14

Cost of Capital
 Key Concepts and Skills
• Know how to determine a firm’s cost of equity
capital
• Know how to determine a firm’s cost of debt
• Know how to determine a firm’s overall cost of
capital
• Understand pitfalls of overall cost of capital
and how to manage them

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 Chapter Outline
• The Cost of Capital: Some Preliminaries
• The Cost of Equity
• The Costs of Debt and Preferred Stock
• The Weighted Average Cost of Capital
• Divisional and Project Costs of Capital
• Flotation Costs and the Weighted Average
Cost of Capital

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 Why Cost of Capital Is Important
• We know that the return earned on assets
depends on the risk of those assets
• The return to an investor is the same as the
cost to the company
• Our cost of capital provides us with an
indication of how the market views the risk of
our assets
• Knowing our cost of capital can also help us
determine our required return for capital
budgeting projects

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 Required Return
• The required return is the same as the
appropriate discount rate and is based on the
risk of the cash flows
• We need to know the required return for an
investment before we can compute the NPV
and make a decision about whether or not to
take the investment
• We need to earn at least the required return
to compensate our investors for the financing
they have provided

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 Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm
– Business risk
– Financial risk
• There are two major methods for determining
the cost of equity
– Dividend growth model
– SML or CAPM

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The Dividend Growth Model Approach
• Start with the dividend growth model formula
and rearrange to solve for RE

D1
P0 
RE  g
D1
RE  g
P0

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 Dividend Growth Model Example
• Suppose that your company is expected to pay
a dividend of $1.50 per share current year.
There has been a steady growth in dividends
of 5.1% per year and the market expects that
to continue. The current price is $25. What is
the cost of equity?

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 Example: Estimating the Dividend
Growth Rate
• One method for estimating the growth rate is
to use the historical average
– Year Dividend Percent Change
– 2000 1.23 -
– 2001 1.30 (1.30 – 1.23) / 1.23 = 5.7%
– 2002 1.36 (1.36 – 1.30) / 1.30 = 4.6%
– 2003 1.43 (1.43 – 1.36) / 1.36 = 5.1%
– 2004 1.50 (1.50 – 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

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 Advantages and Disadvantages of
Dividend Growth Model
• Advantage – easy to understand and use
• Disadvantages
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth rate –
an increase in g of 1% increases the cost of equity
by 1%
– Does not explicitly consider risk
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 The SML Approach
• Use the following information to compute our
cost of equity
– Risk-free rate, Rf
– Market risk premium, E(RM) – Rf
– Systematic risk of asset, 

RE  R f   E ( E ( RM )  R f )

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 Example - SML
• Suppose your company has an equity beta of
.58 and the current risk-free rate is 6.1%. If the
expected market risk premium is 8.6%, what is
your cost of equity capital?
– RE = 6.1 + .58(8.6) = 11.1%
• Since we came up with similar numbers using
both the dividend growth model and the SML
approach, we should feel pretty good about
our estimate
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 Advantages and Disadvantages of
SML
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as we can
estimate beta
• Disadvantages
– Have to estimate the expected market risk
premium, which does vary over time
– Have to estimate beta, which also varies over time
– We are using the past to predict the future, which
is not always reliable
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 Example – Cost of Equity
• Suppose our company has a beta of 1.5. The market
risk premium is expected to be 9% and the current
risk-free rate is 6%. We have used analysts’ estimates
to determine that the market believes our dividends
will grow at 6% per year and our last dividend was
$2. Our stock is currently selling for $15.65. What is
our cost of equity?
– Using SML: RE = 6% + 1.5(9%) = 19.5%
– Using DGM: RE = [2(1.06) / 15.65] + .06 =
19.55%
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 Cost of Debt
• The cost of debt is the required return on our
company’s debt
• We usually focus on the cost of long-term debt or
bonds
• The required return is best estimated by computing
the yield-to-maturity on the existing debt
• We may also use estimates of current rates based on
the bond rating we expect when we issue new debt
• The cost of debt is NOT the coupon rate

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 Example: Cost of Debt
• Suppose we have a bond issue currently
outstanding that has 25 years left to maturity.
The coupon rate is 9% and coupons are paid
semiannually. The bond is currently selling for
$908.72 per $1000 bond. What is the cost of
debt?
– N = 50; PMT = 45; FV = 1000; PV = -908.75; CPT I/Y
= 5%; YTM = 5(2) = 10%

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 Cost of Preferred Stock
• Reminders
– Preferred stock generally pays a constant dividend
each period
– Dividends are expected to be paid every period
forever
• Preferred stock is a perpetuity, so we take the
perpetuity formula, rearrange and solve for RP
• RP = D / P0

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 Example: Cost of Preferred Stock
• Your company has preferred stock that has an
annual dividend of $3. If the current price is
$25, what is the cost of preferred stock?
• RP = 3 / 25 = 12%

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 The Weighted Average Cost of
Capital
• We can use the individual costs of capital that
we have computed to get our “average” cost
of capital for the firm.
• This “average” is the required return on our
assets, based on the market’s perception of
the risk of those assets
• The weights are determined by how much of
each type of financing we use

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 Capital Structure Weights
• Notation
– E = market value of equity = # of outstanding
shares times price per share
– D = market value of debt = # of outstanding bonds
times bond price
– V = market value of the firm = D + E
• Weights
– wE = E/V = percent financed with equity
– wD = D/V = percent financed with debt
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Example: Capital Structure Weights
• Suppose you have a market value of equity
equal to $500 million and a market value of
debt = $475 million.
– What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%

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 Taxes and the WACC
• We are concerned with after-tax cash flows,
so we need to consider the effect of taxes on
the various costs of capital
• Interest expense reduces our tax liability
– This reduction in taxes reduces our cost of debt
– After-tax cost of debt = RD(1-TC)
• Dividends are not tax deductible, so there is
no tax impact on the cost of equity
• WACC = wERE + wDRD(1-TC)
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 Extended Example – WACC - I
• Equity Information • Debt Information
– 50 million shares
– $1 billion in outstanding
– $80 per share debt (face value)
– Beta = 1.15 – Current quote = 110
– Market risk premium = – Coupon rate = 9%,
9% semiannual coupons
– Risk-free rate = 5% – 15 years to maturity
• Tax rate = 40%

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 Extended Example – WACC - II
• What is the cost of equity?
– RE = 5 + 1.15(9) = 15.35%
• What is the cost of debt?
– N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y =
3.9268
– RD = 3.927(2) = 7.854%
• What is the after-tax cost of debt?
– RD(1-TC) = 7.854(1-.4) = 4.712%

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 Extended Example – WACC - III
• What are the capital structure weights?
– E = 50 million (80) = 4 billion
– D = 1 billion (1.10) = 1.1 billion
– V = 4 + 1.1 = 5.1 billion
– wE = E/V = 4 / 5.1 = .7843
– wD = D/V = 1.1 / 5.1 = .2157
• What is the WACC?
– WACC = .7843(15.35%) + .2157(4.712%) = 13.06%

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