Chapter 13

The Cost of Capital

A Basic Balance Sheet
Two Capital Structures
Weighted Average Cost of Capital
Weighted Averages and the Overall Cost of Capital
Weighted Average Cost of Capital (WACC)
Market-Value Balance Sheet
MV(Equity) + MV(Debt) = MV(Assets)
Leverage
Unlevered
Levered

Weighted Average Cost of Capital
Weighted Average Cost of Capital Calculations
The Weighted Average Cost of Capital: Unlevered
Firm
r
WACC
= Equity Cost of Capital = r
E
Weighted Average Cost of Capital: Levered Firm


r
wacc
= r
E
E%+ r
Pfd
P%+ r
D
(1T
c
)D%
Calculating the Weights in the WACC
Problem:
Suppose Kenai Corp. has debt with a book (face) value of $10 million,
trading at 95% of face value. It also has book equity of $10 million, and 1
million shares of common stock trading at $30 per share. What weights
should Kenai use in calculating its WACC?
The weights are the fractions of Kenai financed with debt and financed
with equity. Furthermore, these weights should be based on market values
because the cost of capital is based on investors current assessment of the
value of the firm, not their assessment of accounting-based book values.
As a consequence, we can ignore the book values of debt and equity.
Calculating the Weights in the WACC
Ten million dollars in debt trading at 95% of face value is $9.5 million in
market value. One million shares of stock at $30 per share is $30 million in
market value. So, the total value of the firm is $39.5 million. The weights
are:
9.5 39.5 = 24.1% for debt and 30 39.5 = 75.9% for equity
Costs of Debt and Equity Capital
Cost of Debt Capital
Yield to Maturity and the Cost of Debt
The Yield to Maturity is the yield that investors demand to
hold the firms debt (new or existing).
Taxes and the Cost of Debt
Effective Cost of Debt
r
D
(1 T
C
)
where T
C
is the corporate tax rate.
Effective Cost of Debt
Problem:
By using the yield to maturity on DuPonts debt, we found that its pre-tax
cost of debt is 3.66%. If DuPonts tax rate is 35%, what is its effective cost
of debt?
Calculate DuPonts effective cost of debt:
r
D
= 6.09% (pre-tax cost of debt)
T
C
= 35% (corporate tax rate
DuPonts effective cost of debt is
0.0366 (1 0.35) = 0.02379 = 2.379%.


Effective Cost of Debt
Evaluate:
For every $1000 it borrows, DuPont pays its bondholders
0.0366($1000) = $36.60 in interest every year. Because it can
deduct that $36.60 in interest from its income, every dollar in
interest saves DuPont 35 cents in taxes, so the interest tax
deduction reduces the firms tax payment to the government
by 0.35($36.60) = $12.81. Thus DuPonts net cost of debt is the
$36.60 it pays minus the $12.81 in reduced tax payments,
which is $23.79 per $1000 or 2.379%.
Costs of Debt and Equity Capital
Cost of Preferred Stock Capital



Assume DuPonts class A preferred stock has a price of
$66.67 and an annual dividend of $3.50. Its cost of
preferred stock, therefore, is $3.50 $66.67 = 5.25%
Prefered Dividend
Cost of Preferred Stock Capital =
Preferred Stock Price
pfd
pfd
Div
P
=
Costs of Debt and Equity Capital
Cost of Common Stock Capital
Capital Asset Pricing Model
1. Estimate the firms beta of equity, typically by regressing 60
months of the companys returns against 60 months of
returns for a market proxy such as the S&P 500.
2. Determine the risk-free rate, typically by using the yield on
Treasury bills or bonds.
3. Estimate the market risk premium, typically by comparing
historical returns on a market proxy to contemporaneous
risk-free rates.
4. Apply the CAPM:
Cost of Equity = Risk-Free Rate + Equity Beta Market Risk
Premium



Costs of Debt and Equity Capital
Cost of Common Stock Capital
Capital Asset Pricing Model
Assume the equity beta of DuPont is 1.37, the yield on
ten-year Treasury notes is 3%, and you estimate the
market risk premium to be 6%. DuPonts cost of equity
is 3% + 1.37 6% = 11.22%




Costs of Debt and Equity Capital
Cost of Common Stock Capital
Constant Dividend Growth Model




Costs of Debt and Equity Capital
Cost of Common Stock Capital
Constant Dividend Growth Model
Assume in mid-2010, the average forecast for DuPonts
long-run earnings growth rate was 6.2%. With an
expected dividend in one year of $1.64 and a price of
$36.99, the CDGM estimates DuPonts cost of equity as
follows:



