FINA 6351 - SESSION 3 - COST OF CAPITAL

Managers try to make their firms more valuable. The value of a firm is determined
by the size, timing, and risk of its free cash flows (FCF).
A firms intrinsic value is found as the present value of its FCFs, discounted at the
weighted average cost of capital (WACC).
Since most firms employ different types of capital, the cost of capital is the
weighted average cost of capital, or WACC.
 Businesses require capital to develop new products, build factories and distribution
centers, install information technology, expand internationally, and acquire other
companies.
For each of these actions, a company must estimate the total investment required
and then decide whether the expected rate of return exceeds the cost of the
capital. The weighted average cost of capital, or WACC is a critical element in
many business decisions.
Weighted average of cost of different types of capital

rd the before-tax component cost of debt

rdT = rd (1 - T) the after-tax component cost of debt
rps component cost of preferred stock
rs component cost of retained earnings
re component cost of external equity
wi proportions of each capital
ra= WACC the weighted average cost of capital
WACC = ra wd rd(1-T) + wp rp + ws rs
1. Cost of Debt
Example Two imaginary firms have the same EBIT of $200. Suppose these two firms raise
$100 each. The first sells bonds with interest rate of 10%, and the second firm uses preferred
stock financing with the rate of return of 10%.
Debt Financing Preferred Stock Financing
($100, rd = 10%) ($100, rP = 10%)
Earnings Before Interest and Taxes (EBIT) 200 200

- Interest .10 x 100 =10 0

= Earnings Before Taxes (EBT) 190 200

76 $4 tax savings 80
- Taxes (40%)
114 120
= Net Income (NI)
0 .10 x 100 = 10
- Dividends 114 $4 more 110
= Cash available After All Pmts
Total amount of money available after all payments to the capital contributors is $4
greater for the debt-financed firm compared to the preferred stock- financed firm.
Where does the $4 savings come from?
Annual tax savings = D (rd) (T) = 100 x (.1) x (.4) = $4
After-tax Cost of Debt = 10% (1 - .4) = 6% (r ) (1 - T)
d
Example Suppose NCC has outstanding bonds with an 8% annual coupon rate, 22
years remaining until maturity, and a face value of $ 1,000. The bonds make
semiannual coupon payments and currently are trading in the market at a price of $
904.91. Suppose investment bankers believe that a new, 30-year, noncallable,
straight bond issue with semiannual payments could be issued at the same rate as
the existing bonds. Assume T = 40%. Calculate the after-tax cost of debt of NCC.

40 PMT 1000 FV 44 Nper -904.91 PV Rate = 4.5%

(rd) = 4.5% x 2 = 9% After-tax cost of debt =(rd) (1 - T) = 9% x ( 1-.4) = 5.4%

Example Cont. In the above example of 30-year 9% coupon bond issue, suppose
the flotation costs are 2% of the par value. Calculate the after-tax cost of the new
debt.

-1000(1-.02) = -980 PV 45(1-.4) = 27 PMT 60 Nper 1000 FV Rate = 2.77%

After-tax cost of debt =2.77% x 2 = 5.54%

Flotation Costs A-T Cost of Debt

1% 5.468%
2% 5.537%
3% 5.608%
4% 5.679%
5% 5.752%
Example Cont. In the above example of 30-year 9% coupon bond issue with the 2%
flotation costs, calculate the after-tax cost of the new debt incorporating the tax shield
due to amortization of flotation costs.

