THE COST OF CAPITAL

THE COST OF CAPITAL

@2023 AMPARLAN

▪ Sources of Capital
▪ Component Costs
▪ WACC
▪ Adjusting for Flotation Costs
▪ Adjusting for Risk

COMMON
STOCKS &
DEBT PREFERRED RETAINED
STOCKS EARNINGS

@2023
@2012AMPARLAN
AMPARLAN

THE FIRM’S COST THE FIRM’S SOURCES OF

by OF CAPITAL
LONG-TERM CAPITAL
▪ Cost of Capital - refers to the firm’s opportunity cost of
capital, which is the cost of making a choice in terms of
the next best opportunity that is foregone.
▪ It provides an estimate of how much return the firm’s
combined investors expect from the firm, which involves:
• Identifying all of the firm’s sources of capital and their
relative importance
• Estimating the market’s required rate of return for
each source of capital the firm uses
• Calculating an average of the required rates of return
for each source of capital where the required rate of
return for each source has been weighted by its
contribution to the total capital invested in the firm
@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

THE FIRM’S COST WEIGHTED AVERAGE

by OF CAPITAL COST OF CAPITAL
▪ Importance of Cost of Capital:
• For evaluating the firm’s overall performance
• For assessing the individual decisions made by the
WACC = wdkd(1-T) + wpkp + wcks
firm
▪ The w’s refer to the firm’s capital structure
▪ Weighted Average Cost of Capital (WACC) – a
composite of the individual costs of financing incurred by
weights
each capital source. It is a function of the ff:
▪ The k’s refer to the cost of each component
• The individual costs of capital
• The capital structure mix

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN
 HOW THE WEIGHTS INVESTORS’ REQUIRED
by
ARE DETERMINED RATE OF RETURN
▪ Is the investors’ required rate of return the same
WACC = wdkd(1-T) + wpkp + wcks thing as cost of capital?
Not exactly, the difference is due to:
▪ Use accounting numbers or market value (book • Taxes - when a firm borrows money to finance
vs. market weights)? the purchase of an asset, the interest expense is
deductible for corporate income tax calculations
▪ Use actual numbers or target capital structure?
After–Tax Cost of Borrowing to the Firm
= (Interest Rate - (Corporate Income Tax) X (Interest
Rate))

OR Interest Rate (1- Corporate Income Tax)

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

ANALYSIS FOCUS: INVESTORS’ REQUIRED

BEFORE-TAX vs. AFTER-TAX
▪ Should our analysis focus on before-tax or
after-tax capital costs?
• Stockholders focus on After-Tax Cash Flows
(A-T CFs). Therefore, we should focus on A-T
Capital Costs, i.e. use A-T costs of capital in
WACC.
• Only kd needs adjustment, because interest is
tax deductible.
by
RATE OF RETURN
▪ Is the investors’ required rate of return the
same thing as cost of capital?
Not exactly, the difference is due to:
• Taxes
• Transaction Costs – the costs that the firm
incurs when it raises funds by issuing a
particular type of security
Ex. Flotation Costs – additional costs upon
issuance of new shares

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

INVESTORS’ REQUIRED ANALYSIS FOCUS:

by HISTORICAL vs. MARGINAL COSTS
RATE OF RETURN
Cost of Equity Capital (with Flotation Cost): ▪Should our analysis focus on historical
(embedded) costs or new (marginal) costs?
(Cost of New Shares X
• The cost of capital is used primarily to make
ks = Required Return of Investor)
decisions that involve raising new capital.
Amount of Investment

OR Required Return of Investor • Focus on today’s marginal costs (for WACC)

(1 - % Flotation Cost)

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN
 THE FIRM’S FINANCIAL POLICY COMPONENT COST OF DEBT

▪ Financial Policy – pertains to policies
regarding the sources of finances the firm plans
to use and the particular mix (proportions) in
which they will be used
▪ It governs the use of debt and equity financing,
which impacts on the firm’s cost of capital
▪ Cost of Debt – the return that lenders require on the
firm’s debt
▪ However, for the firm:
WACC = wdkd(1-T) + wpkp + wcks
• kd is the marginal cost of debt capital
• The Yield-to-Maturity (YTM) on outstanding L-T debt
is often used as a measure of kd

• Why tax-adjust, i.e. why kd(1-T)?

