2. 2
Topics in Chapter
Cost of capital components
Debt
Preferred stock
Common equity
WACC
Factors that affect WACC
Adjusting cost of capital for risk
3. COST OF CAPITAL
Why?
Key to understanding cost
of raising $
Risk
Financing costs
Discount Rate
Business Application
Min Req’d return needed
on Project
Reflects blended costs of
raising capital
Relevant “i ”
Discount rate used to
determine Project’s NPV
or to disct FCFs by
Hurdle rate
3
4. 4
What types of long-term
capital do firms use?
Long-term debt
Preferred stock
Common equity
5. 5
Capital Components
Cap. components are sources of funding that
come from investors.
A/P, accruals, and deferred taxes are not
sources of funding that come from investors,
& not included in the calculation of the cost of
capital.
These items are adjusted for when calculating
project cash flows, not when calculating the
cost of capital.
6. 6
Before-tax vs. After-tax Capital
Costs
Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
Most firms incorporate tax effects in the
cost of capital. Therefore, focus on
after-tax costs.
Only cost of debt is affected.
7. 7
Historical (Embedded) Costs
vs. New (Marginal) Costs
The cost of capital is used primarily to
make decisions which involve raising
and investing new capital. So, focus on
marginal (incremental) costs.
8. COST of CAPITAL
Raising $ & its Costs
Debt
Cost of Borrowing
Interest Rate
Equity
Internal
RE
External
Common Stock
Prfd Stock
8
9. Cost of Capital
Raising $ & its Costs
Debt & Equity
Cost Return
Int. pd. Int. recd.
Divids pd. Divids Recd
9
10. EQUITIES
Why?
Key to understanding
valuations
What is investment worth
today?
Value of:
Enterprise
Entity
Company/Firm
Business Application
For Investor:
Determine value of
asset/business/company
For Firm:
Determine cost of
attracting investors &
raising equity capital
Selling ownership stake to
raise $
10
11. Weighted Average Cost of
Capital (WACC)
WACC: Blended cost or raising capital
considering mix of debt & equity
WACC = (Wt of Debt)(After-tax cost of
Debt) + Wt of Eqty)(Cost of Eqty) +
(Wt of Prfd)(Cost of Prfd)
11
12. To put it simply, the weighted average
cost of capital formula helps
management evaluate whether the
company should finance the purchase
of new assets with debt or equity by
comparing the cost of both options.
Financing new purchases with debt or
equity can make a big impact on the
profitability of a company and the
overall stock price.
12
13. Management must use the equation to
balance the stock price, investors’
return expectations, and the total cost
of purchasing the assets. Executives
and the board of directors use weighted
average to judge whether a merger is
appropriate or not.
Investors and creditors, on the other
hand, use WACC to evaluate whether
the company is worth investing in or
loaning money to.
13
14. Since the WACC represents the
average cost of borrowing money
across all financing structures, higher
weighted average percentages mean
the company’s overall cost of financing
is greater and the company will have
less free cash to distribute to its
shareholders or pay off additional debt.
As the weighted average cost of capital
increases, the company is less likely to
create value and investors and creditors
tend to look for other opportunities. 14
15. Cost of Equity
Know: = P0 = D1/ (rs –g)
So then: rs = D1/P0 + g
15
16. Cost of Equity
Cost of External Equity: Function of Dvids,
growth, & net proceeds after adjusting for
flotation costs
Cost of Internal Equity: Function of opp.
Costs of divids not pd out but retained in firm
to grow internally (no flot. req’d)
16
17. Cost of Preferred Stock
r = D1/P0 + g
g= 0, so cost of prfd = function of
divids pd. & flot cost to issue
17
18. Assume newly formed Corporation ABC
needs to raise $1 million in capital so it
can buy office buildings and the
equipment needed to conduct its
business. The company issues and sells
6,000 shares of stock at $100 each to
raise the first $600,000. Because
shareholders expect a return of 6% on
their investment, the cost of equity is
6%.
18
19. Assume newly formed Corporation ABC
needs to raise $1 million in capital so it
can buy office buildings and the
equipment needed to conduct its
business. The company issues and sells
6,000 shares of stock at $100 each to
raise the first $600,000. Because
shareholders expect a return of 6% on
their investment, the cost of equity is
6%.
19
20. Corporation ABC then sells 400 bonds
for $1,000 each to raise the other
$400,000 in capital. The people who
bought those bonds expect a 5%
return, so ABC's cost of debt is 5%.
20
21. Corporation ABC's total market value is
now ($600,000 equity + $400,000
debt) = $1 million and its corporate tax
rate is 35%. Now we have all the
ingredients to calculate Corporation
ABC's weighted average cost of capital
(WACC).
WACC =
(($600,000/$1,000,000) x .06) +
[(($400,000/$1,000,000) x .05) *
(1-0.35))] = 0.049 = 4.9%
21
22. 22
Determining Cost of Debt
Method 1: Ask an investment banker
what coupon rate would be on new
debt.