Amortized flotation cost per bond/period = 20 / 60 = 0.33

Tax shield from flotation per bond/period = 0.33 x 0.4 = 0.13
Net payment, after tax = 27 - 0.13 = 26.87

-1000(1-.02) = -980 PV 26.87 PMT 60 Nper 1000 FV Rate = 2.755%

After-tax cost of debt =2.755% x 2 = 5.510%

A-T Cost of Debt A-T Cost of Debt
Flotation Costs
(w/o amortization of FC) (w/ amortization of FC)
1% 5.468% 5.455%
2% 5.537% 5.510%
3% 5.608% 5.567%
4% 5.679% 5.624%
5% 5.752% 5.682%

Notice that this after-tax cost of debt is only slightly higher than the after-tax cost
of debt where flotation costs are ignored. Therefore, analysts often ignore the
flotation costs of debt.
2. Cost of Preferred Stock
Dp DP DP
rP Pn rP
Pn rP Pn
where Dp = the annual cash dividends paid on the preferred stock
Pn = the proceeds from the sale of the preferred stock

The cost of preferred stock is simply the preferred dividend divided by the price
the company will receive if it issues new preferred stock.
No tax adjustment is necessary, as preferred dividends are not tax deductible.

Example Continued
What is the cost of preferred stock of NCC if it pays a preferred dividend of $8 per
share if the company could sell new preferred with a par value of $100 and a
flotation cost of 2.5%?

Dp 8
rP 8.21%
Pn 100 2.5
Is preferred stock more or less risky to investors than debt?
More risky; company not required to pay preferred dividend.
However, firms want to pay preferred dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise additional funds, and (3) preferred
stockholders may gain control of firm. Some preferred shares gain voting rights
when the preferred dividends are in arrears for a substantial time.

Why is yield on preferred stock lower than rd?

Corporations own most preferred stock, because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred often has a lower B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost to the issuer are higher on preferred than
on debt, which is consistent with the higher risk of preferred.

rps, AT = rps - rps (1 - 0.7)(T) = 8.21% - 8.21%(0.3)(0.4) = 7.22%

rd, AT = 9% - 9%(0.4) = 5.40%

A-T Risk Premium on Preferred = 7.227% - 5.40% = 1.82%

Example In October 2008, Warren Buffett agreed to buy $ 3 billion of a new GE
preferred stock. The preferred stock had a par value of $100, carried a 10% coupon.
It had a 10% call premium, and it was convertible into GEs common stock during the
next 5 years at a rate of 4.4944 shares of common per share of preferred. Assuming
6% growth rate for the common stock price, calculate the cost of preferred stock if it
is converted into common stock in 5 years. GEs stock price was $24.50 in Oct. 2008.

Conversion ratio = 4.4944

Stock price expected in 5 years = 24.5 x (1.06)5 = $32.79
Conversion value in 5 years = $32.79 x 4.4944 = $147.36
0 1 2 3 4 5

-100 10 10 10 10 10+147.36

-100 CF0 10 CF1 10 CF2 10 CF3 10 CF4 157.36 CF5 Rate = 16.78%

Growth Rate of return

0.0% 11.6%
5.0% 15.9%
10.0% 20.3%
13.3% 23.3%
15.0% 24.8%
20.0% 29.4%
25.0% 34.1%
3. Cost of Equity
TWO TYPES OF
EQUITY: A firm can raise common equity in two ways:
(1) by retaining earnings -- internally generated
(2) by issuing new common stock -- externally generated

Balance Sheet

Assets Liabilities
Common Stock
Retained Earnings
Total Common Equity
The costs of these two types of common equity are different. The difference is
mainly due to the flotation costs, or transaction costs, when you sell new common
stock. Of the two types of common equity, therefore, newly issued common stock is
more expensive for the firm than the retained earnings.
Do retained earnings have a cost? Yes! Opportunity Cost
3-1. Cost of Retained Earnings
3-1-(1) CAPM Approach
Security market Line (SML): ri = rRF + i (rM - rRF)
Example NCCs stock has a beta is 1.2, the risk-free rate is 5%, and the market
risk premium is 5.5 %. Calculate the cost of retained earnings based on the CAPM.
ri = 5% + 1.2 (10.5% 5%) = 11.6%

ri
SML
ri=11.6%
rM=10.5%
M

rRF=5%

i
M=1 i=1.2
ESTIMATION OF THE PARAMETERS
Security Market Line (SML): r i = rF + i ( r M rF )
(1) Estimating the Risk-Free Rate
(1) T-bill rate
(2) T-bond rate
(3) current T-bond rate - historical spread (2.2%) - Table on page 43