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

COMPONENT COST OF DEBT COMPONENT COST OF DEBT

▪ Calculating the Before –Tax Cost of Debt or YTM :

▪ A 15-year, 12% semi-annual coupon bond sells
Net Proceeds = _____Interest on Yr 1______ +
for $1,153.72. What is the cost of debt (kd)? (1 + Cost of Debt Capital kd) 1
• Remember, the bond pays a semi-annual coupon, Interest on Yr 2 + Principal
therefore kd = 5.0% x 2 = 10%. (1 + kd) 2 (1 + kd) 2

▪ Interest expense is tax deductible, therefore:

After–Tax Cost kd) = Before–Tax Cost kd (1-T)
INPUTS 30 -1153.72 60 1000
= 10% (1 - 0.30) = 7%
N I/YR PV PMT FV
▪ Use nominal rate
OUTPUT 5 ▪ Flotation costs are small, so ignore them

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

COMPONENT COST OF COMPONENT COST OF

PREFERRED SHARES PREFERRED SHARES
▪ What is the cost of preferred stock?
WACC = wdkd(1-T) + wpkp + wcks The cost of preferred stock can be solved by
using this formula:
▪ kp is the marginal cost of preferred stock
kp = Dp / Pp
▪ The rate of return investors require on the firm’s = $10 / $111.10
preferred stock = 9%

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN
 COMPONENT COST OF COMPONENT COST OF
PREFERRED SHARES PREFERRED SHARES
▪ Preferred dividends are not tax-deductible, so no ▪ Is preferred stock more or less risky to investors
than debt?
tax adjustments necessary. Just use kp.
• More risky; company not required to pay
▪ Nominal kp is used preferred dividend.
▪ Our calculation ignores possible flotation costs. • However, firms try to pay preferred dividend.
Otherwise:
o The firm cannot pay common dividend
o The firm would find it difficult to raise additional
funds
o The preferred stockholders may gain control of firm

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

COMPONENT COST OF A-T DEBT vs. PREFERRED SHARES

PREFERRED SHARES
▪ Illustrating the differences between A-T Costs of Debt
▪ Why is the yield on preferred stock lower and Preferred Stock:
than debt? Recall, that the firm’s tax rate is 30%, and its before-tax costs
of debt and preferred stock are kd = 10% and kp = 9%,
• Corporations own most preferred stock, because respectively.
70% of preferred dividends are non-taxable to
corporations. Cost of Preferred Shares:
A-T kp = kp – kp (1 – 0.7)(T)
• Therefore, preferred stock often has a lower B-T yield = 9% - 9% (0.3)(0.3) = 8.10%
than the B-T yield on debt. Cost of Debt:
• The A-T yield to an investor, and the A-T cost to the A-T kd = B–T kd (1-T)
= 10% - 10% (0.3) = 7.00%
issuer, are higher on preferred stock than on debt.
Consistent with higher risk of preferred stock. A-T Risk Premium = 1.1%
on Preferrred Shares

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

COMPONENT COST OF EQUITY COMPONENT COST OF EQUITY

WACC = wdkd(1-T) + wpkp + wcks
▪ ks 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 ke.
▪ 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).
oInvestors could buy similar stocks and earn ks.
oFirm could repurchase its own stock and
earn ks.
oTherefore, ks is the cost of retained earnings.

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN
 COMPONENT COST OF EQUITY COMPONENT COST OF EQUITY

▪ Three ways to determine the cost of common ▪ If the kRF = 7%, RPM = 6%, and the firm’s beta is
equity, ks : 1.2, what’s the cost of common equity based
• CAPM: ks = kRF + (kM – kRF) β upon the CAPM?
ks = kRF + (kM – kRF) β
• Dividend Growth Model (or DCF):
ks = D0 (1+g) = __D1__ = 7.0% + (6.0%)1.2
P0 + g P0 + g = 14.2%
• Own-Bond-Yield-Plus-Risk Premium:
ks = kd + RP

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

COMPONENT COST OF EQUITY COMPONENT COST OF EQUITY

▪ If D0 = $4.19, P0 = $50, and g = 5%, what’s the ▪ What is the expected future growth rate?
cost of common equity based upon the DCF • The firm has been earning 15% on equity (ROE =
approach? 15%) and retaining 35% of its earnings (dividend
payout = 65%). This situation is expected to
continue.
D1 = D0 (1+g)
D1 = $4.19 (1 + .05) • Dividend’s growth rate is calculated as follows:
D1 = $4.3995 g = ( 1 – Payout ) (ROE)
= (0.35) (15%)
ks = D1 / P0 + g = 5.25%
= $4.3995 / $50 + 0.05
• Very close to the g that was given before.
= 13.8%
@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

COMPONENT COST OF EQUITY COMPONENT COST OF EQUITY

▪ Can DCF methodology be applied if growth is
not constant?
• Yes, non-constant growth stocks are expected
to attain constant growth at some point,
generally in 5 to 10 years.
• May be complicated to compute.
▪ If kd = 10% and RP = 4%, what is ks using the
own-bond-yield-plus-risk-premium method?
• This RP is not the same as the CAPM RPM.
• This method produces a ballpark estimate of
ks, and can serve as a useful check.

ks = kd + RP
ks = 10.0% + 4.0% = 14.0%

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN
 COMPONENT COST OF EQUITY COMPONENT COST OF EQUITY

▪ What is a reasonable final estimate of ks? ▪ Why is the cost of retained earnings cheaper
than the cost of issuing new common stock?
Method Estimate
• When a company issues new common stock
CAPM 14.2% they also have to pay flotation costs to the
DCF 13.8% underwriter.
kd + RP 14.0% • Issuing new common stock may send a
Average 14.0% negative signal to the capital markets, which
may depress the stock price.

