CHAPTER 10

Determining the Cost of Capital

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 Topics in Chapter
• Cost of capital components
– Debt
– Preferred stock
– Common equity
• WACC
• Factors that affect WACC
• Adjusting cost of capital for risk

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 Determinants of Intrinsic Value:
The Weighted Average Cost of Capital

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Firm’s debt/equity mix

Cost of debt
Market risk aversion Cost of equity Firm’s business risk
 What types of long-term capital do
firms use?
• Long-term debt
• Preferred stock
• Common equity

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 Capital Components
• Capital components are sources of funding that come
from investors.
• Accounts payable, accruals, and deferred taxes are not
sources of funding that come from investors, so they are
not included in the calculation of the cost of capital.
• We do adjust for these items when calculating the cash
flows of a project, but not when calculating the cost of
capital.

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 Before-tax vs. After-tax Capital Costs
• Tax effects associated with financing can be
incorporated either in capital budgeting cash
flows or in cost of capital.
• Most firms incorporate tax effects in the cost
of capital. Therefore, focus on after-tax costs.
• Only cost of debt is affected.

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 Historical (Embedded) Costs vs. New
(Marginal) Costs
• The cost of capital is used primarily to make
decisions which involve raising and investing
new capital. So, we should focus on marginal
costs.

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 Cost of Debt
• Method 1: Ask an investment banker what the
coupon rate would be on new debt.
• Method 2: Find the bond rating for the
company and use the yield on other bonds
with a similar rating.
• Method 3: Find the yield on the company’s
debt, if it has any.
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A 15-year, 12% semiannual bond sells for
$1,153.72. What’s rd?
0 1 2 30
rd = ?
...
-1,153.72 60 60 60 + 1,000

INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5.0% x 2 = rd = 10%

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 Component Cost of Debt
• Interest is tax deductible, so the after tax (AT)
cost of debt is:
rd AT = rd BT(1 – T)
rd AT = 10%(1 – 0.40) = 6%.
• Use nominal rate.
• Flotation costs small, so ignore.
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 Cost of preferred stock: Pps = $116.95;
10%Q; Par = $100; F = 5%
Use this formula:
Dps 0.1($100)
rps = =
Pps (1 – F) $116.95(1 – 0.05)
$10
= = 0.090 = 9.0%
$111.10

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 Time Line of Preferred
0 1 2 ∞
rps = ?
...
-111.1 2.50 2.50 2.50

DQ $2.50
$111.10 = =
rPer rPer
$2.50
rPer = = 2.25%; rps(Nom) = 2.25%(4) = 9%
$111.10
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 Note:
• Flotation costs for preferred are significant, so
are reflected. Use net price.
• Preferred dividends are not deductible, so no
tax adjustment. Just rps.
• Nominal rps is used.

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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.
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 Why is yield on preferred
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.

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 Example:
rps = 9%, rd = 10%, T = 40%
rps, AT = rps – rps(1 – 0.7)(T)
= 9% – 9%(0.3)(0.4) = 7.92%
rd, AT = 10% – 10%(0.4) = 6.00%
A-T Risk Premium on Preferred = 1.92%

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 What are the two ways that
companies can raise common equity?
• Directly, by issuing new shares of common stock.
• Indirectly, by reinvesting earnings that are not paid
out as dividends (i.e., retaining earnings).

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 Why is there a cost for reinvested
earnings?
• Earnings can be reinvested or paid out as dividends.
• Investors could buy other securities, earning a
return.
• Thus, there is an opportunity cost if earnings are
reinvested.

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 Cost for Reinvested Earnings
(Continued)
• Opportunity cost: The return stockholders could
earn on alternative investments of equal risk.
• They could buy similar stocks and earn rs, or
company could repurchase its own stock and earn rs.
So, rs, is the cost of reinvested earnings and it is the
cost of common equity.

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 Three ways to determine
the cost of equity, rs:

1. CAPM: rs = rRF + (rM – rRF)b

= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Judgmental-Risk
Premium: rs = rd + Bond RP.

