Slide 1 12-1Cost of CapitalSlide 2.docx

12-1
Cost of Capital
Slide 2
12-2
Key Concepts and Skills
• Know how to determine:
– A firm’s cost of equity capital
– A firm’s cost of debt
– A firm’s overall cost of capital
• Understand pitfalls of overall cost of
capital and how to manage them

From our modules on capital budgeting, we learn that the
discount rate, or required return, on an investment
is a critical input. However, we haven’t discussed how to come
up with that particular number. This module
brings together many of our earlier discussions dealing with
stocks and bonds, capital budgeting, and risk
and return. Our goal is to illustrate how firms go about
determining the required return on a proposed
investment. Understanding required returns is important to
everyone because all proposed projects must
offer returns in excess of their required returns to be acceptable.
In this module, we learn how to compute a firm’s cost of capital
and find out what it means to the firm and
its investors. We will also learn when to use the firm’s cost of
capital and, perhaps more important, when
not to use it.
Why is it important? A good estimate is required for:
• good capital budgeting decisions—neither the NPV rule nor
the IRR rule can be implemented without
knowledge of the appropriate discount rate

• financing decisions—the optimal/target capital structure
minimizes the cost of capital
• operating decisions—cost of capital is used by regulatory
agencies in order to determine the “fair”
return in some regulated industries (e.g. utilities)
Slide 3
12-3
Chapter Outline
• The Cost of Capital: Some Preliminaries
• The Cost of Equity (RE)
• The Costs of Debt (RD) and Preferred Stock (RP)
• The Weighted Average Cost of Capital (WACC)
• Divisional and Project Costs of Capital

12-4
Cost of Capital Basics
• The cost to a firm for capital funding = the
return to the providers of those funds
– The return earned on assets depends on the
risk of those assets
– A firm’s cost of capital indicates how the
market views the risk of the firm’s assets
– A firm must earn at least the required return to
compensate investors for the financing they
have provided
– The required return is the same as the
appropriate discount rate
Cost of capital, required return, and appropriate discount rate
are different phrases that all refer to the
opportunity cost of using capital in one way as opposed to
alternative financial market investments of the
same systematic risk.
• Required return is from an investor’s point of view.

• Cost of capital is the same return from the firm’s point of
view.
• Appropriate discount rate is the same return used in a PV
calculation.
Slide 5
12-5
Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm
• Two major methods for determining the
cost of equity
▪Dividend growth model
▪SML or CAPM
The Cost of Equity = Return required by shareholders.

✓ Dividend Growth Model (or called Gordon Growth Model)
• RE = (D1 / P0) + g
✓ Capital Asset Pricing Model (CAPM - derived from the
Security Market Line ((SML))
- Rf]
12-6
The Dividend Growth Model
Approach
Start with the dividend growth model
formula and rearrange to solve for RE
g
P
D
R
gR
D
P
0
1
E

E
1
0
+=
−
=
According to the dividend growth model,
P0 = D1 ⁄ (RE − g)
Rearranging and solving for the cost of equity gives:
RE = (D1 ⁄ P0) + g
which is equal to the dividend yield (D1 / P0) plus the capital
gains yield, g (growth rate).
Note that D1 = D0(1+g).
Implementing the Approach
• Price and latest dividend are directly observed; g must be

estimated.
• Estimating g – typically use historical growth rates or
analysts’ forecasts.
Slide 7
12-7
Example: Dividend Growth Model
• Your company is expected to pay a dividend of
$4.40 per share next year. (D1)
• Dividends have grown at a steady rate of 5.1% per
year and the market expects that to continue. (g)
• The current stock price is $50. (P0)
• What is the cost of equity?
139.051.
50
40.4
RE =+=

12-8
Example: Estimating the Dividend
Growth Rate
• One method for estimating the growth rate
is to use the historical average
Year Dividend Percent Change
2009 1.23
2010 1.30
2011 1.36
2012 1.43
2013 1.50
(1.30 – 1.23) / 1.23 = 5.7%
(1.36 – 1.30) / 1.30 = 4.6%
(1.43 – 1.36) / 1.36 = 5.1%
(1.50 – 1.43) / 1.43 = 4.9%
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

g can be estimated using the historical average.
Our historical growth rates are fairly close, so we could feel
reasonably comfortable that the market will
expect our dividend to grow at around 5.1%. Note that when we
are computing our cost of equity, it is
important to consider what the market expects our growth rate
to be, not what we may know it to be
internally. The market price is based on market expectations,
not our private information. So, another way
to estimate the market consensus estimate is to look at analysts’
forecasts and take an average.
Slide 9
12-9
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 aren’t growing at a
reasonably constant rate (eg. 5.7->10.5->2.4->8.6)
– RE is extremely sensitive to the estimated growth
rate
– Does not explicitly consider risk
Advantages and Disadvantages of the Approach
-Approach only works for dividend paying firms
-RE is very sensitive to the estimate of g.
-Historical growth rates may not reliably predict future growth
rates.
-Risk is only indirectly accounted for by the use of the price.
You may question how you value the stock for a firm that
doesn’t pay dividends. In the case of growth-
oriented, non-dividend-paying firms, analysts often look at the
trend in earnings or use similar firms to

project the future date of the first expected dividend and its
future growth rate. However, such processes
are subject to greater estimation error, and when companies fail
to meet (or even exceed) estimates, the
stock price can experience a high degree of variability. It should
also be pointed out that no firm pays zero
dividends forever – at some point, every going concern will pay
dividends. Microsoft is a good example.
Many people believed that Microsoft would never pay
dividends, but even it ran out of investments for all
of the cash that it generated and began paying dividends in
2003.
Slide 10
12-10
The SML Approach
• Use the following information to compute
the cost of equity
▪ Risk-free rate, Rf

▪ Market risk premium, E(RM) – Rf
)R)R(E(R
Another method for determining the cost of equity (RE)
You will often hear this referred to as the Capital Asset Pricing
Model Approach as well. Betas are widely
available and T-bill rates are often used for Rf. The S&P 500
returns are usually used for the required return
on the market E(RM).
Visit finance.yahoo.com. Both betas and 3-month T-bills are
available on this site. To get betas, enter a
ticker symbol to get the stock quote, then choose Key Statistics.
To get the T-bill rates, click on “Bonds”
under Investing on the home page.

