Chapter 4 Cost of Capital

Chapter 4
The Cost of Capital
To Thi Thanh Truc

Faculty of Finance and Banking
University of Economics and Law
4-1
Learning outcomes
After studying this chapter you should be able to:
 Define the overall “cost of capital” of the firm.
 Explain why the weighted average cost of capital (WACC) is used
in capital budgeting.
 Estimate the costs of different capital components—debt, preferred
stock, retained earnings, and common stock.
 Combine the different component costs to determine the firm’s
WACC.
 Understand pitfalls of overall cost of capital and how to manage
them
4-2
Materials
 Handout
 Brigham & Houston, Fundamentals of financial
management, chapter 10.
 Ross, Westerfield, Jordan, Fundamentals of Corporate
finance, chapter 14.
 Jim DeMello, 2006, Cases in Finance, Mc Graw- Hill (Case
19, 20)
4-3
Outline
 The Cost of Capital: Some Preliminaries
 The Cost of Equity
 The Costs of Debt and Preferred Stock
 Divisional and Project Costs of Capital
 Flotation Costs and the Weighted Average
Cost of Capital
4-4
Some Preliminaries
4-5
What is Cost of Capital
The required rate of return on the various

types of financing. The overall cost of capital
is a weighted average of the individual
required rates of return (costs).
4-6
Why Cost of Capital Is
Important?
 We know that the return earned on assets
depends on the risk of those assets
 Our cost of capital provides us with an
indication of how the market views the risk of
our assets
 Knowing our cost of capital can also help us
determine our required return for capital
budgeting projects
4-7
Required Return
 The required return is the same as the appropriate
discount rate and is based on the risk of the cash
flows
 We need to know the required return for an
investment before we can compute the NPV and
make a decision about whether or not to take the
investment
 We need to earn at least the required return to
compensate our investors for the financing they
have provided
4-8
What sources of long-term
capital do firms use?
Long-Term
Capital
Long-Term Preferred Common

Debt Stock Stock
Retained New Common

Earnings Stock
4-9
Calculating the weighted
average cost of capital
WACC = wdrd(1-T) + wprp + wcrs
 The w’s refer to the firm’s capital

structure weights.
 The r’s refer to the cost of each
component.
4-10
How are the weights determined?
 Use accounting numbers or market

value (book vs. market weights)?
 Use actual numbers or target capital
structure?
4-11
Capital Structure Weights
 Notation
 E = market value of equity = # of outstanding
shares times price per share

 D = market value of debt = # of outstanding
bonds times bond price

 V = market value of the firm = D + E
 Weights
 wE = E/V = percent financed with equity
 wD = D/V = percent financed with debt
4-12
Taxes and the WACC
 We are concerned with after-tax cash flows,
so we also need to consider the effect of
taxes on the various costs of capital
 Interest expense reduces our tax liability
 This reduction in taxes reduces our cost of debt
 After-tax cost of debt = rd(1-T)
 Dividends are not tax deductible, so there is
no tax impact on the cost of equity
4-13
Should our analysis focus on
historical (embedded) costs or new
(marginal) costs?
 The cost of capital is used primarily to

make decisions that involve raising new
capital. So, focus on today’s marginal
costs (for WACC).
4-14
Overview of Coleman
Technologies Inc.
Firm calculating cost of capital for major expansion
program.
 Tax rate = 40%.
 15-year, 12% coupon, semiannual payment noncallable bonds sell for

$1,153.72. New bonds will be privately placed with no flotation cost.
 10%, $100 par value, quarterly dividend, perpetual preferred stock sells for
$111.10.
 Common stock sells for $50. D0 = $4.19 and g = 5%.
 b = 1.2; rRF = 7%; RPM = 6%.
 Bond-Yield Risk Premium = 4%.
 Target capital structure: 30% debt, 10% preferred, 60% common equity.
4-15
Overview of Coleman
Technologies Inc.
Number of shares not given in problem, so actual

calculations cannot be done. Analysis is meant
for illustration. Typically, book value capital
structure will show a higher percentage of debt
because a typical firm’s M/B ratio > 1.
4-16
Cost of debt
4-17
Cost of debt
 rd is the marginal cost of debt capital.

