Lecture 5:

Cost of Capital

Corporate Finance
Outline
• Cost of Capital
– Cost of Equity
– Cost of Debt

• Project Cost of Capital

– WACC

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Risk-return trade-off
• Risk-return trade-off: There is a reward for
bearing risk. The greater the potential risk, the
greater the return.
– Risk aversion: assumes investors dislike risk and
require higher rates of return to encourage them to
hold riskier assets
– Risk premium: the “extra” return earned for taking on
risk, i.e. the return over and above the risk-free rate

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Cost of Capital
• The cost of capital is the rate of return that the
suppliers of capital – bondholders and owners –
require as compensation for their contributions of
capital.
– This cost reflects the opportunity costs of the suppliers of
capital
– This cost is a marginal cost: the cost of raising additional
capital

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Estimating Cost of Capital
• Estimating the cost of capital is challenging

– Cannot be observed

– Require a number of assumptions

– Require reasonable estimations

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Cost of Equity
• Approaches:
– Capital Asset Pricing Model (CAPM)
– Dividend Discount Model

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CAPM approach
• Step1: Estimate the risk-free rate. The short-term Treasury
bill (T-bill) rate is usually used, but some analysts feel the
long-term Treasury rate should be used
• Step 2: Estimate the stock’s beta, the stock’s risk measure
• Step 3: Estimate the expected rate of return on the market
• Step 4: Use the CAPM equation to estimate the required
rate of return

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 Risk free rate
• Risk-free rate: the return you can get for sure.
– No default risk
– No uncertainty about reinvestment rates
• Determining the risk-free rate
– Ideally, the risk-free rate is the rate on a zero coupon
government bond matching the time horizon of the cash
flow being analyzed
– In practice, surveys suggest most practitioners use 10 to
30 year treasuries.
– The risk-free rate that you use in an analysis should be in
the same currency that your cash flows are estimated in.
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Market risk premium
• Market risk premium is the premium that investors
demand for investing in an average risk investment,
relative to the risk-free rate.
• Market indices
– S&P 500: a value-weighted portfolio of the largest
500 US stocks. It is S&P 200 in Australia.
– Most practitioners use the S&P 500/200 as the market
proxy, even though it is not actually the market portfolio

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Beta estimation
• Estimating Beta from Historical Returns
– Recall, beta is the expected percent change in the
risk premium of the security for a 1% change in the
risk premium of the market portfolio.

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Figure: Monthly Returns Cisco and S&P 500

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Figure: Monthly Returns - Cisco and S&P 500

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Alternative approach
• Dividend Discount Model

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Example: Cost of Equity
• Suppose our company has a beta of 1.5. The market risk
premium is expected to be 9%, and the current risk-free
rate is 6%. We have used analysts’ estimates to determine
that the market believes our dividends will grow at 6% per
year and our last dividend was $2. Our stock is currently
selling for $15.65. What is our cost of equity?

– Using CAPM: RE = 6% + 1.5(9%) = 19.5%

– Using DDM: RE = [2(1.06) / 15.65] + 0.06 = 19.55%

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 CAPM
(Backward looking)
• Explicitly adjusts for
systematic risk
• Applicable to all companies,
Advantage as long as we can estimate
beta
• Have to estimate the
expected market risk
premium, which does vary
over time
• Have to estimate beta, which
Disadvantage also varies over time
• We are using the past to
predict the future, which is
not always reliable
DDM
(Forward looking)
• Easy to understand
• Easy to use
• 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.
• Does not explicitly consider
risk
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Cost of Debt
• More straightforward
• Approaches
– Yield-to-maturity approach: calculate the yield to
maturity on the company’s current debt.
– Debt-rating (or Interest coverage) approach: use
yields on comparably rated bonds with maturities
similar to what the company has outstanding.

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 Debt-rating
/interest
coverage
approach

Interest coverage
=EBIT/interest expense

Source: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.htm 17
A Project’s Cost of Capital
• A project’s cost of capital should reflect the
riskiness of the underlying project
• Differences in project risk
– Firm asset betas reflect market risk of the average
project in a firm.
– Individual projects may be more or less sensitive to
market risk.

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Estimate Project Cost of Capital
• All-equity comparables
– Find an all-equity financed firm in a single line of
business that is comparable to the project.
– Use the comparable firm’s equity beta and cost of
capital as estimates
• Levered firms as comparables
– Use the beta of the comparable company to
estimate an asset beta (beta reflecting only
business risk) and then use it for the subject
project or company.

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Levered Firm as a Comparable

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Estimation of Cost of Capital

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Alternatively: estimation of beta
• Asset (unlevered) beta
E D
βU = βE + βD
E+D E+D
– Beta for equity could be obtained with estimations of
historical return in CAPM
– In practice, beta estimates for debt based on debt’s rating
may be used.

