Session 6, 7 and 8.

Cost of Capital
PGP, IIM INDORE
Discount rate
•Opportunity cost of capital: The return investors could earn on alternative investments of equal
risk
•An appropriate rate that reflects the riskiness of cash flows
• The denominator in the NPV
• Risk: Likelihood that we will receive returns that are different from the returns we expect

•The terms discount rate, required return, and cost of capital – used interchangeably
Company and Project Costs of Capital
Weighted Average Cost of Capital
◦Traditional measure of capital structure, risk and return
𝐷 𝐸
◦𝑊𝐴𝐶𝐶 = ∗ 𝑘𝑑 ∗ 1 − 𝑡 + 𝑘𝑒
𝑉 𝑉
◦V = D+E
◦Because interest expense is tax-deductible, we multiply
the cost of debt by (1 – TC).
Weights in WACC
Note on WACC
Weights in WACC
◦ Market value weights
◦ Target Capital Structure -Weights should represent the long-term target capital structure (if the same is
known)
◦ Consistent rates to be used in deriving cost of equity and WACC
Cost of Debt
Cost of Debt
•Expected return on a long-term debt obligation of a credit quality that corresponds to the
capital structure ratios built into the WACC Formula
Find the yield on the company’s debt, if it has any.
The interest rate likely to be charged on new debt.
Find the bond rating for the company and use the yield on other bonds with a similar rating.
• Default spread
• Rd = Rf + Default spread
• Example - Company debt outstanding (non-traded) – $100 mn, and it has debt rating of A+. The
prevailing default spread on A+ rated securities is 1.5% and the risk free rate is 5%. Then the cost of
debt for this company is 6.5%
Example – Corporate bond Default
Spreads as per credit rating
•Spread over risk free rate
Bond rating Corporate Bond Default spread
AAA 0.75% •Default risk premium
AA 1.02% •If risk free rate is 4.75%, then yield on a AAA
A+ 1.52% rated bond would be 5.5%
A 1.60%
A- 1.75%
BBB+ 2.79%
BBB 2.87%
BBB- 3.89%
BB+ 6.67%
BB 6.74%
BB- 6.95%
B+ 8.53%
B 9.95%
B- 10.71%
Example – Corporate bond yields as per
credit rating
Bond rating Corporate Bond Yields

AAA 5.50%
AA 5.77%
A+ 6.27%
A 6.35%
A- 6.50%
BBB+ 7.54%
BBB 7.62%
BBB- 8.64%
BB+ 11.42%
BB 11.49%
BB- 11.70%
B+ 13.28%
B 14.70%
B- 15.46%
Cost of equity
The Cost of Equity Capital
•From the firm’s perspective, the expected return is the Cost of Equity Capital:

R s  RF  β ( R M  RF )
•To estimate a firm’s cost of equity capital, we need to know three things:
1. The risk-free rate, RF
2. The market risk premium,
3. The company beta
Cost of equity: CAPM
•Marginal investor: A well diversified investor that is most likely to trade next
• the only risk that he or she perceives in an investment is risk that cannot be diversified away (i.e, market
or non-diversifiable risk)
• The only risk for which she earns a risk premium for: systematic risk
Example
Suppose the stock of Stansfield Enterprises, a publisher of
PowerPoint presentations, has a beta of 1.5. The firm is 100% equity
financed.
Assume a risk-free rate of 3% and a market risk premium of 7%.
What is the appropriate discount rate for an expansion of this firm?

R s  3 %  1 .5  7 % R s  13.5%
Risk free rate
•Risk free: actual return = expected return
• No default risk
• No reinvestment risk

•Returns on Government Security

• Yield to Maturity on a long term Treasury bond

•Long-term for a going concern, else the maturity should meet the projected cash flow period
• Match the duration of the analysis to the duration of the risk free rate
• Alternate Approach: CAPM is a period model, hence use T-bill rate

•Debate between using T-bill rate or Treasury bond rate

•Currency choices, and nominal vs. real rates – consistent with cash flows
Market risk premium
•Risk Premium:
• Measures “extra returns” for making an average risk investment rather than risk-free investment.
• Function of risk aversion of an investor
•Estimating Risk premium:
• Historical premium
• Time period used: Estimation as back as 1926, 50 yrs, 20 yrs, 10 yrs

•Mistake to avoid: Historical data for market returns, and current long-term bond
yield
Market risk premium
•Pratt and Grabowski (2008)
• Range for MRP of 3.5% to 6 %, point estimate of 5 % as of 2007

•Fernandez, Aguirreamalloa and Linares (2013)

• MRP in India based on a survey as on June 2013 – 8.5%
• Risk free rate – 6.9 % for India
• Survey on MRP for other countries as well in the same paper

•Many analysts derive estimates from historical data on US Stock and bond returns published by
Ibbotson Intl.
Recap
•The Weighted Average Cost of Capital
• Market value weights
• Tax savings on account of interest

•Cost of Debt
• YTM or Kd=Rf + DRP

•Cost of Equity
• Risk free rate
• Market risk premium
• Beta
Estimation of Beta
Market Portfolio - Portfolio of all assets in the economy. In practice,
a broad stock market index, such as the S&P 500, is used to
represent the market.
Beta - Sensitivity of a stock’s return to the return on the market
portfolio.
Beta (CONTD.)
•Determinants of Beta:
• Type of business – cyclical / non-cyclical, operating leverage, financial leverage
•Highly cyclical stocks have higher betas.
◦ Empirical evidence suggests that automotive firms, luxury products, fluctuate with the business cycle.
◦ Food / Staples, beverages, tobacco, FMCG, household and personal products, utilities and others - are
less dependent on the business cycle.

