Titman PPT Ch14

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 14
The Cost of Capital
Copyright © 2018, 2014, 2011 Pearson

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Learning Objectives (1 of 2)
1. Understand the concepts underlying the firm’s
overall cost of capital and the purpose for its
calculation.
2. Evaluate a firm’s capital structure, and
determine the relative importance (weight) of
each source of financing.
3. Calculate the after-tax cost of debt, preferred
stock, and common equity.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Learning Objectives (2 of 2)
4. Calculate a firm’s weighted average cost of
capital.
5. Discuss the pros and cons of using multiple,
risk-adjusted discount rates and describe the
divisional cost of capital as a viable alternative
for firms with multiple divisions.
6. Adjust the NPV for the costs of issuing new
securities when analyzing new investment
opportunities.
Principles Applied in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 3: Cash Flows Are the Source of Value.
• Principle 4: Market Prices Reflect Information.
• Principle 5: Individuals Respond to Incentives.
14.1 THE COST OF CAPITAL: AN OVERVIEW
The Cost of Capital: An Overview (1 of 3)
• We can view the returns that investors expect to receive
on the firm’s stocks and bonds as the cost to the firm of
attracting the capital used to fund the firm’s investment in
assets. We can think of the cost of capital for a firm as
the weighted average of the required returns of the
securities that are used to finance its business. We refer to
this as the firm’s weighted average cost of capital, or
WACC.
• WACC incorporates the required rates of return demanded
by the firm’s lenders and investors along with the particular
mix of financing sources that the firm uses.
The riskiness of a firm affects its WACC in two
ways:
– First, required rate of return on the debt and equity
securities that the firm issues will be higher if the firm is
riskier, and
– Second, risk influences how the firm chooses the
extent to which it is financed with debt and equity
securities.
The firm’s WACC is used in a number of ways:
– First, WACC is used to value the entire firm.
– Second, firms often use WACC as the starting point for
determining the discount rate for individual investment
projects they might undertake
– Finally, firms sometimes use their WACC to evaluate
their performance
WACC equation
W eighted   Proportion of     Proportion of 

 After-Tax Cost      Cost of Preferred   
Average Cost      Capital Raised      Capital Raised 
 of Debt kd (1  T)     Stock (k ps ) 
of Capital (WACC )    
 by Debt(w d )     by Pr eferred Stock ( k ps )  
  Proportion of 
 Cost of Common   
   Capital Raised 
Stock ( kcs )
   by Common Stock(w )  
 cs  
Figure 14.1 A Template for Calculating WACC
Source of Capitala Market Value After-Tax Cost Product of
× =
(1) Weightb (2) of Capitalc(3) Columns 2 and 3d
Debt wd × kd (1 − T) = wd × kd (1 − T)
Preferred stock wps × kps = wps × kps
Common equity wcs × kcs = wcs × kcs
Sum = 100% Blank Blank Blank WACC
a
The sources of capital included in the WACC calculation include all interest-bearing debt (short- and long-term) but
exclude non-interest-bearing debt such as accounts payable and accrued expenses. In addition, preferred stock and
common equity are included. The total of all the market values of all the capital sources included in the WACC
computation is generally referred to as the firm’s enterprise value, and the mix of debt and equity defines the firm’s capital
structure.
b
The weight used to average the cost of each source of capital should reflect the relative importance of that source of
capital to the firm’s value on the date of the analysis. This means that the proper weight for each source is based on the
market value of that source of capital as a percentage of the sum of the market values of all sources.
c
The investor’s required rate of return is the basis for estimating the cost of capital for each source of financing to the firm.
However, because interest on the firm’s debt is tax-deductible to the firm, we must adjust the lender’s required rate of
return to an after-tax basis. The required rate of return for each source of financing, like the weight used to average it,
should reflect a current estimate based on current market conditions.
d
The weighted average of the individual costs of the sources of capital is found by summing the products of the weight
and cost of each source.
Three—Step Procedure for Estimating the
Firm’s WACC (1 of 2)
1. Define the firm’s capital structure by determining
the weight of each source of capital. (see column 2,
figure 14.1). The weight (importance) of each source
of capital is based on the current market value of
each source of capital.
2. Estimate the cost of each source of financing.
These costs are equal to the investor’s required
rates of return after adjusting the cost of debt for the
effects of taxes (see column 3, figure 14-1)
Three—Step Procedure for Estimating the
Firm’s WACC (2 of 2)
3. Calculate a weighted average of the cost of
capital from all source of financing. This step
requires calculating the product of the after-tax
cost of each capital source used by the firm and
the weight associated with that source. The sum
of these products is the WACC. (see column 4,
figure 14-1)
14.2 DETERMINING THE FIRM’S
CAPITAL STRUCTURE WEIGHTS
Determining the Firm’s Capital Structure
Weights (1 of 2)
The weights are based on the following sources of
financing: debt (short-term and long-term), preferred
stock and common equity. Liabilities such as
accounts payable are not included in capital
structure.
Determining the Firm’s Capital Structure
Weights (2 of 2)
• In theory, market value is preferred for all
securities. However, not all market values may be
readily available.
• In practice, we generally use book values for debt
and market values for equity securities.
CHECKPOINT 14.1: CHECK YOURSELF
Calculating the WACC
The Problem
After completing her estimate of Templeton’s WACC, the
CFO decided to explore the possibility of adding more low-
cost debt to the capital structure. With the help of the firm’s
investment banker, the CFO learned that Templeton could
probably push its use of debt to 37.5% of the firm’s capital
structure by issuing more debt and retiring (purchasing) the
firm’s preferred shares. This could be done without
increasing the firm’s costs of borrowing or the required rate
of return demanded by the firm’s common stockholders.
What is your estimate of the WACC for Templeton under this
new capital structure proposal?
Step 1: Picture the Problem (1 of 2)
Step 2: Decide on a Solution Strategy (1 of 2)
We need to determine the WACC based on the
given information:
– Weight of debt = 37.5%; Cost of debt = 6%
– Weight of common stock = 62.5%; Cost of common
stock =15%
We can compute the WACC based on the following
equation:
W eighted   Proportion of     Proportion of 