1
$1.64
Cost of Equity = 0.062 0.106 or 10.6%
$36.99
E
Div
g
P
+ = + =
Estimating the Cost of Equity
Estimating the Cost of Equity
Problem:
The equity beta for Johnson & Johnson (ticker: JNJ) is 0.67. The yield on ten-
year treasuries is 3%, and you estimate the market risk premium to be 6%.
Further, Johnson & Johnson issues dividends at an annual rate of $2.16. Its
current stock price is $60.50, and you expect dividends to increase at a
constant rate of 4% per year. Estimate J&Js cost of equity in two ways.
The two ways to estimate J&Js cost of equity are to use the CAPM and the
CDGM.
1. The CAPM requires the risk-free rate, an estimate of the equitys beta,
and an estimate of the market risk premium. We can use the yield on
ten-year Treasury bills as the risk-free rate.
2. The CDGM requires the current stock price, the expected dividend next
year, and an estimate of the constant future growth rate for the
dividend
Estimating the Cost of Equity
Risk-free rate: 3% Current price: $60.50
Equity beta: 0.67 Expected dividend: $2.16
Market risk premium: 6% Estimated future dividend growth rate: 4%

The CAPM says that


For J&J, this implies that its cost of equity is 3% + 0.67 6% = 7.0%

The CDGM says

Cost of Equity = Risk-Free Rate +Equity Beta Market Risk Premium
Dividend (in one year) $2.16
Cost of Equity Dividend Growth Rate 4% 7.6%
Current Price $60.50
= + = + =
Estimating the Cost of Equity
Evaluate:
According to the CAPM, the cost of equity capital is 7.0%; the CDGM
produces a result of 7.6%. Because of the different assumptions we make
when using each method, the two methods do not have to produce the
same answerin fact, it would be highly unlikely that they would. When
the two approaches produce different answers, we must examine the
assumptions we made for each approach and decide which set of
assumptions is more realistic. We can also see what assumption about
future dividend growth would be necessary to make the answers converge.
By rearranging the CDGM and using the cost of equity we estimated from
the CAPM, we have:
Dividend(inone year)
DividendGrowthRate Cost of Equity
Current Price
7% 3.6% 3.4%
=
= =
Weighted Average Cost of Capital
WACC Equation
r
wacc
= r
E
E% + r
pfd
P% + r
D
(1 T
C
)D%
For a company that does not have preferred stock,
the WACC condenses to:
r
wacc
= r
E
E% + r
D
(1 T
C
)D%
Weighted Average Cost of Capital
WACC Equation
In mid-2010, the market values of DuPonts common stock, preferred
stock, and debt were $30,860 million, $187 million, and $9543 million,
respectively. Its total value was, therefore, $30,860 million + $187 million +
$9543 million = $40,590. Given the costs of common stock, preferred
stock, and debt we have already computed, DuPonts WACC in late 2010
was:

( )
30,860 187 9, 543
11.22% 5.25% 1 0.35 3.66%
40, 590 40, 590 40, 590
9.11%
WACC
| | | | | |
= + +
| | |
\ . \ . \ .
=
WACCs for Real Companies
Weighted Average Cost of Capital
Methods in Practice
Net Debt
Net Debt = Debt Cash and Risk-Free Securities

WACC E D C
Market Value of Equity Net Debt
r = r r (1 T )
Enterprise Value Enterprise Value
| | | |
+
| |
\ . \ .
Weighted Average Cost of Capital
Methods in Practice
The Risk-Free Interest Rate
Most firms use the yields on long-term treasury bonds
The Market-Risk Premium
Since 1926, the S&P 500 has produced an average
return of 7.1% above the rate for one-year Treasury
securities
Since 1959, the S&P 500 has shown an excess return of
only 4.7% over the rate for one-year Treasury securities
Historical Excess Returns of the S&P 500 Compared to One-Year
Treasury Bills and Ten-Year U.S. Treasury Securities
Using the WACC to Value a Project
Levered Value
The value of an investment, including the benefit
of the interest tax deduction, given the firms
leverage policy
WACC Valuation Method
Discounting future incremental free cash flows
using the firms WACC, which produces the levered
value of a project
Using the WACC to Value a Project
Levered Value