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

COMPONENT COST OF EQUITY FLOTATION COST

▪ If issuing new common stock incurs a flotation • Flotation costs depend on the risk of the firm and
cost of 15% of the proceeds, what is ke? the type of capital being raised.
D 0 (1 + g) • The flotation costs are highest for common equity.
ke = +g
P0 (1 - F) However, since most firms issue equity
$4.19(1.05) infrequently, the per-project cost is fairly small.
= + 5.0%
$50(1 - 0.15) • We will frequently ignore flotation costs when
$4.3995 calculating the WACC.
= + 5.0%
$42.50
= 15.4%
@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

FLOTATION COST FACTORS AFFECTING WACC

▪ Ignoring floatation costs, what is the firm’s ▪ What factors influence a company’s
WACC? composite WACC?
• Market conditions
WACC = wdkd(1-T) + wpkp + wcks
• The firm’s capital structure and dividend policy
= 0.3(10%)(0.7) + 0.1(9%) + 0.6(14%)
= 2.1% + 0.9% + 8.4% • The firm’s investment policy. Firms with riskier
projects generally have a higher WACC.
= 11.4%

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN
 WACC USED AS HURDLE RATE RISK & THE COST OF CAPITAL

Rate of Acceptance
▪ Should the company use the composite WACC as Return Region
the hurdle rate for each of its projects? (%)
WACC
• NO! The composite WACC reflects the risk of an 12.0
H

average project undertaken by the firm. Therefore, 10.5

10.0
A
Rejection
the WACC only represents the “hurdle rate” for a 9.5 B Region
typical project with average risk. 8.0 L

• Different projects have different risks. The

project’s WACC should be adjusted to reflect the
project’s risk.
0
Risk
RiskL RiskA RiskH

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

PROJECT RISK PROJECT RISK

▪ Three Types of Project Risk

▪ How is each type of risk used?
• Stand-Alone Risk - risk associated with a single
operating unit of a company or a specific asset or a project • Market Risk is theoretically best in most
considered by itself, which would not exist if operations in situations
that area were to cease
• Corporate Risk - refers to the liabilities and financial risks
• However, creditors, customers, suppliers, and
that firms face such as interest rate risk, foreign exchange employees are more affected by corporate
risk, e-commerce risk, which the firm must protect itself
from in order to enhance the value of the firm risk
• Market Risk – systematic risk or non-diversifiable risk; the • Therefore, Corporate Risk is also relevant
risk related to an investment return that cannot be
eliminated through diversification

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN

RISK-ADJUSTED DIVISIONAL
COST OF CAPITAL COST OF CAPITAL
▪ How are risk-adjusted costs of capital ▪ Finding a Divisional Cost of Capital:
Using similar stand-alone firms to estimate a project’s
determined for specific projects or cost of capital
divisions?
• Comparison firms have the following characteristics:
• Subjective adjustments to the firm’s – Target capital structure consists of 40% debt and 60%
composite WACC. equity.
– kd = 12%
• Attempt to estimate what the cost of capital – kRF = 7%
would be if the project/division were a stand- – RPM = 6%
alone firm. This requires estimating the – βDIV = 1.7
project’s beta. – Tax rate = 30%

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN
 DIVISIONAL PROBLEM AREAS IN
COST OF CAPITAL COST OF CAPITAL
▪ Calculating a Divisional Cost of Capital: ▪ Depreciation-generated funds
• Division’s Required Return on Equity ▪ Privately-owned firms
ks = kRF + (kM – kRF)β
▪ Measurement problems
= 7% + (6%)1.7 = 17.2%
▪ Adjusting costs of capital for different risk
• Division’s Weighted Average Cost of Capital
▪ Capital structure weights
WACC = wd kd ( 1 – T ) + wc ks
= 0.4 (12%)(0.7) + 0.6 (17.2%) =13.2%

• Typical projects in this division are acceptable if their

returns exceed 13.2%.

@2023
@2012AMPARLAN
AMPARLAN @2023
@2012AMPARLAN
AMPARLAN