 After-Tax Cost      Cost of Preferred   
Average Cost      Capital Raised      Capital Raised 
 of Debt kd (1  T)     Stock ( k ps ) 
of Capital (WACC )    
 by Debt(w d )     by Pr eferred Stock ( k ps )  
  Proportion of 
 Cost of Common   
   Capital Raised 
Stock ( kcs )
   by Common Stock(w )  
 cs  
Step 3: Solve
The WACC is equal to 11.625% as calculated below.
Blank Weights Cost Product
Debt 0.375 0.06 0.0225
Common Stock 0.625 0.15 0.09375
Preferred Stock 0 0.1 0
Blank 1 WACC 0.11625
Step 4: Analyze
We observe that as Templeton chose to increase
the level of debt to 37.5% and retire the preferred
stock, the WACC decreased marginally from
12.125% to 11.625%. Thus altering the weights will
change the WACC.
14.3 ESTIMATING THE COST OF
INDIVIDUAL SOURCES OF CAPITAL
The Cost of Debt (1 of 4)
The cost of debt is the rate of return the firm’s
lenders demand when they loan money to the firm.
We estimate the market’s required rate of return on
a firm’s debt using its yield to maturity and not the
coupon rate.
After-tax cost of debt = Yield (1-tax rate)
Example What will be the yield to maturity on a debt
that has par value of $1,000, a coupon interest rate
of 5%, time to maturity of 10 years and is currently
trading at $900? What will be the cost of debt if the
tax rate is 30%?
Enter:
– N = 10; PV = −900; PMT = 50; FV =1000
– I/Y = 6.38%
– After-tax cost of Debt = Yield (1-tax rate)
= 6.38 (1−.3)
= 4.47%
It is not easy to find the market price of a specific
bond. It is a standard practice to estimate the cost
of debt using yield to maturity on a portfolio of
bonds with similar credit rating and maturity as the
firm’s outstanding debt.
Figure 14-2 A Guide to Corporate Bond Ratings (1 of 2)
Moody’s S&P Fitch Definitions
Aaa AAA AAA Prime, Maximum Safety

Aa1 AA+ AA+ High Grade, High Quality
Aa2 AA AA Blank
Aa3 AA− AA− Blank
A1 A+ A+ Upper Medium Grade