12-11
Example: SML
• Company’s equity beta = 1.2
• Current risk-free rate = 7%
• Expected market risk premium = 6%
• What is the cost of equity capital?
%2.14)6(2.17RE =+=
Slide 12
12-12
Advantages and Disadvantages of
SML
• Advantages

– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as beta is available
• Disadvantages
– Must estimate the expected market risk premium,
which does vary over time
– Must estimate beta, which also varies over time
– Relies on the past to predict the future, which is not
always reliable
Advantages and Disadvantages of the Approach
-This approach explicitly adjusts for risk in a fashion that is
consistent with capital market history.
-It is applicable to virtually all publicly traded stocks.
-The main disadvantage is that the past is not a perfect predictor
of the future, and both beta and the
market risk premium vary through time.
The two approaches may result in slightly different estimates.
Why?
The underlying assumptions of the two approaches are very
different. The constant (dividend) growth

model is a variant of a growing perpetuity model and requires
that dividends are expected to grow at a
constant rate forever and that the discount rate is greater than
the growth rate. The SML approach requires
assumptions of normality of returns and/or quadratic utility
functions. It also requires the absence of
taxes, transaction costs, and other market imperfections.
Slide 13
12-13
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%
Since the two models are reasonably close, we can assume that
our cost of equity is probably around 19.5%.
Again, though, this similarity is a function of the inputs
selected and is not indicative of the true similarity
that could be expected.
Slide 14
12-14
Cost of Debt
• The cost of debt (RD) = the required return
on a company’s debt
• Method 1 = Compute the yield to maturity
on existing debt
• Method 2 = Use estimates of current rates

based on the bond rating expected on new
debt
• The cost of debt is NOT the coupon rate
Cost of debt (RD) – the interest rate on new debt can easily be
estimated using the yield to maturity on
outstanding debt or by knowing the bond rating and looking up
rates on new issues with the same rating.
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. We may also use
estimates of current rates based on the bond
rating we expect when we issue new debt.
The cost of debt is equal to the yield to maturity because it is
the market rate of interest that would be
required on new debt issues. The coupon rate, on the other
hand, is the firm’s promised interest payments
on existing debt.
The coupon rate was the cost of debt for the company when the
bond was issued. We are interested in the
rate we would have to pay on newly issued debt, which could be

very different from past rates.
Slide 15
12-15
• Suppose we have a bond issue currently
outstanding that has 15 years left to maturity.
• The coupon rate is 12%, and coupons are paid
semiannually.
• The bond is currently selling for $1,253.72 per
$1,000 bond.
• What is the cost of debt?
Example: Cost of Debt
Slide 16

12-16
Example: Cost of Debt
Current bond issue:
– 15 years to maturity
– Coupon rate = 12%
– Coupons paid semiannually
– Currently bond price
= $1,253.72
30 N
-1253.72 PV
1000 FV
60 PMT
CPT I/Y 4.45%
YTM = 4.45%*2 = 8.9%
N = 30; PMT = 60; FV = 1000; PV = -1,253.72; CPT I/Y =
4.45%; YTM = 4.45(2) = 8.9%

12-17
Cost of Preferred Stock
• Preferred pays a constant dividend every
period
• Dividends expected to be paid forever
• Preferred stock is a perpetuity
0
P
P
D
R =
Preferred stock is generally considered to be a perpetuity, so
you rearrange the perpetuity equation to get
the cost of preferred, RP
RP = D ⁄ P0

12-18
• 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%
Example: Cost of Preferred Stock
Slide 19
12-19
Weighted Average Cost of Capital

• We can use the individual costs of capital
(RE, RP, RD) to compute a weighted “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
One of the most important concepts we develop is that of the
weighted average cost of capital (WACC).
This is the cost of capital for the firm as a whole, and it can be
interpreted as the required return on the
overall firm.
The WACC is the minimum return a company needs to earn to
satisfy all of its investors, including
stockholders, bondholders, and preferred stockholders.
Slide 20

12-20
Capital Structure Weights
• Notation
E = market value of equity
= # outstanding shares X price per share
D = market value of debt
= # outstanding bonds X 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
Note that for bonds we would find the market value of each
bond issue and then add them together. Also
note that preferred stock would just become another component
of the equation if the firm has issued it.
Finally, we generally ignore current liabilities in our
computations. However, if a company finances a
substantial portion of its assets with current liabilities, it should
be included in the process.

E = market value of the firm’s equity = # of outstanding shares
times stock price per share
D = market value of the firm’s debt = # of bonds times price per
bond or take bond quote as percent of par
value and multiply by total par value
V = combined market value of the firm’s equity and debt = E +
D (Assuming that there is no preferred
stock and current liabilities are negligible. If this is not the
case, then you need to include these components
as well. This is really just the market value version of the
balance sheet identity. The market value of the
firm’s assets = market value of liabilities + market value of
equity.)
Slide 21
12-21

