The document discusses the cost of capital and how to calculate the weighted average cost of capital (WACC) for a firm. It explains the different sources of capital including debt, preferred stock, and common equity. It also discusses how to estimate the costs of each type of capital and calculate WACC, as well as how to adjust the WACC for project-specific risks that differ from the average risk of the firm.

1. Cost of Capital

2. Section 1
Introduction to Cost of
Capital
2

3. Overall Cost of
Capital of the Firm
Cost of Capital is the required
rate of return on the various
types of financing. The overall
cost of capital is a weighted average
of the individual required rates of
return (costs);
In other word, it’s the opportunity
cost of capital for suppliers of capital;

4. The Sources of Cost of
Capital
4

5. Should We Concern About
Short Term Obligations?
 No!!!
 Only non seasonal debts with explicit interest costs
should be considered;
 Payables, accruals and other obligations with similar
nature are excluded;
 In addition maturity hedging approach requires to
achieve a match between duration of investment and the
debt;
5

6. Should We Consider
Historical Costs
 No!!!
 Finance focuses on future cash
flows;
 The cost of each element in
WACC is calculated based on their
current market prices;
6

7. Weighted Average Cost of
Capital
 Weighted average cost of capital is the average after-tax cost of a
company’s various capital sources, including common stock,
preferred stock, bonds and any other long-term debt;
 Therefore, WACC in it’s more general terms is
WACC=wdrd(1-t)+wprp+were
where
wd-proportion of debt
rd-=cost of debt
t-tax rate
wp-proportion of preferred stock
rp-cost of preferred stock
we-proportion of equity
re-cost of equity
7

8. WACC Example
Assume that ABC corporation has following capital
structure;30% debt,10% preferred stock,60%
equity.It’s before tax debt cost is 8%,preferred
stock cost is 10% and equity cost is 15%.If tax rate
is 40% calculate company’s WACC.
Solution
WACC=(0.3)(0.08)(1-0.4)+(0.1)(0.1)+(0.6)(0.15)=
11.44%
8

9. Breaking Down of WACC Formula
Tax Rate
 In many country’s jurisdictions interest rates are tax-
deductible;
 Taking this fact into account pre-tax cost of debts should
be adjusted for this tax shield;
9
Example
Suppose that company pays $1million on $10million of
debt.If company pays 40% of tax then this $1million will
only cost for $0.6million because the interest reduces
company’s tax bill by $0.4million.Therefore,despite the fact
that before tax interest rate is 10%,after-tax cost of debt is
6%

10. Breaking Down of WACC Formula
Estimating The Proportions of
Capital Example
The following information is available for Gewitch GmBh;
Market Value of Debt $ 50 million
Market Value of Equity $60 million
10
Capital Structure
wd=50/110=0.45
we=60/110=0.55

11. Applying of WACC in
Capital Budgeting
 WACC reflects the overall capital cost of company, but it’s
frequently used for evaluation of individual projects as well;
 For an average-risk project the discount
rate will be equal to company’s WACC;
 In systematic risk differs from the
company’s current project portfolio
then downward or upward adjustments
should be made to WACC;
11

12. WACC and NPV
Calculations
 In capital budgeting WACC which corresponds
with the average risk of company is used as
discount rate to find NPV;
 However, if we use WACC as
discount rate we are assuming that;
a. the project has the same risk as the
average-risk project of the company;
a. capital structure is not subject to any
changes during the project’s life;
12

13.  Flotation CostsFlotation Costs are the costs associated
with issuing securities such as
underwriting, legal, listing, and printing
fees.
a. Adjustment to Initial Outlay
b. Adjustment to Discount Rate
Another Limitation of WACC
Flotation Costs

14. Add Flotation Costs (FC) to the Initial Cash
Outlay (ICO).
Impact: ReducesReduces the NPV
Adjustment to
Initial Outlay (AIO)
NPV =
Σ
n
t=1
CFt
(1 + k)t
- ( ICO + FC )