A2 A A Blank
A3 A− A− Blank
Baa1 BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB Blank
Baa3 BBB− BBB− Blank
Ba1 BB+ BB+ Non-investment Grade
Ba2 BB BB Speculative
Ba3 BB− BB− Blank
Figure 14-2 A Guide to Corporate Bond Ratings (2 of 2)
Moody’s S&P Fitch Definitions
B1 B+ B+ Highly Speculative
B2 B B Blank
B3 B− B− Blank
Caa1 CCC+ CCC Substantial Risk
Caa2 CCC − In Poor Standing
Caa3 CCC− − Blank
Ca − − Extremely Speculative
C − − May Be in Default
− − DDD Default
− − DD Blank
− D D Blank
Figure 14-3 Corporate Bond Yields: Default Ratings and
Term to Maturity (1 of 2)
Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years
Aaa/AAA 0.22 0.31 0.42 0.76 1.26 2.00 3.41
Aa1/AA+ 0.26 0.43 0.58 0.96 1.46 2.17 3.62
Aa2/AA 0.29 0.55 0.74 1.16 1.66 2.35 3.83
Aa3/AA− 0.31 0.58 0.77 1.20 1.70 2.39 3.88
A1/A+ 0.32 0.60 0.80 1.23 1.73 2.43 3.93
A2/A 0.55 0.80 0.98 1.40 1.89 2.57 4.03
A3/A− 0.62 0.95 1.18 1.66 2.19 2.92 4.51
Baa1/BBB+ 0.83 1.19 1.42 1.91 2.45 3.18 4.80
Baa2/BBB 1.00 1.39 1.65 2.17 2.73 3.48 5.17
Baa3/BBB− 1.49 1.87 2.11 2.62 3.16 3.91 5.56
Ba1/BB+ 2.27 2.64 2.90 3.41 3.98 4.75 6.37
Ba2/BB 3.04 3.41 3.68 4.21 4.79 5.58 7.19
Figure 14-3 Corporate Bond Yields: Default Ratings and
Term to Maturity (2 of 2)
Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years
Ba3/BB− 3.82 4.18 4.47 5.00 5.61 6.42 8.00
B1/B+ 4.60 4.95 5.25 5.79 6.42 7.26 8.82
B2/B 5.38 5.72 6.04 6.59 7.24 8.10 9.63
B3/B− 6.15 6.49 6.82 7.38 8.06 8.93 10.45
Caa/CCC+ 6.93 7.26 7.61 8.17 8.87 9.77 11.26
U.S. Treasury Yield 0.18 0.25 0.32 0.60 1.00 1.59 2.76
Legend:
These data are actually reported as spread to Treasury yields, so for a 30-year Baa1/BBB+-rated corporate bond, the yield
would be reported as 204 basis points over the 30-year Treasury yield of 2.76%. A basis point is 1/100th of a percent, so 204
basis points correspond to 2.04%.
The Cost of Preferred Equity (1 of 2)
The cost of preferred equity is the rate of return
investors require of the firm when they purchase its
preferred stock.
Div ps
k ps 
Pps
The Cost of Preferred Equity (2 of 2)
Example The preferred shares of Relay Company
that are trading at $25 per share. What will be the
cost of preferred equity if these stocks have a par
value of $35 and pay annual dividend of 4%?
Using equation 14-2a
kps = $1.40 ÷ $25 = .056 or 5.6%
The Cost of Common Equity
The cost of common equity is the rate of return
investors expect to receive from investing in firm’s
stock, which, in turn, reflects the risk of investing in
the equity of the firm. This return comes in the form
of cash distributions (dividends and cash proceeds
from the sale of the stock). There are two commonly
used approaches for calculating the cost of equity:
1. The dividend growth model (from chapter 10)
2. CAPM (from chapter 8)
The Dividend Growth Model: Discounted
Cash Flow Approach (1 of 2)
1. First, estimate the expected stream of dividends
that the common stock is expected to provide t
the stockholder.
2. Second, using these estimated dividends as the
estimated cash flows from the stock, and the
firm’s current stock price, calculate the internal
rate of return on the stock investment.
The Dividend Growth Model – Discounted
Cash Flow Approach (2 of 2)
Market Price Common Stock Dividend for Year 1(D1 )

of Common Stock (Pcs )  Common Equity Required   Growth Rate in 
  
 Rate of Return ( k cs )   Dividends ( g ) 
D1
kcs  g
Pcs
Estimating the Cost of Common Equity for
Pearson plc using the
Constant Dividend Growth Rate Model
The Problem
Prepare two additional estimates of Pearson’s cost
of common equity using the dividend growth model
where you use growth rates in dividends that are
25% lower than the estimated −1.70% (i.e., for g
equal to −2.13% and −1.28%)
We are given the following:
– Price of common stock (Pcs ) = $10.79
– Growth rate of dividends (g) = −2.13% and −1.28%
– Dividend (D0) = $1.08 per share
– Cost of equity is given by dividend yield + growth rate.
Dividend Yield Cost of Equity