That is the required return on the
company’s debt.
 Why tax-adjust, i.e. why rd(1-T)?
4-18
Cost of Debt
 We usually focus on the cost of long-term
debt or bonds
 The required return is best estimated by
computing the yield-to-maturity on the
existing debt
 We may also use estimates of current rates
based on the bond rating we expect when
we issue new debt
 The cost of debt is NOT the coupon rate
4-19
Case: Coleman Technologies
Cost of Debt
 The current price of Coleman’s 12%
coupon, semiannual payment, noncallable
bonds with 15 years remaining to maturity
is $1,153.72. Coleman does not use short-
term interest-bearing debt on a permanent
basis. New bonds would be privately placed
with no flotation cost. What is cost of debt?
4-20
A 15-year, 12% semiannual coupon
bond sells for $1,153.72. What is
the cost of debt (rd)?
 Remember, the bond pays a semiannual
coupon, so rd = 5.0% x 2 = 10%.
INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5
4-21
Cost of debt
 Interest is tax deductible, so
A-T rd = B-T rd (1-T)
= 10% (1 - 0.40) = 6%
 Use nominal rate.
 Flotation costs are small, so ignore
them.
4-22
Cost of preferred stock
4-23
Cost of preferred stock
 rp is the marginal cost of preferred stock,

which is the return investors require on a
firm’s preferred stock.
 Preferred dividends are not tax-deductible,
so no tax adjustments necessary. Just use
nominal rp.
 Our calculation ignores possible flotation
costs.
4-24
Cost of Preferred Stock
 Reminders
 Preferred stock generally pays a constant
dividend each period

 Dividends are expected to be paid every
period forever
 Preferred stock is a perpetuity, so we take the
perpetuity formula, rearrange and solve for rP
 rP = D / P0
4-25
Cost of Preferred Stock
 Coleman has preferred stock that has an
annual dividend of $10. If the current
price is $111.1, what is the cost of
preferred stock?
 rP = 10/ 111.1 = 9%
4-26
Is preferred stock more or less
risky to investors than debt?
 More risky; company not required to pay
preferred dividend.
 However, firms try to pay preferred dividend.
Otherwise, (1) cannot pay common dividend,
(2) difficult to raise additional funds, (3)
preferred stockholders may gain control of
firm.
4-27
Cost of Equity
4-28
Cost of Equity
 rs is the marginal cost of common equity

using retained earnings.
 The rate of return investors require on the

firm’s common equity using new equity is
r e.
4-29
Cost of Equity
 The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm
 Business risk
 Financial risk
 There are three major methods for

determining the cost of equity
 Dividend growth model
 SML or CAPM
 Cost of debt plus risk premium

4-30
Three ways to determine the
cost of common equity, rs
 DCF (DGM): rs = (D1 / P0) + g
 CAPM: rs = rRF + (rM – rRF) b
 Own-Bond-Yield-Plus-Risk-Premium:
rs = rd + RP
4-31
The DCF Approach (Dividend
growth model - DGM)
 Start with the dividend growth model
formula and rearrange to solve for rs
D1
P0 
rs  g
D1
rs  g
P0
4-32
Cost of Equity DCF
 Coleman’s common stock is currently selling for

