Choosing the Right Discount Rate

The numerator focuses on projected cash flows –

we’ll discuss how to do this shortly

The Cost of Capital NPV = CF0 +

CF1
+
CF2
+
CF3
+ ... +
CFN
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) N

Finance 221 The denominator is the discount rate, the focus of

today’s discussion
Summer 2006
Reflect opportunity costs to firm’s investors
The
denominator Reflect the project’s risk
should:
Be derived from market data 2

The Cost of Capital WACC - Components

Definition: A company’s cost of capital is the rd Cost of debt (before tax)
expected return on a portfolio of all the company’s
existing securities. It is used to discount the cash flows
rd(1-tc) After-tax cost of debt
on projects that have similar risk to that of the firm as a
whole.
rp Cost of preferred stock
Often called a “hurdle rate” ⇒ Shareholder value
increases if the firm invests in projects for which earn re Cost of equity. Two Sources: (1)
more than the cost of capital. Retained Earnings, (2) new issues.
Weighted Average Cost of Capital.
WACC Represents the expected return on a
3
portfolio of all the firm’s securities. 4

WACC – Project vs. Firm Risk WACC – Project vs. Firm Risk
The WACC is the right hurdle rate for projects that So why are we going to learn how to calculate the
have the same risk as the firm’s existing business; company cost of capital?

If a project under consideration is more risky than
the firm as a whole, the cost of capital needs to
be adjusted upward so that the project’s cash
flows are discounted at a higher rate. Conversely,
a lower cost of capital is needed for projects that
are safer than the average risk of the firm.
5 scratch.
1. Most projects can be treated as average risk –
many projects will be focused on the company’s
main line of business. Company WACC is
appropriate here.
2. The company WACC is a good starting point – it
is easier to make adjustments to WACC than try
to estimate the project’s cost of capital from
6

1
A Simple Case: All-Equity Firm Pfizer – Cost of Equity
Project discount rate is easy to determine if we Pfizer (1990 - 2005)
Pfizer Return = 0.008619 + 0.7067 Market Return
assume :
0
0.3 S 0.0682330
R-Sq 16.2%
R-Sq(adj) 15.7%
0.2
Firm is financed with 100% Project is similar to the
equity firm’s existing assets

Pfizer Return
0.1

In this case, the appropriate discount rate equals the

cost of equity. 0.0 0

-0.1
Cost of equity estimated using the CAPM
-0.2
re = E ( Ri ) = RF + β i ( E ( Rm ) − RF ) -0.15 -0.10 -0.05 0.00 0.05 0.10
7 Market Return 8

Pfizer - Cost of Equity CAPM and the Cost of Equity

Pfizer, an all-equity firm, is evaluating a proposal to
build a new manufacturing facility.
• We found that Pfizer’s beta was 0.71.
• The standard error of the estimate of beta was
• Firm develops and produces pharmaceutical 0.12.
products (Celebrex, Viagra, Benadryl, etc.). • A 95% confidence interval for beta is
• As a pharmaceutical company, cash flows
are relatively insensitive to economy 0.71 ± (1.96) × 0.12 = (0.47,0.95)
(product demand is inelastic).
• Pfizer’s stock has a beta of 0.71 • This implies that a 95% confidence interval for
• Managers note Rf = 5%, expect the market Pfizer’s cost of equity is (7.82%, 10.7%)
return will be 11%. • ⇒ Industry betas commonly used
re = Rf + β(E(Rm) - Rf) = 5% + 0.71(11%-5%)
= 9.26% cost of equity 9 10

Does Beta Change Over Time? Does Beta Change Over Time?
Pfizer (1990 - 1997) Pfizer (1998 - 2005)
Pfizer Return = 0.01183 + 1.198 Market Return Pfizer Return = 0.000667 + 0.4240 Market Return
0 0
0.3 S 0.0637416 0.2 S 0.0683663
R-Sq 30.2% R-Sq 8.4%
R-Sq(adj) 29.5% R-Sq(adj) 7.4%

0.2 0.1
Pfizer Return

Pfizer Return

0.1
0.0 0

0.0 0
-0.1

-0.1 βˆ = 1.198 βˆ = 0.424

-0.2
-0.10 -0.05 0.00 0.05 0.10 -0.15 -0.10 -0.05 0.00 0.05 0.10
Market Return 11 Market Return 12

2
Cost of Equity: Another Approach Example
Recall the Gordon Growth (constant dividend Allied Steel’s stock currently sells for $23 per
growth) Model share. The next dividend (paid at the end of the
D1 year) is expected to be $1.24. Internal analysis
P0 = suggests that the expected growth rate in
re − g dividends is 8% per year. What is Allied’s cost of
equity?
Rearranging and solving for re gives:

D1 $1.24
rˆe = + E(g) re = + .08 = .054 + .08 = 0.134 ⇒ 13.4%
P0 $23
= the dividend yield plus an estimate of the
expected growth rate 13 14

Capital Structure Cost of Capital: Debt and Preferred Stock

A firm’s capital structure refers to the mix of

debt and equity (both common and preferred) that Interest rate on the firm’s marginal
a firm uses to finance its activities. rd debt. Not necessarily the interest
rate on current debt outstanding.
A value-maximizing firm will determine its
optimal capital structure – this is often Simply equals the dividend yield for
called the firm’s target capital structure. rp preferred stock (preferred dividend
amount dividend by the current price
New capital will be raised to keep the
of preferred stock) = Dp/Pp
capital structure near the target over time.