• Suppose you have a market value of equity equal
to $500 million and a market value of debt equal
to $475 million.
▪ What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%
Example: Capital Structure Weights
Assuming that there is no preferred stock
Slide 22
12-22
Taxes and the WACC
• 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-TC)
• Dividends are not tax deductible, so there is no tax impact on
the cost of equity
• WACC = wERE + wDRD(1-TC)
• wE = E/V = percent financed with equity
• wD = D/V = percent financed with debt
14-22
Assuming that there is no preferred stock
After-tax cash flows require an after-tax discount rate. Let TC
denote the firm’s marginal tax rate. Then,
the weighted average cost of capital is:
WACC = (E⁄V)RE + (D⁄V)RD(1−TC)
With preferred stock:
WACC = (E⁄V)RE + (D⁄V)RD(1−TC) + (P⁄V)RP
The Tax Cuts and Jobs Act of 2017 placed limitations on the
amount of interest that can be deducted in
certain situations. If there is no deduction, then the pretax and
aftertax cost of debt would be equal. If any

deduction is allowed, then the aftertax cost would be lower.
With a lower tax rate and/or less deductibility, the overall
WACC would be higher, which would reduce
project/firm value. However, the lower tax rate also increases
cash flows, which would increase
project/firm value. The latter seems to be the dominant impact.
Slide 23
12-23
WACC
WACC = [(E/V) x RE ] + [(P/V) x RP ] + [(D/V) x RD x (1-
TC)]
Where:
(E/V) = % of common equity in capital structure
(P/V) = % of preferred stock in capital structure
(D/V) = % of debt in capital structure

RE = firm’s cost of equity
RP = firm’s cost of preferred stock
RD = firm’s cost of debt
TC = firm’s corporate tax rate
Weights
Component
costs
WACC—overall return the firm must earn on its assets to
maintain the value of its stock. It is a market
rate that is based on the market’s perception of the risk of the
firm’s assets.
Without preferred stock:
WACC = (E ⁄ V)RE + (D ⁄ V)RD(1 − TC)
Slide 24

12-24
Extended Example: WACC - I
• Equity Information
▪ 50 million shares
▪ $80 per share
▪ Beta = 1.15
▪ Market risk premium
= 9%
▪ Risk-free rate = 5%
• Debt Information
▪ $1 billion in
outstanding debt (face
value)
▪ Current quote = 110%
of face value
▪ Coupon rate = 9%,
semiannual coupons
▪ 15 years to maturity
• Tax rate = 40%
14-24

Assuming that there is no preferred stock.
Note that bond prices are quoted as a percent of par value.
Slide 25
12-25
Extended Example: WACC - II
• What is the cost of equity?
▪ RE = 5 + 1.15(9) = 15.35% (Using CAPM)
• 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-TC) = 7.854(1-.4) = 4.712%
14-25

Dividend growth model cannot be used since no information is
provided in this example. Let’s use
CAPM (SML) to estimate RE.
We assume that the interest expense remains fully deductible.
Slide 26
12-26
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%
14-26
WACC – overall return the firm must earn on its assets to
maintain the value of its stock. It is a market
rate that is based on the market’s perception of the risk of the
firm’s assets.
Slide 27
12-27
Extended Example:
WACC I, II, III - Summary
Cost of capital:
RE = 5 + 1.15 x (9) = 15.35%
RD = 3.927 x (2) = 7.854%
RD x (1-TC) = 7.854 x (1-.4) = 4.712%
Weights:
•WE = E/V = 4/ 5.1 = 0.7843

•WD = D/V = 1.1 / 5.1 = 0.2157
Component Values:
• E = 50 million x (80) = 4 billion
• D = 1 billion x (1.10) = 1.1 billion
• V = 4 + 1.1 = 5.1 billion
WACC = [(E/V) x RE ] + [(P/V) x RP ] + [(D/V) x RD x (1-
TC)]
Component W R
Debt (after tax) 0.2157 4.712%
Common equity 0.7843 15.35%
WACC = .7843 x (15.35%) + .2157 x (4.712%) = 13.06%
Assume that there is no preferred stock.
WACC = .7843 x (15.35%) + .2157 x (4.712%) = 13.06%
If the firm issues preferred stock, WACC will be computed as:
E.g., Preferred Stock Information
• 5 million shares

• Annual dividend of $3
• Current price is $25
Cost of Preferred Stock = RP = 3 / 25 = 12%
Component Values:
E = 50 million x (80) = 4 billion
D = 1 billion x (1.10) = 1.1 billion
P = 5 million x (25) = 0.512 billion
V = 4 + 1.1 + 0.512= 5.612 billion
Weights:
WE = E/V = 4/ 5.612 = 0.7128
WD = D/V = 1.1 / 5.612 = 0.196
Wp = P/V = 0.512 / 5.612 = 0.0912
WACC = .7128 x (15.35%) + .196 x (4.712%) + 0.0912 x (12%)
= 10.94% + 0.924% + 1.094% = 12.96%

12-28
Factors that Influence a
Company’s WACC
• Market conditions, especially interest rates,
tax rates and the market risk premium
• The firm’s capital structure and dividend
policy
• The firm’s investment policy
– Firms with riskier projects generally have a
higher WACC
If market interest rates rise, then both the cost of equity and
debt will rise.
If the market risk premium increases, then the cost of equity
increases.
The firm’s capital structure affects the division between debt
and equity and the weights in the WAC
equation.
Dividend policy affects the amount of retained earnings
available for internal use and thus the amount of
external funding required.