$50.00 per share. Its last dividend (D0) was
$4.19, and dividends are expected to grow at a
constant rate of 5% in the foreseeable future.
Coleman’s beta is 1.2, the yield on T-bonds is
7%, and the market risk premium is estimated to
be 6%. For the bond-yield-plus-riskpremium
approach, the firm uses a risk premium of 4%
4-33
Cost of Equity - DCF Model
D1 = D0 (1 + g)
D1 = $4.19 (1 + .05)
D1 = $4.3995
rs = (D1 / P0) + g
= ($4.3995 / $50) + 0.05
= 13.8%
4-34
Can DCF methodology be applied if
growth is not constant?
 Yes, nonconstant growth stocks are
expected to attain constant growth at
some point, generally in 5 to 10 years.
 May be complicated to compute.
4-35
Advantages and Disadvantages of
DCF Model (DGM)
 Advantage – easy to understand and use
 Disadvantages
 Only applicable to companies currently paying
dividends
 Not applicable if dividends aren’t growing at a
reasonably constant rate
 Extremely sensitive to the estimated growth
rate – an increase in g of 1% increases the cost
of equity by 1%
 Does not explicitly consider risk
4-36
The CAPM Approach
 Use the following information to compute
our cost of equity
 Risk-free rate, rRF
 Market risk premium, rM – rRF
 Systematic risk of asset, 
rs  rRF  β (rM  rRF )
4-37
Cost of Equity - CAPM
If the rRF = 7%, RPM = 6%, and the

firm’s beta is 1.2, what’s the cost of
common equity based upon the CAPM?
rs = rRF + (rM – rRF) b

= 7.0% + (6.0%)1.2 = 14.2%
4-38
Advantages and
Disadvantages of CAPM
 Advantages
 Explicitly adjusts for systematic risk
 Applicable to all companies, as long as we can

estimate beta
 Disadvantages
 Have to estimate the expected market risk
premium, which does vary over time
 Have to estimate beta, which also varies over time
 We are using the past to predict the future, which

is not always reliable
4-39

= 7.0% + (6.0%)1.2 = 14.2%
4-40


= 7.0% + (6.0%)1.2 = 14.2%
4-41
Find rs Using the Bond-Yield-Plus-Risk-
Premium Approach
rd = 10% and RP = 4%.

 This RP is not the same as the CAPM RPM.
 This method produces a ballpark estimate of
rs, and can serve as a useful check.
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
4-42
What is a reasonable final
estimate of rs?
Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%
4-43
Why is there a cost for
retained earnings?
 Earnings can be reinvested or paid out as
dividends.
 Investors could buy other securities, earn a return.
 If earnings are retained, there is an opportunity
cost (the return that stockholders could earn on
alternative investments of equal risk).
 Investors could buy similar stocks and earn rs.
 Firm could repurchase its own stock and earn rs.
4-44
The Weighted Average Cost of
Capital
 We can use the individual costs of capital that
we have computed to get our “average” cost of
capital for the firm.
 This “average” is the required return on the
firm’s assets, based on the market’s perception
of the risk of those assets
 The weights are determined by how much of
each type of financing is used
4-45
What is the firm’s WACC?

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
4-46
What factors influence a
company’s composite WACC?
 Market conditions.
 The firm’s capital structure and
dividend policy.
 The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.
4-47
Extended Example – WACC - I
 Equity  Debt Information
Information  $1 billion in
 50 million shares outstanding debt
(face value)
 $80 per share
 Current quote = 110
 Beta = 1.15
 Coupon rate = 9%,
 Market risk premium
semiannual coupons
= 9%
 15 years to maturity
 Risk-free rate = 5%
 Tax rate = 40%
4-48
Extended Example – WACC -
II
 What is the cost of equity?
 RE = 5 + 1.15(9) = 15.35%
 What is the cost of debt?
 N = 30; PV = -1,100; PMT = 45; FV =
1,000; CPT I/Y = 3.9268
 RD = 3.927(2) = 7.854%
 What is the after-tax cost of debt?
 RD(1-TC) = 7.854(1-.4) = 4.712%
4-49
Extended Example – WACC -
III
 What are the capital structure weights?
 E = 50 million (80) = 4 billion
 D = 1 billion (1.10) = 1.1 billion
 V = 4 + 1.1 = 5.1 billion
 wE = E/V = 4 / 5.1 = .7843
 wD = D/V = 1.1 / 5.1 = .2157
 What is the WACC?
 WACC = .7843(15.35%) + .2157(4.712%)
= 13.06% 4-50
Eastman Chemical I
 Click on the web surfer to go to Yahoo Finance to get
information on Eastman Chemical (EMN)
 Under profile, you can find the following information
 # of shares outstanding
 Book value per share
 Price per share
 Beta
 Under analysts estimates, you can find analysts

