CHAPTER 9

The Cost of Capital

1
Topics in Chapter
 Cost of capital components
 Debt
 Preferred stock
 Common equity
 WACC
 Factors that affect WACC
 Adjusting cost of capital for risk

2
 Determinants of Intrinsic Value:
The Weighted Average Cost of Capital

Net operating Required

−
profit after investments
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 Firm’s debt/equity
rates
Cost of debt mix

Market risk Cost of Firm’s business

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

4
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
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capital.
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.

6
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.

7
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.

10
 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) =
$111.10
9%
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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.

13
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 19
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.

(More…)
22
Issues in Using CAPM
(Continued)
 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%
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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.
27
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 9A worksheet in the
file Ch09 Tool [Link].

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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 over-own-bond-judgmental-
risk premium  CAPM equity risk
premium, RPM.
 Produces ballpark estimate of rs.
Useful check. 29
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.

31
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 (More…)
is
short-term. 32
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…)
33
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 41
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%.

44
What are the three types
of project risk?
 Stand-alone risk
 Corporate risk
 Market risk

45
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.
46
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.

47
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.
48
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(1.05 + 5.8%
=
8)
$50(1 –
0.15)
= $3.30 + 5.8% = 13.6%
$42.50
49
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.
51
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
(More…)

 See next slides for details. 52

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.

(More…)
53
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% (More…)
– 10%
= 2.2%! 54
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. (More…)
55
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.

56