CHAPTER 10

Determining the Cost of Capital

1
Topics in Chapter
 Cost of Capital Components
 Debt
 Preferred
 Common Equity
 WACC

2
What types of long-term
capital do firms use?
 Long-term debt
 Preferred stock
 Common equity

3
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.
4
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.

5
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.

6
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.

7
 A 15-year, 12% semiannual bond
sells for $1,153.72. What’s rd?

0 1 2 30
I=? ...
-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%

8
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.

9
 Cost of preferred stock: Pps =
$113.10; 10%Q; Par = $100; F = $2.

Use this formula:

Dps 0.1($100)
rps = =
Pps (1-F) $116.95(1-0.05)
$10 = 0.090 = 9.0%
=
$111.10

10
 Time Line of Preferred

0 1 2 ∞
rps=?
...
-111.1 2.50 2.50 2.50

DQ
$111.10= = $2.50
rPer rPer

$2.50
rPer = = 2.25%; rps(Nom) = 2.25%(4) = 9%
$111.10
11
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.

12
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.

13
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.
14
 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%

15
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).

16
Why is there a cost for
reinvested earnings?
 Earnings can be reinvested or paid out
as dividends.
 Investors could buy other securities,
earn a return.
 Thus, there is an opportunity cost if
earnings are reinvested.

17
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
equity.
18
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-Risk
Premium: rs = rd + Bond RP.

19
CAPM Cost of Equity: rRF = 7%, RPM
= 6%, b = 1.2.

rs = rRF + (RPM )b.

= 7.0% + (6.0%)1.2 = 14.2%.

20
Issues in Using CAPM
 Most analysts use the rate on a long-
term (10 to 20 years) government bond
as an estimate of rRF.

More…
21
Issues in Using CAPM
(Continued)
 Most analysts use a rate of 5% to 6.5%
for the market risk premium (RPM)
 Estimates of beta vary, and estimates
are “noisy” (they have a wide
confidence interval).

22
DCF Cost of Equity, rs: D0 =
$4.19; P0 = $50; g = 5%.

D1 D0(1+g)
rs = +g= +g
P0 P0

= $4.19(1.05) + 0.05
$50
= 0.088 + 0.05
= 13.8%
23
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.

24
Earnings Retention Model
 Suppose the company has been earning
15% on equity (ROE = 15%) and
retaining 35% (dividend payout =
65%), and this situation is expected to
continue.

What’s the expected future g?

25
Earnings Retention Model
(Continued)
 Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 - payout rate)(ROE)
g = (1 – 0.65)(15%) = 5.25%.

This is close to g = 5% given earlier. Think

of bank account paying 15% with retention
ratio = 0. What is g of account balance? If
retention ratio is 100%, what is g?
26
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 10B worksheet in the file
IFM10 Ch10 Tool Kit.xls.

27
The Own-Bond-Yield-Plus-Risk-Premium
Method: rd = 10%, RP = 4%.

 rs = rd + RP
 rs = 10.0% + 4.0% = 14.0%

 This bond RP  CAPM RPM.

 Produces ballpark estimate of rs. Useful
check.

28
What’s a reasonable final
estimate of rs?
Method Estimate

CAPM 14.2%

DCF 13.8%

rd + RP 14.0%

Average 14.0%

29
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.

30
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.
(More...)
31
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.

(More...)
32
Estimating Weights
(Continued)
 Vce = $50 (3 million) = $150 million.
 Vps = $25 million.
 Vd = $75 million.
 Total value = $150 + $25 + $75 =
$250 million.

33
Estimating Weights
(Continued)
 wce = $150/$250 = 0.6
 wps = $25/$250 = 0.1
 wd = $75/$250 = 0.3

34
What’s the WACC?
WACC = wdrd(1 - T) + wpsrps + wcers

WACC = 0.3(10%)(0.6) + 0.1(9%) +

0.6(14%)

WACC = 1.8% + 0.9% + 8.4% = 11.1%.

35
What factors influence a
company’s WACC?
 Market conditions, especially interest
rates and tax rates.
 The firm’s capital structure and dividend
policy.
 The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.

36
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.

37
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.

39
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.

40
Divisional Cost of Capital
Using CAPM
 Target debt ratio = 10%.
 rd = 12%.
 rRF = 7%.
 Tax rate = 40%.
 betaDivision = 1.7.
 Market risk premium = 6%.

41
Divisional Cost of Capital
Using CAPM (Continued)

Division’s required return on equity:

rs = rRF + (rM – rRF)bDiv.
rs = 7% + (6%)1.7 = 17.2%.
WACCDiv. = wd rd(1 – T) + wc rs
= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.

42
Division’s WACC vs. Firm’s Overall
WACC?
 Division WACC = 16.2% versus
company WACC = 11.1%.
 “Typical” projects within this division
would be accepted if their returns are
above 16.2%.

43
What are the three types of
project risk?
 Stand-alone risk
 Corporate risk
 Market risk

44
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.

45
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.

46
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.

47
Cost of New Common Equity: P0=$50,
D0=$4.19, g=5%, and F=15%.

D0(1 + g)
re = +g
P0(1 - F)
$4.19(1.05) + 5.0%
=
$50(1 – 0.15)

= $4.40 + 5.0% = 15.4%

$42.50
48
Cost of New 30-Year Debt: Par=$1,000,
Coupon=10% paid annually, and F=2%.

 Using a financial calculator:

 N = 30
 PV = 1000(1-.02) = 980
 PMT = -(.10)(1000)(1-.4) = -60
 FV = -1000
 Solving for I/YR: 6.15%

49
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.

50
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

 See next slides for details.

(More ...)
51
Current vs. Historical Cost of
Debt
 When estimating the cost of debt, don’t
use the coupon rate on existing debt.
 Use the current interest rate on new
debt.

(More ...)
52
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%!
(More ...)
53
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, and
never the book 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. (More...)
54
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 the cash flows of the project, but
not when calculating the WACC.

55