L4 Cost of capital (Chapter 13)

Cost of equity
Cost of debt
WACC
Adjustment to WACC

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 Sources of Capital
• Three broad sources of financing available (total capital)
• Debt
• Equity (common stock)
• Preferred stock (hybrid equity)

• Each has its own required rate of return required by investors:

Debt financing, Equity financing, Hybrid equity financing
Rd Re Rps
Banks; Common stockholders; Preferred
Nonbank lenders; Retained earnings stockholders;
Suppliers; (internal funds of the
Bondholders firm)
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 The Cost of Capital
The minimum required return on a new
investment.
Interchangeable terms: required return,
cost of capital, appropriate discount rate
Distinguish between:
• Cost of debt capital
• Cost of equity capital
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 The Cost of Equity Capital

The minimum return that equity investors

require on their investment in the firm.

Estimation methods:

• Dividend growth model

• SML approach/CAPM

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 The Dividend Growth Model
Approach
Under the assumption that the firm’s dividend will grow at a constant
rate g, the share price, P0, can be written below where D0 is the
dividend just paid and D1 is the next period’s projected dividend.
Notice that we have used the symbol RE (the E stands for equity) for
the required return on the equity.

D0 × (1 + g ) D1
P0 =
RE − g RE − g
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 The Dividend Growth Model
Approach

We can rearrange this to solve for RE as follows:

RE = D1/P0 + g
Because RE is the return that the shareholders
require on the equity, it can be interpreted as
the firm’s cost of equity capital.
g can be estimated from historical growth rate
or analysts’ forecasts
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 Implementing the Approach
Great Country Public Service paid a dividend of €4 per
share last year, and the dividend is expected to grow at 6
per cent per year indefinitely. The equity currently sells
for €60 per share. What is the cost of equity capital?

Using the dividend growth model, we can calculate that the expected
dividend for the coming year, D1, is:
D1 = D0 × (1 + g) = €4 × (1+6%) = €4.24
Given this, the cost of equity, RE, is:
RE = D1/P0 + g = €4.24/60 + 0.06 = 13.07%

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 Adv and disadv. RE = D1/P0 + g
Plus points
• Easy to understand and to use
Minus points
• Applicable only to company paying dividends
and dividends grow at a constant rate
• Sensitive to estimate of dividend growth rate
• No explicit link to risk

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The Security Market Line Approach
• Under the CAPM, the expected return on a
security can be written as:
RE = RF + βE × (RM − RF)
– RF is the risk-free rate;
– RM − RF is the expected excess market return or
market risk premium.
• To estimate cost of equity capital you need to
know
– The Risk-Free Rate
– The Market Risk Premium
– The Company Beta
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 Implementing the Approach
The market risk premium is 4 per cent (based on
large UK equities), and Treasury bills are paying
about 2.2 per cent. FT.com shows ITV plc had an
estimated beta of 1.9. What is ITV’s cost of equity
capital?
RE = Rf + βITV × (RM − Rf) = 2.2% + 1.90 × 4% = 9.80%

Thus, using the SML approach, we calculate that

ITV’s cost of equity is 9.80%.
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 Adv. and disadv.
RE = RF + βE × (RM − RF)
Plus points
• Explicitly adjust for risk
• Also applicable to companies paying no
dividends
Minus points
• Need to estimate both market risk premium
and beta coefficient
• Rely on the past
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The Cost of Equity methods across countries
 The Cost of Debt
That is
The minimum YTM!

return that lenders

require on the
firm’s debt.
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 Example 13.2: The Cost of Debt
Suppose General Tools issued a 30-year, 7 per cent
bond 8 years ago. The bond is currently selling for
96 per cent of its face value of £50,000, or £48,000.
Assuming annual coupons. What is General Tool’s
cost of debt?
We need to calculate the yield to maturity on this
bond. Bond value is 48,000. Maturity is 22 years.
Coupon rate is 7%, face value is 50,000.
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7% × 50,000 50,000
48000 = � 𝑡𝑡
+
(1 + 𝑌𝑌𝑌𝑌𝑌𝑌) (1 + 𝑌𝑌𝑌𝑌𝑌𝑌)22
𝑡𝑡=1 Use Solver
YTM = 7.37 per cent. function in
General Tool’s cost of debt, RD, is thus 7.37%.
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Excel
 Tax benefits of using debt: After-
tax cost of debt
Suppose a firm borrows €1 mln at 9% interest. Corporate
tax rate is 34%. What is the after-tax interest on the loan?
• Interest expense: 9% ×1mln= € 90,000;
• Interest expense is tax deductible, so interest expense
reduces the tax bill by
because interests
90,000 ×34%= € 30,600 are paid before
• After-tax interest expense is actually: tax
€ 90,000-30,600= € 59,400
• After-tax interest rate : = € 59,400/1mln=5.94%
• Or simply 9% ×(1-34%)=5.94%
• Therefore, we should consider the after-tax cost of debt 15
 The Weighted Average Cost of
Capital (WACC)

The weighted average of the cost of equity and the

after-tax cost of debt.