Method 2: Find bond rating for the
company and use yield on similarly
rated bonds.
Method 3: Find yield on the company’s
existing debt.
23. 23
Current vs. Historical Cost of
Debt
For cost of debt, don’t use coupon rate
on existing debt, which represents cost
of past debt.
Use the current interest rate on new
debt (think YTM).
(More…)
24. 24
A 15-year, 13.25% semiannual bond sells
for $1,250. Tax = 40%. 60,000 Bonds
o/s. What’s rd?
-66.25 <66.25 + 1,000>
-66.25
0 1 2 30
rd = ?
1,250.00
...
30 1250 -66.25 -1000
5.0% x 2 = rd = 10%
N I/YR PV FV
PMT
INPUTS
OUTPUT
25. 25
Component Cost of Debt
Interest is tax deductible, so the after
tax (AT) cost of debt is:
rd AT = rd BT(1 – T)
rd AT = 10%(1 – 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.
26. 26
Cost of preferred stock: Pps = $125;
10.26% Div; Par = $100; F = 8.8%
Use :
rps =
Dps
Pps (1 – F)
=
.0126($100)
$125.00(1 – 0.088)
=
$10.26
$114.
= 0.090 = 9.0%
28. 28
Note:
Flotation costs for preferred are
significant, so are reflected. Use net
price.
Preferred dividends are not deductible,
so no tax adjustment. Just rps.
Nominal rps is used.
29. 29
Is preferred stock more or less
risky to investors than debt?
More risky; company not required to
pay preferred dividend.
However, firms want to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, and (3) preferred
stockholders may gain control of firm.
30. 30
Why is yield on preferred
lower than rd?
Corporations own most preferred stock,
because 70% of prfd divids nontaxable to
corps.
T/4, prfd often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost to the
issuer are higher on prfd than on debt, which
is consistent w/ higher risk of prfd.
32. 32
What are the two ways that
companies can raise common equity?
Directly, by issuing new shares of
common stock.
Indirectly, by reinvesting earnings that
are not paid out as dividends (i.e.,
retaining earnings).
33. 33
Why is there a cost for
reinvested earnings?
Earnings can be reinvested or paid out
as dividends.
Investors could buy other securities,
earning a return.
Thus, there is an opportunity cost if
earnings are reinvested.
34. 34
Cost for Reinvested Earnings
(Continued)
Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
They could buy similar stocks and earn
rs, or company could repurchase its own
stock and earn rs. So, rs, is cost of
reinvested earnings and is cost of
common equity.
35. 35
Three ways to determine
the cost of equity, rs:
1. CAPM: rs = rRF + (rM – rRF)b
= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Judgmental-
Risk Premium: rs = rd + Bond RP.
38. 38
Issues in Using CAPM
Most analysts use the rate on a
long-term (10 to 20 years)
government bond as an estimate
of rRF.
Can use Bloomberg.com to obtain
US Treasuries Quotes
(More…)
39. 39
Issues in Using CAPM
(Continued)
Most analysts use a rate of 3.5% to
6% for the market risk premium
(RPM)
Estimates of beta vary, and
estimates are “noisy” (they have a
wide confidence interval).
40. 40
DCF Cost of Equity, rs:
D0 = $3.12; P0 = $50; g = 5.8%
rs =
D1
P0
+ g =
D0(1 + g)
P0
+ g
= $3.12(1.058)
$50
+ 0.058
= 6.6% + 5.8%
= 12.4%
41. 41
Estimating the Growth Rate
Use historical growth rate if believe
future be like past.
Obtain analysts’ estimates: Value Line,
Zacks, Yahoo!Finance.
Use earnings retention model.
42. 42
Earnings Retention Model
Suppose company has been earning
15% on equity (ROE = 15%) and
been paying out 62% of its earnings.
If expected to continue as is, what’s
the expected future g?
43. 43
Earnings Retention Model
(Continued)
Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.
Close to g = 5.8% given earlier.
44. 44
Could DCF methodology be
applied if g is not constant?
YES, nonconstant g stocks are
expected to have constant g at some
point, generally in 5 to 10 years.
46. 46
Final estimate of rs?
Method Estimate
CAPM 12.8%
DCF 12.4%
Bond Yld + risk prem 13.2%
Average 12.8%
47. 47
Determining Weights for WACC
Wts are % of firm’s capital to be
financed by each component.
If possible, always use the target wts
for % financed by each type of
capital.
48. 48
Estimating Weights for the
Capital Structure
If don’t know targets, better to estimate
wts using current market values than
current book values.
If don’t know MV of debt, then
reasonable to use BV of debt, especially
if S/T debt.
(More…)
49. 49
Estimating Weights
(Continued)
Suppose the common stock price is $50
with 3 million shares outstanding; the
firm has 200,000 shs of preferred stock
trading at $125; and 60,000 bonds
outstanding trading at quoted price of
125% of par.
