Chapter 14

Cost of Capital

This chapter emphasizes the importance of cost of capital in the corporate

capital budgeting decision-making process. By determining the cost of
capital component, its relative weight and company’s specific tax
environment, we calculate the Weighted Average Cost of Capital (WACC)

Copyright © 2012 by McGraw-Hill Education. All rights reserved.

 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
• Know how to correctly include floatation
costs in capital budgeting

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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: the possibility a company will have lower than
anticipated profits or experience a loss rather than taking a profit
– Financial risks: the possibility that shareholders or other
financial stakeholders will lose money when they invest in a
company that has debt if the company's cash flow proves
inadequate to meet its financial obligations.
• 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 next 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?

1 .50
RE   .051  .111  11 .1 %
25

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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
– 2005 1.23 -
– 2006 1.30 (1.30 – 1.23) / 1.23 = 5.7%
– 2007 1.36 (1.36 – 1.30) / 1.30 = 4.6%
– 2008 1.43
(1.43 – 1.36) / 1.36 = 5.1%
– 2009 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 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: Yield to
maturity divides annual cash inflows from a bond by
the market price of that bond to determine how much
money one would make by buying a bond and
holding it for one year.
• 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 $1,000
bond. What is the cost of debt?
– N = 50; PMT = 45; FV = 1000; PV = -908.72;
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 the
firm’s 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 is used

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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 equal to $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 also 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
– $80 per share outstanding debt
(face value)
– Beta = 1.15
– Current quote = 1.10
– Market risk – Coupon rate = 9%,
premium = 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 = -1,100; PMT = 45; FV = 1,000;
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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Table 14.1 Cost of Equity

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Table 14.1 Cost of Debt

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Table 14.1 WACC

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Divisional and Project Costs
of Capital
• Using the WACC as our discount rate is
only appropriate for projects that have the
same risk as the firm’s current operations
• If we are looking at a project that does
NOT have the same risk as the firm, then
we need to determine the appropriate
discount rate for that project
• Divisions also often require separate
discount rates

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 Using WACC for All Projects
- Example
• What would happen if we use the WACC for
all projects regardless of risk?
• Assume the WACC = 15%
Project Required Return IRR
A 20% 17%
B 15% 18%
C 10% 12%

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 The Pure Play Approach
• Find one or more companies that
specialize in the product or service that we
are considering
• Compute the beta for each company
• Take an average
• Use that beta along with the CAPM to find
the appropriate return for a project of that
risk
• Often difficult to find pure play companies

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 Subjective Approach
• Consider the project’s risk relative to the firm
overall
• If the project has more risk than the firm, use a
discount rate greater than the WACC
• If the project has less risk than the firm, use a
discount rate less than the WACC
• You may still accept projects that you shouldn’t
and reject projects you should accept, but your
error rate should be lower than not considering
differential risk at all

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 Subjective Approach -
Example
Risk Level Discount Rate

Very Low Risk WACC – 8%

Low Risk WACC – 3%

Same Risk as Firm WACC

High Risk WACC + 5%

Very High Risk WACC + 10%

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 Flotation Costs
• The required return depends on the risk,
not how the money is raised
• However, the cost of issuing new
securities should not just be ignored either
• Basic Approach
– Compute the weighted average flotation cost
– Use the target weights because the firm will
issue securities in these percentages over the
long term

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 NPV and Flotation Costs -
Example
• Your company is considering a project that will cost $1
million. The project will generate after-tax cash flows of
$250,000 per year for 7 years. The WACC is 15%, and the
firm’s target D/E ratio is .6 The flotation cost for equity is 5%,
and the flotation cost for debt is 3%. What is the NPV for the
project after adjusting for flotation costs?
– fA = (.375)(3%) + (.625)(5%) = 4.25%
– PV of future cash flows = 1,040,105
– NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281
• The project would have a positive NPV of 40,105 without
considering flotation costs
• Once we consider the cost of issuing new securities, the
NPV becomes negative

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 Quick Quiz
• What are the two approaches for computing the
cost of equity?
• How do you compute the cost of debt and the after-
tax cost of debt?
• How do you compute the capital structure weights
required for the WACC?
• What is the WACC?
• What happens if we use the WACC for the discount
rate for all projects?
• What are two methods that can be used to compute
the appropriate discount rate when WACC isn’t
appropriate?
• How should we factor flotation costs into our
analysis?
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End of Chapter

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