1 Chapter 3
Cost of Capital
Learning Objectives
2
After studying this chapter, you should
understand:
1) How to determine a firm's cost of equity
capital.
2) How to determine a firm's cost of debt.
3) How to determine a firm's overall cost of
capital.
An Overview
3
terms required return, appropriate discount rate, and
cost of capital are more or less interchangeably used.
The cost of capital depends primarily on the use of
the funds, not the source.
We take the firm’s financial policy – capital structure
as given.
Given that a firm uses both debt and equity capital.
Hence, a firm's cost of capital will reflect both its
cost of equity capital and
cost of debt capital.
Why Cost of Capital is Important
4
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
The Cost of Equity
5
Cost of equity = the return that equity investors
require on their investment in the firm.
Q: What is the firm’s overall cost of equity?
A: this is a difficult question is b/c there is no way of directly
observing the return that the firm’s equity investors require on their
investment. Instead, we must somehow estimate it.
There two approaches to determining the cost of equity:
1) the dividend growth model approach and
2) the security market line (SML) approach.
The Cost of Equity
6
Dividend Growth Model Approach
Assumption:
the firm’s dividend will grow at a constant rate, g,
the price per share of the stock, P0, can be written as:
,
Where,
D0 is the dividend just paid
D1 is the next period’s projected dividend
RE (the E stands for equity) for the required return on the stock
The Cost of Equity
7
Dividend Growth Model Approach
Rearrange to solve for RE as:
Because RE is the return that the shareholders require on the
stock, it can be interpreted as the firm’s cost of equity capital.
EX.1: Suppose GS Co., a large public utility, paid a dividend of
br 4 per share last year. The stock currently sells for br 60 per
share. It is estimated that the dividend will grow steadily at a
rate of 6% per year into the indefinite future. What is the cost
of equity capital for GS?
The Cost of Equity
8
Dividend Growth Model Approach
EX.2: ABC Co. is expected to pay an annual dividend
of br 0.80 a share next year. The market price of the
stock is expected to be br 22.40 and the growth rate is
5%. What is the firm's cost of equity?
The Cost of Equity
9
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 are not 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 Cost of Equity
10
The SML Approach/Model:
The notion here is that required/expected return on a
risky investment depends on three things:
1) The risk-free rate, Rf
2) The market risk premium, E(RM) - Rf
3) The systematic risk of the asset relative to average, which
we called its beta coefficient, .
Using the SML, we can write the expected return on the
company’s equity, E(RE), as:
The Cost of Equity
11
Ex1: Suppose your 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 your cost of equity capital?
Given: Rf = 6.1%, E = 0.58, RM-Rf = 8.6%
RE = 6.1% + 0.58(8.6%) = 0.11088 = 11.1%
Suppose that your company is expected to pay a dividend of br
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 br 25. What is the cost of equity?
RE = + g RE = (1.5/25) + 5.1% = 11.1%
The Cost of Equity
12
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
The Cost of Debt
13
Cost of debt measures the current cost to the firm of
borrowing funds to finance projects, such as
interest expense
transaction cost
bond printing cost
taxes
It is measured by the effective interest rate or yield paid to
bondholders.
i.e., before tax cost of debt is equal to the yield to maturity
on bond issue.
If the debt is publically issued, floatation cost incurred.
The Cost of Debt
14
Cost of debt can be
Observed from market (interest rates in the financial markets)
or
firm’s bonds rating, say, AA; interest rate on newly issued
AA-rated bonds.
But required return to debt holders is not equal to the
firm’s cost of debt b/c interest payments are deductible,
which means the government in effect pays part of the
total cost.
after-tax cost of debt is
The Cost of Debt
15
Ex1: assume that ABC’s tax rate is 40%, the cost of new,
or marginal, debt is 9%, then its after-tax cost of debt is
Soln: after-tax cost of debt is
Class-work:
Cost of Preferred Stock
16
Cost of preferred stock is quite straightforward b/c:
Preferred stock generally pays a constant dividend each period
Dividends are expected to be paid every period forever
Preferred stock is a perpetuity, so cost of preferred stock, RP,
RP = D / P0
Ex1: Your company has preferred stock that has an annual
dividend of br 3. If the current price is br 25, what is the
cost of preferred stock?
RP = 3/25 = 12%
Cost of Preferred Stock
17
Class-work:
The Weighted Average Cost of Capital
18
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.
The Weighted Average Cost of Capital
19
WACC:
After calculating individual CC, now can combine them
WACC.
WACC = cost of equity + cost of debt + cost of preferred stock
Where W = Weights
Firm should accept any project with a return which is
more than WACC.
In other words, it’s the minimum return for a project must
be at least equal to WACC.
Capital Structure Weights
20
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
CS Weights
wE = E/V = percent financed with equity
wD = D/V = percent financed with debt
Example: Capital Structure Weights
21
Suppose you have a market value of equity
equal to $520,000 and a market value of
debt equal to $480,000.
What are the capital structure weights?
V = $520,000 + $480,000 = $1,000,000
wE = E/V = 520,000 / 1,000,000 = 0.52 = 52%
wD = D/V = 480,000/ 1,000,000 = 0.48 = 48%
Taxes and the WACC
22
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-T)
Dividends are not tax deductible, so there is no tax
impact on the cost of equity
WACC = w R + w R (1-T)
E E D D
WACC - Example
23
Suppose a firm has following capital structure which it
considers optimal: Debt – 30%, Preferred shares – 18%, Share
Capital (Common shares) – 52%. The firm paid a dividend of
$2/share last year and its stock currently sells at $80/share. Tax
rate is 35% and investors expect earnings and dividend to grow
at a constant rate of 12% in the future. New Common stocks
have a flotation cost of 12%. New Preferred stock would be sold
at $100/share with a dividend of $9. Flotation is $6/share. For
debt, it’s a 9% irredeemable debt with a current value of $1,100.
Annual interest payment has just been made.
What is the weighted average after-tax costs of capital of the
firm?
WACC - Solution
24
What is the weighted average after-tax costs of capital of the
firm?
Cost of debt:
RD = $90/$1,100 = 8.18% 9%*$100 = $90
RDT = 8.18%*(1 – 35%)
RDT = 8.18%*(1 – 35%)
RDT = 5.32%
Cost of Preferred Stock:
WACC – Solution…
25
What is the weighted average after-tax costs of capital of the
firm?
Cost of Common Stock:
WACC:
Extended Example – WACC - I
26
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 = 9% Coupon rate = 9%,
Risk-free rate = 5% semiannual coupons
15 years to maturity
Tax rate = 40%
Extended Example – WACC - II
27
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-T) = 7.854(1-0.4) = 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 = 0.7843
wD = D/V = 1.1 / 5.1 = 0.2157
What is the WACC?
WACC = 0.7843(15.35%) + 0.2157(4.712%) = 13.06%
Check your understanding!
29
Question:
The market values of common stock and debts of a
company are $150 million and $35 million
respectively, in which the required return for
common stock is 17% whilst 7% for debts. The
book value of common stock and debts are $100
million and $20 million respectively.
Calculate the WACC for this company if they are
subject to a 40% tax rate.
30
Thanks!
End of the Chapter,
Questions?
