MBA Corporate Finance BBUS 6020

Dr. Alex Ng

Being in this Class means:

Being Prepared to Participate

Chapter 14, The Cost of Capital

14.1 The Cost of Capital: Some Preliminaries
14.2 The Cost of Equity
14.3 The Costs of Debt and Preferred Stock
14.4 The Weighted Average Cost of Capital
14.5 Divisional and Project Costs of Capital
14.6 Summary and Conclusions © Fundamentals of Corporate Finance, Cdn Ed.,
Ross, Westerfield, Jordan and Roberts
Dr. Alex Ng, Thompson Rivers University

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Why Cost of Capital is Important

• Return earned on assets depends on the risk of their assets

• Returns to an investor is the same as the cost to the company

• Cost of capital provides an indication of how the market views

asset risk

• Knowing cost of capital helps determine required return for capital

budgeting projects

Required Return

• Same as the appropriate discount rate

• Based on the risk of cash flows

• Required for an investment before we can compute NPV and make

a decision to take, or not take the investment

• Earn at least the required return to compensate investors for

financing they provide

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Dr. Alex Ng

Introduction to Long-Term Financing: Cost of Capital

• Long-term financing is making long-term investments. Some

questions are:
• What is the cost of capital?
• How do we raise capital?
• What kind of capital structure do we need?
• What is our dividend policy?

• Recall: discount rate used in time value of money, valuing stocks

and bonds, and capital budgeting; how do we determine it?
• Costs money to raise money – how much does it cost?
• Weighted Average Cost of Capital (WACC) comprised of cost
of equity capital and cost of debt capital

The Cost of Capital Issues

• What do we mean by “cost of capital”

• How can we come up with an estimate?
• Preliminaries
1. Vocabulary – the following mean the same thing:
a. Required return
b. Appropriate discount rate
c. Cost of capital (or cost of money)
2. Cost of capital is an opportunity cost, depends on where
the money goes, not where it comes from
3. Assume firm’s capital structure (mix of debt and equity) is
fixed

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Financial Markets

The Cost of Equity Introduction

• The return equity investors require on their investment in the firm

• No directly observable way to determine; it must be estimated
• Two methods of estimating Cost of Equity:
1. Dividend Growth Model Approach
RE = D1 + g
P0
To estimate g:
• Historical growth rates (compound or year to year)
of dividends
• Analysts’ forecasts of future growth rates available
2. SML Approach

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

The Dividend Growth Model Approach

According to the constant growth model,

P0 = D1
RE - g

Rearranging,

RE = D1 + g
P0

Example: Estimating the Dividend Growth Rate

Year Dividend Dollar Percentage

Change Change
1996 $4.00 - -
1997 4.40 $0.40 10.00%
1998 4.75 0.35 7.95
1999 5.25 0.50 10.53
2000 5.65 0.40 7.62

Average Growth Rate

(10.00 + 7.95 + 10.53 + 7.62) / 4 =

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Example II: Alternative Approach to Estimating Growth

If the company has a table ROE, a stable dividend policy and is not
planning on raising new external capital, then the following
relationship can be used:

g = Retention ratio x ROE

Vanover Toy Company has a ROE of 15%

and payout ratio of 35%. If management is
not planning on raising additional external
capital, what is Vanover’s growth rate?

g = (1 – 0.35) x 0.15 =

Example III: The SML Approach

According to CAPM: RE = Rf + βE x (RM – Rf)

1.Get the risk-free rate from financial press – many use the 1-year T-
bill rate, say 6%

2.Get estimates of market risk premium and security beta

a. Risk premium historical - __________%
b. Beta – historical
i. Investment information services, i.e. S&P
ii. Estimate from historical data

3.Suppose beta is 1.40, then, using the approach:

RE = Rf + βE x (RM – Rf)
= 0.06 + 1.40 x _______
= ___________%

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Example IV: Calculating the Cost of Equity

Do the exercise first with SML Approach, then with Dividend Growth
Approach.

Stock in Alcatel Chemical Company was trading on the TSE at

$53.95. Alcatel has a beta of 0.75. The market risk premium
historically has been around 7%, and the risk-free rate at this time was
4.8%. Alcatel’s last dividend was $1.40 per share, and some analysts
expected the dividend would grow at 7% indefinitely. What is
Alcatel’s cost of equity capital?

Example IV: Calculating the Cost of Equity Cont’d

SML Approach:

Cost of Equity:

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Introduction to Cost of Debt

• Corporations also use debt, and to a lesser extent, preferred stock

to raise money
• Cost of debt is the return lenders require on the firm’s debt
• One way to estimate using SML approach
• Find the beta on company’s debt, then find the expected return
• An easier way – returns can be observed in the market
• Cost of preferred stock
• Equal to the dividend yield on the preferred stock
• Alternatively, because preferred stock is rated like bonds, can
be observed in the market

Costs of Debt and Preferred Stock

• Cost of Debt
1. Cost of debt, RD, is the interest rate on new borrowing

2. Cost of debt is observable:

a. Yield on currently outstanding debt
b. Yields on newly-issues similarly-rated bonds

3. The historic debt is irrelevant, why?

Example: We sold a 20-year, 12% bond 10 years ago at par. It
is currently priced at 86. What is our cost of debt?
The yield to maturity is _______%, so this is what we use as the
cost of debt, not 12%.

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Play Video:

Costs of Debt and Preferred Stock Cont’d

• Cost of Preferred
1. Preferred stock is a perpetuity, so the cost is
RP = D / P0

2. Notice that cost is simply the dividend yield.

Example: We sold an $8 preferred issue 10 years ago. It sells

for $120/share today.

The dividend yield today is $_______ / ______ =

, so this is what we use as the cost of preferred.