Growth Rate (g) (kcs )
=D1 ÷ P0
Step 2: Decide on a Solution Strategy
We can determine the cost of equity using equation
14-3a
D1
kcs  g
Pcs
Step 3: Solve
At growth rate of 4.69%
kcs = {$1.08(.9787)/$10.39} + −.0213 = .0771 or 7.71%
At growth rate of 7.81%
kcs = {$1.08(.9872)/$10.39} −.0128 = .0856 or 8.56 %
Step 4: Analyze
• Pearson’s cost of equity is estimated at 7.33%
and 10.53% based on the different assumptions
for growth rate.
• Thus growth rate is an important variable in
determining the cost of equity. However,
estimating the growth rate is not easy.
Estimating the Rate of Growth, g
The growth rate can be obtained from:
– websites that post analysts forecasts, and
– using historical data to compute the arithmetic average
or geometric average.
Arithmetic and Geometric Average
Year Dividend $ Change % Change
2012 $0.800 Blank Blank
2013 0.825 $0.025 3.1%
2014 0.840 0.015 1.8%
2015 0.875 0.035 4.2%
2016 0.900 0.025 2.9%
Blank Arithmetic Average Blank 3.0%
Blank Geometric Average Blank 2.99%
Pros and Cons of the Dividend Growth
Rate Model Approach
• Pros – Simplicity
• Cons – severely dependent upon the quality of
growth rate estimates; constant dividend growth
rate for ever is an oversimplification
The Capital Asset Pricing Model (1 of 2)
CAPM (from chapter 8) was designed to determine
the expected or required rate of return for risky
investments.
Risk Premium for Common Equity
(  Equity Beta  Market Risk Premium)
                        
Cost of common Risk - Free Equity Beta  Expected Return on Risk - Free 
    
Equity (kcs ) Rate (rf ) Coefficient (  cs )  the Market Portfolio ( rm ) Rate ( rf ) 
                        
Market Risk Premium
The Capital Asset Pricing Model (2 of 2)
Equation 14-4 illustrates that the expected return on
common stock is determined by three key
ingredients:
– The risk-free rate of interest,
– The beta or systematic risk of the common stock
returns, and
– The market risk premium.
Advantages and Disadvantages of the
CAPM approach
Advantages – simplicity, wider applications
Disadvantages – Choice of risk-free is not clearly
defined, estimates of beta and market risk premium
will vary depending on the data used.
Estimating the Cost of Common Equity
Using the CAPM
Prepare two additional estimates of Pearson’s cost of common equity using the CAPM
where you use the most extreme values of each of the three factors that drive the
CAPM.
CAPM describes the relationship between the
expected rates of return on risky assets in terms of
their systematic risk. Its value depends on:
– The risk-free rate of interest,
returns, and
– The market risk premium.
However, there can be wide variation in the
estimates for each one of these variables. Here we
are given the following estimates:
– The risk-free rate of interest (.01% or 2.80%)
returns (.8 or 1.2)
– The market risk premium (4% or 8%)
The cost of equity can be estimated using the
CAPM equation:
( Equity Beta  Market Risk Premium)
                         
Cost of Common Risk - Free Equity Beta  Expected Return on Risk - Free 
    
Equity ( kcs ) Rate ( rf ) Coefficient ( βcs )  theMarket Portfolio ( rm ) Rate ( rf ) 
                         
Market Risk Premium
The cost of equity is given by Risk-free rate + (Risk
premium × Beta):
Risk Premium
Risk-Free Rate Cost of Equity
× Beta
Step 2: Decide on a Solution Strategy
Since we have been given the estimates for market
factors (risk-free rate and risk premium) and firm-
specific factor (beta), we can determine the cost of
equity using CAPM.
Step 3: Solve

(  Equity Beta  Market Risk Premium)
                        