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CAPM Cost of Equity: rRF = 5.6%,
RPM = 6%, b = 1.2

rs = rRF + (RPM )b

= 5.6% + (6.0%)1.2 = 12.8%.

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 Issues in Using CAPM
• Most analysts use the rate on a long-term (10 to 20
years) government bond as an estimate of rRF.
• Most analysts use a rate of 3.5% to 6% for the market
risk premium (RPM)
• Estimates of beta vary, and estimates are “noisy” (they
have a wide confidence interval).

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 DCF Cost of Equity, rs:
D0 = $3.26; P0 = $50; g = 5.8%

D1 D0(1 + g)
rs = +g= +g
P0 P0
= $3.12(1.058) + 0.058
$50
= 6.6% + 5.8%
= 12.4% 23
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 Estimating the Growth Rate
• Use the historical growth rate if you believe the
future will be like the past.
• Obtain analysts’ estimates: Value Line, Zacks,
Yahoo!Finance.
• Use the earnings retention model, illustrated on next
slide.

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 Earnings Retention Model
• Suppose the company has been earning 15% on equity
(ROE = 15%) and has been paying out 62% of its
earnings.
• If this situation is expected to continue, what’s the
expected future g?

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Earnings Retention Model (Continued)
• Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.

This is close to g = 5.8% given earlier.

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 Could DCF methodology be applied if g
is not constant?
• YES, nonconstant g stocks are expected to have constant
g at some point, generally in 5 to 10 years.
• But calculations get complicated. See the Web 10A
worksheet in the file Ch10Tool Kit.xls.

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 The Own-Bond-Yield-Plus-Judgmental-
Risk-Premium Method: rd = 10%, RP =
3.2%
• rs = rd + Judgmental risk premium
• rs = 10.0% + 3.2% = 13.2%

• This judgmental-risk premium  CAPM equity risk

premium, RPM.
• Produces ballpark estimate of rs. Useful check.

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What’s a reasonable final estimate of rs?
Method Estimate
CAPM 12.8%
DCF 12.4%
rd + judgment 13.2%
Average 12.8%

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 Determining the Weights for the WACC

• The weights are the percentages of the firm that

will be financed by each component.
• If possible, always use the target weights for the
percentages of the firm that will be financed with
the various types of capital.

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 Estimating Weights for the Capital
Structure
• If you don’t know the targets, it is better to
estimate the weights using current market values
than current book values.
• If you don’t know the market value of debt, then
it is usually reasonable to use the book values of
debt, especially if the debt is short-term.

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 Estimating Weights (Continued)
• Suppose the stock price is $50, there are 3 million
shares of stock, the firm has $25 million of
preferred stock, and $75 million of debt.

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 Estimating Weights (Continued)

• Vs = $50(3 million) = $150 million.

• Vps = $25 million.
• Vd = $75 million.
• Total value = $150 + $25 + $75
= $250 million.

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 Estimating Weights (Continued)
• ws = $150/$250 = 0.6
• wps = $25/$250 = 0.1
• wd = $75/$250 = 0.3

• The target weights for this company are the same as

these market value weights, but often market weights
temporarily deviate from targets due to changes in
stock prices.
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 What’s the WACC using the target
weights?
WACC = wdrd(1 – T) + wpsrps + wsrs

WACC = 0.3(10%)(1 − 0.4) + 0.1(9%)

+ 0.6(12.8%)

WACC = 10.38% ≈ 10.4%

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 What factors influence a company’s
WACC?
• Uncontrollable factors:
– Market conditions, especially interest rates.
– The market risk premium.
– Tax rates.
• Controllable factors:
– Capital structure policy.
– Dividend policy.
– Investment policy. Firms with riskier projects generally have a
higher cost of equity.

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 Is the firm’s 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
division’s WACC should be adjusted to reflect the
division’s risk and capital structure.

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 The Risk-Adjusted Divisional Cost of
Capital
• Estimate the cost of capital that the division would
have if it were a stand-alone firm.
• This requires estimating the division’s beta, cost of
debt, and capital structure.

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 Pure Play Method for Estimating Beta
for a Division or a Project
• Find several publicly traded companies exclusively in
project’s business.
• Use average of their betas as proxy for project’s beta.
• Hard to find such companies.