3:11PM (EST), 2012
12-29
Eastman Chemical
Equity Data
Source: http://finance.yahoo.com
Several web sites are utilized to find the information required to
compute the WACC.
Go to Yahoo! Finance to get information on Eastman Chemical
(EMN).
Under Profile and Key Statistics, you can find the following
information:
• # of shares outstanding
• Book value per share

• Price per share
• Beta
Stock price: 53.74
Beta: 2.31
Last year dividend: 1.04
Slide 30
12-30
Eastman
Chemical -
Beta and
Shares
Outstanding
Under Key Statistics

Number of share outstanding: 136.92 mil
Slide 31
12-31
Eastman Chemical
Dividend Growth
Under analysts estimates, you can find analysts’ estimates of
earnings growth (use as a proxy for dividend
growth)
Analyst’s estimated dividend growth rate: 7.67

12-32
Eastman Chemical
Cost of Equity - SML
• Beta: Yahoo Finance 2.31
Reuters.com 1.25
(1.25 is a more reasonable value)
• T-Bill rate = 0.05% (Yahoo Finance bonds section)
• Market Risk Premium = 7% (assumed)
• Cost of Equity (SML) = 0.05% + (7%)(1.25)
= 8.80%
Estimates at 3:11PM (EST), 2012
Eastman’s beta on Yahoo! is 2.31, which is much higher than
the beta of the average stock. To check this
number, we went to www.reuters.com. The beta estimates we
found there was 1.25. This estimate is more
realistic, and some financial judgment is required here. Because
the beta estimate from Yahoo! is so much

higher, we will ignore it and use the beta of 1.25. Thus, the beta
estimate we will use is 1.25.
The Bonds section at Yahoo! Finance can provide the T-bill
rate.
Use this information, along with the CAPM and DGM, to
estimate the cost of equity.
Alternatively, we can use an average of betas from three four
sources (finance.yahoo.com,
finance.google.com, www.reuters.com, and
www.valueline.com).
Why do four Web sites report four different betas for the same
stock?
There is more than one way to calculate betas. One of the
variables in the beta calculation is how far
back you go with the calculation. Some calculations are based
on three or four years of data, while others
are based on five or six years of numbers. These variables and
others can make a difference in the beta
that is reported. Most sites don’t provide information on how
many of their numbers were calculated –

many sites buy the data from vendors. Your best bet is to stick
with names you know and trust and if you
want to compare companies, use the same web site since the
numbers should be consistent that way.
https://www.thebalance.com/betas-aid-in-stock-trading-but-
which-beta-do-you-use-3141356
https://www.wallstreetoasis.com/forums/where-to-find-stocks-
beta
http://www.reuters.com/
Slide 33
12-33
Eastman Chemical
Cost of Equity - DCF
• Growth rate 7.67%
• Last dividend $1.04
• Stock price $53.74
• Cost of Equity (DCF) =
%75.9

0767.
74.53
)0767.1(04.1$
0
1
=
+=
+=
E
E
E
R
R
g
P
D
R
Use this information, along with the CAPM and DGM, to
estimate the cost of equity.

12-34
Eastman Chemical - 7
Cost of Equity
Cost of Equity Method Estimated Value
SML 8.80%
DCF 9.75%
Average (RE) 9.28%
Slide 35
12-35

Eastman Chemical
Bond Data
Source: http://www.sec.gov
Go to the SEC website to get book value information from the
firm’s most recent 10Q
Slide 36
12-36
Eastman Chemical
Cost of Debt
• For Eastman, the cost of debt is similar when using either
book values or market values.
Avg. of YTM = RD
Go to FINRA's Market Data Center at http://finra-
markets.morningstar.com/MarketData/ to get market

information on Eastman Chemical’s bond issues.
✓ Enter “Eastman Ch” to find the bond information.
✓ Note that you may not be able to find information on all bond
issues due to the illiquidity of the bond
market.
Go to the SEC website to get book value information from the
firm’s most recent 10Q.
Market values of debts: 1661 mil
The average YTM is the weighted average of the yields on the
bond issues, weighted by the percent of
each issue’s market value on the total market value of
outstanding debt.
Slide 37
12-37
Capital structure weights (market values):

E = 136.92 million x $53.74 = $7.358 billion
D = 1.661 billion
V = $7.358 + 1.661 = 9.019 billion
E/V = 7.358 / 9.019 = .82
D/V = 1.661 / 9.019 = .18
3.81 = RD
9.28 = RE
Tax rate (assumed) = 35%
WACC = .82(9.28%) + .18(3.81%)(1-.35)
= 8.02%
Eastman Chemical - 10
WACC
Slide 38
12-38
Risk-Adjusted WACC
• 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.
It is important to know that a single corporate WACC is not
very useful for companies that have several
disparate divisions.
A firm’s WACC is an average applicable only to projects with
the same risk.
If a proposed project has a risk significantly different from the
firm’s average projects, then the WACC
should be adjusted to reflect that additional risk.
Eg. GE
If GE’s WACC was used for every division, then the riskier
divisions would get more investment capital
and the less risky divisions would lose the opportunity to invest
in positive NPV projects.

12-39
Using WACC for All Projects
• 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%
If you use the firm’s WACC across divisions, then riskier
divisions will receive more funding and less
risky divisions will have to forgo what would be good projects
if the appropriate discount rate were used.
This will lead to an increase in risk for the overall firm.

Which projects would be accepted if you used the WACC for
the discount rate? Compare 15% to IRR and
accept projects A and B.
Which projects should be accepted if you use the required
return based on the risk of the project? Accept
B and C.
So, what happened when we used the WACC? We accepted a
risky project that we shouldn’t have and
rejected a less risky project that we should have accepted. What
will happen to the overall risk of the firm
if the company does this on a consistent basis? The firm will
become riskier. What will happen to the
firm’s cost of capital as the firm becomes riskier? It will
increase (adjusting for changes in market returns
in general) as well.

12-40
Pure Play Approach
• Find one or more companies that specialize
in the product or service being considered
• 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
• Pure play companies can be difficult to find
It is easy to find company betas; however, divisional betas are
not readily available. The pure play
approach can be used to find divisional betas.
Basically, find a company that has a single line of business that
is the same as the project under
consideration. If there is more than one pure play company, you
can take an average of the betas to
determine the divisional beta.