(More…)
51. 51
Estimating Weights
(Continued)
ws = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3
Target wts for this co. are same as these MV
wts, but often MV wts temporarily deviate
from targets due to changes in stock prices.
52. 52
What’s the WACC using the
target weights?
WACC = wdrd(1 – T) + wpsrps + wsrs
WACC = 0.3(10%)(1 − 0.4) + 0.1(9%)
+ 0.6(12.8%)
WACC = 10.38%
53. 53
What factors influence a
company’s WACC?
Uncontrollable factors:
Market conditions, especially interest rates.
The market risk premium.
Tax rates.
Controllable factors:
Capital structure policy.
Dividend policy.
Investment policy. Firms with riskier projects
generally have higher financing costs.
54. 54
Should firm-wide WACC be
used for each of its divisions?
NO! Composite WACC reflects risk of
an average project undertaken by the
firm.
Different divisions may have different
risks. Division’s WACC should be
adjusted to reflect division’s risk and
cap structure.
55. 55
The Risk-Adjusted Divisional
Cost of Capital
Estimate cost of capital division
would have if it were a stand-alone
firm.
This requires estimating division’s
beta, cost of debt, and capital
structure.
56. 56
Pure Play Method for Estimating
Beta for a Division or a Project
Find several publicly traded companies
exclusively in project’s business.
Use average of their betas as proxy for
project’s beta.
Hard to find such companies.
57. 57
Accounting Beta Method for
Estimating Beta
Run regression between project’s
ROA and S&P Index ROA.
Accounting betas correlated (0.5 –
0.6) with market betas.
But normally can’t get data on new
projects’ ROAs before capital
budgeting decision made.
58. 58
Divisional Cost of Capital
Using CAPM
Target debt ratio = 10%.
rd = 12%.
rRF = 5.6%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.
60. 60
Division’s WACC vs. Firm’s Overall
WACC?
Division WACC = 14.9% versus
company WACC = 10.4%.
“Typical” projects within this division
would be accepted if its returns above
14.9%.
61. 61
What are the three types of
project risk?
Stand-alone risk
Corporate risk
Market risk
62. 62
How is each type of risk used?
Stand-alone risk easiest to calculate.
Market risk theoretically best in most
situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
63. A Project-Specific, Risk-Adjusted
Cost of Capital
Start by calculating a divisional cost of
capital.
Use judgment to scale up or down the
cost of capital for an individual project
relative to the divisional cost of capital.
63
64. Costs of Issuing New Common
Stock
When a company issues new common
stock they also have to pay flotation
costs to the underwriter.
Issuing new common stock may send a
negative signal to the capital markets,
which may depress stock price.
64
65. 65
Cost of New Common Equity: P0 = $50,
D0 = $3.12, g = 5.8%, and F = 15%
re =
D0(1 + g)
P0(1 – F)
+ g
=
$3.12(1.058)
$50(1 – 0.15)
+ 5.8%
= $3.30
$42.50
+ 5.8% = 13.6%
66. 66
Cost of New 30-Year Debt: Par = $1,000,
Coupon = 10% paid annually, and F = 2%
Using a financial calculator:
N = 30
PV = 1,000(1 – 0.02) = 980
PMT = -(0.10)(1,000)(1 – 0.4) = -60
FV = -1,000
Solving for I/YR: 6.15%
67. 67
Comments about flotation
costs:
Flot costs depend on risk of firm & type of
capital being raised.
Flot costs highest for common equity.
However, most firms issue equity
infrequently, the per-project cost is fairly
small.
We will frequently ignore flotation costs when
calculating the WACC.
68. 68
Four Mistakes to Avoid
Current vs. historical cost of debt
Mixing current and historical measures
to estimate the market risk premium
Book weights vs. Market Weights
Incorrect cost of capital components
(More…)
69. 69
Current vs. Historical Cost of
Debt
When estimating the cost of debt, don’t
use the coupon rate on existing debt,
which represents the cost of past debt.
Use the current interest rate on new
debt.
(More…)
70. 70
Estimating the Market Risk
Premium
When estimating the risk premium for the
CAPM approach, don’t subtract the current
long-term T-bond rate from the historical
average return on common stocks.
For example, if the historical rM has been
about 12.2% and inflation drives the current
rRF up to 10%, the current market risk
premium is not 12.2% – 10% = 2.2%!
(More…)
71. 71
Estimating Weights
Use target cap structure to determine wts.
If don’t know target wts, use MV of equity.
If don’t know MV of debt, then use BV of
debt.
(More…)
72. 72
Capital components are sources of
funding that come from investors.
Accounts payable, accruals, and deferred
taxes are not sources of funding that come
from investors, so they are not included in
the calculation of the WACC.
We do adjust for these items when
calculating project cash flows, but not when
calculating the WACC.
