TOPIC 8: COST OF CAPITAL

FINANCIAL MANAGEMENT, SPRING 2020

Topic outline
1. Capital components

2. WACC

◦ Cost of Debt

◦ Cost of Preferred stock

◦ Cost of Common equity

3. Factors that affect WACC

4. Mistakes to avoid when calculating WACC

Learning objectives
v To estimate the costs of different capital components

o Debt

o Preferred stock

o Common stock

v To combine the different component costs to determine the

firm’s WACC.

1. Capital Components
◦ Capital components are sources of funding (capital) that come
from investors.

Long-term Capital

Debt Equity

Long-term Debt Preferred Stock Common Equity

Retained Earning New Common Stock

Cost of Capital Components

Cost of Capital

Cost of Debt Cost of Equity

Cost of Preferred Stock Cost of Common Equity

Before-tax vs. After-tax Capital Costs

◦ Tax effects associated with financing can be incorporated either

in capital budgeting cash flows or in cost of capital.

◦ Most firms incorporate tax effects in the cost of capital.

Þ Therefore, focus on after-tax costs.

◦ Only cost of debt is affected by tax.

 Historical (Embedded) vs. New (Marginal)
Capital Costs

The cost of capital is used primarily to make decisions which

involve raising and investing new capital.

Þ So, focus on marginal (incremental) costs.

2. WACC
WACC - Weighted Average Cost of Capital is calculated as the weighted
average of the component costs of debt, preferred stock, and common equity

WHY? BUSINESS APPLICATION

Key to understanding cost • Minimum required return needed on Project
of raising capital • Reflects blended costs of raising capital
• Risk • Discount rate used to determine Project’s
• Financing costs NPV or to discount FCFs
• Discount Rate • Hurdle rate
Whereas:

§ WACC: Blended cost or raising capital considering mixture of debt &

equity

§ rD = the before-tax cost of debt

§ TC = the corporate tax rate

§ rs = the cost of common stock

§ rP = the cost of preferred stock
§ WD , Ws , WP are the respective weights of debts, common stock, and
preferred stock

2.1. Cost of debt

HOW TO DETERMINE COST OF DEBT?

Ø Method 1: Ask an investment banker what coupon rate would

be on new debt.

Ø Method 2: Find bond rating for the company and use yield on
similarly rated bonds.

Ø Method 3: Find yield on the company’s existing debt.

 Before-tax vs After-tax Cost of Debt

Before-tax cost of debt, rD - The interest rate a firm must pay on its
new debt

However, Interest payment is tax deductible

Þ Therefore, after-tax cost of debt, rD(1 – TC), should be used to

calculate WACC

Historical vs New Cost of Debt

For cost of debt, don’t use coupon rate on existing debt, which
represents cost of past debt.

Þ Use the current interest rate on new debt (Yield to Maturity - YTM)
Cost of Debt example:
A 15-year, 13.25% semiannual bond sells for $1,250. Tax = 40%.
60,000 Bonds o/s. What’s rD?

◦ Interest is tax deductible, so the after tax (AT) cost of debt is:

rD AT = rD BT(1 – T)

◦ Use nominal rate

2.2. Cost of Preferred Stock

HOW TO CALCULATE COST OF EQUITY?

$%
Know: !" = &' ()

$%
So then: Cost of equity = *+ = +/
,-

Preferred stock has a constant dividend payment, g= 0

Þ Cost of Preferred Stock is a function of dividends paid

$%
Þ Cost of Preferred Stock = !" =
"&
Cost of Preferred Stock Example

Cost of preferred stock: PP = $125; 10.26% Dividend; Par value= $100

Note:

◦ Preferred dividends are not deductible, so no tax adjustment.

Just rP.

◦ Nominal rP is used.
Is preferred stock more or less risky to
investors than debt?
q Preferred stock is riskier than debt

Company is not required to pay preferred dividend; however, firms

want to pay preferred dividend.

Otherwise,

(1) cannot pay common dividend,

(2) difficult to raise additional funds,

(3) preferred stockholders may gain control of firm.

2.3. Cost of common equity

What are the two ways that companies can raise common
equity?

◦ Directly, by issuing new shares of common stock.

◦ Indirectly, by reinvesting earnings that are not paid out as

dividends (i.e., retaining earnings)
 Cost of Retained Earnings

◦ Opportunity cost: The return stockholders could earn on

alternative investments of equal risk.

◦ They could buy similar stocks and earn rs, or company could
repurchase its own stock and earn rs. So, rs, is cost of reinvested
earnings and is cost of common equity.

Two ways to determine the cost of common equity, rs

1 – CAPM: rs = rRF + (rM – rRF)β

= rRF + (RPM)β.

2 – Dividend Growth Model (DGM): rs = D1/P0 + g.

1 – Using CAPM

CAPM Cost of Equity: rRF = 5.6%, RPM = 6%, β = 1.2

Issues in Using CAPM

• Most analysts use the rate on a long-term (10 to 20 years)

government bond as an estimate of rRF.

• Can use Bloomberg.com to obtain US Treasuries Quotes

• Most analysts use a rate of 3.5% to 6% for the market risk

premium (RPM)

• Estimates of beta vary, and estimates are “noisy” (they have a

wide confidence interval).
2 – Using DGM

DGM Cost of Equity, rs: D0 = $3.12; P0 = $50; g = 5.8%

Issues in Using DGM

Estimating the Growth Rate

◦ Use historical growth rate if believe future be like past.

◦ Obtain analysts’ estimates: Value Line, Zacks, Yahoo!Finance.

◦ Use earnings retention model.

EARNINGS RETENTION MODEL

Growth from earnings retention model:

g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)

Payout rate = 62%, ROE = 15%

Could DGM methodology be applied if g is not constant?

YES, non-constant g stocks are expected to have constant g at

some point, generally in 5 to 10 years.
 Final estimate of rs?

Method Estimate
CAPM 12.8%
DGM 12.4%

Costs of Issuing New Common Stock

◦ Issuing new common stock may send a negative signal to the

capital markets, which may depress stock price.

◦ Cost of issuing new common stock is also rS

2.4 Determining Weights for WACC
◦ Weights are % of firm’s capital to be financed by each
component – debt and equity.

◦ If possible, always use the target weights of each type of capital

– target capital structure.

Estimating Weights for the Capital Structure

◦ If don’t know targets, better to estimate weights using current

market values than current book values.

◦ If don’t know MV of debt, then reasonable to use BV of debt.

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 Estimating Weights (Continued)

◦ Suppose the common stock price is $50 with 3 million shares

outstanding; the firm has 200,000 shares of preferred stock trading
at $125; and 60,000 bonds outstanding trading at quoted price of
125% of par.

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Estimating Weights (Continued)

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 Estimating Weights (Continued)

◦ Target weights for this company are same as these MV weights,

but often MV weights temporarily deviate from targets due to
changes in stock prices.
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What’s the WACC using the target weights?

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3. Factors that affect WACC
◦ Uncontrollable factors:
◦ Market conditions, especially interest rates.
◦ Tax rates.
◦ Market risk premium.

◦ Controllable factors:
◦ Capital structure
◦ Dividend policy
◦ Capital budgeting decision
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Should firm-wide WACC be used for each of

its divisions?
◦ NO! Composite WACC reflects risk of an average project
undertaken by the firm.

◦ Different divisions may have different risks. Division’s WACC

should be adjusted to reflect division’s risk and capital structure.

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4. Mistakes to avoid when calculating WACC will be
discussed in the live session