•Operating Leverage
 Operating leverage increases as fixed costs rise and variable costs fall.
 Other things being equal, higher ratio of fixed costs to project value will have higher beta
Financial Leverage and Beta
•Financial leverage is the sensitivity to a firm’s fixed costs of financing.
•The relationship between the betas of the firm’s debt, equity, and assets is
given by:
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
𝛽𝑎𝑠𝑠𝑒𝑡 = ∗ 𝛽𝑑𝑒𝑏𝑡 + 𝛽𝑒𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡+𝐸𝑞𝑖𝑡𝑦 𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦
•Financial leverage increases the equity beta relative to the asset beta.
Example
•Consider Grand Sport, Inc., which is currently all-equity financed and has a beta of
0.90.
•The firm has decided to lever up to a capital structure of 1 part debt to 1 part
equity.
•Since the firm will remain in the same industry, its asset beta should remain 0.90.
•Assuming a zero beta for its debt, calculate its equity beta.
1
•𝛽𝑎𝑠𝑠𝑒𝑡 = 0.90 = ∗ 𝛽𝑒𝑞𝑢𝑖𝑡𝑦
1+1
•𝛽𝑒𝑞𝑢𝑖𝑡𝑦 = 2 ∗ 0.90 = 1.80
Beta and leverage
•If beta of debt is assumed to be zero:
𝑉
•𝛽𝑒𝑞𝑢𝑖𝑡𝑦 = 𝛽𝑎𝑠𝑠𝑒𝑡 ∗
𝐸

•There is alternate formula derived by Robert Hamada:

𝐷
•𝛽𝑒𝑞𝑢𝑖𝑡𝑦 = 𝛽𝑎𝑠𝑠𝑒𝑡 ∗ [1 + { 1 − 𝑡 ∗ }]
𝐸
A numerical Example: WACC
Example: International Paper
 The beta is 0.82, the risk free rate is 3%, and the market risk premium
is 8.4%.
 Thus, the cost of equity capital is:

RS = RF + bi × ( RM – RF)

= 3% + 0.82×8.4%

= 9.89%
Example: International Paper
•The yield on the company’s debt is 8%, and the firm has a 37% marginal tax rate.
•The debt to value ratio is 32%
S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
•8.34% is International Paper’s cost of capital.
•It should be used to discount any project where one believes that the project’s risk is equal to
the risk of the firm as a whole
Company and Project Cost of Capital
•Suppose the Conglomerate Company is an all equity firm. The risk-free rate is 4%, the market
risk premium is 10%, and the firm’s beta is 1.3.
•Cost of capital as per CAPM:
• 17% = 4% + 1.3 × 10%
•This is a breakdown of the company’s investment projects:
• 1/3 Automotive Retail b = 2.0
• 1/3 Computer Hard Drive Manufacture b = 1.3
• 1/3 Electric Utility b = 0.6
• Average b of assets = 1.3

• When evaluating a new electrical generation investment, which cost of capital should be used?
 Capital Budgeting & Project Risk
SML

return 24%
Project
Investments in hard
drives or auto retailing
17%
should have higher
10% discount rates.

Project’s risk (b)

0.6 1.3 2.0
R = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of
the project.
Capital Budgeting & Project Risk

Project IRR
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle
R F  β FIRM ( R M  R F )
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
bFIRM
Assume this is an all equity firm, and the firm’s cost of capital is the cost of
equity
Should the company use the same WACC (i.e., company WACC) as the
hurdle rate for each of its divisions/projects?
•NO! The company WACC reflects the risk of an average project undertaken by the firm.
• Company WACC is appropriate for discounting the cash flows of division/project with average risk as
the business
•Different divisions/projects may have different risks.
• The division’s WACC should be adjusted to reflect the division’s risk
Methods for Estimating Beta for a Division or a Project
•Pure play: Find a set of publicly traded companies exclusively in project’s/division’s business.
• Use average of their betas as proxy for project’s beta.
•Detailed steps (USING PURE PLAY firms)
• Pure play approach - Identify the business lines, i.e., industry (for the division or the project)
• Estimate unlevered (asset) beta for comparable public firms in the corresponding industry
• Estimate simple or weighted average of unlevered betas
• Estimate levered beta by current market value of debt and equity
Data on Industry peers (pure plays)
Company Equity Beta Debt proportion in total capital

ABCL Corp. 1.45 20%

National Media Corp. 1.75 33.33%

Tax rate 30%

Data on Industry peers (pure plays)
Unlevered beta
Company Equity Beta Debt proportion in total capital D/E
(Hamada)

ABCL Corp. 1.45

20% 0.25 1.23
National Media Corp. 1.75
33.33% 0.50 1.296
Average 2.526
Reference
•Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education.