Cost of Common Risk - Free Equity Beta  Expected Return on Risk - Free 
    
Equity (kcs ) Rate ( rf ) Coefficient ( βcs )  the Market Portfolio ( rm ) Rate ( rf ) 
                        
Market Risk Premium
• kcs = 0.014 + 0.8(4) = 3.214%

• kcs = 3.01 + 1.2(8) = 12.61%
Step 4: Analyze
• Pearson’s cost of equity is shown to be sensitive
to the estimates used for risk-free rate of interest,
beta and market risk premium.
• Based on the estimates used, the cost of common
equity ranges from 3.21% to 12.61%.
14.4 SUMMING UP: CALCULATING THE
FIRM’S WACC
Summing Up: Calculating the Firm’s
WACC
When estimating the firm’s WACC, following issues
should be kept in mind:
– Use Market-Based Weights: weights should be based
on market values of firm’s securities rather than their
book values
– Use Market-Based Costs of Capital: the cost of capital
for each source of funds should reflect the current
market prices and expected future returns rather than
historical rates from the past.
– Use Forward-Looking weights and Opportunity Costs.
Weighted Average Cost of Capital in
Practice
• The cost of capital varies across firms because of
differences in their lines of business, which
determine business risk, and differences in
individual firms’ capital structures or financial
leverage, which is the source of financial risk.
• Figure 14.4 shows the estimates of WACCs for a
sample of large U.S. firms. The WACCs range
from 3.31 percent to 7.20 percent. In general, the
firms with the highest costs of capital are those
with the lowest use of debt financing.
Figure 14.4 WACCs for a Sample of Large U.S. Firms (1 of 2)
(Panel A) Cost of Capital Estimates
After-Tax Cost of
Blank % Debt a
Cost of Debtb % Equity Equityc WACC
American Airlines (AAL) 28.20% 2.94% 71.80% 7.50% 6.22%
American Electric Power (AEP) 40.61% 2.60% 59.39% 3.80% 3.31%

