This document discusses the importance of correctly calculating a firm's cost of capital and the various components that make up its cost of capital. It explains that a firm uses its cost of capital to determine if investments are profitable. If the cost of capital is miscalculated, the firm could invest in too many unprofitable projects or not enough profitable ones. The document then outlines the various sources of long-term capital firms use, including long-term debt, preferred stock, and common equity. It discusses methods for calculating the costs of each component, such as using current market yields or the CAPM model. The weighted average cost of capital (WACC) is calculated using the costs of each component weighted by the firm's target

1. CHAPTER
1
The Cost of Capital
1

2. The Goal of the Firm


The goal of a firm’s financial
management is to maximize the
market value.
Market value is measured by common
stock prices in corporations. Thus
market value maximization would imply
maximizing the price of common stock.
2

3. Maximizing Market Value
Risk
Financial Decisions
MARKET
VALUE
1) Financing Decisions
2) Investment Decisions
Return
3

4. Balance Sheet
ASSETS
Debt
Current Liabilities
L.T. Debt (Bonds)
+
Preferred Stock
+
Common Equity
Common Stock
Retained Earnings

5. Why is it important to calculate
the firm’s cost of capital correctly?


A firm uses its cost of capital
to determine if its investments
are profitable.
To make the right amount of
investment, the firm’s cost of
capital has to be calculated
correctly.
5

6. Why is it important to calculate
the firm’s cost of capital correctly?


Assume that a firm miscalculates
its cost of capital to be less than
its true cost of capital.
The firm would invest in many
non-profitable projects and it
would lose equity in the long run.
6

7. Why is it important to calculate
the firm’s cost of capital correctly?


Assume that a firm miscalculates
its cost of capital to be more than
it actually is.
It would not invest in many
profitable projects and it would
become less competitive in the
long-run.
7

8. What types of long-term
capital do firms use?

Long-term debt

Preferred stock

Common equity
8

9. Capital Components


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 cost of capital.
9

10. Before-Tax vs.
After-Tax Capital Costs


Firms should incorporate the
tax effects in the cost of
capital. They should focus on
the after-tax costs.
Only the cost of debt is
affected because interest is a
tax-deductable expense.
10

11. 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, we should
focus on marginal costs.
11

12. Cost of Debt



Method 1: Ask an investment
banker what the coupon rate
would be on new debt.
Method 2: Find the bond rating for
the company and use the yield on
other bonds with a similar rating.
Method 3: Find the yield on the
company’s debt, if it has any.
12

13. COST OF DEBT (ISSUING BONDS)
Pb
Pb
BOND
The Firm
rd BT
(Cost of Debt)
The Investor
INT, M
=
rd BT
(Yield to Maturity)
(no flotation cost is assumed)
13

14. FLOTATION COSTS

Flotation cost is small for bonds
compared with preferred stock
and common stock. There is no
flotation cost if the issue is
privately (directly) placed.
14

15. Financial Calculator
A financial calculator can
make the cost of capital and
capital budgeting calculations
easier. The financial calculator
I would recommend is: Texas
Instruments BA II PLUS.
15

16. A 15-year, 12% semiannual bond
sells for $1,153.72. What’s rd BT?
0
rd BT = ?
-1,153.72
INPUTS
1
2
60
60
30
N
OUTPUT
...
60 + 1,000
-1153.72 60
I/YR
30
PV
1000
PMT
FV
5.0% x 2 = rd BT = 10%
16

17. What’s rd BT using PV tables?
0
rd BT = ?
-1,153.72
1
2
30
...
60
60
60 + 1,000
VB = (INT/2)(PVIFAr/2,2n) + (M)(PVIFr/2,2n)
$1,153.72 = ($60)(PVIFA5% ,30) + ($1,000)(PVIF5%,30)
$1,153.72 = ($60)(15.3725) + ($1,000)(0.2314)
The percentage is exact. No interpolation is needed.
Annual Cost of Capital: rd BT = 5% x 2 = 10%
17

18. Finding the YTM of
the Bond with Excel
A
1
interest rate (rate):
B
? = 5.00%
2
number of periods (nper):
30
3
payment (pmt):
60
4
present value (pv):
5
future value:
-$1,153.72
$1,000
Formula for Cell B1 = Rate(nper,pmt,pv,fv)
Values entered into Cell B1 = Rate(B2,B3,B4,B5)
18

