Business Finance I

Lecture 11
Cost of Capital
Readings: Chapter 14

Course Professor: Dr. Shi Li

1
Overview
◼ Cost of Capital
❑ 100% equity financed firm

◼ Weighted Average Cost of Capital (WACC)

❑ Cost of equity capital
➢ Common stock

➢ Preferred stock

❑ Cost of debt

◼ Liquidity and Cost of Capital

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What is Cost of Capital: Example
◼ If we were developing a piece of software and
required $75,000 today to fund our work. At the end
of three years we believe we could sell the software
for $200,000.
◼ Let’s say that a venture capitalist looked at our
business plan and concluded that she would require a
return of 35% per year compounded annually to fund
this deal.
◼ This is like renting us the money at a cost of 35% per
year.

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Cost of Capital: Example
◼ Does our software project cover the 35% cost of capital?
Interests (B)
$ we owe (A) A x 35% A+B
Opening Cost of Closing
Year Balance Capital Balance
1 75,000 26,250 101,250
2 101,250 35,438 136,688
3 136,688 47,841 184,528
< 200,000
◼ We plan to rake in $200,000 by selling the software. We
can repay our financier or, in other words, repay our cost of
capital.
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Cost of Capital: Example
◼ What if the financier wants 40%?
Interests (B)
$ we owe (A) A x 35% A+B

Opening Cost of Closing

Year Balance Capital Balance
1 75,000 30,000 105,000
2 105,000 42,000 147,000
3 147,000 58,800 205,800
> 200,000
◼ Uh oh!

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Cost of Capital: All Equity Firm
◼ From the firm’s perspective, the cost of (equity) capital is
the investors’ required return (on equity):

Investor’s
Return
E (ri ) = rF + βi ( E (rM ) − rF ) Firm’s
Cost

◼ To estimate a firm’s cost of equity capital using CAPM (1st

way), we need to know three things
❑ The risk-free rate: rF βi =
Cov( Ri , RM ) σ i , M
= 2
❑ The company’s beta: Var ( RM ) σM
❑The market risk premium E (rM ) − rF
◼ OR using DGM (2nd way): 𝐷1
𝑟𝑖 = +𝑔
𝑃𝑖,0
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Example
◼ Suppose the stock of Facebook has a beta of 2.5.
The firm is 100-percent equity financed.

◼ Assume a risk-free rate of 5-percent and a market

risk premium of 10-percent. Q: Is this Rm or (Rm - Rf)?

◼ Q: What is the appropriate discount rate for this

firm?
Capital Budgeting & Project Risk
◼ Higher risk, higher return…

❑ A project’s cost of capital depends on the risk of the project

not the risk of the firm.

❑ If a new project has the same risk as the company’s existing

operations, we can use the firm’s cost of capital as the project’s
discount rate.

❑ The project’s cost of capital also does not depend on the

source of the funds.

8
Using Industry Betas

◼ Industry beta is a weighted average of firms’ betas

from a given industry

◼ It is frequently argued that using industry beta gives

better estimates of a firm’s beta.

❑ Use the industry beta if a firm’s operations are similar to

those of other firms in the industry.
❑ Use the firm’s beta if that firm’s operations are
fundamentally different from other firms in the industry.

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Example: Capital Budgeting & Project Risk
Toucho Inc. has a 19% cost of equity (using CAPM). It has a
number of ongoing projects:
Project Project Beta rF = 4%
Touch screen TVs 1.9
E (rM ) = 14%
Tablet PCs 1.5
USB Memory Sticks 0.8
β = 1.50

If Toucho Inc. is interested in expanding its memory stick

production facility, what will be the cost of capital for that
project?