estimates of earnings growth (use as a proxy for
dividend growth)
 The bonds section at Yahoo Finance can provide the T-
bill rate
 Use this information, along with the CAPM and DGM to
estimate the cost of equity 4-51
Eastman Chemical II
 Go to NASD’s bond information to get market
information on Eastman Chemical’s bond issues
 Enter Eastman Ch to find the bond information
 Note that you may not be able to find
information on all bond issues due to the

illiquidity of the bond market
 Go to the SEC site to get book market information
from the firm’s most recent 10Q
4-52
Eastman Chemical III
 Find the weighted average cost of the
debt
 Use market values if you were able to get
the information
 Use the book values if market information
was not available
 They are often very close
 Compute the WACC
 Use market value weights if available 4-53
Flotation costs
4-54
Flotation costs
 If a company accepts a new project, it may
be required to to issue new bonds and stocks.
This means that the firm will incur some
costs, which is flotation costs.
 Companies generally use an investment
banker when they issue new stocks and
bonds. In return for a fee, investment bankers
help the company structure the terms, set a
price for the issue, and sell the issue to
investors.
 The bankers’ fees are called flotation costs.
4-55
Flotation costs
 Flotation costs depend on the firm’s risk
and the type of capital being raised.
 Flotation costs are highest for common
equity. However, since most firms
issue equity infrequently, the per-
project cost is fairly small.
4-56
How to account for flotation
costs?
 Two approaches:
 The firm’s WACC should be adjusted
upward to reflect flotation costs.
 Add flotation costs to a project’s initial
costs
4-57
Flotation Costs – adjust upward
WACC
 If there are flotation costs, the issuing firm receives
only a portion of the capital provided by investors, with
the remainder going to the underwriter.
 To provide investors with their required rate of return
on the capital they contributed, each dollar the firm
actually receives must “work harder”
 That is, each dollar must earn a higher rate of return
than the investors’ required rate of return
4-58
Flotation Costs – adjust upward
WACC
 Cost of capital is the discount rate that equates the
present value of CFs the firm have to pay investors with
the useable capital today.
 For common equity: re = D1/P0(1-F) + g
 For preferred stock: rp = D/P0(1-F)
 For debt:
P0(1-F) = C/(1+rd) + C/(1+rd)2 +…+ C/(1+rd)n + FV/(1+rd)n
4-59
Coleman Technologies:
If issuing new common stock incurs a flotation
cost of 15% of the proceeds, what is re?
D 0 (1  g)
re  g
P0 (1 - F)
$4.19(1.05 )
  5.0%
$50(1 - 0.15)
$4.3995
  5.0%
$42.50
 15.4%
4-60
Flotation Costs – considered
as initial cost of project
 The required return depends on the risk, not how the
money is raised
 However, the cost of issuing new securities should not just
be ignored either
 Basic Approach
 Compute the weighted average flotation cost
 Use the target weights because the firm will issue
securities in these percentages over the long term
4-61
NPV and Flotation Costs -
Example
 Your company is considering a project that will cost $1
million. The project will generate after-tax cash flows
of $250,000 per year for 7 years. The WACC is 15%
and the firm’s target D/E ratio is .6 The flotation cost
for equity is 5% and the flotation cost for debt is 3%.
What is the NPV for the project after adjusting for
flotation costs?
 FA = (.375)(3%) + (.625)(5%) = 4.25%
 PV of future cash flows = 1,040,105
 NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281
 The project would have a positive NPV of 40,105
without considering flotation costs
 Once we consider the cost of issuing new securities,
the NPV becomes negative 4-62
Divisional and Project Costs
of Capital
4-63
Divisional and Project Costs of
Capital
 Using the WACC as our discount rate is only
appropriate for projects that have the same
risk as the firm’s current operations
 If we are looking at a project that does NOT
have the same risk as the firm, then we need
to determine the appropriate discount rate for
that project
 Divisions also often require separate
discount rates
4-64
Risk and cost of capital
Rate of Return
(%) Acceptance Region
W ACC
12.0 H
10.5 A Rejection Region