Pure play – a company that has a single line of business. The
idea is to find the required return on a near
substitute investment.
Slide 41
12-41
Subjective Approach
• Consider the project’s risk relative to the
firm overall
– If the project is riskier 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 - Assigns investment to “risk” categories
that have higher or lower risk premiums
than the firm as a whole.
Slide 42
12-42
Subjective Approach - Example
Risk Level Discount Rate
Very Low Risk WACC – 8% 6%
Low Risk WACC – 4% 10%
Same Risk as Firm WACC 14%
High Risk WACC + 6% 20%
Very High Risk WACC + 10% 24%
WACC = 14%

15-1
Raising Capital
Slide 2
15-2
Key Concepts and Skills
Understand:
• How securities are sold to the public, and
the role of investment bankers
• Initial public offerings, and the costs of
going public

15-3
Selling Securities to the Public
• Management must obtain permission from the Board of
Directors.
• Firm must file a registration statement with the SEC.
• The SEC examines the registration during a 20-day waiting
period.
▪ A preliminary prospectus, called a red herring, is distributed
during
the waiting period.
▪ If there are problems, the company is allowed to amend the
registration and the waiting period starts over.
• Securities may not be sold during the waiting period.
• The price is determined on the effective date of the
registration and the selling effort begins.
Process for issuing securities:
1. Obtain approval from the Board of Directors
2. File registration statement with the SEC
3. SEC requires a 20-day waiting period

• Company distributes a preliminary prospectus called a red
herring
• Cannot sell securities during waiting period
4. The price is set when the registration becomes effective and
the securities can be sold
Registration Statements
• contains many pages (50 or more) of financial information,
including a financial history, details of the
existing business, proposed financing, and plans for the future.
• does not initially contain the price of the new issue.
• does not have to be filed if the loan will mature in less than
nine months or the issue involves less than
$5 million.
SEC examines the registration statement during a waiting
period. During this time, the firm may distribute
copies of a preliminary prospectus to potential Investors.
• The preliminary prospectus is sometimes called a red herring
because bold red letters are printed on the
cover.
• Prospectus: shows potential investors and describes a new
security offering
SEC makes no statement about the financial strength of the

firm, it simply indicates that the registration is
in order.
A registration statement becomes effective on the 20th day after
its filing unless the SEC sends a letter of
comment suggesting changes. In that case, after the changes are
made, the 20-day waiting period starts
again.
The company cannot sell these securities during the waiting
period. However, oral offers can be made
Slide 4
15-4
Issue Methods
• Public Issue
• General cash offer—securities offered for sale to the general
public
on a cash basis
• Rights offer—public issue in which securities are first offered
to
existing shareholders on a pro-rata basis
• Initial Public Offering (IPO)—a company’s first equity issue

made
available to the public
• Seasoned equity offering—a new equity issue of securities by
a
company that has previously issued securities to the public
• Private Issue
– Sold to fewer than 35 investors
– SEC registration not required
When a company decides to issue a new security, it can sell it
as a public issue or a private Issue. In the
case of a public issue, the firm is required to register the issue
with the SEC.
Rights offers are fairly common in other countries, but they are
relatively rare in the United States,
particularly in recent years. We therefore focus primarily on
cash offers in this module.
IPO is also called an unseasoned new issue.
A seasoned equity offering of common stock can be made by
using a cash offer or a rights offer.

15-5
Methods of Issuing New Securities
Slide 6
15-6
Underwriters
• Underwriters: investment firms that act as intermediaries
between the issuer and the public
• Underwriting services:
– Formulate method to issue securities
– Price the securities
– Sell the securities
– Price stabilization by lead underwriter in the aftermarket

• Syndicate = group of investment bankers (Underwriters)
that market the securities and share the risk associated
with selling the issue
• Spread = difference between what the syndicate pays the
company (buying price) and what the security sells for in
the market (offering price)
If the public issue of securities is a cash offer, underwriters are
usually involved. Underwriting is an
important line of business for large investment firms such as
Merrill Lynch.
Some of the services provided by underwriters include:
• Help in determining the type of security to issue
• Help in determining the method used to issue the securities
• Pricing of the securities
• Selling the securities
• In the case of an IPO, stabilizing the price in the aftermarket
Price stabilization is an important component of the lead
underwriter’s job for IPOs.
Underwriters usually combine to form an underwriting group
called a syndicate to share the risk and to
help sell the issue, managed by a lead underwriter

Spread—the difference between the underwriter’s buying price
and the offering price; it is the
underwriter’s main source of compensation and for IPOs in the
range of $20 to $80 million the spread is
typically 7%. For penny stock IPOs, the spread is generally
10%. Spread is also called gross spread.
Sometimes, on smaller deals, the underwriter will get noncash
compensation in the form of warrants and
stock in addition to the spread.
Ethics Note: The regulatory process attempts to ensure that
investors receive enough information to make
informed decisions; this is the role of the prospectus. However,
this is not always the case. Brokers have
been known to sell securities based on sales scripts that have
little to do with the information provided in
the prospectus. Also, investors often make investment decisions
before receiving (or reading) the prospectus.
While the behavior of the brokers is hardly ethical, it reinforces
the point that you should take what the
broker says with a grain of salt and always read the prospectus
before making a purchase decision.

15-7
Tombstone
Tombstones—large
advertisements used by
underwriters to let
investors know that new
securities are coming to
market.
Tombstone advertisements (or, simply, tombstones) are used by
underwriters during and after the 20 days
waiting period. The tombstone contains the name of the issuer
(the World Wrestling Federation, or WWF,
in this case.

15-8
Tombstone
Figure 15.1
• Investment banks in
syndicate divided into
brackets
•Firms listed alphabetically
within each bracket
•“Pecking order”
•Higher bracket = greater
prestige
•Underwriting success
built on reputation
Tombstone lists the investment banks (the underwriters
involved with selling the issue). The investment
banks on the tombstone are divided into groups called brackets
based on their participation in the issue

The brackets are often viewed as a kind of pecking order. In
general, the higher the bracket, the greater is
the underwriter’s prestige.
Slide 9
15-9
Firm Commitment Underwriting
• Issuer sells entire issue to underwriting syndicate
• Syndicate resells issue to the public
• Underwriter makes money on the spread between
the price paid to the issuer and the price received
from investors when the stock is sold
• Syndicate bears the risk of not being able to sell the
entire issue for more than the cost
• Most common type of underwriting in the United
States
This is a good place to review the difference between primary
and secondary market transactions.