15. Subtract Flotation Costs from the proceeds
(price) of the security and recalculate yield
figures.
Re=D/P(1-F)+g
Impact: IncreasesIncreases the cost for any capital
component with flotation costs.
Result: Increases the WACC, which
decreasesdecreases the NPV.
Adjustment to
Discount Rate (ADR)

16. Example of Flotation
Costs
Let’s consider a project that has $60 000 initial cash outlay and is
expected to produce $10 000 cash inflow for each of next 10 years.
Assume that company’s tax rate is 40% and before-tax debt cost is
5%.Furthermore suppose that dividend of next period is $1,the current
market price of stock is $20 and the expected growth rate is 5%.
Please consider the following information on capital structure. Flotation
costs are 5% of new capital raised
Source of Capital Amount Raised Proportion
Debt 24 000 0.40
Equity 36 000 0.60
Required
Compare NPV figures by employing the both methods
16

17. Example of Flotation
Costs
Cost of equity=(1/20)+0.05=10%
After tax cost of debt=5(1-0.4)=3%
WACC=(0.40)(0.03)+(0.60)(0.1)=7.2%
Standard NPV=69591-60 000=$9591
a.AIO NPV=9591- 1800=$7791
b.ADR NPV=69089-60000=$9089(WACC
7.3%)
17

18. Which Approach is
Better?
18
 ADR approach is misleading because it
affects the PV of all future cash flows;
 In this respect AIO is more logical as it
only affects the initial cash outflow;
 However, it might be quite a hard task
to find project specific flotation costs;
 As a result some textbooks offers to use
ADR despite of it’s flaws;

19. Section 2
Cost of Different Sources of
Capital
19

20. Type of Financing Mrkt Val Weight
Long-Term Debt $ 35M 35%
Preferred Stock $ 15M 15%
Common Stock Equity $ 50M 50%
Market Value of
Long-Term Financing

21. Cost of Debt
 Cost of DebtCost of Debt is the cost of debt financing
when company issues bond or apply for
long-term bank loan;
 YTM(yield to maturity) approach will be
employed if the market price of bond is
known;
 Otherwise, debt rating approach should
be employed;

22. Yield To Maturity
 YTM is annual return that investor will make if heYTM is annual return that investor will make if he
purchases bond today and keeps it until maturity;purchases bond today and keeps it until maturity;
Bond Price=Cash FlowBond Price=Cash Flow11/(1+Yield)/(1+Yield)11
+Cash Flow 2/(1+Yield)+Cash Flow 2/(1+Yield)22
……+(Par Value)/……+(Par Value)/
(1+Yield)(1+Yield)nn
22
Example;
Valence Industries issues a new 10 year bond to finance a
project.Coupon rate is 5% semi-annual.Upon issue the bond sell for $
1025.If tax rate is 35% find after tax cost of debt.
Coupon payment=(%5*1000)=$50-----Semiannual payment=$25
$1025=25/(1+i)1
+25/(1+i)2
+….+1000/(1+i)20
=2.3
After tax rate=2.3*2(1-0.35)=4.6(0.65)=3%

23. Cost of Preferred StockCost of Preferred Stock is the required
rate of return on investment of the
preferred shareholders of the company.
rP = DP / Pp
Cost of Preferred
Stock
where,
dp-dividend per share
pp-price per share

24. Assume that Basket Wonders (BW) has
preferred stock outstanding with par value
of $100, dividend per share of $6.30, and a
current market value of $70 per share.
rP = $6.30 / $70
rrPP = 9%9%
Determination of the
Cost of Preferred
Stock

25. Cost of Common Equity
 Cost of equity is desired rate
of return by shareholders in
exchange of their investment
in company;
 Estimating the cost of
common equity is the most
challenging because of
uncertainty that surrounds
timing and amount of returns;
25

26.  Capital-Asset Pricing ModelCapital-Asset Pricing Model
 Dividend Discount ModelDividend Discount Model
Cost of Equity Approaches