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Example V: Calculating the Cost of Debt

Union Gas has a bond outstanding with 27 years to

maturity and a coupon rate of 8.65%. The bond is
currently selling for 134.58 percent of its face
value, or $134.58. What is Union Gas’s cost of
debt?

Recall: We just mentioned that it is the yield that matters (not the coupon rate)
of the bond that determines the cost of debt.

Yield = Coupon + (Face value – Price) / Maturity

(Price + Face Value) / 2

Example V: Calculating the Cost of Debt Cont’d

Preferred stock: Alcatel preferred stock traded

on the TSE with a dividend of $4.75 annually
and a price of $89. What is Alcatel’s cost of
preferred stock?

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

The Weighted Average Cost of Capital

• We can use individual costs of capital that we computed to get our

“average” cost of capital for the firm

• This “average” is the required return on our assets, based on the

market’s perception of the asset’s risk

• Weights determined by how much of each type of financing we use

The Weighted Average Cost of Capital Cont’d

Capital structure weights:

1.Let: E = the market value of the equity
D = the market value of the debt
Then: V = E + D, so E/V + D/V = 100%

2.Firm’s capital structure weights are E/V and D/V

3.Interest payments on debt are tax-deductible, so after-tax cost of

debt is pretax cost multiplied by (1 – corporate tax rate)

After-tax cost of debt = RD x ( ________________)

4.Thus the weighted average cost of capital is:

WACC = (E/V) x RE + (D/V) x RD x (1 – TC)

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Example VI: Eastman Chemical’s WACC

Eastman Pharmaceutical has 80 million shares of

common stock outstanding. The book value is
$19.10 and the market price is $62.375 per share.
T-bills yield 5%, and the market risk premium is
assumed to be 8.5%. The stock beta is 1.1.

The firm has three debt issues outstanding:

Coupon Book Value Market Value Yield-to-Maturity

6.375% $499m $521m 5.70%
7.250% $495m $543m 6.50%
7.625% $200m $225m 6.60%

Example VI: Eastman Chemical’s WACC Cont’d

Cost of equity (SML approach):

RE = 0.05 + 1.1 x (0.085) =

Cost of debt:

Multiply the proportion of total debt represented by each issue by its yield
to maturity; the weighted average cost of debt =

Capital structure weights:

Market value of equity = 80 million x $62.375 = $

Market value of debt = $521m + $543m + $225m = $

V=

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Example VI: Eastman Chemical’s WACC Cont’d

Capital structure weights cont’d:

D/V = $1.29b / $6.28b =

E/V = $4.99b / $6.28b =

WACC =

Summary of Capital Cost Calculations

1. Cost of Equity, RE
A. Dividend growth model approach
RE = D1/P0 + g
B. SML approach
RE = Rf + βE x (RM – Rf)

2. Cost of Debt, RD
A. For a firm with publicly held debt, cost of debt can be
measured as the yield to maturity on the outstanding debt
B. If the firm has no publicly traded debt, cost of debt can be
measured as the yield to maturity on similarly rated bonds

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Summary of Capital Cost Calculations

3. Weighted Average Cost of Capital

A. WACC is the required return on the firm as a whole. It is
the appropriate discount rate for cash flows similar in risk
to the firm.

B. WACC calculated as:

WACC = (E/V) x RE + (D/V) x RD x (1 – TC)
Where Tc is the most corporate tax rate, E is the market value of
the firm’s equity, D is the market value of the firm’s debt,
and V = E + D

Example VII: WACC

Independence Mining Corporation has 7 million shares of common stock

outstanding, 1 million shares of 6% preferred outstanding, and 100,000
$1,000 par, 9% semiannual coupon bonds outstanding. The stock sells for
$35 per share and has a beta of 1.0, the preferred stock sells for $60 per
share, and the bonds have 15 years to maturity and sell for 89% of par. The
market risk premium is 8%, T-bills are yielding 7%, and the firm’s tax rate
is 34%.

a.What is the firm’s market value capital structure?

b. If the firm is evaluating a new investment project that is equally as risky
as the firm’s typical project, what rate should they use to discount the
project’s cash flows?

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Example VII: WACC Cont’d

a. MVD = _____________ ($1,000) (0.89) = $___________

MVE = 7m ($35) =

MVP = ______________ ($60) = $____________

V = ___________ + 245 + _____________ = $___________

D/V = _________ / __________ =

E/V = _________ / __________ =

P/V = _________ / __________ =

Example VII: WACC Cont’d

b. For projects as risky as the firm itself, the WAC is the appropriate
discount rate. So:

RE = 0.07 + ________ (0.08) = __________%

YTM =

RD = _______% and RD (1 – TC) = (._______)(1 – 0.34) =

_______

RP = $______ / $______ = _______%

WACC = ______ (______) + ______ (______) + _______

(______) = ____________ %

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Divisional and Project Costs of Capital

• When is WACC the appropriate discount rate?

• WACC used as discount rate for project investments similar to the

firm’s existing activities
• i.e. airlines investing in new aircraft

• Investments having cash flows with distinctly different risks from

the overall firm require a different discount rate
• Divisional cost of capital – separate costs of capital for
separate divisions
• Pure play approach – use of a WACC that is unique to a
particular project
• Subjective approach – making subjective adjustments to the
WACC to reflect risk

Capital Budgeting “Other Industries”

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MBA Corporate Finance BBUS 6020
Dr. Alex Ng

Today, We learned….
Chapter 14
Cost of Capital
14.1 The Cost of Capital: Some Preliminaries
14.2 The Cost of Equity
14.3 The Costs of Debt and Preferred Stock
14.4 The Weighted Average Cost of Capital
14.5 Divisional and Project Costs of Capital
14.6 Summary and Conclusions

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