To Compute WACC, You need

• After-tax Cost of Debt
• Cost of Equity
• Proportions of Each in Capital Structure 16
 The Capital Structure Weights
Equity Debt

• We calculate this • We calculate this

by taking the by multiplying the
number of shares market price of a
outstanding and single bond by the
multiplying it by number of bonds
the share price. outstanding.
• Use the symbol, E. • Use the symbol, D.
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 The Capital Structure Weights
we will use the symbol V (for value) to stand for the combined
market value of the debt and equity:
V=E+D

If we divide both sides by V, we can calculate the percentages

of the total capital represented by the debt and equity:
100% = E/V + D/V

These percentages can be interpreted just like portfolio

weights, and they are often called the capital structure weights.
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 Taxes and WACC
• Suppose a firm uses both debt and equity to
finance its investments. If the firm pays RD for
its debt financing and RE for its equity, the
overall or average cost of its capital
𝐸𝐸 𝐷𝐷
× 𝑅𝑅𝐸𝐸 + × 𝑅𝑅𝐷𝐷 (1 − 𝑇𝑇𝑐𝑐 )
𝑉𝑉 𝑉𝑉

This is called the

Weighted Average Cost of Capital
(WACC)
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 Example 13.4
Calculating the WACC
Travis SpA. has 1.4 million shares of equity
outstanding. The equity currently sells for €20
per share. The firm’s debt is publicly traded and
was recently quoted at 93 per cent of face value.
It has a total face value of €5 million, and it is
currently priced to yield 11 per cent. The risk-
free rate is 8 per cent, and the market risk
premium is 7 per cent. You’ve estimated that
Travis has a beta of .74. If the corporate tax rate
is 34 per cent, what is the WACC of Travis SpA?

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 Example 13.4: Calculating WACC
1. Using the SML, cost of equity is 8% + .74 × 7% = 13.18%.
2. The pre-tax cost of debt is the yield to maturity on the outstanding debt,
11 per cent.
3. The total value of the equity is 1.4 million × €20 = €28 million.
The debt sells for 93 per cent of its face value, so its current market value is
.93 × €5 million = €4.65 million.
The total market value of the equity and debt together is €28 million + 4.65
million = €32.65 million.

The percentage of equity used by Travis to finance its operations is

€28 million/€32.65 million = 85.76%.
The percentage of debt is 1 − .8576 = 14.24%.

The WACC is thus:

WACC = (E/V) × RE + (D/V) × RD × (1 − TC)
= .8576 × 13.18% + .1424 × 11% × (1 − .34) = 12.34%
Travis thus has an overall weighted average cost of capital of 12.34 per cent.
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 WACC with preference share
capital
• Suppose a firm uses also preference share
capital, as well as debt and equity to finance its
investments. If the firm pays RD for its debt
financing, RE for its common equity, Rps for its
preference share capital, the overall or average
cost of its capital
V= E + PS + D
𝐸𝐸 𝑃𝑃𝑃𝑃 𝐷𝐷
× 𝑅𝑅𝐸𝐸 + × 𝑅𝑅𝑝𝑝𝑝𝑝 + × 𝑅𝑅𝐷𝐷 (1 − 𝑇𝑇𝑐𝑐 )
𝑉𝑉 𝑉𝑉 𝑉𝑉

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 Example 13.5: Applying WACC
You are considering a project that will results in initial after-tax saving of £5
million at the end of first year. These savings will grow at the rate of 5 per
cent per year. The firm has a debt-equity ratio of 0.5, a cost of equity of
29.2% and a cost of debt of 10 per cent. The cost-saving proposal is closely
related to the firm’s core business. Assume a 28 per cent tax rate. What is
the PV of all the savings from this project?

The savings are a growing perpetuity. To calculate the PV of growing

perpetuity, we need a discount rate, which is the WACC of the firm, since
this project has the similar risk profile as the firm.
D/E=0.5; since D+E=V, so D/V=1/3, and E/V=2/3
The WACC is us:
WACC = (E/V) × RE + (D/V) × RD × (1 − TC)
= 2/3× 29.2% + 1/3× 10% × (1 − 0.28) = 21.87%
5 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
PV= =£29.64 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
0.2187−0.05
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 Divisional and Project Costs of
Capital

There will clearly be situations in which

the cash flows under consideration have
risks distinctly different from those of
the overall firm.

We may use a too high WACC if the project is less risky

than the firm risk, or too low WACC if the project is
more risky than the firm. 24
 The Pure Play Approach

The use of a WACC that is

unique to a particular
project, based on companies
in similar lines of business

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The Subjective Approach

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 Prepare Tutorial 4

Ch13

• 13.4, 13.7, 13.9, 13.12, 13.14, and

• a comprehensive question

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