Emerson Electric (EMR) 11.64% 2.26% 88.36% 7.85% 7.20%
Exxon-Mobil (XOM) 8.53% 1.79% 91.47% 7.10% 6.65%
Ford (F) 65.21% 2.94% 34.79% 7.90% 4.67%
General Electric (GE) 19.11% 2.15% 80.89% 8.05% 6.92%
Starbucks (SBUX) 0.81% 2.86% 99.19% 6.15% 6.12%
Target (TGT) 19.23% 2.26% 80.77% 5.20% 4.63%
Wal-Mart (WMT) 16.77% 2.09% 83.23% 3.90% 3.60%
Figure 14.4 WACCs for a Sample of Large U.S. Firms (2 of 2)
(Panel B) Supporting Information Used to estimate the WACC
Spread to Risk-Free Before- Cost of
Bond 10-Year Rate (10- Tax Cost Equity
Blank Ratingd Treasury Year Treasury) of Debt Beta (CAPM)
American Airlines (AAL) Baa3 2.53% 2.0% 4.53% 1.10 7.50%
American Electric Power Baa1 2.00% 2.0% 4.00% 0.36 3.80%
(AEP)
Emerson Electric (EMR) A2 1.47% 2.0% 3.47% 1.17 7.85%
Exxon-Mobil (XOM) Aaa 0.76% 2.0% 2.76% 1.02 7.10%
Ford (F) Baa3 2.53% 2.0% 4.53% 1.18 7.90%
General Electric (GE) A1 1.30% 2.0% 3.30% 1.21 8.05%
Starbucks (SBUX) Baa2 2.40% 2.0% 4.40% 0.83 6.15%
Target (TGT) A2 1.47% 2.0% 3.47% 0.64 5.20%
Wal-Mart (WMT) Aa2 1.21% 2.0% 3.21% 0.38 3.90%
Source: Computations performed by the authors using publicly available sources in 2016.
a
% Debt = Net Debt/Enterprise Value.
b
The assumed tax rate is 35%, so After-Tax Cost of Debt = Before-Tax Cost of Debt (1 − .35).
c
% Equity = Equity Value/Enterprise Value = 1 − % Debt.
d
Moody's rating for a recent debt issue by the firm.
14.5 ESTIMATING PROJECT COSTS OF CAPITAL
Estimating Project Cost of Capital
• Should one overall WACC be used to evaluate all
new investments? In theory, No, since all projects
may not the same risk characteristics as the
overall firm.
• However, a recent survey found that more than 50
percent of firms tend to use a single, company-
wide discount rate to evaluate all of their
investment proposals.
The Rationale for Using Multiple Discount
Rates
Figure 14.5 illustrates the danger of using a single
discount rate to evaluate investment projects with
different levels of risk. There will be a tendency to to
take on too many risky investment projects, and
pass up good investment projects that are relatively
safe.
Figure 14.5 Using the Firm’s WACC Can Bias Investment
Decisions toward Risky Projects
Why Don’t Firms Typically Use Project
Cost of Capital?
1. It may be difficult to trace the source of financing
for individual project since most firms raise
money in bulk for all the projects.
2. It adds to the time and cost in getting approval
for new projects.
Estimating Divisional WACCs (1 of 2)
• If a firm undertakes investment with very different
risk characteristics, it will try to estimate
divisional WACCs.
• Generally, the divisions are defined either by
geographical regions (e.g., Latin American region)
or by industry (e.g., exploration and production,
pipelines, and refining for a large, integrated oil
company)
Estimating Divisional WACCs (2 of 2)
• The advantages of using a divisional WACC
include the following:
– It provides different discount rates that reflect
differences in the systematic risk of the projects
evaluated by different divisions
– It entails only one cost of capital estimate per division
(as opposed to unique discount rates for each project)
– The use of common discount rate throughout the
division limits managerial latitude and the attendant
influence costs
Using Pure Play Firms to Estimate
Divisional WACCs
• Here a firm with multiple divisions may identify a
comparable firm with only one division (called a
“pure play” comparison firms or “comps”).
• The estimate of pure play firm’s cost of capital can
then be used as a proxy for that particular
division’s cost of capital.
Figure 14.6 Choosing the Right WACC: Discount Rates and
Project Risk
Method Description Advantages Disadvantages When to Use
WACC Estimated WACC • Is a familiar concept to • Does not adjust discount • When projects are similar in
for the firm as an most business executives. rate for differences in risk to the firm as a whole.
entity; used as the • Minimizes estimation project risk. • When using multiple discount
discount rate on all costs, as there is only one • Does not provide for rates creates significant
projects.
cost-of capital calculation flexibility in adjusting for problems with influence
for the firm. differences in project debt in costs.
• Reduces the problem of the capital structure.
influence cost issues.
Divisional Estimated WACC for • Uses division-level risk to • Does not capture • When individual projects
WACC individual business adjust discount rates for intradivision risk differences within each division have
units or divisions individual projects. in projects. similar risks and debt
within the firm; used • • Does not account for capacities.
Reduces influence costs
as the only discount • When discount rate
to the competition among differences in project debt
rate within each
division managers to capacities within divisions. discretion creates significant
division.
lower their division’s cost • Allows potential influence influence costs within
of capital. costs associated with the divisions but not between
choice of discount rates divisions.
across divisions.
• Is difficult to find single-
division firms to be proxies
for divisions.
Divisional WACC—Estimation Issues and
Limitations (1 of 2)
Although divisional WACC is generally a significant
improvement over the single, company-wide WACC, the
way that it is often implemented using industry-based
comparison firms has a number of potential
shortcomings:
• The sample of firms in a given industry may include
firms that are not good matches for the firm doing the
analysis or for one of its divisions.
• The division being analyzed may not have a capital
structure that is similar to that of the sample firms in
the industry data.
Divisional WACC—Estimation Issues and
Limitations (2 of 2)
• The firms in the chosen industry that are used as
proxies for divisional risk may not be good
reflections of project risk.
• Good comparison firms for particular division may
be difficult to find.
14.6 FLOATATION COSTS AND PROJECT NPV
Floatation Costs
Floatation costs are fees paid to an investment
banker and costs incurred when securities are sold
at a discount to the current market price.
WACC, Floatation Costs and Project NPV
(1 of 3)
Because of floatation costs, the firm will have to

raise more than the amount it needs.
Financing
Flotation-Cost-Adjusted Needed

Initial Outlay  Flotation Cost 
 1  
 as a Percent of Funds Raised 
(2 of 3)
Example If a firm needs $100 million to finance its

new project and the floatation cost is expected to be
5.5%, how much should the firm raise by selling
securities?
(3 of 3)
Financing

