Cost of Capital

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

What is Cost of Capital ?
Cost of capital i.e., weighted average cost of capital is
the summation of the weighted average cost of each
component of capital. The specific cost and respective
weight of each component of capital are multiplied and
added up to determine the WACC or cost of capital.
WACC i.e, cost of capital = We× Ke + Wd × Kd + Wp×Kp
Example: If cost of capital is 12%, this indicates that to
acquire each Tk.100 capital, it cost on an average Tk.12
to the company.
Why Cost of Capital Is Important?
Cost of capital is the minimum rate of return that the
company must earn to satisfy the suppliers of capital.
If the company fails to earn the cost of capital from
investment, the market price of shares will fall.
Therefore, for the company’s future prospect and
satisfactory performance, it is very important that the
company must earn at least equal to the cost of
capital.
For making capital investment decision, the company
needs to know its cost of capital. Only those projects are
undertaken, where the return is more than the cost of
capital.
Why Cost of Capital Is Important?
In order to construct the capital structure of the firm cost
of capital is also used. The optimum capital structure
is that proportion debt and equity where the cost of
capital is minimum.
Moreover, the minimum cost of capital results in
maximum value of the firm. Therefore the concept of
cost of capital helps us to maximize the wealth of the
owners, i.e., to attain the goal of the firm.
Required Return
The required return is the same as the appropriate
discount rate and is based on the risk of the cash
flows
The terms required return, appropriate discount
rate and cost of capital are more or less used
interchangeably because they all mean essentially the
same thing.
The cost of capital depends primarily on the use of
the funds, not the source.
It is assumed that the firm has a fixed debt-equity ratio
and this ratio reflects the firm’s target capital structure.
The Cost of Equity
• The cost of equity is the return required by equity
investors given the risk of the cash flows from the
firm
• There are two major methods for determining the
cost of equity

– Dividend Growth Model (DGM) or DDM

– SML or CAPM
The Dividend Growth Model Approach
Estimating the cost of equity - dividend growth
model approach.
According to the constant growth model:

D1
P0 
RE - g
Rearranging:

D1
RE  g
P0
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
25
Example: Estimating the Dividend Growth Rate
• One method for estimating the growth rate is
to use the historical average
– Year Dividend Percent Change
– 1995 1.23
– 1996 1.30 (1.30 – 1.23) / 1.23 = 5.7%
– 1997 1.36 (1.36 – 1.30) / 1.30 = 4.6%
– 1998 1.43 (1.43 – 1.36) / 1.36 = 5.1%
– 1999 1.50 (1.50 – 1.43) / 1.43 = 4.9%

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

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
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, 

R E  R f   E ( E ( RM )  R f )
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
Advantages and Disadvantages of SML
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as we can
compute 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 relying on the past to predict the future,
which is not always reliable
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%
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
• The cost of debt is NOT the coupon rate
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%
Cost of Preferred Stock
• Reminders
– Preferred generally pays a constant dividend every
period
– Dividends are expected to be paid every period
forever
• Preferred stock is an annuity, so we take the
annuity formula, rearrange and solve for R P
• RP = D / P 0
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%
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 that we use
Capital Structure Weights
• Notation
– E = market value of equity = # outstanding shares
times price per share
– D = market value of debt = # 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
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/D = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%
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)
Extended Example – WACC - I
• Debt
EquityInformation
Information
– $1
50 billion
millioninshares
outstanding debt (face value)
– Current
$80 per share
quote = 110
– Coupon
Beta = 1.15
rate = 9%, semiannual coupons
– 15
Market
yearsrisk
to maturity
premium = 9%
– Risk-free
• Tax rate = 5%
rate = 40%
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%
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%
Cost of Equity
Cost of Debt
WACC
Divisional and Project Costs of
Capital
• Using the WACC as our discount rate is only
appropriate for projects that are the same risk as
the firm’s current operations
• If we are looking at a project that is NOT 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
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%
 The SML and the WACC
SML
Expected
return (%)

16 = 8%
15 WACC = 15%
14 Incorrect
B acceptance
A
Incorrect
rejection

Rf =7

Beta
A = .60 firm = 1.0 B = 1.2

If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a
tendency toward incorrectly accepting risky projects and incorrectly rejecting less risky projects.
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
Subjective Approach
• Consider the project’s risk relative to the firm
overall
• If the project is more risky than the firm, use a
discount rate greater than the WACC
• If the project is less risky 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
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%

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
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