Financial M. Chapter 07

Financial Management
Lecture 7: Estimating Costs of Capital
Tak-Yuen Wong
Department of Quantitative Finance

National Tsing Hua University
Motivation: Cost of Capital
▶ Firm issues financial securities (stocks, bonds...) to raise funds

▶ Investors buy these securities
▶ They forgo the opportunity to invest that money elsewhere
▶ Expected return from those alternative investments constitutes an
opportunity cost to them
▶ To attract capital, a firm must offer potential investors an expected return
equal to what they could expect to earn elsewhere for the same level of
risk
▶ Hence, the expected return to investors is the cost of capital to firm
Capital Structure
A firm’s sources of financing consist of debt and equity

▶ Equity: funds raised by selling shares to stockholders
▶ Debt: borrowing from lenders
Capital structure: the relative proportions of debt, equity, and other securities
▶ In 2019, Facebook: 100% equity; Apple: 89% equity; United Continental:

37% debt
Weighted Average Cost of Capital
To determine the firm’s overall cost of capital, must take into account each
component of the firm’s capital structure
▶ With each component weighted by the relative proportion in terms of
market value of that source
▶ For simplicity, consider only debt and equity
Weighted average cost of capital (WACC):
rwacc =fraction of the firm financed by equity × equity cost of capital

+ fraction of the firm financed by debt × debt cost of capital
For example, WACC for Apple in 2019:

rwacc = 0.89 × equity cost + 0.11 × debt cost
Debt Cost of Capital (1)
Yield to maturity of a bond is the return an investor will earn from holding the
bond to maturity
▶ With little default risk, the bond’s yield to maturity is a good estimate of
investors’ expected return
▶ With a significant default risk, we must adjust for the possibility of default
Consider one-year bond with a yield to maturity y . For $1 investment, the

bond promises to pay $(1 + y ) in one year
▶ Suppose the bond will default with probability p, in which case bond
holders receive only $(1 + y − L), where L is the expected loss per $1
Cost of Debt: Default Rate
The expected return of the bond, i.e., the debt cost of capital, is
rD =(1 − p)y + p(y − L)

=y − pL
=yield to maturity − Prob(default) × expected loss rate (1)
How do we know the default rate?
▶ E.g., for a B-rated bond with an average 60% loss rate, then outside
recessions, rD = y − 0.055 × 0.60 = y − 3.3%
Cost of Debt: Historical Recovery Rates
Two-side of the same coin: recovery rate = 1 - loss rate
Over 1982-2008, long-term average recovery rate is 41.4% per Moody’s data
What About Debt Betas?
In principle, debt cost of capital can be estimated using the CAPM

▶ Debt betas can be obtained using historical returns
▶ However, banks loans and many corporate bonds are traded infrequently...
Some estimates of average debt betas across industries
▶ Average debt betas across industries

Taxes and Cost of Debt
With corporate taxes, the return paid to the debt holders is not the same as
the cost to the firm
▶ Key: interest expenses are tax-deductible
Example 1: suppose a firm faces a τC = 25% corporate tax rate and borrows
$100, 000 at 10% interest rate per year. The net cost at the end of the year:
Year-End
Interest expense rD × $100, 000 $10, 000
Tax savings −tax rate × rD × $100, 000 −$2, 500
Effective after-tax int. exp. rD × (1 − τC ) × $100, 000 $7, 500
So, the effective cost of debt is 7, 500/10, 000 = 7.5%, which is
rD (1 − τC ) =0.10 × (1 − 0.25) = 7.5%

Equity Cost of Capital
We can estimate the equity cost of capital using the CAPM

▶ Unlike debt, stocks are frequently traded
Example 2: monthly returns for Cisco Stock and for the S&P500, 2000-2015
▶ Observation: Cisco’s returns tend to move in the same direction, but with
greater amplitude, than those of the S&P500
Scatter-plot of Monthly Excess Returns
Plot of Cisco’s excess return against the S&P500 excess return
▶ Each point is the excess returns of both assets. Say, in Nov 2002, Cisco was up
33.4% and the S&P500 was up 6.1%
▶ Can find a “best fitting” line that goes through these data points
The Best-Fitting Line
A security’s beta βi corresponds to the slope of the best-fitting line in the

scatter-plot of the security’s excess returns vs. the market excess return
▶ In the plot, a 10% increase in the market’s return ⇒ around a 15%
increase in Cisco’s return
▶ By definition, βCisco ≈ 1.5
Conceptually, the best-fitting line captures the components of a security’s

return that can be explained by market risk
▶ In any month, the security’s returns will be higher or lower than the line
▶ Deviations result from firm-specific risk that is not related to the market
as a whole.
Linear Regression
Linear regression: statistical technique that identifies the best-fitting line

through a set of data points
▶ In our application,
ri − rf =αi + βi (rm − rf ) + εi
where αi is the intercept term of the regression; βi is the slope term

