Chapte

r 14

Cost of Capital

14-1
McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-2

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-3

Why the Cost of

Capital
Is Important
1. We know that the return
earned on assets depends on
the risk of those assets
2. The return to an investor is the
same as the cost to the
company

14-4

Capital
Is Important
3. Our cost of capital provides us
with an indication of how the
market views the risk of our
assets
4. Knowing our cost of capital
can also help us determine our
required return for capital
budgeting projects
14-5

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-6

The 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
14-7

The Cost of Equity

There are two major methods for
determining the cost of equity:

1. Dividend growth
model (aka: the
Gordon Model)
14-8

2.

SML, or the

The Dividend Growth

Model
(The Gordon Model)
Start with the dividend growth
model formula and rearrange to
solve for RE

D1
P0
RE g

D1
RE
g
P0
14-9

Dividend Growth
Model Example
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.

RE
14-10

1.50 is the cost of equity?

What

.051 .111 11.1%

25

Example: Estimating
the Dividend Growth
Rate
One method for estimating the growth rate is
to use the historical average:
Year Dividend Percent Change
2005 1.23 (1.30 1.23) / 1.23 =
2006 1.30
(1.36 1.30) / 1.30 =
2007 1.36
2008 1.43 (1.43 1.36) / 1.36 =
2009 1.50 (1.50 1.43) / 1.43 =

14-11

5.7%
4.6%
5.1%
4.9%

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

4 = 5.1%

Advantages and
Disadvantages of the
Dividend Growth Model
Advantage:
Easy to
understand and
use

14-12

Advantages and
Disadvantages of the
Dividend Growth Model
Disadvantages:
Only applicable to
companies
currently paying
dividends

14-13

Not applicable if
dividends arent
growing at a
reasonably constant
rate

Advantages and
Disadvantages of the
Dividend Growth Model
Disadvantages :
Extremely
sensitive to the
estimated growth
rate an increase
in g of 1%
increases the cost
of equity by 1%
14-14

Does not
explicitly consider

The SML Approach

Use the following
information to compute
our cost of equity:
Risk-free rate, Rf
Market risk premium, E(RM)
Rf

RSystematic
E (asset,
RM ) R f )
risk
E Rf
E ( of
14-15

Example - SML
Suppose your company has:
an equity beta of .58
the current risk-free rate is
6.1%
What
the expected
market
riskusing
is the cost
of equity
premium
is 8.6% technique?
the
SML valuation

RE = 6.1 + .58(8.6) = 11.1%

14-16

How Did We Do?

Since we came up
with similar
numbers using
both the dividend
growth model
(11.1%) and the
SML approach
(11.1%), we should
feel good about our
estimate!
14-17

Advantages and
Disadvantages of
SML
Advantages:
Explicitly adjusts for
systematic risk
Applicable to all companies,
as long as we can estimate
beta
14-18

Advantages and
Disadvantages of
SML
Disadvantages:
Have to estimate the expected
market risk premium, which
does vary over time
Have to estimate beta, which
also varies over time

14-19

We are using the past to predict

the future, which is not always
reliable

Example Cost of
Equity
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 the

SML?

14-20

RE = 6% + 1.5(9%) = 19.5%

Example Cost of
Equity
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 the

DGM?

RE= [2(1.06) / 15.65] + .06 = 19.55%

14-21

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-22

Cost of Debt
The cost of debt is the
required return on our
companys debt
We usually focus on the cost
of long-term debt or bonds
(as opposed to short-term
debt like notes payable)
14-23

Cost of Debt
The required return is best
estimated by computing the
yield-to-maturity on the
existing long-term debt (the
YTM).
The computation of the YTM
was presented in the
chapter on Bond Valuation
14-24

Example: Cost of
Debt: computing the
YTM
Suppose we have a corporate 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.

14-25

What is the cost of

debt?