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WACC: Cost of Common Stock
◼ Two methods previously introduced in this course
❑ Dividend Growth Models (DGM)
D1 D1
PE , 0 = → rE = +g
rE − g PE , 0

❑ CAPM Market Return

E (ri ) = rF + βi ( E (rM ) − rF )
Market Risk Premium

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 Tax Advantage of Debt
Issue $1000 debt at 6% Issue $1000 equity with 6% div.
Income Statement Income Statement

Revenues 5500 Revenues 5500

Expenses Expenses
Cost of goods sold 4125 Cost of goods sold 4125
Interest expense 60 Pre-tax profits 1375
Total Expenses 4185 Tax (@ 40%) 550
Pre-tax profits 1315 After-tax profit 825
Tax (@ 40%) 526 Less dividends 60
After-tax Profit 789 Profit 765

Tax difference: 550 - 526 = 24

Profit difference: 789 - 765 = 24
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WACC: Cost of Debt

◼ Observe or compute the interest rate a firm must pay on

new borrowing
❑ We can observe interest rates in the market and assume that
new debt would require the same rate of return.
❑ If the firm has outstanding bonds, then the YTM on those bonds
may be used as the market’s required rate of return on new debt

◼ Don’t forget to make the tax-adjustment to the observed or

computed rate.

r = rD (1 − TC )
*
D

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Capital Structure Weights

◼ Notation
❑ E = market value of equity = # outstanding shares
times price per share
❑ D = market value of debt = # outstanding bonds times
bond price
❑ V = market value of the firm = D + E
◼ Weights
❑ wE = E/V = Proportion financed with equity
❑ wD = D/V = Proportion financed with debt
Cost of Capital with Common Stock and Debt

Weighted Average Cost of Capital (WACC)

Computed in a similar manner to other weighted averages

rWACC = wE rE + wD rD (1 − TC )
 E   D 
rWACC = rE +  rD (1 − TC )
D+E D+E

We make a “taxation adjustment” (1-TC) because a firm’s interest

payments are tax deductible.
(Remember: Debt is considered as “cost of doing business”. Thus,
it provides Interest Tax Shield to firms)

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Estimating Cost of Capital for a company
(very important!!)
◼ To estimate the cost of capital for a company…
◼ Step 1: estimate the costs of debt and equity
❑ Estimate cost of equity with equity beta
❑ Estimate cost of debt using the YTM of the firm’s debt
◼ Step 2: calculate the weight of debt and equity
◼ Step 3: determine the WACC
rWACC = wE rE + wD rD (1 − TC )
 E   D 
rWACC = rE +  rD (1 − TC )
D+E D+E
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Estimating Cost of Capital for a company I

◼ Company’s beta is 1.39

◼ Risk-free rate is 4.16%
◼ Market risk premium is 4.32%
◼ The yield on the company’s bonds is 6.547%
◼ The firm has a 36.1% marginal tax rate
Security Market
value ($M)
Debt $6,245

Common $19,682
shares

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Estimating Cost of Capital for a company II

◼ Company’s beta is 1.39

◼ Risk-free rate is 4.16%
◼ Market risk premium is 4.32%

◼ Cost of equity is easily calculated:

E (rE ) = rF + βi ( E (rM ) − rF ) Market risk
premium

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Estimating Cost of Capital for a company III

◼ The yield on the company’s outstanding bonds is

6.547%
◼ The firm has a 36.1% marginal tax rate
◼ Cost of debt is easily calculated:

𝑟𝐷∗ = 𝑟𝐷 1 − 𝑇𝐶

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Estimating Cost of Capital for a company IV
▪ To calculate the cost of capital, we need to estimate the
market-valued weights of equity and debt:
Security Market value ($M) Weight (%)

Debt $6,245

Common $19,682
shares

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Estimating Cost of Capital for a company V

With the preliminary steps complete, compute WACC:

𝑟𝑊𝐴𝐶𝐶 = 𝑤𝐸 𝑟𝐸 + 𝑤𝐷 𝑟𝐷 (1 − 𝑇𝐶 )

