Week 9

Lecture 9
Ross, Westerfield and Jordan 7e
Chapter 15
Cost of Capital

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 Last Week..
• Expected Returns and Variances
• Single asset & Portfolios
• Using probabilities & Historical returns
• Principle of Diversification
• Systematic and Unsystematic Risk
• Beta
• CAPM
• SML
• Reward to Risk Ratio
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 Chapter 15 Outline
• Cost of Capital: Introduction
• Cost of Equity
• Costs of Debt
• Cost of Preferred Stock
• Weighted Average Cost of Capital
• Divisional and Project Costs of Capital
• Flotation Costs

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Why Cost of Capital Is Important
• 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 = Cost of Capital

• The Required Rate of Return = Discount Rate =

Hurdle Rate = Cost of Capital
• Need to know the required return for an
investment so we can compute the NPV and
decide whether or not to take the investment
• Need to earn at least the required return to
compensate investors for their financing
• Required return – from the investor’s point of
view
• Cost of capital – from the firm’s point of view
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 Cost of Capital
• The firm is financed by a mixture of equity and
debt
• Cost of Capital is a mix of Cost of Equity and
Cost of Debt
• These costs are determined by the market
• The firm determines the mix, Debt/Equity (D/E)
reflecting it’s target capital structure.
• To calculate cost of capital:
• Calculate cost of equity
• Calculate cost of debt
• Combine them
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 Cost of Equity
• The cost of equity is the return required by
equity investors, the shareholders on their
investment in the firm
• Since this cost is not directly observable, it
must be estimated
• There are two main methods for
determining the cost of equity:
• Dividend Growth Model
• CAPM
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 Cost of Equity - DGM Approach

• Start with the dividend growth model formula where g is

constant: D (1 g) D
P0  0
 1

RE  g RE  g

• Where: RE is the required return for shareholders, P0 is

the current price, D0 is the current/last dividend, D1 is the
next dividend
• and rearrange to solve for RE:
D1
RE  g
P0
• Where D1/P0 is the dividend yield, and g is the growth rate
of dividends
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 DGM - Example 1

• Bentex Ltd. recently paid a dividend of 40 cents

per share. This dividend is expected to grow at
6% per year indefinitely. If the current market
price of Bentex shares is $6 per share, estimate
its cost of equity.
• D0 = $0.40, g = 6%, P0 = $6, RE = ?
D1 = D0(1 + g) = $0.40(1.06) = $0.424
RE = (D1 / P0) + g = (0.424/6.00) + 0.06
= 0.1307, and thus the cost of equity is 13.07%.
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 DGM – Example 2
• Suppose ABC 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. The current price is $25. What is the cost of
equity?
• D1 = $1.50, g = 5.1%, P0 = $25, RE = ?
D1
P0 
RE  g
D1 1.50
RE  g  .051  .111  11.1%
P0 25
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 Example - Estimating the Dividend
Growth Rate ‘g’
• One method for estimating the growth rate
is to use the historical average
Year Dividend Change Return%
• 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%
• Another way is use analysts’ forecast
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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
• Assumes dividend growth is constant
• Cost of equity is sensitive to growth estimate
• Does not explicitly consider risk

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 Cost of Equity - CAPM or SML
Approach
• Recall CAPM for any asset i is:
E(Ri )  R f  βi (E(RM )  R f )
• The CAPM cost of equity is:
RE  R f  βE (E(RM )  R f )
• Use the following information to compute our
cost of equity
• RE = Required return for shareholders
• Rf = Risk-free rate
• E(RM) – Rf = Market risk premium
 E = Systematic risk of firm’s equity relative to the
market
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 CAPM - Example
• Suppose our ABC company has an equity beta of
0.58 and the current risk-free rate is 6.1%. If the
expected market risk premium is 8.6%, what is
the cost of equity capital?
• βE = 0.58, Rf = 6.1%, E(RM) – Rf = 8.6%
RE  R f  βE (E(RM )  R f )

RE = 0.061 + 0.58(0.086) = 11.1%

• What if the expected market return is 8.6%?
• RE = 0.061 + 0.58(0.086 – 0.061) = 7.55%
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 Advantages and Disadvantages of
CAPM
• Advantages
• Explicitly adjusts for risk
• Applicable to all companies
• 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%. The market
believes our dividends will grow at 6% per year
and our last dividend was $2. The stock is
currently selling for $15.65. What is the cost of
equity?
• Using CAPM: RE = 6% + 1.5(9%) = 19.5%
• Using DGM: RE = [2(1.06) / 15.65] + .06 =
19.55%
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 Cost of Preferred Stock
• Reminders
• Preferred stock pays a constant dividend
• Dividends are expected to be paid forever
• Preferred stock return = Perpetuity RP
• P0 = D/Rp RP = D / P0
• Example:
• 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?
• 25 = 3/Rp therefore RP = 3 / 25 = 12%
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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 or YTM
• The cost of debt is NOT the coupon rate
• For publicly listed debt use YTM
• If the firm has no publicly traded debt, use YTM on
similar debt that is traded.

