Lecture 5

Lecture 5
The cost of capital

 In this lecture, we study the estimation of the firm’s Weighted
Average Cost of Capital (WACC).
 The WACC has important uses in finance:
1. It is used as the discount rate for a firm’s anticipated cash flows

(CF), EVA, ...
2. The WACC is also the appropriate risk-adjusted discount rate for

firm projects whose riskiness is similar to the average riskiness of the
firm’s cash flows.
 The WACC is a weighted average of the firm’s cost of equity rE and its cost of debt rD, with the
weights created by the market values of the firm’s equity (E) and debt (D):
E D
WACC  rE  rD 1  TC 
ED ED
• where rE is the firm’s cost of equity, rD is the firm’s cost of debt, E is the market value of the firm’s
equity, D is the market value of the firm’s debt, and TC is the firm’s corporate tax rate.
How to estimate the cost of equity?
 The discount rate for valuing a proposed capital investment project
should be the opportunity cost of capital, defined as the expected rate of
return that the company’s shareholders could achieve by investing on
their own.
 We consider two models for calculating the cost of equity rE:
1. The Gordon model.
2. The capital asset pricing model (CAPM).

The Gordon dividend model
 Suppose that the current stock price is P0, the current dividend is Div0, and the anticipated growth
rate of future dividends is g.
•  The Gordon model states that the stock price equals the discounted (at the appropriate cost of
equity rE) future dividends:
𝐷𝑖𝑣 1 + 𝑔 𝐷𝑖𝑣 1 + 𝑔 𝐷𝑖𝑣 1 + 𝑔
𝑃 = + +. . . =
1+𝑟 1+𝑟 1+𝑟
𝐷𝑖𝑣 1 + 𝑔
 If g  rE  𝑃 =
𝑟 −𝑔
Div0 1  g 
 We derive the Gordon model cost of equity: rE  g
P0
Application 1
Consider a firm whose expected dividend is Div1 = $3 per share and
whose share price is P0 = $50. Suppose the dividend is anticipated to
grow by 12% per year. What is the firm’s cost of equity rE using the
Gordon model?
CAPM
 The capital asset pricing model (CAPM) is a viable alternative to the Gordon
model for calculating the cost of capital. It is also the most widely used cost-of-
equity model.
 The classic CAPM formula for the firm’s cost of equity is: rE  rf    E  rM   rf 
where rf is the risk-free rate of interest, E(rM) is the expected return on the
market portfolio, and β is a firm-specific risk measure


Cov rstock , rM .
Var  rM 
CAPM - The Security Market Line (SML)
Application 2
Consider a firm whose beta coefficient is 1.2. The expected return on
the market is 12% and the risk free rate is 2%. What is the firm’s cost of
equity rE using the CAPM?
Application 3
• Suppose you estimate that Google’s stock has a beta of 1.45 and
UPS has a beta of 0.79. The risk-free interest rate is 3% and you
estimate the market’s expected return to be 8%,
 Calculate the equity cost of capital for Google and UPS.
Application 4
• Suppose ABCWorld Company, a large public utility, paid a dividend
of $4 per share last year. The stock currently sells for $60 per
share. You estimate that the dividend will grow steadily at a rate of
6 percent per year into the indefinite future.
• What is the cost of equity capital for ABCWorld?
Application 5
• Suppose stock in Alpha Air Freight has a beta of 1.2. The market
risk premium is 7 percent, and the risk-free rate is 6 percent.
Alpha’s last dividend was $2 per share, and the dividend is
expected to grow at 8 percent indefinitely. The stock currently
sells for $30.
• What is Alpha’s cost of equity capital using the CAPM and the
Gordon dividend growth model approaches?
What is the cost of debt?
 The interest paid by a corporation is deductible for tax purposes. (Payments to
stockholders, such as dividends, are not).
 Effectively, the government pays some of the interest.
 Thus, in determining an aftertax discount rate, we need to distinguish between the

pretax and the aftertax cost of debt.
 In general, the aftertax interest rate is simply equal to the pretax rate multiplied by 1
minus the tax rate.
 If we use the symbol TC to stand for the corporate tax rate, then the aftertax rate can be
written as rD × (1 ‒ TC ).
The Weighted Average Cost of Capital
E D
WACC   rE   rD  1  TC 
V V
• It is the overall return the firm It is also the required return on any
must earn on its existing assets to investments by the firm that have
maintain the value of its stock. essentially the same risks as existing
operations.
Application 6
• The B.B. Lean Co. has 1.4 million shares of stock outstanding. The
stock currently sells for $20 per share. The firm’s debt is publicly
traded and was recently quoted at 93% of face value. It has a total
face value of $5 million, and it is currently priced to yield 11%. The
risk-free rate is 8%, and the market risk premium is 7%. You’ve
estimated that Lean has a beta of .74.
• If the corporate tax rate is 34 percent, what is the WACC of Lean
Co.?

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The cost of capital

 The WACC has important uses in finance:

1. It is used as the discount rate for a firm’s anticipated cash flows

2. The WACC is also the appropriate risk-adjusted discount rate for

1. The Gordon model.

2. The capital asset pricing model (CAPM).

market portfolio, and β is a firm-specific risk measure

 Effectively, the government pays some of the interest.

 Thus, in determining an aftertax discount rate, we need to distinguish between the

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