Technically, the sale to the syndicate is the primary market
transaction, and the sale to the public is the
secondary market transaction.
Three basic types of underwriting are involved in a cash offer:
firm commitment, best efforts, and Dutch
auction.
Firm commitment underwriting – the underwriting syndicate
purchases the shares from the issuing
company and then sells them to the public. The syndicate’s
profit comes from the spread between the prices,
and it bears the risk that the actual spread earned will not be as
high as anticipated (or may not even cover
costs). This is the most common type of underwriting in the
United States.
For a new issue of seasoned equity, more than 95 percent of all
such new issues are firm commitments.

15-10
Best Efforts Underwriting
• Underwriter makes “best effort” to sell the securities
at an agreed-upon offering price
• Issuing company bears the risk of the issue not being
sold
• Offer may be pulled if not enough interest at the
offer price
– Company does not get the capital and they have still
incurred substantial flotation costs
• Not as common as it used to be
Best efforts underwriting – the underwriters are legally bound
to make their “best effort” to sell the
securities at the offer price, but do not actually purchase the
securities from the issuing firm. In this case,
the issuing firm bears the risk of the market being unwilling to
buy at the offer price.
The underwriter sells as much of the issue as possible, but can
return any unsold shares to the issuer.

This form of underwriting has become uncommon in recent
years.
Slide 11
15-11
Dutch Auction Underwriting
• Underwriter accepts a series of bids that include number of
shares and price per share.
• The price that everyone pays is the highest price that will
result in all shares being sold.
• There is an incentive to bid high to make sure you get in on
the auction but knowing that you will probably pay a lower
price than you bid.
• The Treasury has used Dutch auctions for years.
• Google was the first large Dutch auction IPO.
Dutch auction underwriting (also known by the uniform price
auction) – the underwriter does not set the

offer price. Instead, a series of bids is solicited from potential
investors and the price that is paid by everyone
is the price that will result in all shares being sold. The
incentive is to bid high to guarantee that you get in
on the offer price, knowing that you will only pay the lowest
accepted price. The U.S. Treasury has sold
bills, bonds, and notes using the Dutch auction process for
many years. Google is the highest profile Dutch
auction IPO to date.
Buyers:
• Bid a price and number of shares
Seller:
• Work down the list of bidders
• Determine the highest price at which they can sell the desired
number of shares
All successful bidders pay the same price per share.

15-12
Dutch or Uniform Price
Auction Example
The company wants to sell 1,500 shares of stock.
The firm will sell 1,500 shares at $15 per share.
Bidders A, B, C, and D will get shares.
Bidder Quantity Bid
A 500 $20
B 400 18
C 250 16
D 350 15
E 200 12
Bidder Quantity Bid Σ Qty
A 500 $20 500
B 400 18 900
C 250 16 1,150

D 350 15 1,500
E 200 12 1,700
With Dutch auction underwriting, the underwriter does not set a
fixed price for the shares to be sold.
Instead, the underwriter conducts an auction in which investors
bid for shares. When the auction closes,
bidders are listed in descending order of price bid.
Bidder A is willing to buy 500 shares at $20 each.
Bidder B is willing to buy 400 shares at $18 each.
Bidder C is willing to buy 250 shares at $16 each.
Bidder D is willing to buy 350 shares at $15 each.
Bidder E is willing to buy 200 shares at $12 each.
$15 is the highest price at which the company can sell the
desired number of shares.

15-13
Green Shoe Provision
• “Overallotment Option”
• Allows syndicate to purchase an additional
15% of the issue from the issuer
• Allows the issue to be oversubscribed
• Provides some protection for the lead
underwriter as they perform their price
stabilization function
• In all IPO and SEO offerings but not in ordinary
debt offerings
The Aftermarket - Trading period after a new issue is initially
sold to the public.
Many underwriting contracts contain a Green Shoe provision
(sometimes called the overallotment option),
which gives the members of the underwriting group the option
to purchase additional shares from the issuer
at the offering price (i.e. the stated reason for the Green Shoe
option is to cover excess demand and

oversubscriptions).
The term Green Shoe provision sounds quite exotic, but the
origin is relatively mundane. The term comes
from the name of the Green Shoe Manufacturing Company,
which, in 1963, was the first issuer that granted
such an option.
The Green Shoe provision allows the underwriters to purchase
additional shares (up to 15% of the issue) at
the original price up to 30 days after the initial sale. This
provision is used primarily when an offering goes
well and the underwriters need to cover their short positions
created by overallotment of the issue. See the
references provided above for more information.
In practice, usually underwriters initially go ahead and sell 115
percent of the shares offered. If the demand
for the issue is strong after the offering, the underwriters
exercise the Green Shoe option to get the extra 15
percent from the company.

15-14
Lockup Agreements
• Not legally required but common
• Restricts insiders from selling IPO shares for
a specified time period
– Common lockup period = 180 days
• Stock price tends to drop when the lockup
period expires due to market anticipation of
additional shares hitting the Street
The lockup agreement prevents insiders from selling their
shares for some period after the IPO, usually 180
days. The stock price often drops right before the lockup period
expires in anticipation of a large number
of shares flooding the market (excess supply causes the price to
drop). This is the time that venture
capitalists and other early-stage investors will be able to
exercise their “exit” strategy.

