Chapter 4

Slide Contents
Learning Objectives Principles Used in This Chapter
1. The Cost of Capital: An Overview 2. Determining the Firms Capital Structure Weights 3. Estimating the Costs of Individual Sources of Capital 4. Summing Up Calculating the Firms WACC 5. Estimating Project Cost of Capital 6. Floatation costs and Project NPV

The Cost of Capital

Key Terms
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Learning Objectives
1. Understand the concepts underlying the firms overall cost of capital and the purpose of its calculation. 2. Evaluate a firms capital structure, and determine the relative importance (weight) of each source of financing. 3. Calculate the after-tax cost of debt, preferred stock, and common equity.

Learning Objectives (cont.)

4. Calculate a firms weighted average cost of capital 5. Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe the divisional cost of capital as a viable alternative for firms with multiple divisions. 6. Adjust NPV for the costs of issuing new securities when analyzing new investment opportunities.
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Principles Used in This Chapter

Principle #1: Money Has a Time Value. Principle #3: Cash Flows Are the Source of Value.
Estimates of investors required rate of return extracted from observed market prices are based on principles #1 and #3.

Principles Used in This Chapter (cont.)

Principle #2: There Is a Risk-Return Tradeoff.
Investors who purchase a firms common stock require a higher expected return than investors who loan money.

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The Cost of Capital: An Overview

Cost of capital is the weighted average of the required returns of the securities that are used to finance the firm. We refer to this as the firms Weighted Average Cost of Capital, or WACC.

4.1 The Cost of Capital: An Overview

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The Cost of Capital: An Overview (cont.)

Most firms raise capital with a combination of debt, equity, and hybrid securities. WACC incorporates the required rates of return of the firms lenders and investors and the particular mix of financing sources that the firm uses.

The Cost of Capital: An Overview (cont.)

How does riskiness of firm affect WACC?
Required rate of return on securities will be higher if the firm is riskier. Risk will influence how the firm chooses to finance i.e. proportion of debt and equity.

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The Cost of Capital: An Overview (cont.)

WACC is useful in a number of settings:
WACC is used to value the firm. WACC is used as a starting point for determining the discount rate for investment projects the firm might undertake. WACC is the appropriate rate to use when evaluating performance, specifically whether or not the firm has created value for its shareholders.

WACC equation

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Three Step Procedure for Estimating Firm WACC

1. Define the firms capital structure by determining the weight of each source of capital. (see column 2, figure 4-2) 2. Estimate the opportunity cost of each source of financing. We will use the current market value of each source of capital based on its current, not historical, costs. (see column 3, figure 4-2)

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Three Step Procedure for Estimating Firm WACC (cont.)

3. Calculate a weighted average of the costs of each source of financing. (see column 4, figure 4-2)

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Determining the Firms Capital Structure Weights

The weights are based on the following sources of capital: debt (short-term and long-term), preferred stock and common equity. Liabilities such as accounts payable and accrued expenses are not included in capital structure.

4.2 Determining the Firms Capital Structure Weights

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Determining the Firms Capital Structure Weights (cont.)

Ideally, the weights should be based on observed market values. However, not all market values may be readily available. Hence, we generally use book values for debt and market values for equity.

Checkpoint 4.1
Calculating the WACC for Templeton Extended Care Facilities, Inc.
In the spring of 2010, Templeton was considering the acquisition of a chain of extended care facilities and wanted to estimate its own WACC as a guide to the cost of capital for the acquisition. Templetons capital structure consists of the following:

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Checkpoint 4.1
Calculating the WACC for Templeton Extended Care Facilities, Inc. (Cont.)
Templeton contacted the firms investment banker to get estimates of the firms current cost of financing and was told that if the firm were to borrow the same amount of money today, it would have to pay lenders 8%; however, given the firms 25% tax rate, the after-tax cost of borrowing would only be 6%  8%(1.25). Preferred stockholders currently demand a 10% rate of return, and common stockholders demand 15%. Templetons CFO knew that the WACC would be somewhere between 6% and 15% since the firms capital structure is a blend of the three sources of capital whose costs are bounded by this range.

Checkpoint 4.1

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Checkpoint 4.1

Checkpoint 4.1

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Checkpoint 4.1: Check Yourself

After completing her estimate of Templetons WACC, the CFO decided to explore the possibility of adding more low-cost debt to the capital structure. With the help of the firms investment banker, the CFO learned that Templeton could probably push its use of debt to 37.5% of the firms capital structure by issuing more debt and retiring (purchasing) the firms preferred shares. This could be done without increasing the firms costs of borrowing or the required rate of return demanded by the firms common stockholders. What is your estimate of the WACC for Templeton under this new capital structure proposal?

Step 1: Picture the Problem

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Step 1: Picture the Problem (cont.)

Step 2: Decide on a Solution Strategy

We need to determine the WACC based on the given information:
Weight of debt = 37.5%; Cost of debt = 6% Weight of common stock = 62.5%; Cost of common stock =15%

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Step 2: Decide on a Solution Strategy (cont.)

