Professor K.

Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

THE COST OF CAPITAL

 The question we are going to consider in this lecture is what discount rate should
we use when valuing a company.

 Such a discount rate is called the firm’s cost of capital.

1. Capital Structure: Firm’s mix of long-term financing.

Example 1.

Assets Liabilities and Shareholders’ equity

Assets $647 Debt $194 30%

Common equity $453 70%
Total $647 Total $647 100%

Capital structure: 30% debt + 70% equity

May also have preferred equity.

Target capital structure: a particular capital structure the firm plans to maintain.

2. Basic Definitions

 rd = cost of debt.

 rps = cost of preferred stock.

 rs = cost of common equity.

 rd, rs, rps = required rates of return for these securities or

capital component costs

 T = marginal tax rate of the firm.

1
Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

3. Estimating the cost of debt

Example 2. The Fisher Company plans to issue $100MM worth of 12-year bonds.
Its investment bankers estimate that the risk exposure of these bonds
will be similar to the risk of an outstanding issue of 11% bonds that
also mature in 12 years. These existing bonds currently trade for
$1,100. Find the firm's cost of new debt. The firm is in the 34 percent
marginal tax bracket.

 Let's first find the YTM of the existing bonds.

Coupon rate = 11%  coupon = $55

55  1  1000
$1,100 = 1  24 

r  (1  r )  (1  r ) 24

r = 4.79%  YTM = 9.58%

 Because the two bond issues are subject to the same level of risk, they
have to have the same YTM. Therefore, the component cost of new (or
marginal) debt,

rd = YTM = 9.58%

 Note that, the cost of debt is actually 34% lower, because interest
payments on debt are tax-deductible.

After-tax cost of debt = rd (1-T)

= 9.58%(1-0.34) = 6.32%

Note: cost of debt is the expected return not the promised return. Therefore, the
above calculations are correct only for safe highly-rated bonds.

2
Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

4. Estimating the cost of preferred stock

Example 3. The Fisher Company could sell new shares of preferred stock with a
$10 annual dividend for $100.

Preferred Dividend
rps = = 10 / 100 = 10%
price

5. Estimating the cost of common equity

Example 4. The Fisher Company's common stock is expected to pay a dividend

over the next year of $5.00, and it sells for $50.00. The firm has an
expected constant growth rate of 5 percent, its beta is 1.6, the risk-free
rate is 7 percent, and the market risk premium is 5 percent.

 CAPM Approach:

rs = rrf + (rm- rrf) = 7 + 1.6(5) = 15%

Notes on obtaining estimates for CAPM:

 Some text prefers long-term (10-yr) T-bonds rather than T-bills for
risk-free rate.(WRONG)

 Historical market risk premium = 7.8% (Ibbotson Associates, 1926-

99).

 Dividend Discount Model:

D1
rs =  g = 5 / 50 + 0.05 = 15%
P0

Notes on obtaining an estimate of g:

 Historical average growth rates.

 Retention growth model: g = retention rate  ROE

In addition to usual stability of variables and risk assumption, this

requires no new equity issues or that new equity is sold at book value.

3
Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

 Security analysts’ forecasts (possibly the best estimate)

5. Weighted-Average Cost of Capital (WACC) - expected rate of return on a portfolio

of all the firm's securities.

WACC = wdrd(1-T) + wsrs + wpsrps

Note:

We must use target capital structure weights. These weights should be based on
market rather than book values. In reality the difference between the market and book
values of debt is small. However the difference between the market and book values
of equity may substantial.

Example 5. Nutty Candy Inc. has the following target capital structure. Its
corporate tax rate is 40 percent. What is Nutty Candy's WACC?

Security Market Value Required Rate of Return

Debt $80 million 10%

Preferred Stock $30 million 13%

Common Stock $90 million 20%

D E PS
WACC = rd (1  T )  rs  rps
V V V

= (80/200)(1-0.4)(0.10) + (90/200)(0.20) + (30/200)(0.13)

= .1335 or 13.35%

4
Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

Example 6. Acme Electric's common stock has a beta of 1.5. The Treasury Bill
rate is 5 percent and the market risk premium is estimated at 8 percent.
The market value of Acme’s common stock is $5 million. The YTM
on Acme’s marginal debt is 8%. Acme's tax rate is 35 percent. The
weighted average cost of capital for the firm is 11.1%.

 What is Acme's cost of equity capital?

rs = rrf + s(rm - rrf) = 0.05 + 1.5(0.08) = .17 or 17%

 What is the market value of Acme’s debt?

WACC = wd(1-0.35)(0.08) + (1 - wd)(0.17) = .111

wd(0.052) + 0.17 - wd(0.17) = .111

wd(0.052 - 0.17) + 0.17 = .111

wd(-0.118) = .111 - 0.17 = - 0.059

wd = (-0.059) / (-0.118) = 0.5

VD = VS = $5MM

5
Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

Note:

WACC can be used to discount the after-tax CFs on new projects that are “carbon copies”
of the firm's existing business, i.e., have similar risk and do not induce a change in capital
structure policy.

6. Project beta - market risk of the project

Example 7.

You are considering investing in one of two projects.

The company’s target capital structure is 70% equity and 30% debt. The projects will
be financed using similar mix of debt and equity. Assume that the company’s debt is
risk-free. The risk-free rate is currently 6%. The expected market rate of return is
14%. The equity beta for this company is 1.2. There are no taxes.

 Project A is just an expansion of the firm’s existing business. Find the cost of
capital for this project.

rs = rrf + s(rm - rrf) = 6 + 1.2(14 - 6) = 15.6%

rproject = (.7)(15.6) + (.3)(6) = 12.7%

 Project B represents an expansion into a different line of business. We know that

the betas for pure-play companies in that line of business, financed with the same
70% equity and 30% debt capital mix, average to 0.45. Find the cost of capital for
this project.

rS = rrf + project(rm - rrf) = 6 + 0.45(14 - 6) = 9.6%

rproject = (.7)(9.6) + (.3)(6) = 8.5%

6
Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

Example 8.

Compute GN’s costs for the following sources of financing.

a) GN’s preferred stock is selling for $108 with an annual dividend payment of $10.
The company's marginal tax rate is 34%.

10 10
price = 108 =  rps = = 0.0926
r ps 108

b) New common stock where the most recent dividend was $3.20. The company's
dividends per share should continue to increase at a 7% growth rate into the
indefinite future. The market price of the stock is currently $52.

D1 D (1  g ) 3.20(1  0.07)
P0 =  0 =
rs  g rs  g rs  0.07

3.20(1  0.07)
 rs = + 0.07 = 0.1358
52

c) What is GN’s cost of capital if GN’s cost of debt is 7.8%, and its capital structure
consists of 20% preferred stock, 40% common equity, and 40% debt?

WACC = 0.40(0.078)(1-0.34) + 0.40(0.1358) + 0.20(0.0926) = 9.343%