19. Component Cost of Debt

Interest is tax deductible, so the after
tax (AT) cost of debt is:
rd AT = rd BT(1 – T)
= 10% (1 – 0.40) = 6%

Flotation costs small, so ignore.
19

20. COST OF PREFERRED STOCK
Pnet = Pps (1 - F)
Pps
PREFERRED
STOCK
The Firm
rps = Dps / Pnet
The Investor
Dps
rps = Dps / Pps
(Yield)
(Cost of Preferred Stock)
(Cost of P.S. financing) > (Yield)
20

21. Cost of preferred stock: Pps = $116.95,
Div=10%, Par = $100, F = 5%
Use this formula:
rps =
Dps
Pps (1 – F)
=
=
0.1 ($100)
$116.95 (1 – 0.05)
$10
$111.10
= 0.09 = 9.0%
21

22. Cost of Preferred Stock


Flotation costs for preferred
stock are significant, so are
reflected. Use net price.
Preferred dividends are not
tax deductible, so no tax
adjustment.
22

23. What are the two ways that
companies can raise common
equity?


By retaining earnings that are
not paid out as dividends.
By issuing new shares of
common stock.
23

24. Why is there a cost for
retained 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.
24

25. Cost for Retained Earnings


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 the cost of
reinvested earnings and it is the cost of
common equity.
25

26. Three ways to determine
the cost of retained earnings
1. CAPM: rs = rRF + (rM – rRF) b
= rRF + (RPM) b
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield + Judgmental
Risk Premium: rs = rd + JRP
26

27. Comparing the Three
Methods



In practice, most firms use the CAPM
to estimate the cost of equity capital.
Many firms use the DCF method.
Some firms estimate the cost of
equity capital by adding a risk
premium to their bond interest rate.
27

28. CAPM Cost of Retained Earnings:
rRF = 5.6%, RPM = 6%, b = 1.2
rs = rRF + (RPM ) b
= 5.6% + (6.0%)1.2 = 12.8%
28

29. Issues in Using CAPM

Most analysts use the rate
on a long-term (10 to 20
years) government bond
as an estimate of rRF.
29

30. Issues in Using CAPM


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).
30

31. Beta Estimation

Estimating Beta from Historical Returns


Beta is the expected percent change in the
excess return of the security for a 1% change
in the excess return of the market portfolio.
Consider Cisco Systems stock and
how it changes with the market
portfolio.

32. Monthly Returns for Cisco Stock
and for the S&P 500, 1996–2009

33. Scatterplot of Monthly Returns for Cisco
Versus the S&P 500, 1996–2009

34. Beta Estimation for Cisco


As the scatterplot on the previous slide
shows, Cisco tends to be up when the
market is up, and vice versa.
We can see that a 10% change in the
market’s return corresponds to about a
20% change in Cisco’s return.

Thus, Cisco’s return moves about two for
one with the overall market, so Cisco’s
beta is about 2.

35. DCF Approach: Cost of Retained
Earnings D0 = $3.12; P0 = $50; g =
5.8%
rs =
D1
P0
+g=
D0(1 + g)
P0
+g
= $3.12 (1.058) + 0.058
$50
= 6.6% + 5.8% = 12.4%
35

36. Estimating the Growth Rate



Use the historical growth rate if you
believe the future will be like the past.
Obtain analysts’ estimates: Value Line,
Zacks, Yahoo!Finance.
Use the earnings retention model,
illustrated on next slide.
36

37. Earnings Retention Model


Suppose the company has been
earning 15% on equity (ROE =
15%) and has been paying out
62% of its earnings.
If this situation is expected to
continue, what’s the expected
future g?
37

38. Earnings Retention Model

Growth from earnings retention model:
g = (Retention rate)(ROE)
= (1 – Payout rate)(ROE)
= (1 – 0.62)(15%) = 5.7%
This is close to g = 5.8% given earlier.
38

39. Own-Bond-Yield + Judgmental Risk Premium:
rd = 10%, JRP = 3.2%

rs = rd + Judgmental risk premium
= 10.0% + 3.2% = 13.2%


This judgmental risk premium ≠
CAPM equity risk premium, RPM.
Produces ballpark estimate of rs.
Useful check.
39

