Level I - Corporate Finance

Cost of Capital

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 Contents and Introduction
1. Introduction

2. Cost of Capital

3. Costs of the Different Sources of Capital

4. Topics in Cost of Capital Estimation

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 1. Introduction
• A company grows by investing in projects that are profitable and survives by its
revenue streams.

• All investments have associated costs and the most critical is the cost of capital.

• The cost of capital is an important ingredient in both investment decision making

by company’s management and also its valuation by investors

• Cost of capital estimation is a complex undertaking which requires many

assumptions and, factors that need to be taken into account.

• Investments that alter a company’s capital structure require project specific cost of
capital adjustments
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2. Cost of Capital
Lenders/Bondholders Cost of capital is the rate of
return that the suppliers of
capital require as compensation
for their contribution of capital

Invest if return > cost of capital

Owners/ Equity holders

Riskier projects will have a
higher cost of capital

Marginal cost of capital (MCC)

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 Weighted average cost of capital (WACC)

WACC = wd rd (1-t) + wp rp + were

wd = proportion of debt that the company uses when it raises new funds
rd = before tax marginal cost of debt
t = company’s marginal tax rate
wp= proportion of preferred stock the company uses when it raises new funds
rp= marginal cost of preferred stock
we= proportion of equity that the company uses when it raises new funds
re = the marginal cost of capital

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 Example
IFT has the following capital structure: 30 percent debt, 10 percent preferred stock
and 60 percent equity. The before tax cost of debt is 8 percent, cost of preferred stock
is 10 percent and cost of equity is 15 percent. If the marginal tax rate is 40%, what is
the WACC?.

WACC = (0.3)(0.08)(1-0.40) + (0.1)(0.1) + (0.6)(0.15) = 11.44 percent

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 Example
Machiavelli Co. has an after tax cost of debt capital of 4%, a cost of preferred stock of
8%, a cost of equity capital of 10% and a weighted average cost of capital of 7%. MC
intends to maintain its current capital structure as it raises additional capital. In
making its capital budgeting decisions for the average risk project the relevant cost of
capital is
A. 4%
B. 7%
C. 8%

Answer: B
The WACC using weights derived from the current capital structure, is the best estimate of the cost of capital
for the average risk project of a company.

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 Taxes and Cost of Capital
Payments to owners (dividends) are not tax deductible
Interest costs are tax deductible, which means that they provide tax savings
Example: Debt = 100, interest rate = 10%, tax rate = 40%

Calculation of net income assuming Calculation of net income assuming

interest is tax deductible interest is NOT tax deductible

Revenue 100 Revenue 100

Operating Expenses 50 Operating Expenses 50
Interest 10 EBT 50
EBT 40 Tax Expense (40%) 20
Tax Expense (40%) 16 Interest expense 10
Net Income 24 Net Income 20

After-tax cost of debt = Before-tax cost of debt (1- tax rate)

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 Weights of the Weighted Average
Weights should be based on:
• Market values
• Target capital structure

In the absence of explicit information about a firm’s target capital structure, use:
• Current capital structure based on market values
• Trend in the firm’s capital structure
• Average of comparable companies

Example 3
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 Example
You gather the following information about the capital structure and before-tax
component costs for a company. The company’s marginal tax rate is 40 percent.
What is the cost of capital?

Capital component Book Value (000) Market Value (000) Component cost
Debt $100 $90 8%
Preferred stock $20 $20 10%
Common stock $100 $300 14%

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MCC and IOS

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 Role of WACC (MCC)

• For average risk projects use WACC to compute NPV

• Adjustments to the cost of capital are necessary when a project differs

in risk from the average risk of a firm’s existing projects

• The discount rate should be adjusted upward for higher risk projects
and downwards for lower risk projects

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 3. Costs of the Different Sources of Capital
• Each source of capital has a different cost because of differences in
seniority, contractual commitments, and potential value as a tax shield

• Three primary source of capital are:

 Debt
 Preferred equity
 Common equity

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 3.1 Cost of Debt
• Cost of debt is the cost of debt financing to a company
when it issues a bond or takes out a bank loan

• Two methods of estimating before tax cost of debt:

 The yield to maturity approach

 Debt rating approach

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 Yield to Maturity Approach
The yield to maturity (YTM) is the annual return that an investor earns if he
purchases the bond today and holds it until maturity

Example: A company issues a 10-year, 8% semi-annual coupon bond. Upon issue, the
bond sells for $980. If the marginal tax rate is 30%, what is the after-tax cost of
debt?

Example 4
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 Debt Rating Approach
• Use the debt rating approach when a reliable current market price for
a company’s debt is not available can be use

• Estimate before-tax cost of debt based on comparable bonds

 Similar rating
 Similar maturity

• Use the company’s marginal tax rate to determine after-tax cost

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 3.2 Cost of Preferred Stock
The cost of preferred stock is the cost that a company has committed to pay
preferred stockholders and preferred dividend

Cost of preferred stock = preferred dividend / current price

Example: A company issues preferred stock with a par value = 100 and preferred
dividend = 5 per share. The current share price is 125 and the marginal tax rate is
33%. What is the cost of preferred stock?

