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CHAPTER 9The Cost of Capital

Cost of Capital Components

Debt

PreferredCommon Equity

WACC

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What types of long-term capital do

firms use?

Long-term debtPreferred stock

Common equity

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Capital components are sources offunding that come from investors.

Accounts payable, accruals, anddeferred taxes are not sources of

funding that come from investors, sothey are not included in thecalculation of the cost of capital.

We do adjust for these items whencalculating the cash flows of aproject, but not when calculating thecost of capital.

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Should we focus on before-tax or

after-tax capital costs?

Tax effects associated with financingcan be incorporated either in capitalbudgeting cash flows or in cost ofcapital.

Most firms incorporate tax effects in

the cost of capital. Therefore, focuson after-tax costs.

Only cost of debt is affected.

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Should we focus on historical

(embedded) costs or new (marginal)costs?

The cost of capital is used primarilyto make decisions which involveraising and investing new capital.

So, we should focus on marginalcosts.

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Cost of Debt

Method 1: Ask an investment bankerwhat the coupon rate would be on

new debt.Method 2: Find the bond rating for

the company and use the yield onother bonds with a similar rating.

Method 3: Find the yield on thecompanys debt, if it has any.

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A 15-year, 12% semiannual bond sells

for $1,153.72. Whats rd?

60 60 + 1,00060

0 1 2 30

i = ?

30 -1153.72 60 1000

5.0% x 2 = rd = 10%

N I/YR PV FVPMT

-1,153.72...

INPUTS

OUTPUT

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Component Cost of Debt

Interest is tax deductible, so theafter tax (AT) cost of debt is:

rd AT = rd BT(1 - T)

= 10%(1 - 0.40) = 6%.

Use nominal rate.Flotation costs small, so ignore.

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Whats the cost of preferred stock?

PP = $113.10; 10%Q; Par = $100; F = $2.

%.0.9090.010.111$

10$

00.2$10.113$

100$1.0

n

ps

psP

Dr

Use this formula:

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Picture of Preferred

2.50 2.50

0 1 2rps = ?

-111.1

...

2.50

.50.2$

10.111$PerPer

Q

rr

D

%.9)4%(25.2%;25.210.111$

50.2$)( NompsPer rr

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Note:

Flotation costs for preferred aresignificant, so are reflected. Usenet price.

Preferred dividends are notdeductible, 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 toraise additional funds, and (3)preferred stockholders may gaincontrol 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 costto the issuer are higher on preferredthan on debt, which is consistent withthe 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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Directly, by issuing new shares ofcommon stock.

Indirectly, by reinvesting earningsthat are not paid out as dividends(i.e., retaining earnings).

What are the two ways that companies

can raise common equity?

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Earnings can be reinvested or paid

out as dividends.

Investors could buy other securities,earn a return.

Thus, there is an opportunity cost ifearnings are reinvested.

Why is there a cost for reinvested

earnings?

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Opportunity cost: The returnstockholders could earn onalternative investments of equalrisk.

They could buy similar stocksand earn rs, or company couldrepurchase its own stock and

earn rs. So, rs, is the cost ofreinvested earnings and it is thecost of 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-RiskPremium:

rs = rd + Bond RP.

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Find rs using the own-bond-yield-

plus-risk-premium method.(rd = 10%, RP = 4%.)

This RP CAPM RPM. Produces ballpark estimate of rs.

Useful check.

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

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Whats the DCF cost of equity, rs?

Given: D0 = $4.19;P0 = $50; g = 5%.

g

P

gDg

P

Drs

0

0

0

1 1

$4. .

$50.

. .

.

19 1050 05

0 088 0 05

13 8%.

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Estimating the Growth Rate

Use the historical growth rate if youbelieve 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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Suppose the company has beenearning 15% on equity (ROE = 15%)and retaining 35% (dividend payout

= 65%), and this situation isexpected to continue.

Whats the expected future g?

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Retention growth rate:

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier.

Think of bank account paying 15% withretention ratio = 0. What is g ofaccount balance? If retention ratio is100%, what is g?

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Could DCF methodology be applied

if g is not constant?

YES, nonconstant g stocks areexpected to have constant g atsome point, generally in 5 to 10years.

But calculations get complicated.See FM11 Ch 9 Tool Kit.xls.

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Whats the cost of equity

based on the CAPM?rRF = 7%, RPM = 6%, b = 1.2.

rs = rRF + (rM - rRF )b.

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

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Issues in Using CAPM

Most analysts use the rate on a long-term (10 to 20 years) governmentbond as an estimate of rRF. For a

current estimate, go towww.bloomberg.com, select U.S.Treasuries from the section on the

left under the heading Market.

More

http://www.bloomberg.com/http://www.bloomberg.com/

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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 estimatesare noisy (they have a wideconfidence interval). For an estimateof beta, go to www.bloomberg.com

and enter the ticker symbol for STOCKQUOTES.

http://www.bloomberg.com/http://www.bloomberg.com/

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Whats a reasonable final estimate

of rs?

Method Estimate

CAPM 14.2%

DCF 13.8%

rd + RP 14.0%

Average 14.0%

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Determining the Weights for the WACC

The weights are the percentages ofthe 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 thevarious types of capital.

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Estimating Weights for the

Capital Structure If you dont know the targets, it is

better to estimate the weights using

current market values than currentbook values.

If you dont know the market value of

debt, then it is usually reasonable touse the book values of debt,especially if the debt is short-term.

(More...)

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Estimating Weights (Continued)

Suppose the stock price is $50, there

are 3 million shares of stock, the firmhas $25 million of preferred stock,and $75 million of debt.

(More...)