40. Average of the Three Methods
Brigham and Ehrhardt
suggest that the average
of the three methods can
be used in estimating the
cost of equity capital.
40

41. What’s a reasonable final
estimate of rs?
Method
Estimate
CAPM
12.8%
DCF
12.4%
rd + JRP
13.2%
Average
12.8%
41

42. Determining the Weights
for the WACC


The weights are the percentages
of the firm that will be financed by
each component.
If possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital.
42

43. Estimating Weights for
the Capital Structure


If you don’t know the targets, it is
better to estimate the weights using
current market values than current
book values.
If you don’t know the market value of
debt, then it is usually reasonable to
use the book values of debt,
especially if the debt is short-term.
43

44. Estimating Weights:
A Numerical Example

Suppose the stock price is
$50, there are 3 million
shares of stock, the firm has
$25 million of preferred
stock, and $75 million of
debt.
44

45. Estimating Weights:
A Numerical Example

Vs = $50 (3 million) = $150 million
Vps = $25 million
Vd = $75 million

Total value = $150 + $25 + $75
= $250 million
45

46. Estimating Weights:
A Numerical Example

ws = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3

The target weights for this company are the
same as these market value weights, but
often market weights temporarily deviate from
targets due to changes in stock prices.
46

47. What’s the WACC using
the target weights?
WACC
= wd rd (1 – T) + wps rps + ws rs
= 0.3 (10%) (1 − 0.4) + 0.1 (9%)
+ 0.6 (12.8%)
= 10.38% ≈ 10.4%
47

48. 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 a higher cost of equity.
48

49. Is the firm’s WACC correct
for each of its divisions?


No! The composite WACC reflects
the risk of an average project
undertaken by the firm.
Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk
and capital structure.
49

50. The Risk-Adjusted
Divisional Cost of Capital


Estimate the cost of capital that
the division would have if it
were a stand-alone firm.
This requires estimating the
division’s beta, cost of debt,
and capital structure.
50

51. 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.
51

52. 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%
52

53. Divisional Cost of Capital
Using CAPM
Division’s required return on equity:
rs = rRF + (rM – rRF) bDiv.
= 5.6% + (6%) 1.7 = 15.8%
WACCDiv. = wd rd(1 – T) + wsrs
= 0.1 (12%) (0.6) + 0.9 (15.8%)
= 14.94% ≈ 14.9%
53

54. 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
their returns are above 14.9%.
54

55. What are the three
types of project risk?

Stand-alone risk

Corporate risk

Market risk
55

56. How is each type of risk used?



Stand-alone risk is easiest to calculate.
Market risk is theoretically best in most
situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk. Therefore,
corporate risk is also relevant.
56

57. 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.
57

58. Cost 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.
58

59. THE COST OF FINANCING WITH
A NEW COMMON STOCK ISSUE (re)
Pn = Po (1 - F)
The Firm
Po
COMMON
STOCK
re = [D1 / Po(1-F)] + g
Dt , g
(Cost of Common Stock)
re > rs
The Investor
rs = (D1 / Po) + g
(Yield)
59

60. Cost of New Common Equity:
P0 = $50, D0 = $3.12, g = 5.8%, F = 15%
re =
D0 (1 + g)
P0 (1 – F)
+g
$3.12 (1.058) + 5.8%
=
$50 (1 – 0.15)
=
$3.30
$42.50
+ 5.8% = 13.6%
60

61. COST OF DEBT
(Issuing Bonds with Flotation Costs)
Pn = Pb - F
Pb
BOND
The Firm
rd BT
(Cost of Debt)
The Investor
INT, M
>
rd BT
(Yield to Maturity)
(flotation cost is assumed)
61

62. Cost of Debt with Flotation Costs:
A Numerical Example
Cost of New 30-Year Debt: Par = $1,000,
Coupon = 10% paid annually, 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: rd AT = 6.15%
62

63. 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
63

64. 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.
64

65. 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%!
65

66. Estimating Weights



Use the target capital structure to determine
the weights.
If you don’t know the target weights, then use
the current market value of equity.
If you don’t know the market value of debt,
then the book value of debt often is a
reasonable approximation, especially for
short-term debt.
66

67. 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.
67