A survey of highly regarded companies shows that about two-thirds of them use
the rate on 10- year Treasury bonds.
Since common stocks are long- term securities, it is reasonable to think that
stock returns embody relatively long-term inflation expectations.
In theory, the CAPM is supposed to measure the required return over a particular
holding period. When it is used to estimate the cost of equity for a project, the
theoretically correct holding period is the life of the project. Since a time period of
10 years is a reasonable average for projects lives, the return on a 10- year T-
bond is a logical choice for the risk- free rate.
ESTIMATION OF THE PARAMETERS
Security Market Line (SML): r i = r F + i ( rM rF )
(2) Estimating the Market Risk Premium
2-1. Ex-post Risk Premium = Historical Risk Premium (Table on page 43)
r(large company stocks) r(US T-bond) = 11.9% - 5.9% = 6%
2-2. Ex-ante Risk Premium = Forward-Looking Risk Premium
(Value Line, Merrill Lynch, IBES, etc.)
i) Constant growth rate model allowing no stock repurchases
RM = (D1 / P0) + g = RF + RPM S&P 500 Dividend Yield
(D1 / P0) = 1.84%; RF = 3.34%;
g = sales revenue growth = growth in prices + growth in sales units
= expected inflation + population growth (+ growth from innovation)
= (2.37% ~ 3%) + (1% ~ 2.5%) = 3.37% ~ 5.5% = average 4.44%
RM = 1.84% + 4.44% = 6.28% RPM = 6.28% - 3.34% = 2.94%

ii) Constant growth rate model allowing stock repurchases

RM = (D1 / P0) + (Rep1 / P0) + g = RF + RPM
= (D1 / P0) (1 + Rep1 / D1) + g
= 1.84% (1 + 1) + 4.44% = 8.12% (Assume Rep / D = 1.)
RPM = 8.12% - 3.34% = 4.78%
(2) Estimating the Market Risk Premium
2-2. Ex-ante Risk Premium = Forward-Looking Risk Premium
iii) Non-constant growth model allowing stock repurchases
RM = 7.87% RPM = 7.87% - 3.34% = 4.53%
ESTIMATION OF THE PARAMETERS
Security Market Line (SML): r i = r F + i ( rM rF )

(3) Estimating Beta

3-1. Historical Beta: Linear Regression Analysis (Figure 2-14)
3-2. Adjusted Beta = (2/3) Historical Beta + (1/3) (1.0)
3-3. Industry Beta

To implement the CAPM, we

can use the index model and
use realized returns, instead
of expected returns.
Market Model:
rit = i + i(rMt) + eit

iM iM i M
i 2

M 2M
Estimating Beta
First, there is no theoretical guidance as to the correct holding period for
measuring returns. With too few years, there will be few observations and the
regression will not be statistically significant. With too many years the statistical
significance may be improved but the true beta may have changed over the
sample period. In practice, it is common to use either 3 to 5 years of monthly
returns, or perhaps 1 to 2 years of weekly returns.
The estimate of beta for any individual company is statistically imprecise. The
average company has an estimated beta of 1.0, but the 95% confidence interval
ranges from about 0.6 to 1.4.
Using different indexes in the
regression will result in a
different beta, and we would
surely obtain a different beta if
we broadened the index to
include real estate and other
assets.
In countries with less-
developed financial markets,
the true value of a companys
beta can be calculated with
less certainty.
 iM iM i M
Determinants of Beta i 2

M 2M

(1) Cyclicality of Revenues (i,M)

The revenues of a firm are cyclical if the firm does well in the expansion phase of
the business cycle, and does poorly in the contraction phase.
Stocks of firms in highly cyclical industry, such as high-tech firms, retailers and
automotive firms have high betas. Transportation firms, food companies and
utilities are less dependent upon the business cycle, and have low betas.
Cyclicality (i,M) is not the same as variability (i).