 1  
= $100 million ÷ (1−.055) = $105.82 million

• Thus the firm will raise $105.82 million, which
includes floatation cost of $5.82 million.
Incorporating Floatation Costs
Into the Calculation of NPV
The Problem
Before Tricon could finalize the financing for the
new project, stock market conditions changed such
that new stock became more expensive to issue. In
fact, floatation costs rose to 15% of new equity
issued and 3% of new debt issued. Is the project
still viable (assuming the present value of future
cash flows remain unchanged)?
The NPV will be equal to the present value of the
future cash flows less the initial outlay and floatation
costs.
NPV = PV(inflows)
– Initial outlay
– Floatation costs
We need to first estimate the average floatation
costs that Tricon will incur when raising the funds.
This can be done using equation 14-5.
W eighted Average  Flotation Cost   Flotation Cost 

  wd   w
  cs  
Flotation Cost  of Debt as a Percent   of Equity as a Percent 
Next, the “grossed-up” investment outlay can be
estimated using equation 14-6 and subtracted from
the present value of the expected future cash flows
to determine whether the project has a positive
NPV.
Financing

 1  
Step 3: Solve (1 of 3)
We can use equation 14-5 to estimate the weighted
average floatation cost as follows:
W eighted Average  Flotation Cost   Flotation Cost 

  wd   w
  cs  
Flotation Cost  of Debt as a Percent   of Equity as a Percent 
= .40 × .03 + .60 × .15

= .102 or 10.2%
The “grossed up” initial outlay for $100 million
project can be estimated using equation 14-6:
Financing
Flotation Cost Adjusted Needed

1 
 as a Percent 
= $100 million ÷ (1 − 0.102) = $111.36 million
• Thus, floatation costs is equal to $11.36 million.
• NPV = $115 million − $111.36 million
= $3.64 million
Step 4: Analyze
• The project is feasible even after consideration of
higher floatation costs as the NPV is positive at
$3.64 million.
• However, the problem illustrates that floatation
costs can be significant and cannot be ignored
while evaluating projects.
Key Terms
• Cost of capital
• Cost of common equity
• Cost of debt
• Cost of preferred equity
• Divisional WACC
• Floatation costs
• Risk Premium
• Weighted Average Cost of Capital (WACC)
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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson

W eighted   Proportion of     Proportion of 

W eighted   Proportion of     Proportion of 

Blank Weights Cost Product

Debt 0.375 0.06 0.0225

Common Stock 0.625 0.15 0.09375

Preferred Stock 0 0.1 0

Blank 1 WACC 0.11625

Aaa AAA AAA Prime, Maximum Safety

A1 A+ A+ Upper Medium Grade

Caa1 CCC+ CCC Substantial Risk

Caa2 CCC − In Poor Standing

Caa3 CCC− − Blank

B1/B+ 4.60 4.95 5.25 5.79 6.42 7.26 8.82

B2/B 5.38 5.72 6.04 6.59 7.24 8.10 9.63

B3/B− 6.15 6.49 6.82 7.38 8.06 8.93 10.45

Caa/CCC+ 6.93 7.26 7.61 8.17 8.87 9.77 11.26

Dividend Yield Cost of Equity

2012 $0.800 Blank Blank

2013 0.825 $0.025 3.1%

2014 0.840 0.015 1.8%

2015 0.875 0.035 4.2%

2016 0.900 0.025 2.9%

Blank Arithmetic Average Blank 3.0%

Blank Geometric Average Blank 2.99%

Using the CAPM

Risk Premium for Common Equity

• kcs = 0.014 + 0.8(4) = 3.214%

American Electric Power (AEP) 40.61% 2.60% 59.39% 3.80% 3.31%

General Electric (GE) 19.11% 2.15% 80.89% 8.05% 6.92%

Starbucks (SBUX) 0.81% 2.86% 99.19% 6.15% 6.12%

Target (TGT) 19.23% 2.26% 80.77% 5.20% 4.63%

Wal-Mart (WMT) 16.77% 2.09% 83.23% 3.90% 3.60%

Because of floatation costs, the firm will have to

Example If a firm needs $100 million to finance its

= $100 million ÷ (1−.055) = $105.82 million

Into the Calculation of NPV

W eighted Average  Flotation Cost   Flotation Cost 

W eighted Average  Flotation Cost   Flotation Cost 

= .40 × .03 + .60 × .15

= $100 million ÷ (1 − 0.102) = $111.36 million

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