(sensitivity of the stock to market risk); εi is the error (or residual) term
with a zero average error
▶ Taking expectations,
E(ri ) = αi + rf + βi (E(ri ) − rf )
|{z} | {z }
distance above/below the SML expected return for i from the SML
By CAPM, αi should not be different from zero

▶ Practitioners measure investment performance/skills in stock picking
using α
Putting Together
WACC equation:
rwacc =rE × E % + rD (1 − τC ) × D%
where
▶ Debt cost of capital: rD = y − pL is from the expected return on debt (1)
▶ Equity cost of capital: rE = rf + βE (E(rm ) − rf ) is estimated from the
CAPM equation1
Example 3: Assume the expected return on Target’s equity is 11.5%, and the
firm has a yield to maturity on its debt of 6%. Debt accounts for 18% and
equity for 82% of Target’s total market value. If its tax rate is 25%, what is an
estimate of this firm’s WACC?
▶ rwacc = 0.115 × 0.82 + 0.06 × (1 − 0.25) × 0.18 = 10.2%
WACCs for Real Companies
▶ Data in 2019
Using the WACC to Value a Project (1)
Consider an investment project that generates a stream of free cash flows

{FCF0 , FCF1 , ...}
▶ WACC method: If the company finances the project with debt, the
levered value is incremental FCFs discounted at WACC
FCF1 FCF2
V0L =FCF0 + + + ...
1 + rwacc (1 + rwacc )2
▶ Intuition: WACC reflects the opportunity cost of all sources of capital for
the company
There are some assumptions behind the method

1. The project has average risk of the firm’s existing investments
2. Fraction of the project financed by debt is the same as the firm’s
debt-equity ratio
3. Other effects of taking leverage are small enough
Using the WACC to Value a Project (2)
Example 4: Suppose Anheuser-Busch InBev is considering introducing a new

ultra-light beer with zero calories to be called BudZero. The firm believes that
the beer’s flavor and appeal to calorie-conscious drinkers will make it a success.
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 InBev’s
WACC is 5.7%, should it go ahead with the project?
▶ Using the WACC method,
FCF1 100
V0L = FCF0 + = − 200 + = $3.5 billion
rwacc − g 0.057 − 0.03
Summary
▶ Weighted average cost of capital is the weighted average of its equity and
debt costs of capital
▶ Reflect the overall cost of financing the firm
▶ Weights are based on market values of securities
▶ In practice, applying CAPM to estimate equity costs of capital requires

selection of the horizon of risk-free rate and the market
▶ Risk-free rate determined by the yields of U.S. Treasury securities.
Majority of large firms and financial analysts report using yields of
long-term (10- to 30-year) bonds
▶ Many financial managers use a 5% to 7% market risk premium

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Financial Management

Lecture 7: Estimating Costs of Capital

Department of Quantitative Finance

▶ Firm issues financial securities (stocks, bonds...) to raise funds

A firm’s sources of financing consist of debt and equity

▶ In 2019, Facebook: 100% equity; Apple: 89% equity; United Continental:

Weighted average cost of capital (WACC):

rwacc =fraction of the firm financed by equity × equity cost of capital

For example, WACC for Apple in 2019:

Consider one-year bond with a yield to maturity y . For $1 investment, the

rD =(1 − p)y + p(y − L)

How do we know the default rate?

In principle, debt cost of capital can be estimated using the CAPM

▶ Average debt betas across industries

So, the effective cost of debt is 7, 500/10, 000 = 7.5%, which is

rD (1 − τC ) =0.10 × (1 − 0.25) = 7.5%

We can estimate the equity cost of capital using the CAPM

A security’s beta βi corresponds to the slope of the best-fitting line in the

Conceptually, the best-fitting line captures the components of a security’s

Linear regression: statistical technique that identifies the best-fitting line

where αi is the intercept term of the regression; βi is the slope term

By CAPM, αi should not be different from zero

Consider an investment project that generates a stream of free cash flows

There are some assumptions behind the method

Example 4: Suppose Anheuser-Busch InBev is considering introducing a new

▶ In practice, applying CAPM to estimate equity costs of capital requires

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