LECTURE 6

COST OF CAPITAL

Ross, S. A., Westerfield, R. W. & Jordan B.D. (2013): Ch 14

Arnold, G. (2013): Ch 16

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 Key Concepts and Skills

 Know how to determine a firm’s cost of equity

capital

 Know how to determine a firm’s cost of debt

 Know how to determine a firm’s overall cost of

capital

 Know how to handle flotation costs

 Understand pitfalls of overall cost of capital and

how to manage them

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 Lecture Outline

 The Cost of Capital: Some Preliminaries

 The Cost of Equity

 The Costs of Debt and Preferred Stock

 The Weighted Average Cost of Capital

 Divisional and Project Costs of Capital

 Flotation Costs and the Weighted Average Cost of

Capital

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 Why Cost of Capital Is Important

 We know that the return earned on assets depends

on the risk of those assets
 The return to an investor is the same as the cost to
the company
 Our cost of capital provides us with an indication of
how the market views the risk of our assets
 Knowing our cost of capital can also help us
determine our required return for capital
budgeting projects

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 Required Return

 The required return is the same as the appropriate

discount rate and is based on the risk of the cash flows

 We need to know the required return for an investment

before we can compute the NPV and make a decision about
whether or not to take the investment

 We need to earn at least the required return to compensate

our investors for the financing they have provided

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 Cost of Equity

 The cost of equity is the return required by equity

investors given the risk of the cash flows from the
firm
 Business risk
 Financial risk
 There are two major methods for determining the
cost of equity
 Dividend growth model
 SML, or CAPM

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The Dividend Growth Model Approach

 Start with the dividend growth model formula and

rearrange to solve for RE

D1
P0 
RE  g
D1
RE  g
P0
= D0 (
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 Example: Dividend Growth Model

 Suppose that your company is expected to pay a

dividend of $1.50 per share next year.
 There has been a steady growth in dividends of 5.1%
per year and the market expects that to continue.
 The current price is $25. What is the cost of equity?

1 .50
RE   .051  .111  11 .1 %
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Example: Estimating the Dividend Growth Rate

 One method for estimating the growth rate is to

use the historical average
Year Dividend Percent Change
2008 1.23 -
2009 1.30 (1.30 – 1.23) / 1.23 = 5.7%
2010 1.36 (1.36 – 1.30) / 1.30 = 4.6%
2011 1.43 (1.43 – 1.36) / 1.36 = 5.1%
2012 1.50 (1.50 – 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

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Advantages and Disadvantages of Dividend
Growth Model DGM

 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
 Extremely sensitive to the estimated growth rate -
-- an increase in g of 1% increases the cost of
equity by 1%
 Does not explicitly consider risk

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 The SML Approach
 Use the following information to compute our cost
of equity
 Risk-free rate, Rf
 Market risk premium, E(RM) – Rf
 Systematic risk of asset, 

RE  R f   E (E (RM )  R f )

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 Example - SML
 Suppose your company has an equity beta of
.58, and the current risk-free rate is 6.1%. If
the expected market risk premium is 8.6%,
what is your cost of equity capital?
 RE = 6.1 + .58(8.6) = 11.1%

 Since we came up with similar numbers

using both the dividend growth model and
the SML approach, we should feel good about
our estimate

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 Advantages and Disadvantages of SML

Advantages
security market line

 Explicitly adjusts for systematic risk
 Applicable to all companies, as long as we can estimate
beta

 Disadvantages
 Have to estimate the expected market risk premium,
which does vary over time
 Have to estimate beta, which also varies over time
 We are using the past to predict the future, which is not
always reliable

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 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%

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 Cost of Debt

 The cost of debt is the required return on our

company’s debt
 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 NOT the coupon rate

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 Example: Cost of Debt

 Suppose we have a bond issue currently outstanding that

has 25 years left to maturity.
 The coupon rate is 9%, and coupons are paid semiannually.
 The bond is currently selling for $908.72 per $1,000 bond.
 What is the cost of debt?

 N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT I/Y =

5%; YTM = 5(2) = 10%
lãi sut áo hn

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 Cost of Preferred Stock

 Reminders
 Preferred stock generally pays a constant dividend each
period
 Dividends are expected to be paid every period forever

 Preferred stock is a perpetuity, so we take the

perpetuity formula, rearrange and solve for RP

 RP = D / P0

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 Example: Cost of Preferred Stock

 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%

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 The Weighted Average Cost of Capital

 We can use the individual costs of capital that we

have computed to get our “average” cost of capital
for the firm

 This “average” is the required return on the firm’s

assets, based on the market’s perception of the risk
of those assets

 The weights are determined by how much of each

type of financing is used

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 Capital Structure Weights

 Notation
 E = market value of equity = # of outstanding
shares times price per share
 D = market value of debt = # of outstanding
bonds times bond price
 V = market value of the firm = D + E

 Weights
 wE = E/V = percent financed with equity
 wD = D/V = percent financed with debt

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 Example: Capital Structure Weights

 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%

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 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)

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 Extended Example: WACC - I

 Equity Information  Debt Information

 50 million shares  $1 billion in
 $80 per share outstanding debt
 Beta = 1.15 (face value) = 1000
 Market risk  Current quote = 110%
premium = 9%  Coupon rate = 9%,
 Risk-free rate = 5% semiannual coupons
 15 years to maturity
 Tax rate = 40%

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 Extended Example: WACC - II

 What is the cost of equity?