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 YTM of Bond
• In general:
 1 
1 
 (1 R )T  F
P0  C  D

 (1 RD )
T
 RD
 
• Where
• C is coupon interest payment,
• RD is required market return or YTM,
• T is the number of periods left until repayment,
• F is face value.

• Need to solve for RD

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 Example – Cost of Debt
• Gloss Ltd issued a 20-year, 12% bond 10 years
ago. The bond is currently priced at $860, and
pays interest annually. What is its cost of debt?
 1 
1 (1 R )10  $1000
$860  $120  D

 RD  (1  R D )10

 

• Excel solution gives RD = 0.1476, meaning that

Gloss’s cost of debt is 14.76%.
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 Example - Cost of Debt
• Suppose a firm has a bond issue currently
outstanding that has 25 years left to
maturity and pays coupons semiannually.
The coupon rate is 9% per year. The
bond’s current price is $908.72 per $1000
bond. What is the cost of debt?
• t = 25 years x 2 = 50; C = $90/2 = 45;
• F = $1000; Bond Price or P = $908.75;
• RD or YTM = ?
• By trial and error semiannual yield = 5%
• YTM = RD = 5% x 2 = 10%
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 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.
• WACC 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
WACC = wE*RE + wP*RP + wD*RD

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 Capital Structure Weights
• Notation
• E = market value of equity = nr. of outstanding shares
times price per share
• P = market value of preference shares = nr. of
outstanding preference shares times price per share
• D = market value of debt = nr. of outstanding bonds
times bond price
• V = market value of the firm = E + P + D
• Weights
• wE = E/V = percent financed with equity
• wP = P/V = percent financed with preference stock
• wD = D/V = percent financed with debt
• wE + w P + w D = 1
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 Example – Weights & WACC
Cost of debt = 5.7 %, Cost of equity = 14.0 %
Cost of preference shares = 9.0 %
Source of Capital M.Value Weight
Long term debt $40 m 40%
Pref. shares $10 m 10%
Equity $ 50 m 50%
Total 100 m 100 %
WACC = (E/V)*RE + (P/V)*RP + (D/V)*RD
= (0.5)*0.14 + (0.1)*0.09 + (0.4)*0.057
= 0.1018
WACC = 10.18% (Unadjusted)
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 WACC – Adjusted
• The company gets a tax deduction for interest on debt,
reducing the effective cost of debt.
• If TC is the corporate tax rate then the after tax cost of
debt is RD*(1  TC), and the WACC adjusted for taxation
effects is given by:
• WACC = wE*RE + wP*RPS + wD*RD*(1  TC) or

• WACC = (E/V)*RE + (P/V)*RPS +(D/V)*RD*(1  TC)