10.0
9.5 B
8.0 L
Risk
0 Risk L Risk A Risk H 4-65
Cost of capital for projects with
different risk
Rate of Return
(%)
WACC
Division H’s WACC
13.0
Project H
11.0
10.0
Composite WACC
9.0 Project L
for Firm A
7.0 Division L’s WACC
Risk
0 RiskL Risk Average RiskH
4-66
Divisional and Project Costs of
Capital
 Note, if the company correctly risk-adjusted the
WACC, then it would select Project L and reject
Project H.
 Alternatively, if the company didn’t risk-adjust
and instead used the composite WACC for all
projects, it would mistakenly select Project H and
reject Project L.
4-67
The Pure Play Approach
 Find one or more companies that specialize in
the product or service that we are considering
 Compute the beta for each company
 Take an average
 Use that beta along with the CAPM to find the
appropriate return for a project of that risk
 Often difficult to find pure play companies
4-68
Subjective Approach
 Consider the project’s risk relative to the firm
overall
 If the project has more risk than the firm, use
a discount rate greater than the WACC
 If the project has less risk than the firm, use
a discount rate less than the WACC
 You may still accept projects that you
shouldn’t and reject projects you should
accept, but your error rate should be lower
than not considering differential risk at all4-69
Subjective Approach - Example
Risk Level Discount Rate
Very Low Risk WACC – 8%
Low Risk WACC – 3%
Same Risk as Firm WACC
High Risk WACC + 5%
Very High Risk WACC + 10%
4-70

Chapter 4 Cost of Capital

Uploaded by

Copyright:

Available Formats

You might also like

Chapter 4 Cost of Capital

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 4 Cost of Capital

Uploaded by

Copyright:

Available Formats

Chapter 4

The Cost of Capital

To Thi Thanh Truc

The required rate of return on the various

Long-Term Preferred Common

Retained New Common

 The w’s refer to the firm’s capital

WACC = wdrd(1-T) + wprp + wcrs

 Use accounting numbers or market

shares times price per share

bonds times bond price

 wD = D/V = percent financed with debt

 The cost of capital is used primarily to

 15-year, 12% coupon, semiannual payment noncallable bonds sell for

 Common stock sells for $50. D0 = $4.19 and g = 5%.

 b = 1.2; rRF = 7%; RPM = 6%.

 Bond-Yield Risk Premium = 4%.

Number of shares not given in problem, so actual

 rd is the marginal cost of debt capital.

INPUTS 30 -1153.72 60 1000

 rp is the marginal cost of preferred stock,

dividend each period

 rs is the marginal cost of common equity

 The rate of return investors require on the

 There are three major methods for

 Cost of debt plus risk premium

 DCF (DGM): rs = (D1 / P0) + g

 CAPM: rs = rRF + (rM – rRF) b

 Coleman’s common stock is currently selling for

 Market risk premium, rM – rRF

 Systematic risk of asset, 

rs  rRF  β (rM  rRF )

If the rRF = 7%, RPM = 6%, and the

rs = rRF + (rM – rRF) b

 Applicable to all companies, as long as we can

 We are using the past to predict the future, which

rs = rRF + (rM – rRF) b

If the rRF = 7%, RPM = 6%, and the

rs = rRF + (rM – rRF) b

rd = 10% and RP = 4%.

 Firm could repurchase its own stock and earn rs.

WACC = wdrd(1-T) + wprp + wcrs

 Book value per share

 Price per share

 Under analysts estimates, you can find analysts

 Note that you may not be able to find

information on all bond issues due to the

 For preferred stock: rp = D/P0(1-F)

P0(1-F) = C/(1+rd) + C/(1+rd)2 +…+ C/(1+rd)n + FV/(1+rd)n

 Use the target weights because the firm will issue

securities in these percentages over the long term

10.5 A Rejection Region

7.0 Division L’s WACC

You might also like