( ) ( )
3 1 2
0
2 3
...
1
1 1
L
WACC
WACC WACC
FCF FCF FCF
V
r
r r
= + + +
+
+ +
The WACC Method
Problem:
Suppose Anheuser Busch InBev is considering introducing a new ultra-light
beer with zero calories to be called BudZero. The firm believes that the
beers flavor and appeal to calorie-conscious drinkers will make it a
success. The risk of the project is judged to be similar to the risk of the
company. The cost of bringing the beer to market is $200 million, but
Anheuser Busch InBev expects first-year incremental free cash flows from
BudZero to be $100 million and to grow at 3% per year thereafter. If
Anheuser Busch InBevs WACC is 5.7%, should it go ahead with the project?
The cash flows for BudZero are a growing perpetuity. Applying the growing
perpetuity formula with the WACC method, we have:

Using the WACC to Value a Project
Key Assumptions
Average Risk
We assume initially that the market risk of the project is equivalent
to the average market risk of the firms investments
Constant Debt-Equity Ratio
We assume that the firm adjusts its leverage continuously to
maintain a constant ratio of the market value of debt to the market
value of equity
Limited Leverage Effects
We assume initially that the main effect of leverage on valuation
follows from the interest tax deduction and that any other factors
are not significant at the level of debt chosen



Using the WACC to Value a Project
WACC Method Application: Extending the Life of a DuPont Facility
Suppose DuPont is considering an investment that would extend the
life of one of its chemical facilities for four years
The project would require upfront costs of $6.67 million plus a $24
million investment in equipment
The equipment will be obsolete in four years and will be depreciated
via straight-line over that period
During the next four years, however, DuPont expects annual sales of
$60 million per year from this facility
Material costs and operating expenses are expected to total $25
million and $9 million, respectively, per year
DuPont expects no net working capital requirements for the project,
and it pays a tax rate of 35%.

Expected Free Cash Flow from DuPonts Facility
Project
Using the WACC to Value a Project
WACC Method Application: Extending the Life
of a DuPont Facility


NPV = $61.41 million - $28.34 million = $33.07 million

0
2 3 4
19 19 19 19
$61.41 million
1.0911 1.0911 1.0911 1.0911
L
V = + + + =
Using the WACC to Value a Project
Summary of WACC Method
1. Determine the incremental free cash flow of the
investment
2. Compute the weighted average cost of capital
3. Compute the value of the investment, including
the tax benefit of leverage, by discounting the
incremental free cash flow of the investment
using the WACC

Project-Based Costs of Capital
Cost of Capital of a New Acquisition
Suppose DuPont is considering acquiring
Weyerhaeuser, a company that is focused on
timber, paper, and other forest products
Weyerhaeuser faces different market risks than
DuPont does in its chemicals business
What cost of capital should DuPont use to value a
possible acquisition of Weyerhaeuser?

Project-Based Costs of Capital
Cost of Capital of a New Acquisition
Because the risks are different, DuPonts WACC
would be inappropriate for valuing Weyerhaeuser
Instead, DuPont should calculate and use
Weyerhaeusers WACC of 8.8% when assessing the
acquisition

Project-Based Costs of Capital
Divisional Costs of Capital
Now assume DuPont decides to create a forest
products division internally, rather than buying
Weyerhaeuser
What should the cost of capital for the new
division be?
If DuPont plans to finance the division with the same
proportion of debt as is used by Weyerhaeuser, then
DuPont would use Weyerhaeusers WACC as the WACC
for its new division
When Raising External Capital Is Costly
Issuing new equity or bonds carries a number
of costs
Issuing costs should be treated as cash outflows
that are necessary to the project
They can be incorporated as additional costs
(negative cash flows) in the NPV analysis
Costly External Financing
Problem:
You are analyzing DuPonts potential acquisition of
Weyerhaeuser. DuPont plans to offer $23 billion as the
purchase price for Weyerhaeuser, and it will need to issue
additional debt and equity to finance such a large acquisition.
You estimate that the issuance costs will be $800 million and
will be paid as soon as the transaction closes. You estimate the
incremental free cash flows from the acquisition will be $1.4
billion in the first year and will grow at 3% per year thereafter.
What is the NPV of the proposed acquisition?
Costly External Financing
The correct cost of capital for this acquisition is Weyerhaeusers WACC. We can
value the incremental free cash flows as a growing perpetuity:







The NPV of the transaction, including the costly external financing, is the
present value of this growing perpetuity net of both the purchase cost and the
transaction costs of using external financing.







Costly External Financing
Evaluate:
It is not necessary to try to adjust Weyerhaeusers WACC for the issuance
costs of debt and equity. Instead, we can subtract the issuance costs from
the NPV of the acquisition to confirm that the acquisition remains a
positive-NPV project even if it must be financed externally.