(2) Operating Leverage

Operatingleverage is the extent to which fixed costs are used in a firm's
operations. If a high percentage of a firm's total costs are fixed, the firm is said to
have a high degree of operating leverage.
Holding other things constant, the higher the degree of operating leverage, the
greater the degree of business risk as measured by variability of EBIT (= EBIT).
Operating leverage magnifies the effect of cyclicality on beta.
(3) Financial Leverage
Financial leverage is the extent to which fixed-income securities are used in a
firm's capital structure. If a high percentage of a firm's capital is fixed-income
securities, the firm is said to have a high degree of financial leverage.
Holding other things constant, the higher the degree of financial leverage, the
greater the degree of financial risk as measured by variability of EPS (= EPS).
Financial leverage always increases the equity beta relative to the asset beta.
D E
Asset D S ...(1)
DE DE
Assuming D = 0, (1) becomes
S = A (1 + D/E) .. (2)

Financial leverage always increases the equity beta relative to the asset beta.
Financial Risk: The additional risk borne by the stockholders as a result of the
firm's use of debt.
Substituting (2) into the SML, rS,L = rF + S,L ( rM rF ), we have the following:

rS,L = rF + S,U (rM - rF ) + S,U (D/E) (rM - rF)

Risk Premium for Risk Premium for

Business Risk Financial Risk
3-1-(2) Dividend-Yield-plus-Growth-Rate,
or Discounted Cash Flow (DCF), Approach
D1
rS g
P0
where rS = cost of equity; P0 = current (t=0) stock price;
D1 = dividend expected 1 year from now; g = the constant growth rate in dividends

D1 D1 D1
P0 rS g rS g
rS g P0 P0

Example continued NCCs stock is expected to pay a dividend over the next year
of $1.82, and it sells for $32. The firm has an expected constant growth rate of 5.5%.
Calculate the cost of retained earnings based on the Dividend-Yield-plus-Growth-
Rate Approach.
D1 1.82
rS g .055 .112 11.2%
P0 32
Estimation of the Growth Rate (1) Historical Growth Rates
If earnings and dividend growth rates have been relatively stable in the past, and if
investors expect these trends to continue, then the past realized growth rate may be
used as an estimate of the expected future growth rate.
(1) Compound Growth rate, Point-to-point
(2) Compound Growth rate, Average-to-average
(3) Least Square Regression

Least Square Regression

Et = E0 (1 + g)t
ln(Et) = ln(E0) + ln [ (1 + g)t ] = ln(E0) + t ln (1 + g)
ln(Et) = ln(E0) + ln (1 + g) t
Y = + X
ln(1 + g) = -coefficient = slope of the regression equation
e slope = 1 + g g = e slope - 1

** Dividends, Earnings, Cash Flows, or Sales?

** How many years?
Estimation of the Growth Rate (2) Retention Growth Model
The earnings growth rate depends on the amount of income the firm retains and the
rate of return it earns on those retained earnings, and the retention growth equation
can be expressed as follows: g = ROE x b, where b = retention ratio

t=1 t=2 t=3

E E1 E2 = E1+ ROE x bE1 E3 = E1+ ROE x bE1 + ROE x bE2

= E1(1+ ROE x b) = = E1(1+ ROE x b)2
RE RE1 = bE1 RE2 = bE2= bE1(1+ROE x b) RE3 = RE1(1+ ROE x b)2
= RE1(1+ ROE x b)
D D1 = (1b)E1D2 =(1-b)E2 D3 = D1(1+ ROE x b)2
=(1-b) E1 (1+ ROE x b)
=g
= D (1+ ROE x b)
EPS1 = EPS0 + PB0 x ROE 1
Diving each term by EPS0, we have the following equation:
EPS1 EPS0 PB0 ROE
= + 1 + Retention Ratio ROE 1 (b)(ROE) 1 g
EPS0 EPS0 EPS0
=b
Therefore, the constant growth rate g can be calculated as follows:
g = ROE x b
where ROE = return on equity, b = retention ratio
Example continued: Growth Rate NCCs dividend payout ratio has averaged 63%
over the past 15 years. Also NCCs ROE has averaged 14.5% over the same 15 year
period. Calculate the estimated growth rate of NCCs dividends.
g = ROE x b = 14.5% x (1 63%) = 5.37%