• Previous example: If tax rate is 30%, then
WACC = (0.5)*0.14 + (0.1)*0.09 + (0.4)*0.057(0.7)
= 0.0950 or 9.5%.
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WACC - Extended Example (1)
• 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%
Step 1: Calculate cost of equity and cost of debt
Step 2: Calculate the market value of each source of
financing and the weights
Step 3: Calculate the WACC adjusting for tax.
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WACC - Extended Example (2)
• What is the cost of equity?
• βE = 1.5, Rf = 5%, RM – Rf = 9%, RE = ?
• RE = 5% + 1.15(9%) = 15.35%
• What is the cost of debt?
• t = 15y x 2=30; Price = $1100; C = $90/2 = 45;
F = $1000; by trial & error semi yield = 3.9268
• RD = 3.927% x 2 = 7.854%
• What is the after-tax cost of debt?
• RD(1-TC) = 7.854(1-0.4) = 4.712%
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WACC - Extended Example (3)
• What are the capital structure weights?
• E = 50 million x $80 = $4 billion
• D = $1 b x 110% = $1.1 billion Or
$1 b/1000 = 1 million bonds issued
1 m bonds x $1100 = $1.1 billion
• V = 4 + 1.1 = 5.1 billion
• wE = E/V = 4 / 5.1 = 0.7843
• wD = D/V = 1.1 / 5.1 = 0.2157
• What is the WACC?
• WACC = wE*RE + wD*RD*(1  TC)
• WACC = 0.7843(15.35%) + 0.2157(4.712%) = 13.06%
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 Finding the Weights from D/E
• Suppose Belo Corp has a target D/E ratio of 0.33. Cost of
Debt is 10% and cost of equity is 20%. If tax is 34%, what
is WACC?
• First calculate WE and WD.
• If D/E = 0.33 what is E = ? D = ?
• Assign any value to equity. E = 1
• D/1= 0.33 then D = 0.33 and V = 1.33
• E/V = 1/1.33 = 0.7519 and
• D/V = 0.33/1.33 = 0.2481
• WACC = wE*RE + wD*RD*(1  TC)
• WACC = 0.75 x 0.20 + 0.25 x 0.10 x (1-0.34) = 16.65%
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 Finding D/E
• If BHP has a WACC of 21.67% and the cost
of equity is 29.2%, cost of debt is 10%, what
is it’s target D/E ratio? Assume tax is 34%.
• We know that E + D = V or WE + WD = 1
• We express one in terms of another:
• WE = 1 - WD
• And insert in WACC equation:
• 0.2167 = WE x 0.292 + WD x 0.10 x (1-0.34)
• 0.2167 = (1-WD) x 0.292 + WD x 0.10 x (1-0.34)
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 Finding D/E (cont.)
• 0.2167 = (1-WD) x 0.292 + WD x 0.10 x (1-0.34)
• Solve for WD the only unknown variable:
• 0.2167 = 0.292 – WD x 0.292 + WD x 0.066
• 0.2167 – 0.292 = – WD x 0.292 + WD x 0.066
• -0.0753 = -WD x (0.292 - 0.066)
• 0.0753 = WD x 0.226
• WD = 0.0753/0.2260 = 0.333
• Therefore WE = 1 – WD, WE = 1- 0.333 = 0.667
• D/E = 0.333/0.667 = 0.5
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Table 15.1 Cost of Equity & Debt

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Table 15.1 WACC

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 Useful Websites
• Yahoo Finance
• Share price
• Beta
• Book value per share
• Analysts estimates
• T-Bill rate
• www.nasdbondinfo.com
• Bond information
• www.sec.gov
• Company filings
• www.valuepro.net
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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
Project Req. Ret. IRR WACC
A 20% reject 17% accept 15%
B 15% accept 18% accept 15%
C 10% accept 12% reject 15%
• Assume the WACC = 15%
• If we use the WACC for all projects
regardless of risk
• Accept A and B, reject C
• If correct required return based on specific
risk is used
• Accept B and C, reject A
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Divisional and Project costs of capital

• WACC is the appropriate discount rate only

when the project is about the same risk as the
firm.
• Other approaches to estimating a discount rate:
• divisional cost of capital—used if a company has
more than one division with different levels of risk;
• pure play approach—a discount rate that is unique to
a particular project is used;
• subjective approach—projects are allocated to
specific risk classes which, in turn, have specified
discount rates.

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 Other Approaches
• Pure Play Approach:
• Look at companies in the same line of business as the
new project
• Calculate an average WACC for all the companies
and use this rate as the discount rate of the new
project
• Subjective Approach:
• Consider the project’s risk relative to the firm overall
risk
• If the project risk > firm risk,
use a discount rate > WACC
• If the project risk < firm risk,
use a discount rate < WACC
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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
fA = (E/V)*fE + (D/V)* fD
• where fA is the weighted average flotation cost, fE is
the equity flotation cost proportion, and fD is debt
flotation cost proportion.
• True cost of project = Cost/(1-fA)
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 Flotation Cost Example
• A firm has a target structure that is 80% equity and 20%
debt. The costs for raising equity are 20% and the cost of
raising debt are 6%. If the firm needs $65 million for a new
facility, what is the true cost after accounting for flotation
costs?
fA = (E/V)*fE + (D/V)* fD
= 0.8*0.2 + 0.2*0.06 fA = 0.172 or 17.2%
• If the flotation cost is 17.2%, and we need to raise $65
million net, the true cost of the facility would be:
$65/(1 - fA) = 65/0.828 = $78.50 million
• The firm needs to raise $78.5 million to account for flotation
costs and to have $65 million left to invest.
• Since 78.5/65 = 1.2077, this suggests that for every dollar
required by the project, the firm must raise $1.2077 to
finance its projects. 15-40
 Quick Quiz
• What are the two approaches for computing the cost
of equity?
• What is the cost of debt?
• How do you compute the after-tax cost of debt?
• How do you compute the capital structure weights
required for the WACC?
• When is appropriate to use WACC as the discount
rate for projects?
• What is the proportion of E and D if we have a D/E
ratio of 1.2
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End Chapter 15

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