25 years/2 = 50 periods = N
HP
$-908.72 = PV
$90/2 = $45 = Payment12-C
(PMT)
YTM = i = ?
$1,000 = FV
5.00

14-26

(x2 = 10%)

TI BA II
Plus
25 yrs/2
= 50 payments = N
5%(5 x 2 = 10%

$ -908.72 = PV
$90/2 = $45 (PMT)

$1,000 = FV
YTM = I/Y = ?
1st
2nd
14-27

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-28

Cost of Preferred
Stock
Preferred stock is a
perpetuity, so we take
the perpetuity
formula:
and then rearrange the
terms to solve for RP

P0 = D_
Rps
14-29

Rps = D_
P0

Example: Cost of
Preferred Stock
Your company has
preferred stock that has
an annual dividend of
$3.00
The current price is $25
What is the cost of preferred
stock?

RP = 3 / 25 = 12%

14-30

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-31

Capital Structure
Weights
To compute the
WACC, we first
need the weights
of each source of
funds: namely
debt, preferred
stock and equity

14-32

Capital Structure
Weights
Lets simplify with
an example of just
debt and equity.
We often use the
market value of
both debt and
equity
14-33

Capital Structure
Valuation
Debts Market Value = (# of
outstanding bonds ) x (the
market price of one bond)
Equitys Market Value = (#
shares of outstanding common
stock) x (the market price of one
share of common stock)
14-34

Capital Structure
Valuation
A firms market value is
simply the added value of
both the debt and the equity:

V=D + E

14-35

Capital Structure
Weights
WD = D/V
This is the %
financed with debt
WE = E/V
This is the %
financed with
equity
14-36

Student Alert!
The capital
structure weights
must always add up
to 100%

WD + WE = 100%
or
WD + WPS + WE =
100%
14-37

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
wD = D/V = 475 / 975 = .4872 = 48.72%
wE = E/V = 500 / 975 = .5128 = 51.28%
14-38

Taxes and the WACC

Wait a minute!
Debt and Equity
are not equal in
the eyes of the
firm.

14-39

Debt gets a tax

advantage and
Equity does not.

Taxes and the WACC

Interest expense reduces
our tax liability
This reduction in taxes
reduces our cost of debt
Thus, our real cost of debt
is actually the AFTER-TAX
cost of debt or
After-tax cost of debt = RD(1-TC)
14-40

Taxes and the WACC

Our new equation for the
WACC is:

WACC = WDRD(1-TC) + WE RE

14-41

This is one of the

most powerful
relationships in
finance.

Together WACC
Example
Equity
Information:
50 million shares
$80 per share
Beta = 1.15
Market risk
premium = 9%

Debt Information:
$1 billion in
outstanding debt
(face value)
Current quote = 110
Coupon rate = 9%,
semiannual coupons
15 years to maturity

14-42

Risk-free
rate =tax rate is 40%
The firms
5%

WACC Example
1. 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%
2. What is the cost of
equity (using the CAPM)?
RE = 5 + 1.15(9) = 15.35%
14-43

WACC Example
3. What is the AFTER-TAX
cost of debt?

RD (1 TC) = 7.854 (1 - .40)

= 4.712%

14-44

WACC Example
4. What are the capital structure
weights?
Debt = 1 billion ($1.10) = $1.1
billion
Equity = 50 million ($80) = $4
billion
Value of the Firm = 4 + 1.1 =
$5.1 billion

14-45

WACC Example (Plug

and Chug)
5. Compute the Weighted Average
Cost of Capital (the WACC)

WACC = WDRD(1-TC) + WE RE
WACC = .2157 (4.712%) + .7843 (15.35%)

= 13.06%
14-46

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:

14-47

# of shares outstanding
Book value per share
Price per share
Beta

Eastman Chemical IV
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

14-48

Use market value weights if

Work the Web

Find estimates of WACC at
www.valuepro.net
How do the assumptions
impact the estimate of
WACC?
14-49

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-50

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
firms 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
14-51

Divisional and Project

Costs of Capital
Divisions also often require
separate
discount rates

14-52

Project Risk An
Example
What would happen if we use the
WACC for all projects regardless of
risk?
Assume the WACC = 15%
Project

14-53

A
B
C

Required Return

20%
15%
10%

17%
18%
12%

IRR

Project Risk
Differentiation
We have two tools in finance to
help us here:

1.The Pure Play Approach

2.The Subjective
Approach
14-54

Project Risk
Differentiation
We have two tools in finance to
help us here:

1. The Pure Play

Approach
2. The Subjective
Approach
14-55

The Pure Play

Approach
1.Find one or more
companies that specialize
in the product or service
that we are considering
2.Compute (or research) the
beta for each company

14-56

3.Take an average of the

betas

The Pure Play

Approach
4. Use that beta along with
the CAPM to find the
appropriate return for a
project of that identical
risk
5. Use this computed cost
of capital for capital
budgeting computations
14-57

Project Risk
Differentiation
We have two tools in finance to
help us here:

1. The Pure Play

Approach
2. The Subjective
Approach
14-58

Subjective Approach
Consider the projects risk relative
to the firm overall:

14-59

If the project has more risk than

the firm, use a discount rate
greater
than
the WACC
If the
projects
risk >
firms risk,
increase the WACC number
If the project has less risk than the
firm,Ifuse
discountrisk
rate<less
than
theaprojects
firms
the WACC
risk,
Decrease the WACC

Subjective Approach
You may still
accept projects
that you shouldnt
and reject projects
you should accept,
but your error
rate should be
lower than not
considering
differential risk at
all.
14-60

Subjective Approach:
An Example

14-61

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%

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-62

Flotation Costs
Flotation costs are the
fees paid to issue stocks or
bonds
While the required return
for a project depends on
the risk, it should not
depend upon how the
money is raised
14-63

However, the cost of

issuing new securities

Flotation Costs
However, the cost of
issuing new securities
should not just be ignored
either.
The Basic Approach:
1. Compute the weighted
average flotation cost
2.
14-64

Use the target weights

because the firm will

Flotation Costs: An NPV

Example
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 firms
target D/E ratio is .6
14-65

The flotation cost for equity is 5%,

and the flotation cost for debt is

Flotation Costs: An NPV

Example
What is the NPV for the project
before adjusting for flotation
costs?
WACC = 15%
PV of future cash flows = $1,040,105
NPV = 1,040,105 - 1,000,000
= $ 40,105
14-66

Flotation Costs: An NPV

Example
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
14-67

Flotation Costs: An NPV

Example
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 a
negative $4,281!
14-68

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 companys 100,000 shares of preferred
stock pay a $3 annual dividend, and sell for
$30 per share.
The companys 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%.
14-69

Assuming a 40% tax rate, what is the

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
14-70

sound?

Terminology
Security Market Line (SML)
Capital Asset Pricing Model
(CAPM)
Yield or Yield to Maturity (YTM)
Cost of Capital
Weighted Average Cost of Capital
(WACC)
Pure Play risk
Subjective Risk
14-71

Terminology (ctd)
Capital Structure
Cost of Equity
Cost of Debt
Cost of Capital
Capital Budgeting (NPV, IRR)
Floatation Costs

14-72

Formulas
D1
P0
RE g
D1
RE
g
P0

Cost of
Equity
(Dividend
Growth
Model)

RE R f E ( E ( RM ) R f )
14-73

Cost of Equity (CAPM)

Formulas
(continued)
Rps =

D_ Cost of Preferred
P0 Stock

After-tax cost of debt = RD(1-TC)

WACC = WDRD(1-TC) + WE RE
14-74

Key Concepts and

Skills
Be able to compute a
firms cost of equity
using the CAPM and the
Dividend Growth model
Be able to compute a
firms after-tax cost of
debt
14-75

Key Concepts and

Skills
Know how to
compute the WACC
of a firm
Identify the
consequences to the
WACC of considering
floatation costs
14-76

What are the most

important topics of
this chapter?
1. There are two ways to
compute the cost of equity:
DGM and CAPM.
2. The relevant cost of debt to
a firm is the after-tax cost.

14-77

3. Capital structure determines

the weights of debt,
preferred stock and equity

What are the most

important topics of
this chapter?
4. The WACC determines the
discount rate to be used for
capital budgeting purposes
for NPV, IRR and MIRR.

14-78

5. All projects may not have

the identical risk
classification and we may
need to adjust the WACC
accordingly.

Questions?
14-79