Estimation of the Growth Rate (3) Analysts Forecasts

Analysts publish earnings growth rate estimates for most of the larger publicly
owned companies. For example, Value Line provides such forecasts on about
1,700 companies, and all of the larger brokerage houses provide similar forecasts.
Note, however, that analysts forecasts often involve non-constant growth. Such
non-constant growth forecasts can be converted to an approximate constant
growth rate.

Example continued: Growth Rate One widely followed analyst forecasted that
NCC would have a 10.4% annual growth rate in earnings and dividends over the
next 5 years, after which the growth rate would decline to 5%. Assuming a 50- year
horizon, calculate the average growth rate.

g = 10.4% (5/50) + 5% (45/50) = 5.54%

3-1-(3) Non-Constant-Growth Discounted Cash Flow (DCF) Approach
Example continued Suppose the current dividend of NCC is $1.65 per share and
the current actual price is $32.00 per share. The company is not expected to
repurchase shares of stock. Analysts forecast growth of 10.4% per year for the first 5
years. After this, they assume a constant growth rate of 5%. Calculate the cost of
retained earnings based on the non-constant-growth DCF approach.
3-1-(4) Bond-Yield-Plus-Risk-Premium Approach

rs = bond yield + risk premium

According to surveys, managers use risk premium in the range of 3-5%.

Example continued NCC is using a 3% risk premium for its common stock over
the firm's bond yield. Calculate the cost of retained earnings.
rs = bond yield + risk premium = 9% + 3% = 12%

3-1-(5) Comparison of the CAPM, DCF, AND Bond-Yield-Plus-Risk-

Premium Approach
Method Cost of Equity
CAPM rs = 11.6%
Constant growth DCF rs = 11.2%
Bond-yield-plus-risk-premium rs = 12.0%
Non-Constant growth DCF rs = 11.8%
Average rS 11.65%
3.2. Cost of New Common Stock
Dividend-Yield-plus-Growth-Rate Approach
The cost of the newly issued common stock is higher than that of the retained
earnings because of the flotation costs. Flotation costs are the transaction costs that
are incurred when a firm sells new issues of securities. They are the difference
between what the securities are sold to investors for (the gross proceeds) and what
the issuing firm actually receives (the net proceeds). They include underwriting fees
and other expenses.
D1 D1
re g g
Pn P0 (1 F)
where F = the percentage flotation cost; Pn = net price after flotation costs
D1 = the cash dividend expected 1 year from now
g = the constant growth rate in cash dividends
D1 D1 D1 D1
Pn P0 (1 F) re g re g g
re g Pn Pn P0 (1 F)

Asymmetric Information and Signaling

The announcement of a stock offering by a mature firm that seems to have
financing alternatives is taken as a signal that the firm's prospects as seen by its
management are not bright.
Example continued NCCs stock is expected to pay a dividend over the next year
of $1.82, and it sells for $32. The firm has an expected constant growth rate of
5.5%. Calculate the cost of retained earnings based on the Dividend-Yield-plus-
Growth-Rate Approach. NCC expects flotation costs of 12.5% on new common
stock sales. Calculate the cost of new common stock based on the Dividend-Yield-
plus-Growth-Rate Approach.
D D1 1.85
re 1 g g .055 .12 12%
Pn P0 (1 F) 32 (1 0 .125)

Example continued Calculate the cost of new common stock for NCC based on
other approaches using the flotation costs calculated based on the Dividend-Yield-
plus-Growth-Rate approach.