Such agreements specify how long insiders must wait after an
IPO before they can sell some or all of their
stock.
The Quiet Period - The quiet period is a period of time around
the IPO when company employees and the
underwriters must limit communications with the public to
“ordinary announcements and other purely
factual matters.” This is done to prevent too much hype in the
hope of increasing demand for the stock.
Slide 15
15-15
IPO Underpricing
• IPO underpricing: a large increase above the offer price the
first day of trading
• IPO pricing may be difficult to price an IPO because there
isn’t a current market price available
– Private companies tend to have more asymmetric information

than
companies that are already publicly traded.
– Underwriters want to ensure that, on average, their clients
earn a
good return on IPOs.
• Dutch Auctions designed to eliminate first day IPO price
“pop”
• Underpricing causes the issuer to “leave money on the
table”
• Degree of underpricing varies over time
Determining the correct offering price is the most difficult thing
an underwriter must do for an initial public
offering. The issuing firm faces a potential cost if the offering
price is set too high or too low. If the issue
is priced too high, it may be unsuccessful and have to be
withdrawn.
Underpricing: too low offering price < market closing price in
the first day of trading
Underpricing (a large increase above the offer price the first
day of trading) is fairly common. It obviously
helps new shareholders earn a higher return on the shares they

buy. However, the existing shareholders of
the issuing firm are not helped by underpricing. To them, it is
an indirect cost of issuing new securities.
Consider the Visa IPO. The stock opened at $44 and rose to a
first-day high of $69, before closing at $56.50,
a gain of about 28 percent. Based on these numbers, Visa was
underpriced by about $12.50 per share, which
means the company missed out on an additional $5.6 billion or
so, the largest dollar amount “left on the
table” in history.
Such young firms can be very risky investments. Arguably, they
must be significantly underpriced, on
average, just to attract investors, and this is one explanation for
the underpricing phenomenon.
Furthermore, when the price is too low, the issue is often
“oversubscribed.
Slide 16
15-16

IPO Underpricing
The underpricing (there is a large increase above the offer price
the first day of trading) of IPOs is very
common. Empirical evidence suggests that it has gotten worse
in recent years. As Table 15.2 points out,
the average underpricing has been higher from 2000 to 2007,
even with a down market, than any other
period in time. The record year, though, is still 1999 with an
average first day return of almost 70 percent.
How have recent IPOs performed?
Hoovers.com’s “IPO Central”
Use the “IPO Calendar” to determine how many companies went
public during the last week
Slide 17

15-17
IPO Underpricing Reasons
• Underwriters want offerings to sell out
▪ Reputation for successful IPOs is critical
▪ Underpricing = insurance for underwriters
▪ Oversubscription & allotment
▪ “Winner’s Curse”
• Smaller, riskier IPOs underprice to attract
investors
Why Does Underpricing Exist?
Possible explanations include:
• most are driven by smaller, speculative issues
• oversubscription of issues due to a limited number of shares
• investment banks need to be sure they can clear an issue
• a reward to institutional investors for helping in the book
building process
To illustrate, consider this tale of two investors. Smith knows
very accurately what the Bonanza Corporation
is worth when its shares are offered. She is confident that the
shares are underpriced. Jones knows only that

prices usually rise one month after an IPO. Armed with this
information, Jones decides to buy 1,000 shares
of every IPO. Does he actually earn an abnormally high return
on the initial offering?
The answer is no, and at least one reason is Smith. Knowing
about the Bonanza Corporation, Smith invests
all her money in its IPO. When the issue is oversubscribed, the
underwriters have to somehow allocate the
shares between Smith and Jones. The net result is that when an
issue is underpriced, Jones doesn’t get to
buy as much of it as he wanted. Smith also knows that the Blue
Sky Corporation IPO is overpriced. In this
case, she avoids its IPO altogether, and Jones ends up with a
full 1,000 shares. To summarize this tale,
Jones gets fewer shares when more knowledgeable investors
swarm to buy an underpriced issue and gets
all he wants when the smart money avoids the issue. This is an
example of a “winner’s curse,” and it is
thought to be another reason why IPOs have such a large
average return. When the average investor “wins”
and gets the entire allocation, it may be because those who
knew better avoided the issue. Another reason
for underpricing is that the underpricing is a kind of insurance
for the investment banks. Conceivably, an

investment bank could be sued successfully by angry customers
if it consistently overpriced securities.
Underpricing guarantees that, at least on average, customers
will come out ahead.
Ethics Note: Traditionally, IPOs have been reserved for the
syndicates’ best customers, but the investment
bankers have to be careful how they allocate those shares. In
July, 2004, Piper Jaffray was fined $2.4
million for selling shares of “hot” IPOs to the executives of
firms that they have either recently done
business with or with whom they were trying to gain business.
Slide 18
15-18
New Equity Issues and Price
• Stock prices tend to decline when new equity
is issued
• Possible explanations for this phenomenon:
▪ Signaling explanations:

• Equity overvalued: If management believes equity is
overvalued, they would choose to issue stock shares
• Debt usage: Issuing stock may indicate firm has too
much debt and can not issue more debt
▪ Issue costs
• equity is more expensive to issue than debt
from a straight flotation cost perspective.
It seems reasonable to believe that new long-term financing is
arranged by firms after positive net present
value projects are put together. As a consequence, when the
announcement of external financing is made,
the firm’s market value should go up. Interestingly, this is not
what happens. Stock prices tend to decline
following the announcement of a new equity issue (a seasoned
equity offering).
Why? A number of researchers have studied this issue.
Much of the decline may be due to the private information
known by management (called asymmetric

information) and the signals that the choice to issue equity
sends to the market.
• Managerial information concerning value of the stock (Equity
Overvalued) – expectation that managers
will issue equity only when they believe the current price is too
high
• Equity Overvalued - This will benefit existing shareholders.
However, the potential new
shareholders are not stupid, and they will anticipate this
superior information and discount it in
lower market prices at the new-issue date.
• Debt usage – issuing equity may send a signal that
management believes the company currently has too
much debt.
• Issue costs – equity is more expensive to issue than debt from
a straight flotation cost perspective
Since the drop in price can be significant, and much of the drop
may be attributable to negative signals, it
is important for management to understand the signals that are
being sent and try to reduce the effect when
possible.