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Vce = $50 (3 million) = $150 million.

Vps = $25 million.

Vd = $75 million.

Total value = $150 + $25 + $75 = $250million.

wce = $150/$250 = 0.6

wps = $25/$250 = 0.1

wd = $75/$250 = 0.3

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Whats the WACC?

WACC = wd

rd

(1 - T) + wps

rps

+ wce

rs

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

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

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WACC Estimates for Some LargeU. S. Corporations

Company WACC wdIntel (INTC) 16.0 2.0%

Dell Computer (DEL 12.5 9.1%BellSouth (BLS) 10.3 39.8%

Wal-Mart (WMT) 8.8 33.3%

Walt Disney (DIS) 8.7 35.5%

Coca-Cola (KO) 6.9 33.8%

H.J. Heinz (HNZ) 6.5 74.9%

Georgia-Pacific (GP) 5.9 69.9%

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What factors influence a companys

WACC?

Market conditions, especially interestrates and tax rates.

The firms capital structure anddividend policy.

The firms investment policy. Firmswith riskier projects generally have ahigher WACC.

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Four Mistakes to Avoid

1. When estimating the cost of debt,dont use the coupon rate on existing

debt. Use the current interest rate onnew debt.

2. When estimating the risk premium for

the CAPM approach, dont subtractthe currentlong-term T-bond rate fromthe historicalaverage return oncommon stocks. (More ...)

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For example, if the historical rM hasbeen about 12.2% and inflation

drives the current rRF up to 10%, thecurrent market risk premium is not12.2% - 10% = 2.2%!

(More ...)

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3. Dont use book weights to estimatethe weights for the capital structure.

Use the target capital structure to determinethe weights.

If you dont know the target weights, thenuse the current market value of equity, andnever the book value of equity.

If you dont know the market value of debt,

then the book value of debt often is areasonable approximation, especially forshort-term debt.

(More...)

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4. Always remember that capital

components are sources of fundingthat come from investors.

Accounts payable, accruals, anddeferred taxes are not sources of

funding that come from investors, sothey are not included in thecalculation of the WACC.

We do adjust for these items whencalculating the cash flows of theproject, but not when calculating theWACC.

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1. When a company issues new

common stock they also have to payflotation costs to the underwriter.

2. Issuing new common stock may

send a negative signal to the capitalmarkets, which may depress stockprice.

Why is the cost of internal equity fromreinvested earnings cheaper than thecost of issuing new common stock?

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Estimate the cost of new commonequity: P

0=$50, D

0=$4.19, g=5%, and

F=15%.

g

FP

gDre

)1(

)1(

0

0

%.4.15%0.550.42$

40.4$

%0.515.0150$

05.119.4$

9 42

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Estimate the cost of new 30-year debt:Par=$1,000, Coupon=10%paid annually,

and F=2%.

Using a financial calculator:

N = 30PV = 1000(1-.02) = 980

PMT = -(.10)(1000)(1-.4) = -60

FV = -1000

Solving for I: 10.2116%

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Comments about flotation costs:

Flotation costs depend on the risk of thefirm and the type of capital being raised.

The flotation costs are highest forcommon equity. However, since mostfirms issue equity infrequently, the per-project cost is fairly small.

We will frequently ignore flotation costswhen calculating the WACC.

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Should the company use thecomposite WACC as the hurdle rate for

each of its divisions?

NO! The composite WACC reflects the

risk of an average project undertakenby the firm.

Different divisions may have different

risks. The divisions WACC should beadjusted to reflect the divisions riskand capital structure.

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A Project-Specific, Risk-AdjustedCost of Capital

Start by calculating a divisional costof capital.

Estimate the risk of the project usingthe techniques in Chapter 11.

Use judgment to scale up or downthe cost of capital for an individualproject relative to the divisional costof capital.

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Divisional Risk and the Cost of Capital

Rate of Return(%)

WACC

Rejection Region

Acceptance Region

Risk

L

B

A

HWACCH

WACCLWACCA

0 RiskL RiskA RiskH

9 47

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Estimate the cost of capital that

the division would have if it were astand-alone firm.

This requires estimating the

divisions beta, cost of debt, andcapital structure.

What procedures are used to determinethe risk-adjusted cost of capital for a

particular division?

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Methods for Estimating Beta for a

Division or a Project

1. Pure play. Find several publicly

traded companies exclusively inprojects business.

Use average of their betas as

proxy for projects beta.Hard to find such companies.

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2. Accounting beta. Run regressionbetween projects ROA and S&Pindex ROA.

Accounting betas are correlated

(0.5 0.6) with market betas.But normally cant get data on newprojects ROAs before the capital

budgeting decision has been made.

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Find the divisions market risk and costof capital based on the CAPM, given

these inputs:

Target debt ratio = 10%.

rd = 12%.

rRF = 7%.

Tax rate = 40%.betaDivision = 1.7.

Market risk premium = 6%.

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Beta = 1.7, so division has more marketrisk than average.

Divisions required return on equity:

rs = rRF + (rM rRF)bDiv.= 7% + (6%)1.7 = 17.2%.

WACCDiv. = wdrd(1 T) + wcrs

= 0.1(12%)(0.6) + 0.9(17.2%)= 16.2%.

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How does the divisions WACC

compare with the firms 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%.

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Divisional Risk and the Cost of Capital

Rate of Return(%)

WACC

Rejection Region

Acceptance Region

Risk

L

B

A

HWACCH

WACCLWACCA

0 RiskL RiskA RiskH

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What are the three types of project

risk?

Stand-alone riskCorporate risk

Market risk

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How is each type of risk used?

Stand-alone risk is easiest tocalculate.

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.