 RE = 5 + 1.15(9) = 15.35%

 What is the cost of debt?

 N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y =
3.9268
 RD = 3.927(2) = 7.854%

 What is the after-tax cost of debt?

 RD(1-TC) = 7.854(1-.4) = 4.712%
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 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%

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 Eastman Chemical I
 Click on the web surfer to 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
 Under analysts estimates, you can find analysts estimates of
earnings growth (use as a proxy for dividend growth)
 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

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 Eastman Chemical II

 Go to FINRA 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

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 Eastman Chemical III

 Find the weighted average cost of the debt

 Use market values if you were able to get the
information
 Use the book values if market information was not
available
 They are often very close

 Compute the WACC

 Use market value weights if available

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 Example: Work the Web

 Find estimates of WACC at www.valuepro.net

 Look at the assumptions

 How do the assumptions impact the estimate of
WACC?
Table 7.1(a)
Cost of Equity

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Table 7.1 (b)
Cost of Debt

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Table 7.1(c)
WACC

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 Divisional and Project Costs of Capital

 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

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 Example: 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%

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 The Pure Play Approach

 Find one or more companies that specialize in the

product or service that we are considering

 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

 Often difficult to find pure play companies

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 Subjective Approach

 Consider the project’s risk relative to the firm overall

 If the project has more risk than the firm, use a discount
rate greater than the WACC

 If the project has less risk 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

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 Example: Subjective Approach

Risk Level Discount Rate

Very Low Risk WACC – 8%

Low Risk WACC – 3%

Same Risk as Firm WACC

High Risk WACC + 5%

Very High Risk WACC + 10%

 Company Valuation with the WACC
• The WACC can be useful for investment analysts when trying to
measure the value of a company

• If an analyst can predict future CFFA for the entire firm, WACC
becomes the firm’s discount rate.

• To separate financing costs from the cash flows, the tax amount
should be the amount that would be paid if the firm used no debt.

• With no debt, Adjusted CFFA, or ACFA:

ACFA = EBIT × (1 – TC) + Depreciation
– Change in NWC – Capital spending

• If these cash flows continue to grow at growth rate g perpetually,

the firm value today is:
V0 = ACFA1 / (WACC – g); ACFA1 is next year’s projected value

• See Example 14.6 in the book for an application of this

methodology
 Flotation Costs

 The required return depends on the risk, not how the

money is raised

 However, the cost of issuing new securities should not

just be ignored either

 Basic Approach
 Compute the weighted average flotation cost
 Use the target weights because the firm will issue
securities in these percentages over the long term

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 Example: NPV and Flotation Costs
 Your company is considering a project that will cost $1 million.
The project will generate after-tax cash flows of $250,000 per
year for 7 years. The WACC is 15%, and the firm’s target D/E
ratio is .6 The flotation cost for equity is 5%, and the flotation
cost for debt is 3%. What is the NPV for the project after
adjusting for flotation costs?
 fA = (.375)(3%) + (.625)(5%) = 4.25%
 PV of future cash flows = 1,040,105
 NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281

 The project would have a positive NPV of 40,105 without

considering flotation costs

 Once we consider the cost of issuing new securities, the NPV

becomes negative

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 Quick Quiz

 What are the two approaches for computing the cost of equity?
 How do you compute the cost of debt and the after-tax cost of debt?
 How do you compute the capital structure weights required for the
WACC?
 What is the WACC?
 What happens if we use the WACC for the discount rate for all
projects?
 What are two methods that can be used to compute the appropriate
discount rate when WACC isn’t appropriate?
 How should we factor flotation costs into our analysis?

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 Ethics Issues

 How could a project manager adjust the cost of

capital (i.e., appropriate discount rate) to increase
the likelihood of having his/her project accepted?
 Is this ethical or financially sound?

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 Comprehensive Problem

 A corporation has 10,000 bonds outstanding with a 6%

annual coupon rate, 8 years to maturity, a $1,000 face
value, and a $1,100 market price.
 The company’s 100,000 shares of preferred stock pay a
$3 annual dividend, and sell for $30 per share.
 The company’s 500,000 shares of common stock sell for
$25 per share and have a beta of 1.5. The risk free rate is
4%, and the market return is 12%. Rf = 16%
 Assuming a 40% tax rate, what is the company’s WACC?

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