15-19
The Cost of Issuing Securities
Issuing securities to the public isn’t free, and the costs of
different methods are important determinants of
which is used. These costs associated with floating a new issue
are generically called flotation costs.
The cost of issuing securities can be broken down into the
following main categories:
• Spread
• Other direct expenses – legal fees, filing fees, etc.
• Indirect expenses – opportunity costs, i.e., management time
spent working on issue
• Abnormal returns – price drop on existing stock
• Underpricing – below market issue price on IPOs
• Green Shoe option – cost of additional shares that the
syndicate can purchase after the issue has gone
to market

15-20
IPO Cost – Example
• The Faulk Co. has just gone public under a firm commitment
agreement. Faulk received $32 for each of the 4.1 million
shares sold. The initial offering price was $34.40 per share,
and the stock rose to $41 per share in the first few minutes of
trading. Faulk paid $905,000 in legal and other direct costs
and $250,000 in indirect costs. What was the flotation cost as
a percentage of funds raised?
• The net amount raised is the number of shares offered times
the price received by the company, minus the costs
associated with the offer, so:
• Net amount raised = (4,100,000 shares)($32) – 905,000 –
250,000 = $130,045,000
The company received $130,045,000 from the stock offering

15-21
• Next, we can calculate the direct costs. Part of the direct costs
are given in the problem, but the company also had to pay
the underwriters. The stock was offered at $34.40 per share,
and the company received $32 per share. The difference,
which is the underwriters’ spread, is also a direct cost.
• Total direct costs = $905,000
+ ($34.40 – 32)(4,100,000 shares) = $10,745,000
• We are given part of the indirect costs, but the underpricing is
another indirect cost.
• Total indirect costs = $250,000
+ ($41 – 34.40)(4,100,000 shares) = $27,310,000
Now we can calculate the direct costs. Part of the direct costs
are given in the problem, but the company
also had to pay the underwriters. The stock was offered at $25
per share, and the company received
$23.25 per share. The difference, which is the underwriters
spread, is also a direct cost.

15-22
• Total costs = $10,745,000 + 27,310,000 = $38,055,000
• The flotation costs as a percentage of the amount raised is
the total cost divided by the amount raised, or:
• Flotation cost percentage = $38,055,000 / $130,045,000
• Flotation cost percentage = .2926, or 29.26%
Slide 23
15-23
Rights Offerings: Basic Concepts
• Issue of common stock offered to existing

shareholders
• Allows current shareholders to avoid the
dilution that can occur with a new stock issue
• “Rights” are given to the shareholders
▪ Specify number of shares that can be purchased
▪ Specify purchase price
▪ Specify time frame
• Rights may be traded OTC or on an exchange 15-23
Privileged subscription – issue of common stock offered to
existing stockholders.
Offer terms are evidenced by warrants or rights.
Rights are often traded on exchanges or over the counter.
If a preemptive right is contained in the firm’s articles of
incorporation, the firm must first offer any new
issue of common stock to existing shareholders.
In a rights offering, each shareholder is issued rights to buy a
specified number of new shares from the
firm at a specified price within a specified time
Rights offerings have some interesting advantages relative to
cash offers. For example, they appear to be

cheaper for the issuing firm than cash offers. In fact, a firm can
do a rights offering without using an
underwriter.
Rights offerings are fairly rare in the United States.
The Mechanics of a Rights Offering
Early stages are the same as for a general cash offer, i.e., obtain
approval from directors, file a registration
statement, etc. The difference is in the sale of the securities.
Current shareholders get rights to buy new
shares. They can subscribe (buy) the entitled shares, sell the
rights, or do nothing.
Slide 24
15-24
• Dilution is a loss in value for existing
shareholders.
▪ Percentage ownership – shares sold to the general

public without a rights offering
▪ Market value – firm accepts negative NPV projects
▪ Book value and EPS – occurs when market-to-book
value is less than one
Dilution
Dilution of Proportionate Ownership
This occurs when the firm sells stock through a general cash
offer and new stock is sold to persons who
previously weren’t stockholders. For many large, publicly held
firms this simply isn’t an issue, since there
are many different stockholders to begin with. For some firms
with a few large stockholders it may be of
concern.
Eg. If Joe does not participate in the new issue, his ownership
will drop. Notice that the value of Joe’s
shares is unaffected; but he will own a smaller percentage of the
firm.
Dilution of Value: Book versus Market Values

A stock’s market value will fall if the NPV of the project being
financed is negative and rise if the NPV is
positive. Whenever a stock’s book value is greater than its
market value, selling new stock will result in
accounting dilution (but not necessarily result in market value
dilution)
Slide 25
15-25
• Permits a corporation to register a large issue with the SEC
and sell it in small portions over a two-year period
• Reduces the flotation costs of registration
• Allows the company more flexibility to raise money quickly
• Requirements
▪ Company must be rated investment grade.
▪ Cannot have defaulted on debt within last three years
▪ Market value of stock must be greater than $150 million.

▪ No violations of the Securities Act of 1934 in the last
three years
Shelf Registration
Shelf registration – SEC Rule 415 allows a company to register
all securities that it expects to issue
within the next two years in one registration statement. The firm
can then issue the securities in smaller
increments, as funds are needed during the two-year period.
Both debt and equity can be registered using
Rule 415.
Qualifications:
-Securities must be investment grade
-No debt defaults in the last three years
-Market value of stock must be greater than $150 million
-No violations of the Securities Act of 1934 within the last
three years

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