Cost of Capital – Part 2

ESE400/540

Weighted Average Cost of Capital

WACC   1  t K D  1   K E

•  = leverage
• t = tax rate
• KD = debt interest rate
• KE = cost of equity

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 Illustrative WACC Calculation

• WACC is calculated as follows assuming a

capital structure of 70% equity and 30% debt
with a 40% effective tax rate:

Weighted
Capital Structure Cost After-tax
cost
Debt 30% 5.5% 3.3% 1%
Equity 70% 20% 20% 14%
WACC: 15%

Weighted Average Cost of Capital

WACC

Debt Equity

Risk Risk
RFR Premium RFR Beta Premium

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 Debt Component of WACC

WACC

Debt Equity

Risk Risk
RFR Premium RFR Beta Premium

Debt Rate = Risk-free Rate + Risk Premium

• Interest rate on debt is commensurate with risk.

Interest
Rate

“Risk Premium”
“Risk-free Rate”
Risk

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 Cost of Debt

• Before-tax: • After-tax:
KD = iD KD = iD (1-teff)

where:
KD = annual cost of capital from a loan
iD = annual rate of interest on a loan
teff = effective corporate tax rate = ts + tf (1-ts)

The Corporate Objective

• Ultimately, the objective of a corporation
is to create shareholder value and wealth
– Increase stock price
– Pay dividends

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Equity: Shareholder Value Model…

Shareholders Shareholders
$ Wealth
•Dividends
•Appreciation
Firm

Capital Excess
Assets
Structure Income

Balance Sheet Income Statement

Cost of Equity
Firm’s Perspective
• Preferred Shares: • Common Shares:
Div p Div
ep  ea  g
Pp P0
where:
ep = rate of return to preferred shareholders
Divp = annual preferred dividend per share
Pp = purchase price per preferred share
ea = rate of return to common shareholders
Div = annual common dividend per share
P0 = purchase price per common share
g = annual rate of growth in value (appreciation)

Before-tax and after-tax are identical

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 Equity Component of WACC

WACC

Debt Equity

Risk Risk
RFR Premium RFR Beta Premium

CAPM: Capital Asset Pricing Model

Pricing the Equity Component

- Market Perspective -

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 Expected Return = Risk-free Rate + Risk Premium

• Return on investment is commensurate with risk.

• Equity buys ownership in the firm, and shares
ownership risk. Return on equity is subject to
performance risk.

Return on
Investment

“Risk Premium”
“Risk-free Return”
Risk

Cost of Equity = RFR + Beta * (RP)

Risk Free Rate (RFR) Beta Risk Premium (RP)

Time Value of Money Systematic Systematic
Minimal Default Risk Risk Multiplier Risk Diversified
for Company Market Portfolio

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 Capital Asset Pricing Model
KE = RF + Risk Premium

Expected Return on “Risky” Asset “Quantity” of Risk

K E  R S  R F   R M  R F 

“Riskless” Rate Market Risk Premium:

“Price” of Risk

…where RM = expected return on a diversified market portfolio of stocks.

– Systematic Risk
• Risk associated with macroeconomic
conditions. Diversification cannot mitigate
this risk
– Diversifiable Risk
• Risk associated with the individual firm that
can be mitigated through diversification
50
Portfolio Risk (Std Dev %)

40

30 Diversifiable risk

20

Non-diversifiable,
10 “Systematic” risk

0
0 5 10 15 20 25
Number of Stocks in Portfolio

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 Stock Risk Factors
• Non-diversifiable, • Diversifiable, “Unsystematic”
“Systematic” Risk Factors Risk Factors
– Congress votes a massive – Raw material supplier goes
tax cut bankrupt
– Federal Reserve increases – Low-cost competitor enters
interest rates company’s market
– Economy enters a – Breakthrough discovery in
recession company lab
– Republicans lose control of – Fraudulent accounting scheme
Congress uncovered
– Oil-producing countries – COGS very sensitive to oil
reduce output: prices rise prices

– Systematic Risk
• Risk associated with macroeconomic
conditions. Diversification cannot mitigate
this risk
– Diversifiable Risk
• Risk associated with the individual firm that
can be mitigated through diversification
50
Portfolio Risk (Std Dev %)

40

30 Diversifiable risk

20

Non-diversifiable,
10 “Systematic” risk

0
0 5 10 15 20 25
Number of Stocks in Portfolio

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 Capital Asset Pricing Model

Return on “Risky” Asset “Quantity” of Risk

R S  RF   RM  RF 

“Riskless” Rate Market Risk Premium:

“Price” of Risk

…where RM = expected return on a diversified market portfolio of stocks.

β
A company’s “beta” measures the volatility
(“riskiness”) of a company’s common stock
price relative to the volatility of a fully
diversified portfolio of common stocks.

• β=0 : Risk-free stock (hypothetical)

• β<1 : Company less risky than diversified portfolio
• β=1 : Company risk equivalent to diversified portfolio
• β>1 : Company more risky than diversified portfolio

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 The Security Market Line
RS  RF   RM  RF 
Expected Return, RS RS

RM
Risk Premium

RF

β
0 0.5 1.0 1.5 2.0

Industry & Company Betas

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 Asset Beta

 D   E 
 Asset     Debt     Equity
 D  E   D  E 

• D = Amount of debt in company’s capital structure

• E = Amount of equity in company’s capital structure
• (D/D+E) = Leverage (a.k.a. )

“Unlevered” Asset Beta

 D   E 
 Asset     Debt     Equity
 D  E   D  E 
≈0

 E 
 Asset    Equity  1    Equity
U

D E

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 “Re-Levered” Equity Beta
At Target Leverage, 2

1
 Equity,2   Asset
U

1  2 

Example: G.E.
βE = 1.24, D/E = 0.33, RM = 15%, RF = 7%
(a) Find cost of equity, RS
(b) Find cost of equity if D/E decreased to 0.11

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 Equity Risk = f(Leverage)

βEquity 1
 Equity  U
1    Asset

 Asset
U

0 1
Leverage, 

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Weighted Average Cost of Capital

WACC   1  t K D  1   K E

•  = leverage
• t = tax rate
• KD = debt interest rate
• KE = cost of equity = RF + βEquity(RM-RF)

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