We can compute the WACC based on the following equation:

Step 3: Solve
The WACC is equal to 11.625% as calculated below.
Weights Debt Common Stock Preferred Stock 0.375 0.625 0 1 Cost 0.06 0.15 0.1 WACC Product 0.0225 0.09375 0 0.11625

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Step 4: Analyze
We observe that as Templeton chose to increase the level of debt to 37.5% and retire the preferred stock, the WACC decreased marginally from 12.125% to 11.625%. Thus altering the weights will change the WACC.

4.3 Estimating the Cost of Individual Sources of Capital

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The Cost of Debt

The cost of debt is the rate of return the firms lenders demand when they loan money to the firm. Note, the rate of return is not the same as coupon rate, which is the rate contractually set at the time of issue. We can estimate the markets required rate of return by examining the yield to maturity on the firms debt.
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The Cost of Debt (cont.)

After-tax cost of debt = Yield (1-tax rate) Example 4.1 What will be the yield to maturity on a debt that has par value of $1,000, a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at $900? What will be the cost of debt if the tax rate is 30%?

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The Cost of Debt (cont.)

Enter:
N = 10; PV = -900; PMT = 50; FV =1000 I/Y = 6.38% After-tax cost of Debt = Yield (1-tax rate) = 6.38 (1-.3) = 4.47%

The Cost of Debt (cont.)

It is not easy to find the market price of a specific bond as most bonds do not trade in the public market. Because of this, it is a standard practice to estimate the cost of debt using yield to maturity on a portfolio of bonds with similar credit rating and maturity as the firms outstanding debt.

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The Cost of Preferred Equity

The cost of preferred equity is the rate of return investors require of the firm when they purchase its preferred stock. The cost is not adjusted for taxes since dividends are paid to preferred stockholders out of after-tax income.

The Cost of Preferred Equity (cont.)

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The Cost of Preferred Equity (cont.)

Example 4.2 Consider the preferred shares of Relay Company that are trading at $25 per share. What will be the cost of preferred equity if these stocks have a par value of $35 and pay annual dividend of 4%?

The Cost of Preferred Equity (cont.)

kps = $1.40 $25 = .056 or 5.6%

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The Cost of Common Equity

The cost of common equity is the rate of return investors expect to receive from investing in firms stock. This return comes in the form of cash distributions of dividends and cash proceeds from the sale of the stock.

The Cost of Common Equity (cont.)

Cost of common equity is harder to estimate since common stockholders do not have a contractually defined return (similar to interest on bonds or dividends on preferred stock). There are two approaches to estimating the cost of common equity:
Dividend growth model (introduced in chapter 10) CAPM (introduced in chapter 8)
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The Dividend Growth Model Discounted Cash Flow Approach

Using this approach, we estimate the expected stream of dividends as the source of future estimated cash flows. We use the estimated dividends and current stock price to calculate the internal rate of return on the stock investment. This return is used as an estimate of cost of equity.

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Checkpoint 4.2
Estimating the Cost of Common Equity for Pearson plc Using the Dividend Growth Model Pearson plc (PSO) is an international media company that operates three business groups: Pearson Education, the Financial Times, and Penguin. In the spring of 2009, Pearsons CFO called for an update of the firms cost of capital. The first phase of the estimation focused on the firms cost of common equity. How would the CFO determine the cost of the companys equity, using the dividend growth model?

Checkpoint 4.2

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Checkpoint 4.2

Checkpoint 4.2: Check Yourself Prepare two additional estimates of Pearsons cost of common equity using the dividend growth model where you use growth rates in dividends that are 25% lower than the estimated 6.25% (i.e., for g equal to 5% and 7.81%)

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Step 1: Picture the Problem

We are given the following:
Price of common stock (Pcs ) = $10.09 Growth rate of dividends (g) = 5% and 7.81% Dividend (D0) = $0.47 per share Cost of equity is given by dividend yield + growth rate.

Step 1: Picture the Problem (cont.)

Dividend Yield =D1 P0

Growth Rate (g)

Cost of Equity (kcs )

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Step 2: Decide on a Solution Strategy

We can determine the cost of equity using equation 4-3a

Step 3: Solve

At growth rate of 5% kcs = {$0.47(1.05)/$10.09} + .05 = .0989 or 9.89%

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Step 3: Solve (cont.)

Step 4: Analyze
Pearsons cost of equity is estimated at 9.89% and 12.83% based on the different assumptions for growth rate. Thus growth rate is an important variable in determining the cost of equity. However, estimating the growth rate is not easy.

At growth rate of 7.81% kcs = {$0.47(1.0781)/$10.09} + .0781 = .1283 or 12.83 %

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Estimating the Rate of Growth, g

The growth rate can be obtained from various websites that post analysts forecasts of growth rates. We can also estimate the growth rate using the historical data and computing the arithmetic average or geometric average.

Estimating the Rate of Growth, g (cont.)

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Pros and Cons of the Dividend Growth Model Approach

While dividend growth model is easy to use, it is severely dependent upon the quality of growth rate estimates. Furthermore, not all firms pay dividends.

