Reading 36– Cost of Capital

A-C - weighted average cost of capital and how taxes affect the MCC.

The cost of capital of a company is the required rate of return that investors ( equity and
debt holders ) demand for the average-risk investment of a company.

The cost of capital is calculated using the marginal cost of each of the various sources of
capital and then calculate a weighted average of these costs to produce us WACC and it’s
sometimes called MCC.

The major components of capital are Debt, Preferred equity and Common equity
A-C- weighted average cost of capital and how taxes affect the MCC.
❑ Understanding the weights
The target capital structure is the capital structure that a company is striving to obtain. If
we know the company’s target capital structure, then, of course, we should use this in our
analysis, if we don’t we can estimate the capital structure as follow;

▪ Assume the company’s current capital structure, at market value weights for the
components, represents the company’s target capital structure.

▪ Examine trends in the company’s capital structure or statements by management

regarding capital structure policy to infer the target capital structure.

▪ Use averages of comparable companies’ capital structures as the target capital

structure.
D - weighted average cost of capital and how taxes affect the MCC.

Understanding cost of Debt.

The interest expense

is deducted before
taxable income; this
means that the
interest expense
reduces the amount
due to the tax
authority.

Cost of debt = rd * (1-t)

Change the tax rate
and see how it
affects the cost.
E - weighted average cost of capital and how taxes affect the MCC.

❑ Cost of Capital and Capital budgeting

❑ The WACC is used in capital budgeting as a discount rate if the risk of the undertaken
project is similar to the company risk. WACC may be adjusted upward and downward
to compensate for the risk difference.

❑ MCC is used to determine the optimal capital budget as follow – the graph

The IOS is downward line

and MCC is upward line.

The interception is the

optimal capital budget.
F- The cost of debt capital using the yield-tomaturity approach and the
debt-rating approach.

Cost of Debt :
The yield to maturity (YTM) is the annual return that an investor earns on a bond if the
investor purchases the bond today and holds it until maturity or the yield that equates the
present value of the bond’s promised payments toits market price “ looks like IRR ”

This bond is
semiannual
coupon
F- The cost of debt capital using the yield-to-maturity approach and the
debt-rating approach.
F- The cost of debt capital using the yield-to-maturity approach and the
debt-rating approach.

The debt rating approach is used when a reliable current market price for a company’s
debt is not available. We compare the company rating and maturity to other competitors -
matrix pricing - or using the yield curve.

Cost of Debt issue:

▪ Fixed-Rate Debt versus Floating-Rate Debt

▪ Debt with Option-like Features
▪ Nonrated Debt
▪ Leases
G- cost of non-callable, nonconvertible preferred stock.

The cost of preferred stock is the cost that a company has committed to pay preferred
stockholders as a preferred dividend when it issues preferred stock

• Use the most recent coupon payment “ rate ”

• Note that the preferred dividends come below the line and therefore no tax
adjustments needed.
H- cost of equity capital using the CAPM, DDM, and the bond yield- plus risk-
premium approach.

The cost of common equity is the required rate of return on the firm’s common stock and it
can be calculated using Capital Asset Pricing Model Approach as follow

The expected market risk premium, or E(RM − RF), is the premium that investors demand
for investing in a market portfolio relative to the risk-free rate. When using the CAPM to
estimate the cost of equity, in practice we typically estimate beta relative to an equity
market index. In that case, the market premium estimate we are using is actually an
estimate of the equity risk premium.
H- cost of equity capital using the CAPM, DDM, and the bond yield- plus
risk-premium approach.

dividend discount model based approach If dividends are expected to grow at a

constant rate, g, then the current value of the stock is given by the dividend growth
model.
g is the constant growth rate the company grow at and
it could be calculated as follow

g = (retention rate)(return on equity) = (1 – payout

ratio)(ROE)

❑ The bond yield plus risk premium approach is

Rearranging based on the fundamental tenet in financial theory
that the cost of capital of riskier cash flows is higher
than that of less risky cash flows

re = r d + Risk premium
I- beta and cost of capital for a project

Business risk of a company or project is the risk related to the uncertainty of revenues,
referred to as sales risk, and to operating risk, which is the risk attributed to the
company’s operating cost structure

Financial risk is the uncertainty of net income and net cash flows attributed to the use of
financing that has a fixed cost, such as debt and leases. The greater the use of fixed
financing sources of capital, relative to variable sources, the greater the financial risk.

We will
derive
this

equation
together
I- Estimating a Beta Using the Pure-Play Method

Step 1: Select the comparable Determine comparable company or companies. These

are companies with similar business risk.

Step 2: Estimate comparable’s beta Estimate the equity beta of the comparable
company or companies.

Step 3: Unlever the comparable’s beta Unlever the beta of the comparable company
or companies, removing the financial risk component of the equity beta, leaving the
business risk component of the beta.

Step 4: Lever the beta for the project’s financial risk Lever the beta of the project by
adjusting the asset beta for the financial risk of the project.
I- Estimating a Beta Using the Pure-Play Method
J- country risk premiums in estimating the cost of equity

a country risk premium is added to the market risk premium when using the CAPM To
reflect the increased risk associated with investing in a developing country.
K- The marginal cost of capital schedule and the breakpoint

The marginal cost of capital (MCC) is the cost of the last new dollar of capital a
firm raises. As a firm raises more and more capital, the costs of different sources
of financing will increase

Break points occur any time the cost of one of the components of the
company’s WACC changes. A break point is calculated as

• If a company increase its debt it

would increase the cost of debt
because of the incremental financial
risk added.
• In addition the debt holder may
require not to issue new debt
securities in the same seniority which
means higher prices.

• Equity issuance is more expensive

due to floatation costs.
 L- Flotation costs treatment

Flotation costs are the fees charged by investment bankers when a company raises external
equity capital. Flotation costs can be substantial and often amount to between 2% and 7%
of the total amount of equity capital raised, depending on the type of offering.

The incorrect treatment

In this method we deduct the floatation costs from

the share price to reach the rrr and it will shift the In terms of #
result upward Ex.
• Stock price 40
• Floatation cost 7 %
• Growth rate 5 % In terms of %
• Most recent dividends $ 2

(2*1.05)
R= + 5 = 10.65 %
(40*.93)

If there’s no floatation cost the rr on equity will be

10.25%
 L- Flotation costs treatment

Correct Treatment of Flotation Costs:

Flotation costs are a cash outflow that occurs at the initiation of a project and affect the
project NPV by increasing the initial cash outflow. Therefore, the correct way to account for
flotation costs is to adjust the initial project cost.

Example: Correctly accounting for flotation costs

Omni Corporation is considering a project that requires a $400,000 cash outlay and is
expected to produce cash flows of $150,000 per year for the next four years. Omni’s tax
rate is 35%, and the before-tax cost of debt is 6.5%. The current share price for Omni’s
stock is $36 per share, and the expected dividend next year is $2 per share. Omni’s
expected growth rate is 5%. Assume that Omni finances the project with 50% debt and 50%
equity capital and that flotation costs for equity are 4.5%. The appropriate discount rate for
the project is the WACC.

Calculate the NPV of the project using the correct treatment of flotation costs and discuss
how the result of this method differs from the result obtained from the incorrect
treatment of flotation costs.
 L- Flotation costs treatment

The answer :