Examples 5 and 6

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 3.3 Cost of Common Equity
• Cost of equity is the rate of return required by a company’s common shareholders

• Estimation of cost of equity is challenging because of the uncertain nature of future

cash flows

• Commonly used approach for estimating cost of equity are:

 Capital asset pricing model
 Dividend discount model
 Bond yield plus risk premium method

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 Capital Asset Pricing Model
Expected return = risk free rate + premium for stock’s market risk

re = Rf + β [E(Rmkt ) – Rf]

Example: In a developing market the risk free rate is 10% and the equity risk premium
is 6%. The equity beta for a given company is 2. What is the cost of equity using the
CAPM approach?

Risk free rate: use long term government bonds

Equity risk premium can be calculated using historical returns
Examples 7 and 8

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 Pre-Requisites for Understanding the DDM

Present value of a perpetuity

Present value of a growing perpetuity

Value of a financial asset, such as a stock, is the

present value of future cash flows (dividends)

Gordon growth model is one example of a DCF

model
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 Dividend Discount Model
P0= D1 / (re- g)

re = D1 / P0 + g

g= (retention rate)(return on equity) = (1- payout rate) (ROE)

Cost of equity is the same as cost of retained earnings

Gordon growth model is also called the constant-growth dividend discount model

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 Example
You have gathered the following information about a company and the market
• Current share price = 30
• Most recent dividend paid = 2
• Expected dividend payout rate = 40%
• Expected ROE = 15%
• Equity beta = 1.5
• Expected return on market = 15%
• Risk free rate = 8%

Using the DCF approach, what is the cost of

retained earnings?

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 Bond Yield Plus Risk Premium Approach
Add a risk premium to the yield on the firm’s long term debt

re = bond yield + risk premium

A company’s interest rate on long term debt is 8%. The risk premium is estimated to
be 5%. What is the cost of equity?

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 4. Topics in Cost of Capital Estimation
• Estimating Beta and Determining Project Beta

• Country Risk

• Marginal Cost of Capital Schedule

• Flotation Costs

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4.1 Estimating Beta and Determining a Project Beta
• A firm’s beta is used to estimate its required return on equity

• Beta is a measure of risk; riskier firm’s will have higher betas

• Beta is estimated by regressing a stock’s returns with overall

market returns

• At times we need to estimate the beta for a company or project

that is not publicly traded

• Use the pure-play method. Terminology: comparable, equity

beta, levered beta, asset beta, unlevered beta

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 Pure Play Method
Example: AA Corp. is a large conglomerate and wants to determine the equity beta of
its food division. This division has a D/E ratio of 0.7. The tax rate is 40%. A comparable
publicly traded food company has an equity beta of 1.2 and a D/E ratio of 0.5. What is
the equity beta of AA’s food division?

1. Identify comparable publically traded company and estimate its beta

2. Determine comparable’s asset (unlevered) beta βasset = βequity {1/1+[(1-t) D/E]}

3. Get the equity (levered) beta for the project = βasset {1+[(1-t) D/E]}

Examples 9, 10 and 11
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 4.2 Country Risk
For companies in developing countries add a country risk premium to CAPM

re = Rf + β[E(rmkt) – Rf + CRP]

CRP = sovereign yield spread * (annualized standard deviation of equity index of

developing country/annualized standard deviation of sovereign bond market in terms of
developed market currency)

Sovereign yield spread = developing country government bond yield (denominated in the
developed market currency) – developed country bond yield

Example 12

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 4.3 Marginal Cost of Capital Schedule
A company’s target capital structure is 60 percent equity and 40 percent debt. The cost and
availability of raising various amounts of new debt and equity capital is shown below:
Amount of new debt Cost of debt Amount of new equity Cost of
(in millions) (after tax) (in millions) equity
≤ 4.0 14% ≤ 9.0 20%
> 4.0 16% > 9.0 22%
WACC(%)
What is the WACC for raising the
following amounts of capital:
5
10
15
20

Capital
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 MCC and Breakpoints
• As a firm raises more capital, the cost of different sources of finance will increase
• MCC shows the WACC for different levels of financing
• Breakpoint = amount of capital at which the component cost of capital changes /
weight of the component in the capital structure

WACC(%)

Debt = 40% and Equity = 60%

Debt Rd Equity re
≤ 4.0 14% ≤ 9.0 20%
> 4.0 16% > 9.0 22%

Capital

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 Pre-Requisites for Curriculum’s Example 13
• To calculate borrowing rates use Table 4
 Spreads over LIBOR for Alternative Debt/Capital Ratios
 LIBOR is given as 4.5%

• To calculate cost of equity fist compute beta at different levels of

debt/capital
 The unleveraged (asset) beta is given: 0.9
 Tax rate is given: 36%
 If Debt / Capital = 0.1 what is D/E?
 βequity= βasset {1+[(1-t) D/E]}
 Use CAPM

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 4.4 Flotation Costs
Floatation cost are the fees charged by investment bankers when a company raises
external capital; two approaches for dealing with flotation costs

Approach 1: Incorporate flotation costs Approach 2: Adjust cash flows

into cost of capital
Do not adjust discount rate:
re = D1 / (P0 – F) + g re = D1 / P0 + g

A higher discount rate reduces the Adjust cash flow by amount of flotation
present value of future cash flows; is this costs
appropriate?
Recommended approach

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 Summary
• WACC concept and calculation

• Cost of debt

• Cost of preferred shares

• Cost of equity

• Other topics: pure-play, CRP, MCC schedule, flotation costs

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 Conclusion
• Read summary

• Review learning objectives

• Examples are good

• Practice problems: good but not enough

• Practice questions from other sources

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