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 Accounting Beta Method for
Estimating Beta

• Run regression between project’s ROA and S&P Index

ROA.
• Accounting betas are correlated (0.5 – 0.6) with market
betas.
• But normally can’t get data on new projects’ ROAs
before the capital budgeting decision has been made.

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 Divisional Cost of Capital Using CAPM
• Target debt ratio = 10%.
• rd = 12%.
• rRF = 5.6%.
• Tax rate = 40%.
• betaDivision = 1.7.
• Market risk premium = 6%.

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Divisional Cost of Capital Using CAPM
(Continued)
Division’s required return on equity:
rs = rRF + (rM – rRF)bDiv.
rs = 5.6% + (6%)1.7 = 15.8%.
WACCDiv. = wd rd(1 – T) + wsrs
= 0.1(12%)(0.6) + 0.9(15.8%)
= 14.94% ≈ 14.9%

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 Division’s WACC vs. Firm’s Overall
WACC?
• Division WACC = 14.9% versus company WACC =
10.4%.
• “Typical” projects within this division would be
accepted if their returns are above 14.9%.

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 What are the three types of project
risk?
• Stand-alone risk
• Corporate risk
• Market risk

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 How is each type of risk used?
• Stand-alone risk is easiest to calculate.
• Market risk is theoretically best in most situations.
• However, creditors, customers, suppliers, and
employees are more affected by corporate risk.
• Therefore, corporate risk is also relevant.

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 A Project-Specific, Risk-Adjusted
Cost of Capital
• Start by calculating a divisional cost of capital.
• Use judgment to scale up or down the cost of capital
for an individual project relative to the divisional cost
of capital.

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 Costs of Issuing New Common Stock
• When a company issues new common stock they
also have to pay flotation costs to the underwriter.
• Issuing new common stock may send a negative
signal to the capital markets, which may depress
stock price.

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Cost of New Common Equity: P0 = $50,
D0 = $3.12, g = 5.8%, and F = 15%
D0(1 + g)
re = +g
P0(1 – F)
= $3.12(1.058) + 5.8%
$50(1 – 0.15)
= $3.30 + 5.8% = 13.6%
$42.50
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 Cost of New 30-Year Debt: Par = $1,000,
Coupon = 10% paid annually, and F = 2%

• Using a financial calculator:

– N = 30
– PV = 1,000(1 – 0.02) = 980
– PMT = -(0.10)(1,000)(1 – 0.4) = -60
– FV = -1,000
• Solving for I/YR: 6.15%

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 Comments about flotation costs:
• Flotation costs depend on the risk of the firm and the
type of capital being raised.
• The flotation costs are highest for common equity.
However, since most firms issue equity infrequently,
the per-project cost is fairly small.
• We will frequently ignore flotation costs when
calculating the WACC.

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 Four Mistakes to Avoid
• Current vs. historical cost of debt
• Mixing current and historical measures to estimate
the market risk premium
• Book weights vs. Market Weights
• Incorrect cost of capital components

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 Current vs. Historical Cost of Debt
• When estimating the cost of debt, don’t use the
coupon rate on existing debt, which represents the
cost of past debt.
• Use the current interest rate on new debt.

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 Estimating the Market Risk Premium
• When estimating the risk premium for the CAPM
approach, don’t subtract the current long-term T-
bond rate from the historical average return on
common stocks.
• For example, if the historical rM has been about
12.2% and inflation drives the current rRF up to 10%,
the current market risk premium is not 12.2% – 10%
= 2.2%!
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 Estimating Weights
• Use the target capital structure to determine the
weights.
• If you don’t know the target weights, then use the
current market value of equity.
• If you don’t know the market value of debt, then the
book value of debt often is a reasonable
approximation, especially for short-term debt.

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 Capital components are sources of funding
that come from investors.
• Accounts payable, accruals, and deferred taxes are
not sources of funding that come from investors, so
they are not included in the calculation of the WACC.
• We do adjust for these items when calculating
project cash flows, but not when calculating the
WACC.

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