Extra Costs due to Flotation Costs = 12% - 11.2% = 0.8%

Cost of New Common Stock w/ Flotation Costs = 11.65% + 0.8% = 12.45%
4. WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC = wd rd (1-T) + wp rp + ws rs
The primary reason for calculating the WACC is to use it in capital budgeting or
corporate valuation, since we need to compare the expected returns on projects
and companies with the cost of the funds used to finance them.
One issue is whether we should use MV weights or BV weights in calculating the
WACC. Theoretically, MV weights are more appropriate because market values
are more consistent with the idea of value maximization.
However, as a result of the stock market crash of 2008 2009, many firms saw
their equity ratios drop from about 75% to near 10%, and managers concluded
that neither the book value nor market value numbers represented how they
wanted to finance in the future. Thus, they didnt want to use either book value or
market value weights.
What they did was focus on the target capital structure. At the target structure,
the firm uses enough debt to gain the benefits of interest tax shields and also
leverages up earnings per share. However, the amount of debt is not so great
that it subjects the firm to a high probability of financial distress during a period of
economic recession.
Therefore, the weighted average cost of capital (WACC) is calculated using the
firm's target capital structure together with its after-tax cost of debt, cost of
preferred stock, and cost of common equity.
Example continued Assume that NCC has a target capital structure of 60%
common equity, 30% debt, and 10% preferred stock. Calculate the weighted
average of cost of capital.

WACC1 = wd rd(1-T) + wp rp + ws rs
= (.3) x (9%) x (1-.4) + (.1) x (8.2%) + (.6)x(11.65) = 9.43%
WACC2 = wd rd(1-T) + wp rp + ws re
= (.3) x (9%) x (1-.4) + (.1) x (8.2) + (.6)x(12.45) = 9.91%
5. THE FIRM VERSUS THE DIVISION
Is the firms 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 divisions WACC should be
adjusted to reflect the divisions risk and capital structure.

28
Example Allied Products Inc. is a conglomerate which consists of three major
divisions with the following characteristics.
In order to estimate the cost of capital for each division, Allied Products has
identified the following three principal competitors.
Assume rF = 5% and rM = 15%.
Divisions Weights (MV) Pure Play Firm Estimated
Chemical Division 20% Associated Chemicals 1.2
Electronics Division 50% General Electronics 1.6
Food Division 30% United Foods 0.9

a) Calculate the cost of capital of each division.

Chemical Division rP = rRF + P ( rM - rRF ) = 5% + 1.2 (15%-5%) = 17%
Electronics Division rP = rRF + P ( rM - rRF ) = 5% + 1.6 (15%-5%) = 21%
Food Division rP = rRF + P ( rM - rRF ) = 5% + 0.9 (15%-5%) = 14%

rP

21% Electronics

17% Chemical

rM = 15% M
14% Food

rRF = 5%

P
0.9 1.0 1.2 1.6
Example Continued: (b) Suppose you have a project which costs $190,000, has a
10-year life, and provides expected after-tax net cash flows of $40,000 per year.
Would you accept the project if it is in the Electronics division? What if it is a
Chemical division project, or a Food division project?

Division NPV Decision

Chemical Div. -190,000 + 40,000 A17%,10 = -3656 Reject 17% > 16.47%
Electronics Div. -190,000 + 40,000 A21%,10 = -27837 Reject 21% > 16.47%
-190,000 + 40,000 A14%,10 = 18645 Accept 14% < 16.47%
Food Div.
NPV

Food
18645 IRR = 16.47%

r
14 17 21
-3656
Chemical

-27837
Electronics
Example Continued c) What is the beta of the firm? What is the required
rate of return on the common stock of the company?

Firm = w Chemicals x Chemicals + w Electronics x Electronics + w Food x Food

= (0.2) x (1.2) + (0.5) x (1.6) + (0.3) x (0.9) = 1.31
rFirm = rRF + Firm ( rM - rRF ) = 5 + 1.31 (15 - 5) = 18.1%

Or, rFirm = w Chemicals x r Chemicals + w Electronics x r Electronics + w Food x r Food

= (0.2) x (17) + (0.5) x (21) + (0.3) x (14)= 18.1