Copyright © 2015 by the McGraw-Hill Education (Asia). All rights reserved.

Key Concepts and Skills

Know how to determine:
A firm’s cost of equity capital
A firm’s cost of debt
A firm’s overall cost of capital
Understand pitfalls of overall cost of
capital and how to manage them

12-2
Chapter Outline
12.1 The Cost of Capital: Some Preliminaries
12.2 The Cost of Equity
12.3 The Costs of Debt and Preferred Stock
12.4 The Weighted Average Cost of Capital
12.5 Divisional and Project Costs of Capital

12-3
Cost of Capital Basics
The cost to a firm for capital funding = the return to
the providers of those funds
 The return earned on assets depends on the risk of
those assets
 A firm’s cost of capital indicates how the market
views the risk of the firm’s assets
 A firm must earn at least the required return to
compensate investors for the financing they have
provided
 The required return is the same as the appropriate
discount rate
12-4
Cost of Equity
The cost of equity is the return required by equity
investors given the risk of the cash flows from the firm
Two major methods for determining the cost of equity
- Dividend growth model (DGM)
- Security Market Line (SML) or Capital
Asset Pricing Model (CAPM)

Return to 12-5

Quick Quiz
The Dividend Growth Model
Approach
Start with the dividend growth model formula and
rearrange to solve for RE
D1
P0 
RE  g
D1
RE  g
P0

12-6
Example: Dividend Growth Model
Your company is expected to pay a dividend of
$4.40 per share next year. (D1)
Dividends have grown at a steady rate of 5.1%
per year and the market expects that to
continue. (g)
The current stock price is $50. (P0)
What is the cost of equity?
4.40
RE   .051  .139
50
12-7
Example: Estimating the Dividend Growth
Rate
One method for estimating the growth rate is to use
the historical average
Year Dividend Percent Change
2009 1.23 (1.30 – 1.23) / 1.23 = 5.7%
2010 1.30 (1.36 – 1.30) / 1.30 = 4.6%
2011 1.36 (1.43 – 1.36) / 1.36 = 5.1%
2012 1.43
(1.50 – 1.43) / 1.43 = 4.9%
2013 1.50

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

12-8
Advantages and Disadvantages of
Dividend Growth Model
Advantage – easy to understand and use
Disadvantages
Only applicable to companies currently paying
dividends
Not applicable if dividends aren’t growing at a
reasonably constant rate
Extremely sensitive to the estimated growth rate
Does not explicitly consider risk

12-9
The SML Approach
Use the following information to compute the cost of
equity
Risk-free rate, Rf
Market risk premium, E(RM) – Rf
Systematic risk of asset, 

RE  Rf   E ( E ( RM )  Rf )

12-10
Example: SML
Company’s equity beta = 1.2
Current risk-free rate = 7%
Expected market risk premium = 6%
What is the cost of equity capital?

RE  7  1.2 ( 6 )  14.2%

12-11
Advantages and Disadvantages of SML
Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as beta is
available
Disadvantages
Must estimate the expected market risk premium,
which does vary over time
Must estimate beta, which also varies over time
Relies on the past to predict the future, which is not
always reliable
12-12
Example: Cost of Equity
Data:
Beta = 1.5
Market risk premium = 9%
Current risk-free rate = 6%.
Analysts’ estimates of growth = 6% per year
Last dividend = $2.
Currently stock price =$15.65

Using SML: R = 6% + 1.5(9%) = 19.5%

E
Using DGM: RE = [2(1.06) / 15.65] + .06
= 19.55%
12-13
Cost of Debt
The cost of debt = the required return on a
company’s debt
Method 1 = Compute the yield to maturity on
existing debt
Method 2 = Use estimates of current rates based on
the bond rating expected on new debt
The cost of debt is NOT the coupon rate

12-14
Example: Cost of Debt
Current bond issue: 30 N
15 years to maturity -1253.72 PV
Coupon rate = 12%
1000 FV
60 PMT
Coupons paid semiannually
CPT I/Y4.45%
Currently bond price = $1,253.72
YTM = 4.45%*2 = 8.9%

12-15
Component Cost of Debt
Use the YTM on the firm’s debt
Interest is tax deductible, so the after-tax (AT) cost of
debt is:

R D , AT  R D ,BT ( 1  TC )
If the corporate tax rate = 40%:

R D , AT  8.9%( 1  .40 )  5.34%

Return to 12-16

Quick Quiz
Cost of Preferred Stock
Preferred pays a constant dividend every period
Dividends expected to be paid forever
Preferred stock is a perpetuity D
RP 
Example: P0

Preferred annual dividend = $10

Current stock price = $111.10
RP = 10 / 111.10 = 9%

12-17
Weighted Average Cost of Capital
Use the individual costs of capital to compute a
weighted “average” cost of capital for the firm
This “average” = the required return on the firm’s
assets, based on the market’s perception of the risk
of those assets
The weights are determined by how much of
each type of financing is used

Return to 12-18

Quick Quiz
Determining the Weights for the
WACC
Weights = percentages of the firm
that will be financed by each
component
Always use the target weights, if
possible
If not available, use market values
12-19
Capital Structure Weights
Notation
E = market value of equity
= # outstanding shares times price per share
D = market value of debt
= # outstanding bonds times bond price
V = market value of the firm = D + E
Weights
E/V = percent financed with equity
D/V = percent financed with debt

Return to 12-20

Quick Quiz
WACC
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)

Where:

(E/V) = % of common equity in capital structure

Weights (P/V) = % of preferred stock in capital structure
(D/V) = % of debt in capital structure

RE = firm’s cost of equity

Component RP = firm’s cost of preferred stock
costs
RD = firm’s cost of debt

TC = firm’s corporate tax rate

12-21
Estimating Weights
Given: Component Values:
Stock price = $50 • VE = $50 x (3 m) = $150m
3m shares common stock • V = $25m
P
$25m preferred stock
• VD = $75m
$75m debt
• VF = $150+$25+$75=$250m
40% Tax rate

Weights:
E/V = $150/$250 = 0.6 (60%)
P/V = $25/$250 = 0.1 (10%)
D/V = $75/$250 = 0.3 (30%) 12-22
WACC
Component W R
Debt (before tax) 0.30 10%
Preferred Stock 0.10 9%
Common equity 0.60 14%

WACC = E/V x RE + P/V x RP + D/V x RD (1 - TC)

WACC = 0.6(14%) + 0.1(9%) + 0.3(10%)(1-.40)

WACC = 8.4% + 0.9% + 1.8% = 11.1%
12-23
Table 12.1

12-24
Factors that Influence a
Company’s WACC
Market conditions, especially interest rates, tax
rates and the market risk premium
The firm’s capital structure and dividend policy
The firm’s investment policy
Firms with riskier projects generally have a higher
WACC

12-25
Eastman Chemical – 1
Equity Data

Source: [Link]
12-26
 Eastman Chemical – 2
Dividend Growth

Source: [Link]
12-27
 Eastman
Chemical -
3
Beta and
Shares
Outstanding
12-28
Source: [Link]
 Eastman
Chemical -
4
Dividends
12-29
Source: [Link]
Eastman Chemical - 5
Cost of Equity - SML
Beta: Yahoo Finance 2.31
Value Line 1.25
(1.25 is a more reasonable value)
T-Bill rate = 0.05% (Yahoo Finance bonds section)
Market Risk Premium = 7% (assumed)

Cost of Equity (SML) = 0.05% + (7%)(1.25)

= 8.80%

RE  Rf   E ( E ( RM )  Rf )
12-30
Eastman Chemical - 6
Cost of Equity - DCF
Growth rate 7.67%
Last dividend $1.04
Stock price $53.74

D1
Cost of Equity (DCF) = RE  g
P0
$1.04(1.0767)
RE   .0767
53.74
RE  9.75%

12-31
Eastman Chemical - 7
Cost of Equity
Cost of Equity Method Estimated Value
SML 8.80%
DCF 9.75%
Average 9.28%

12-32
Eastman Chemical - 8
Bond Data

Source: [Link] 12-33

Eastman Chemical - 9
Cost of Debt

For Eastman, the cost of debt is similar when

using either book values or market values.

12-34
Eastman Chemical - 10
WACC
Capital structure weights (market values):
E = 136.92 million x $53.74 = $7.358 billion
D = 1.661 billion
V = $7.358 + 1.661 = 9.019 billion
E/V = 7.358 / 9.019 = .82
D/V = 1.661 / 9.019 = .18
Tax rate (assumed) = 35%

WACC = .82(9.28%) + .18(3.81%)(1-.35)

= 8.02%
12-35
Risk-Adjusted WACC
A firm’s WACC reflects the risk of an average project
undertaken by the firm
“Average”  risk = the firm’s current operations

Different divisions/projects may have different risks

The division’s or project’s WACC should be adjusted to
reflect the appropriate risk and capital structure

Return to 12-36

Quick Quiz
Using WACC for All Projects
What would happen if we use the WACC for all
projects regardless of risk?
Assume the WACC = 15%

Project IRR Project Beta WACC=15%

A 14% 0.60 Reject
B 16% 1.20 Accept

12-37
Using WACC for All Projects
Assume the WACC = 15%
A project’s required return is calculated using the
SML and the project’s Beta
Adjusting for risk changes the decisions

Required Decision
Project IRR Return WACC=15% Risk Adj
A 14% 11.8% Reject Accept
B 16% 16.6% Accept Reject

12-38
12-39
Pure Play Approach
Find one or more companies that specialize in the
product or service being considered
Compute the beta for each company
Take an average
Use that beta along with the CAPM to find the
appropriate return for a project of that risk
Pure play companies can be difficult to find

Return to 12-40

Quick Quiz
Subjective Approach
Consider the project’s risk relative to
the firm overall
If the project is riskier than the firm,
use a discount rate greater than the
WACC
If the project is less risky than the firm,
use a discount rate less than the WACC
Return to 12-41

Quick Quiz
Subjective Approach - Example
Risk Level Discount Rate
Very Low Risk WACC – 8% 6%
Low Risk WACC – 4% 10%
Same Risk as Firm WACC 14%
High Risk WACC + 6% 20%
Very High Risk WACC + 10% 24%

12-42
Quick Quiz
What are the two approaches for computing the cost
of equity? (Slide 12.5)
How do you compute the cost of debt and the after
tax cost of debt? (Slide 12.16)
How do you compute the capital structure weights
required for the WACC? (Slide 12.20)
What is the WACC? (Slide 12.18)
What happens if we use the WACC as the discount
rate for all projects? (Slide 12.36)
What are two methods that can be used to compute
the appropriate discount rate when WACC isn’t
appropriate? (Slide 12.40 and Slide 12.41) 12-43
Chapter 12
 END 12-44