27. Capital Asset Pricing
Model
Assumes that expected rate of return on stock is the
sum of risk free-rate and the premium for bearing the
stock’s market risk.
ke = Rj = Rf + (Rm - Rf)βj
Rf is a risk-free rate
Rm is market return rate
Βj is sensitivity of stock return to market returns

28. Assume that Basket Wonders (BW) has a
company beta of 1.25. Research by Julie
Miller suggests that the risk-free rate is 4%
and the expected return on the market is
11.2%
ke = Rf + (Rm - Rf)βj
= 4% + (11.2% - 4%)1.25
kkee = 4% + 9% = 13%13%
Determination of the
Cost of Equity (CAPM)

29. Dividend Discount
Model
The cost of equity capitalcost of equity capital, ke, is the
discount rate that equates the
present value of all expected future
dividends with the current market
price of the stock.
D1 D2 D
(1+ke)1
(1+ke)2
(1+ke)
+ . . . ++P0 =
∞
∞

30. Constant Growth
Model
The constant dividend growthconstant dividend growth
assumptionassumption reduces the model to:
ke = ( D1 / P0 ) + g
Assumes that dividends will grow at
the constant rate “g” forever.

31. Assume that Basket Wonders (BW) has common stock
outstanding with a current market value of $64.80 per share,
current dividend of $3 per share, and a dividend growth rate
of 8% forever
ke = ( D1 / P0 ) + g
ke = ($3(1.08) / $64.80) + .08
kkee = .05 + .08 = .13.13 or 13%13%
Determination of the
Cost of Equity Capital

32. SECTION 3
Project Specific Risk
32

33. CAPM in Risk Calculations
When the business risk of an investment project
differs from the business risk of the investing
company,it means that it is not appropriate to
use the investing company’s existing cost of capital
as the discount rate for the investment project;
Instead, the CAPM can be used to calculate
a project-specific discount rate that reflects
the business risk of the investment project;
33

34. SUMMARY OF STEPS IN
THE CALCULATION
The steps in calculating a project-specific discount rate for
privately held company using the CAPM can be
summarized, as follows:
a. Locate suitable proxy companies.
b. Determine the equity betas of the proxy companies,
their gearings and tax rates.
c. Unlever the proxy equity betas to obtain asset
betas(exclude financial risk).
d. Calculate an average asset beta.
e. Adjust this unlevered beta based on company’s
financial risk.
f. Use the CAPM to calculate a project-specific cost of
equity.
34

35. Project Specific Risk
EXAMPLE
A company is planning to invest in a new project that is significantly different
from its existing business operations. This company
is financed 30% by debt and 70% by equity. It has located three companies
with business operations similar to the proposed investment, and details of
these companies are as follows:
Company A has an equity beta of 0.81 and is financed 25% by debt and 75%
by equity.
Company B has an equity beta of 0.98 and is financed 40% by debt and 60%
by equity.
Company C has an equity beta of 1.16 and is financed 50% by debt and 50%
by equity.
Assume that the risk-free rate of return is 4% per year, and that the equity risk
premium
is 6% per year. Assume also that all the companies pay tax at a rate of 30% per
year. Calculate a project-specific discount rate for the proposed investment.
35

36. Project Specific Risk
EXAMPLE
Unlevering the proxy equity betas:
Asset beta for Company A
= 0.81/((1+(1 - 0.30)*25/75)) = 0.657 Asset beta
for Company B
= 0.98/((1+(1 - 0.30)*40/60)) = 0.668 Asset beta
for Company C
= 1.16/((1+(1 - 0.30)*50/50)) = 0.682
Averaging the asset betas: (0.657 + 0.668 +
0.682)/3 = 2.007/3 = 0.669
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37. Project Specific Risk
EXAMPLE
Regearing the average asset beta:
0.669 = βe/ ((1+ (1 - 0.3)30/70)) =
Hence βe = 0.870
Calculating the project-specific discount
rate:
E(ri) = Rf + βi(E(rm) - Rf) = 4 + (0.870 x 6) =
4 + 5.22 = 9.2%
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38. Thank You