Cost of Capital

January 4, 2018 3:28 PM

Cost of Capital
• The return that equity investors require on their investment in a firm
• Is the risk-free rate in a risk-free investment, and is greater than the risk-free rate in a risky investment
○ Required return, appropriate discount rate, and cost of capital synonymous
○ Cost of capital dependent on risk of an investment (also known as the use of the fund), not how
(or where) capital is used
• Managerial variable of capital structure composed of debt-equity mixture
• Assume fixed debt/equity variable (D/E) to reflect firm target capital structure - cost of capital reflects
cost of debt, and cost of equity capital

Cost of Equity
Dividend Growth Model
= return shareholders require on a stock/cost of equity capital
= dividend paid 1 year from today
= price of stock today
= annual growth rate of dividend

Alternative Approaches to Determining g

Retention ratio is the retained earnings divided by net income.

Advantages and Disadvantages to the DGM

• Simple, but is most applicable to dividend-paying companies (g can be estimated in non-dividend paying
companies from growth in earnings)
• Requires assumptions that dividends will be paid and will grow at a constant rate
• Cost of equity becomes very sensitive to estimated growth rate and does not explicitly consider risk
unlike the CAPM/SML approach

CAPM/SML Model
= estimated beta = statistical measure of risk/volatility of stock over
time
= riskfree rate/T-bill return
= average expected stock market (TSX 300) return
= market risk premium = on average
• During booms market risk premium decreases and during crashes, it increases due to being driven by
emotion
A of Implies that
<1 Company risk is less than the average risk in the market
1 Company risk equals average risk in the market
>1 Company risk is greater than the average risk in the market

Advantages and Disadvantages to the CAPM/SML Model

• Explicitly adjusts for risk and is applicable to companies without steady dividend growth, is more widely
used by CFOs while the DGM may be used to check reasonableness of estimates
• Requires estimates to market risk premium and beta which can affect resulting cost of equity
• Relies on past economic conditions which change rapidly

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Cost of Equity in Rate Hearings
• Regulatory authorities determine the fair rate of return on capital and allow an increase only if the
company can demonstrate that revenues are insufficient to achieve this fair rate

Cost of Debt
• The cost of debt is the return that lenders require on the firm's debt
• Observed directly or indirectly as the interest rate that must be paid on new borrowings, taken from
interest rates in the market
• Derived from yield to maturity (YTM)
• When based of historic borrowing it is known as embedded debt cost

Cost of Preferred Stock

• Shares of preferred stocks are perpetuities with costs equal to dividend yield
= dividend yield
= dividend per share
= market price of preferred share today

WACC
WACC is the weighted average of the costs of debt and equity.
= equity
= preferred shares
= average expected stock market (TSX 300) return
= value of the firm
cost of equity
cost of preferred shares
cost of debt
= tax rate
• Is overall return that firm must earn on existing assets to maintain stock value
○ Is the discount or hurdle rate
• The lower the WACC, the greater advantage a firm has over competitors
• Use market values as they measure management success in maximizing shareholder wealth
• Use book values when market values not readily available

Taxation
Cost Taxation
Equity Most expensive Dividends not tax deductible
Preferred Shares Dividends not tax deductible
Debt Least expensive Interest is tax deductible
• Equity can be driven to bankruptcy but in practice never happens, while debt can lead to bankruptcy if
the interest is held and lost
• In the interest of a debtor to force bankruptcy quickly

Performance Evaluation
The economic value added (EVA) approach is a performance measure based on WACC. Companies with higher
EVA have larger shareholder returns.

Divisional and Project Costs of Capital

• Investments with substantially different risks from a firm lead to poor decisions
• WACC as a cut-off for project acceptance/rejection leads to incorrect rejections of less risky profitable
investments and incorrect acceptances of riskier profitable investments
• Pure play approach is when you take WACC of similar investment or firm and use it as your own
• Subjective approach is when you take WACC of low risk investment and add or subtract arbitrary amount

Company Valuation with WACC

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Flotation Costs and the WACC
• Flotation costs are costs associated with the issuance of new securities
• Do not affect WACC but are instead treated as negative cash flows
= flotation cost of equity
= flotation cost of debt
= average total flotation cost

Internal Equity and Flotation Costs

• Use of internal equity does not change approach
• Value of 0 can be applied to flotation cost of equity as the cost no longer exists

Case Studies
General Motors
2008 - GM had a WACC so they'd need projects with returns which is nearly impossible
• Bankruptcy was a way to repair WACC, so although shareholders lost all of their money, debtors became
partial owners of the company

Examples
Example 1: Dividend Growth Model
A company paid dividends of this year. Expected growth is . Current price is . What is the current
cost of the equity?

Example 1.1
A company has paid a dividend of , , , , per share over the past 5 years. Using an
average arithmetic mean growth rate, what is the dividend that will be paid next year?
Year Dividend Growth

Example 2: CAPM/SML
Find the cost of equity if the T-bill rate is , the beta is , and the market risk premium is .

Example 3: Cost of Preferred Shares

A company issues $25 par value preferred shares. They [ay 10% dividends and are trading at $27.45. What is the
cost of preferred shares?

Example 4: WACC
Apple marked capitalization of $890 billion. This is the number of shares multiplied by share price. They have
$50 billion in debt. What is the enterprise value of Apple?
(in billions)

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 (in billions)

Example 4.1
A house purchased for $500000 with a mortgage of $400000 and a down payment of $100000 has what value?

Example 4.2
Take Company A. What is the cost of capital?
Equity Debt

is the market, not book value

Example 5: Flotation Costs

You want to raise for a project. You determine that the project has a positive NPV of . You want a
debt equity ratio of . Flotation cost of equity is and debt is .
,

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