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Example
Problem
You have just graduated with an MBA, and decide to pursue
your dream of starting a line of designer clothes and
accessories. You are working on your business plan, and
believe your firm will face similar market risk to Lululemon
(L U L U). To develop your financial plan, estimate the cost of
capital of this opportunity assuming a risk-free rate of 3%
and a market risk premium of 5%

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Example
Solution
Checking Yahoo! Finance, you find that Lululemon has no debt. Using
five years of weekly data, you estimate their beta to be 0.80. Using
LULU’s beta as the estimate of the project beta, we can estimate the
cost of capital of this investment opportunity as

rproject = rf + BLULU ( E[ RMkt ] - r ) = 3% + 0.80 × 5% = 7%

Thus, assuming your business has a similar sensitivity to market risk as

Lululemon, you can estimate the appropriate cost of capital as 7%. In
other words, rather than investing in the new business, you could invest
in the fashion industry simply by buying LULU stock. Given this
alternative, to be attractive, the new investment must have an expected
return at least equal to that of LULU, which from the CAPM is 7%.

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Textbook Example

Risk-free

Market capitalisation = Market value of equity = Share price * # shares outstanding

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Textbook Example

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Weighted Average Cost of Capital (WACC)
• The weighted average cost of capital is
the cost raising additional capital, with the
weights representing the proportion of each
source of financing that is used.
• It is also known as the marginal cost of
capital (MCC)

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Taxes and cost of capital
• Perfect capital market: no taxes, no transaction
costs, no other friction, then the choice of financing
does not affect the cost of capital or NPV of a
project.

• However, in reality, market is imperfect. Then, firm’s

decision regarding how to finance the project may
have consequences that affect the project’s value.

• Interest on debt is tax deductible, therefore, the

cost of debt must be adjusted to reflect this
deductibility, whereas payments to owners are not
tax deductible.
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Weighted Average Cost of Capital (WACC)
• For now, it is assumed that the firm maintains a constant
debt-equity ratio and that the WACC remains constant
over time.

E D
rwacc = rE + rD (1 - t c )
E + D E + D
E & D = market value of equity and debt
rE = cost of equity
rD = before-tax cost of debt

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Textbook Example

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Textbook Example

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Apply WACC to capital budgeting
• Because the WACC incorporates the tax savings
from debt, we can compute the levered value of
an investment, by discounting its future free cash
flow using the after-tax WACC.

FCF1 FCF2 FCF3

V0
L
= + + + 
1 + rwacc (1 + rwacc ) 2
(1 + rwacc ) 3

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More Examples
Question 1
• Assume that the S&P 500 currently has a
dividend yield of 3% and that on average, the
dividends of S&P 500 firms have increased by
about 5% per year. If the risk-free interest rate
is 4%, then your estimate for the future market
risk premium is?
"!
• A: 𝑟! = + 𝑔 = 3% + 5% = 8%
#"
• Market RP=8%-4%=4%

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Question 2
• London Supermarket’s latest balance sheet shows
$300mil debt and $400mil equity, while its market
capitalization is currently $600mil.
• Based on historical estimation, London Supermarket’s
beta is around 0.9
• The market risk premium is 5%
• The 10-year government bond is currently yielding 4%,
while London Supermarkets can currently raise debt at
a rate of 7%.
• The current tax rate is 30%
• Calculate the WACC of London Supermarket
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Question 2 (cont’d)
• 𝑟! = 𝑟" + 𝛽 𝑟# − 𝑟" = 4% + 0.9 ∗ 5% =
8.5%
• 𝑟$ =7%
% '
• 𝑊𝐴𝐶𝐶 = 𝑟! + 𝑟' 1 − 𝜏
%&' %&'
()) *))
= 8.5%+ 7% 1 − 30%
())&*)) ())&*))
=7.3%

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Question 3
Your firm is planning to invest in an automated
packaging plant. Harburtin Industries is an all-equity
firm that specializes in this business. Suppose
Harburtin’s equity beta is 0.85, the risk-free rate is 4%,
and the market risk premium is 5%.
Q: If your firm’s project is all equity financed, estimate
its cost of capital.
A: 𝑟! =4%+0.85*5%=8.25%

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Question 3 (cont’d)
You decided to look for other comparables to
reduce estimation error in your cost of capital
estimate. You find a second firm, Thurbinar
Design, which is also engaged in a similar line of
business. Thurbinar has a stock price of $20 per
share, with 15 million shares outstanding. It also
has $100 million in outstanding debt, with a yield
on the debt of 4.5%. Thurbinar’s equity beta is
1.00.

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Question 3 (cont’d)
a. Assume Thurbinar’s debt has a beta of zero.
Estimate Thurbinar’s unlevered beta. Use the
unlevered beta and the CAPM to estimate
Thurbinar’s unlevered cost of capital.

#$$ &$$
• 𝛽" = ∗1+ ∗0 = 0.75
%$$ %$$
• 𝑟" = 4% + 0.75 ∗ 5% = 7.75%

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Question 3 (cont’d)
• b. Estimate Thurbinar’s equity cost of capital using the
CAPM. Then assume its debt cost of capital equals its
yield, and using these results, estimate Thurbinar’s
unlevered cost of capital.
• 𝑟! =4%+1*5%=9% 𝑟" =4.5%
• E=20*15=300 D=100
$%% '%%
• 𝑟# = ∗ 9% + ∗ 4.5% = 7.875%
&%% &%%
• c. Explain the difference between your estimate in part
(a) and part (b).
• In the first case, we assumed the debt had a beta of
zero, so rd = rf = 4%. In the second case, we assumed
rd = ytm = 4.5%
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