15 16

The Weighted Average Cost of Finding WACC for Firms with

Capital (WACC): No Taxes Complex Capital Structures
Cost of equity applies to projects of an all-equity How do we calculate WACC if firm has long-term (D)
firm. debt as well as preferred (P) and common stock (E)?
• But what if firm has both debt and equity? ⎛ E ⎞ ⎛ D ⎞ ⎛ P ⎞
• Problem is akin to finding expected return of WACC = ⎜ ⎟re + ⎜ ⎟rd + ⎜ ⎟rp
portfolio. ⎝E+D+P⎠ ⎝E+D+P⎠ ⎝E+D+P⎠
Use weighted average cost of capital (WACC) as Has 1,000,000 common shares; price =
$50/share; re = 15%.
discount rate. An example....
Has 200,000 preferred shares, 8% coupon, price
• Lox-in-a-Box is a chain of fast food stores. S.D. Williams = $80/share, 10% rate of return, $16 million
Total value = value.
• Firm has $100 million equity (E), with cost of equity re = 15%; $50 million
• Also has bonds (D) worth $50 million, with rd = 9%. Has $47.1 million long term debt, fixed rate
notes with 8% coupon rate, but 7% YTM.
• Assume that the investment considered will not change the cost Notes sell at premium and worth $49 million.
structure or financial structure.
⎛ D ⎞ ⎛ E ⎞ ⎛ 50 ⎞ ⎛ 100 ⎞ ⎛ 50 ⎞ ⎛ 49 ⎞ ⎛ 16 ⎞
WACC = ⎜ ⎟rd + ⎜ ⎟re = ⎜ ⎟9% + ⎜ ⎟15% = 13% WACC = ⎜ ⎟15% + ⎜ ⎟7% + ⎜ ⎟10% = 10.9%
⎝D+E⎠ ⎝D+E⎠ ⎝ 50 + 100 ⎠ ⎝ 50 + 100 ⎠ 17
⎝ 115 ⎠ ⎝ 115 ⎠ ⎝ 115 ⎠ 18

3
Rules for Selecting an Appropriate
Project Discount Rate Project Cost of Capital vs. WACC

Cost of equity is the appropriate discount rate for 15

Acceptance Region
an all-equity firm. 14
WACC
13

12

11
When a levered firm invests in a project similar to 10 A
H
Rejection Region
its existing projects, the WACC is the right

Rate of Return
9

discount rate. 8 B
7

6 L

5
When a firm invests in a project different than its 4
existing projects, using the WACC may lead to 3

mistakes. 2

0
Low Average High
19 Risk Risk Risk RISK 20

Accounting for Taxes in Finding

Divisional Cost of Capital WACC
We have thus far assumed away taxes, which are
15 often important in financing decisions.
14

13 WACC • Tax deductibility of interest payments favors use

12
Division H's WACC
of debt.
• Accounting for interest tax shields yields after-
11

10 Project H

tax WACC.
Rate of Return

⎛ D ⎞ ⎛ E ⎞
Com posite WACC
8 Project L

WACC= ⎜ ⎟(1 − tc )rd + ⎜

for Firm A
7
⎟re
6 Division L's WACC
⎝ D+ E⎠ ⎝ D+ E⎠
5

Accounting for taxes doesn’t change the rules for

3

1
selecting the discount rate.
0
Low Average High
Risk Risk Risk RISK 21 22

Example Example
Firm A’s capital structure contains 20% debt and 80% A firm has a capital structure containing 40% debt, 20% preferred
equity. Firm B’s capital structure contains 50% debt and stock, and 40% common stock equity. The firm’s debt has a
50% equity. Both firms pay 7% annual interest on their yield-to-maturity of 8.1% and its preferred stock annual dividend
debt. The stock of Firm A has a beta of 1.0 and the stock of is $3.10 and the preferred stock’s current market price is $50.00
per share. The firm’s common stock has a beta of 0.90 and the
Firm B has a beta of 1.375. The risk-free rate is 4% and the
risk-free rate and market return are 4% and 13.5%, respectively.
expected return on the market portfolio is 12%
The firm is subject to a 40% marginal tax rate.

1. Calculate the WACC for each firm assuming no taxes.

1. What is the firm’s cost of preferred stock?
2. Recalculate the WACC for each firm assuming the firms
face a marginal tax rate of 34%. 2. What is the firm’s cost of equity?

3. What impact did taxes have in this example? 3. Calculate the firm’s after-tax WACC.

23 24