Cost of Capital

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 1. INTRODUCTION
• The cost of capital is the cost of using the funds of creditors and owners.

• Creating value requires investing in capital projects that provide a return

greater than the project’s cost of capital.

- When we view the firm as a whole, the firm creates value when it provides a
return greater than its cost of capital.

• Estimating the cost of capital is challenging.

- We must estimate it because it cannot be observed.

- We must make a number of assumptions.
- For a given project, a firm’s financial manager must estimate its cost of
capital.

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 2. COST OF CAPITAL
• The cost of capital is the rate of return that the suppliers of capital—
bondholders and owners—require as compensation for their contributions of
capital.
- This cost reflects the opportunity costs of the suppliers of capital.
• The cost of capital is a marginal cost: the cost of raising additional capital.
• The weighted average cost of capital (WACC) is the cost of raising additional
capital, with the weights representing the proportion of each source of financing
that is used.
- Also known as the marginal cost of capital (MCC).

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 WACC
WACC = wd rd (1  t) + wp rp + we re (3-1)
 
where
wd is the proportion of debt that the company uses when it raises new funds
rd is the before-tax marginal cost of debt
t is the company’s marginal tax rate
wp is the proportion of preferred stock the company uses when it raises new
funds
rp is the marginal cost of preferred stock
we is the proportion of equity that the company uses when it raises new
funds
re is the marginal cost of equity

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 EXAMPLE: WACC
Suppose the Widget Company has a capital structure composed of the following,
in billions:

Debt €10
Common equity €40

If the before-tax cost of debt is 9%, the required rate of return on equity is 15%,
and the marginal tax rate is 30%, what is Widget’s weighted average cost of
capital?

Solution:
WACC = WACC = wd rd (1  t) + wp rp + we re

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 TAXES AND THE COST OF CAPITAL
• Interest on debt is tax deductible; therefore, the cost of
debt must be adjusted to reflect this deductibility.

- We multiply the before-tax cost of debt (rd) by the factor

(1 – t), with t as the marginal tax rate.
- Thus, rd × (1  t) is the after-tax cost of debt.

• Payments to owners are not tax deductible, so the required

rate of return on equity (whether preferred or common) is
the cost of capital.

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 WEIGHTS OF THE WEIGHTED AVERAGE
• The weights should reflect how the company will raise additional capital.
• Ideally, we would like to know the company’s target capital structure, which is
the capital structure that is the company’s goal, but we cannot observe this
goal.
• Alternatives
- Assess the market value of the company’s capital structure components.
- Examine trends in the company’s capital structure.
- Use capital structures of comparable companies (e.g., weighted average of
comparables’ capital structure).

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 APPLYING THE COST OF CAPITAL TO CAPITAL
BUDGETING AND SECURITY VALUATION
• The investment opportunity schedule (IOS) is a representation of the
returns on investments.
• We assume that the IOS is downward sloping: the more a company invests,
the lower the additional opportunities.
- That is, the company will invest in the highest-returning investments first,
followed by lower-yielding investments as more capital is available to invest.
• The marginal cost of capital (MCC) schedule is the representation of the
costs of raising additional capital.
- We generally assume that the MCC is upward sloping: the more funds a
company raises, the greater the cost.

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 OPTIMAL INVESTMENT DECISION
Marginal cost of capital Investment opportunity schedule

Cost
or
Return

Optimal
Capital
Budget

Amount of New Capital

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 USING THE MCC IN CAPITAL
BUDGETING AND ANALYSIS
• The WACC is the marginal cost for additional funds and, hence, additional
investments.
• In capital budgeting
- We use the WACC, adjusted for project-specific risk, to calculate the net
present value (NPV).
- Using a company’s overall WACC in evaluating a capital project assumes
that the project has risk similar to the average project of the company.
• In analysis
- Analysts can use the WACC in valuing the company by discounting cash
flows to the firm.

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 3. COSTS OF THE DIFFERENT
SOURCES OF CAPITAL
Costs of Capital

Cost of Debt Cost of Preferred Equity Cost of Common Equity

Return on Preferred Capital Asset Pricing

Yield to Maturity Stock Model

Variations because of Dividend Discount

Debt Rating Callability, etc. Model

Bond Yield plus Risk

Premium

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 THE COST OF DEBT
Alternative approaches
1. Yield-to-maturity approach: Calculate the yield to maturity on the
company’s current debt.
2. Debt-rating approach: Use yields on comparably rated bonds with
maturities similar to what the company has outstanding.

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 THE COST OF PREFERRED STOCK
The cost of preferred stock that is noncallable and nonconvertible is based on
the perpetuity formula:
→ (3-3)

Problem
Suppose a company has preferred stock outstanding that has a dividend of
$1.25 per share and a price of $20. What is the company’s cost of preferred
equity?

Solution

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 THE COST OF EQUITY
Methods of estimating the cost of equity:
1. Capital asset pricing model
2. Dividend discount model
3. Bond yield plus risk premium

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 USING THE CAPM TO ESTIMATE THE
COST OF EQUITY
The capital asset pricing model (CAPM) states that the expected return on
equity, E(Ri) , is the sum of the risk-free rate of interest, RF, and a premium for
bearing market risk, bi [E(RM) – RF]:

E(Ri) = RF + bi [E(RM) – RF] (3-4)

where
bi is the return sensitivity of stock i to changes in the market return
E(RM) is the expected return on the market
E(RM) – RF is the expected market risk premium or equity risk premium
(ERP)

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EXAMPLE: COST OF EQUITY USING THE CAPM
Problem:
If the risk-free rate is 3%, the expected market risk premium is 5%, and the
company’s stock beta is 1.2, what is the company’s cost of equity?

Solution:
Cost of equity = E(Ri) = RF + bi [E(RM) – RF]

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9-4A EXPECTED DIVIDENDS AS THE BASIS FOR
STOCK VALUES
9-5 CONSTANT GROWTH STOCKS
 USING THE DIVIDEND VALUATION MODEL TO
ESTIMATE THE COST OF EQUITY
• The dividend discount model (DDM) assumes that the value of a stock today is
the present value of all future dividends, discounted at the required rate of return.
• Assuming a constant growth in dividends:
• price per/share

which we can rearrange to solve for the required rate of return:

(3-6)
• We can estimate the growth rate, g, by using third-party estimates of the
company’s dividend growth or estimating the company’s sustainable growth.
• The sustainable growth is the product of the return on equity (ROE) and the
retention rate (1 minus the dividend payout ratio, or ):
ROE

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 USING THE BOND YIELD PLUS RISK PREMIUM
APPROACH TO ESTIMATING THE COST OF EQUITY
• The bond yield plus risk premium approach requires adding a premium to a
company’s yield on its debt:
re = rd + Risk premium (3-8)

- This approach is based on the idea that the equity of the company is riskier
than its debt, but the cost of these sources move in tandem.

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