaproject
withthesamebusinessriskasthefirm.
IfNPV>0,thenacceptproject.Theprojectsreturnisgreaterthan
whatisdeemedappropriatebyourstakeholdersgiventheprojects
risk.
ApositiveNPVprojectincreasesfirmvaluebytheNPV.
Sinceshareholdersreceiveallupsidepotential(shareholdersarethe
residualclaimants),shareholderswealthincreasesbytheNPV
InterpretingWACC
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CompanyversusProjectRisk
Companycostofcapital: theexpectedrateofreturndemanded
bytheinvestorsinacompany,determinedbytheaverageriskof
thecompanysassetsandoperations(computedusingWACC).
Projectcostofcapital: minimumacceptedexpectedrateofreturn
onaproject,givenitsrisk.
Thecompanycostofcapitalisthecorrectdiscountratefor
projectsthathavethesame riskasthecompanysexisting
business.Thisistypicallythecaseforexpansionsofexisting
activities,orprojectsinthesameriskclassasthefirm.
However,sometimesprojectsmayhavedifferentriskthanthe
existingoperationsofthefirm.ThefirmsWACCisnotthecorrect
discountratefortheseprojects.
ConsistentlyusingtheWACCasthediscountrateforprojectswith
differingrisksresultsindeclineinfirmvalueandincreaseinfirms
riskovertime(seenextslide).
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CompanyversusProjectRisk
Project B
Project A
SM L
W ACC
0.0 0.5 1.0 1.5 2.0
0.00
0.05
0.10
0.15
0.20
0.25
beta
R
e
t
u
r
n
8
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EstimatingaProjectSpecificDiscountRate:PurePlay
Approach
Apureplayer:acompanythatfocusesonasinglelineof
businessiscalledapureplayer.
THEPUREPLAYAPPROACH:
1)Findpubliccompaniesthatinvestexclusivelyinthetypeof
projectunderevaluation.
Thesecompaniesarelikelytohavethesamemarketriskas
theprojectbeingevaluated.
2)ComputetheaverageoftheWACCofthesefirms.This
measureisthebestestimateoftheprojectsrequiredrateof
returngivenitssystematicrisks.Useittodiscountthe
projectscashflows.
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EstimatingaProjectSpecificDiscountRate:The
SubjectiveApproach
Because of the difficulties that exist in objectively establishing discount
rates for individual projects, firms sometimes adopt an approach that
involves making subjective adjustments to the companys overall WACC.
Steps in the Subjective Approach:
1) Create different risk categories relative to the firms overall business
risk (high, moderate and low risk, for example).
2) Assign a risk adjustment to the benchmark WACC for each risk
category
3) Use the adjusted rate as the discount rate for the project based on
the risk category of the project
Projects discount rate = WACC +/ risk adjustment
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TheSubjectiveApproach
Project B
Project A
SML
WACC
WACC + Adjustme
WACC - Adjustment
0.0 0.5 1.0 1.5 2.0
0.00
0.05
0.10
0.15
0.20
0.25
beta
R
e
t
u
r
n
9
Thetradeoffbetweenriskandrewardisafundamentalconceptinfinance.
Likefinancialsecurities,projectsmustcompensateinvestorsforrisk.
Thediscountrateusedinprojectevaluationmustreflectprojectsbusiness
risk(projectbeta).
Thecorrectapproachtocapitalbudgetingistousemarketriskconceptsto
valueprojects
Ifexactmarketriskisnotattainable,thenmanagermusttrytobeascloseto
itaspossible.
WorkonallCriticalthinkingandconceptreviewproblems
QuestionsandProblems:2,4,5,6,7,8,9,10,12,15,16,17,22,26,27,28,29
FINS1613S2Yr2013KyungHwanShim 25
Conclusions