This rate can be used to discount projects of similar risk to the

firm as a whole

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WACC: Cost of Preferred Stock
Cost of preferred equity can be estimated using the
DGM:
Case I Case II
𝐷𝑝 𝐷𝑝 𝐷𝑝,1 𝐷𝑝,1
𝑃𝑝 = → 𝑟𝑝 = 𝑃𝑝,0 = → 𝑟𝑝 = +𝑔
𝑟𝑝 𝑃𝑝 𝑟𝑝 − 𝑔 𝑃𝑝,0

The New WACC becomes:

rWACC = wS rS + wB (1 − TC )rB + wP rP
 S   B   P 
rWACC =  rS +  (1 − TC )rB +  rP
S +B+P S +B+P S +B+P
Notation:
S: Common Stock - B: Bonds (Debt) - P: Preferred Stock

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Bond Pricing Notation

◼ Sometimes bond prices are expressed as a number

relative to 100.

❑ Eg. If a bond has a face value of $1,000 and the bond

price is expressed as “105” This means that the bond is
trading at $1050. ($1,000 x 105%)

❑ Similarly, if the bond price is expressed as “97”, it

means that the bond is trading at $970.

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Problems and Pitfalls of WACC: 1

◼ WACC is an appropriate discount rate only if the

risk of the project is similar to the risk of the firm.

◼ If project risk differs from firm risk, other

approaches to determining the discount rate must
be adopted

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Problems and Pitfalls of WACC: 2
◼ Comparing project return to the cost of
incremental financing to undertake the project

◼ Example: if a project yields 12% and can be

100% financed by debt that yields 8%, is it an
economically viable project?

◼ The side effect of the debt financing on yields of

other firm financing(s) must be taken into
account.

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Problems and Pitfalls of WACC: 3
◼ Temporary Capital Structure
◼ If a firm’s capital structure is temporary, it may
not produce a WACC that is consistent with the
long-term risk/return relationship in the financial
markets.
𝑟𝑊𝐴𝐶𝐶
= 𝑤𝐸 𝑟𝐸 + 𝑤𝐷 𝑟𝐷 (1 − 𝑇𝐶 )

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Problems and Pitfalls of WACC: 4
◼ Lack of market values of outstanding issues
◼ Use of book values of financings to determine
weights

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Cost of Capital with Flotation Costs
◼ The transaction costs will increase the cost of capital for
firms beyond the required return of investors…
◼ Example: if you need $1M, but your underwriters ask for
a flotation cost of 10%. To ensure you have $1M in the
end, how much do you need to raise?
$1M = X * (1-10%) X = $1.11M
◼ General case:
𝑟 ∗ (1 − 𝑡𝑐 )
𝑟 ∗ (1 − 𝑡𝑐 )
1−𝐹

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Cost of Capital and Liquidity
Liquidity
◼ Academics have argued that the expected return on a stock and the
firm’s cost of capital are negatively related to the liquidity of the
firm’s shares.

◼ The cost of trading an illiquid stock reduces the total return an

investor receives (Bid-Ask spreads, brokerage fees, market-impact costs)

For stocks with

Investors demand higher trading costs Firms pay a higher
higher returns cost of capital
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Liquidity and the Cost of Capital

Cost of Capital

Liquidity

→ An increase in liquidity lowers a firm’s cost of capital

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Bond Credit Ratings and Cost of Debt
Credit Ratings
◼ Major bond rating firms: Standard & Poor’s (S&P), Moody’s, and
Fitch.

Also called high-yield

bond…attractive now?

◼ Credit rating is assigned based on a company’s default risk:

1) how likely a firms is to default;
2) protection for creditors in default events.
◼ Lower credit rating, higher cost of debt (i.e., higher YTM).
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Conclusion
◼ Cost of Capital is the yardstick against which new
projects are measured

◼ Projects must earn at least the cost of capital to be

financially viable

◼ One indicator of the cost of capital is the cost of the firm’s

existing financing mix
❑ WACC is a technique to determine existing cost of capital

◼ Be aware of the limitations of WACC

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