The Capital Asset Pricing Model

CAPM was used in chapter 8 to determine the expected or required rate of return for risky investments.

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The Capital Asset Pricing Model (cont.)

Equation 4-4 illustrates that the expected return on common stock is determined by three key ingredients:
The risk-free rate of interest, The beta or systematic risk of the common stock returns, and The market risk premium.

Advantages of the CAPM approach

1. The model is simple to understand and use. 2. The model does not depend on dividends or growth rate so it can be applied to companies that do not currently pay dividends or are not expected to experience a constant rate of growth in dividends.
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Disadvantages of the CAPM Approach

1. CAPM does not offer any guidance on the appropriate choice for the risk-free rate. Risk-free rate may vary widely depending on the Treasury security chosen. 2. Estimates of beta can vary widely depending upon the market index and time period chosen. 3. Estimates of market risk premium will also vary depending on the time period and security chosen.
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Checkpoint 4.3
Estimating the Cost of Common Equity for Pearson plc using the CAPM A review of current market conditions at the end of March 2009 reveals that the 10-year U.S. Treasury Bond yield that we will use to measure the risk-free rate was 2.81%, the estimated market risk premium is 6.5%, and the beta for Pearsons common stock is 1.20. Determine Pearsons cost of common equity using the CAPM, as of March 2009.

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Checkpoint 4.3

Checkpoint 4.3

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Checkpoint 4.3: Check Yourself

Prepare two additional estimates of Pearsons cost of common equity using the CAPM where you use the most extreme values of each of the three factors that drive the CAPM.

Step 1: Picture the Problem

CAPM describes the relationship between the expected rates of return on risky assets in terms of their systematic risk. Its value depends on:
The risk-free rate of interest, The beta or systematic risk of the common stock returns, and The market risk premium.

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Step 1: Picture the Problem

However, there can be wide variation in the estimates for each one of these variables. Here we are given the following estimates:
The risk-free rate of interest (.03% or 3.73%) The beta or systematic risk of the common stock returns (1 or 1.5) The market risk premium (4% or 8%)

Step 1: Picture the Problem (cont.)

The cost of equity can be estimated using the CAPM equation:

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Step 1: Picture the Problem (cont.)

The cost of equity is given by Risk-free rate + (Risk premium Beta) :

Step 2: Decide on a Solution Strategy

Since we have been given the estimates for market factors (risk-free rate and risk premium) and firm-specific factor (beta), we can determine the cost of equity using CAPM.

Risk-Free Rate

Risk Premium Beta

Cost of Equity

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Step 3: Solve

Step 4: Analyze
Pearsons cost of equity is shown to be sensitive to the estimates used for riskfree rate of interest, beta and market risk premium.

kcs = 0.03 + 1(4) = 4.03% kcs = 3.73 + 1.5(8) = 15.73%

Based on the estimates used, the cost of common equity ranges from 4.03% to 15.73%.

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Summing Up Calculating the Firms WACC

The final step is to calculate the firms overall cost of capital by taking the weighted average of the firms financing mix that we evaluated in Steps One and Two.

4.4 Summing Up Calculating the Firms WACC

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Summing Up Calculating the Firms WACC (cont.)

When estimating the firms WACC, following issues should be kept in mind:
Determine weights based on market value rather than book value. Use market based opportunity costs rather than historical rates (such as coupon rates). Use forward looking weights and opportunity costs.

4.5 Estimating Project Cost of Capital

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Estimating Project Cost of Capital

Should the firms WACC be used to evaluate all new investments?
In theory, it is appropriate only if the risk of the new project is equal to the overall risk of the firm. This may generally not be the case necessitating the need for a unique cost of capital for each project.

Estimating Project Cost of Capital (cont.)

However, a recent survey found that more than 50% of the firms tend to use single, company-wide discount rate to evaluate all of their investment proposals. There are advantages and costs associated with estimating a unique discount rate for each project.

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The Rationale for Using Multiple Discount Rates

Multiple discount rates is consistent with finance theory that suggests that unique discount rate will reflect the unique risk of the investment. Figure 4-6 illustrates the problems that arise when a single discount rate is used to evaluate investment projects with different levels of risk.
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Why Dont Firms Typically Use Project Cost of Capital?

1. It may be difficult to trace the source of financing for individual project since most firms raise money in bulk for all the projects. 2. It adds to the time and cost in getting approval for new projects.

Estimating Divisional WACCs

If a firm undertakes investment with very different risk characteristics, it will try to estimate divisional WACCs. The divisions are generally defined by geographical regions (e.g., Asian region versus European region) or industry.

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Estimating Divisional WACCs (cont.)

Advantages of a divisional WACC:
The discount rate reflects the risk of projects evaluated by different divisions. It requires estimating only one cost of capital estimate for the entire division (rather than one for each project). It limits managerial latitude and the attendant influence costs.

Using Pure Play Firms to Estimate Divisional WACCs

Here a firm with multiple divisions may identify a comparable firm with only one division (called a pure play firm). The estimate of pure play firms cost of capital can then be used as a proxy for that particular divisions cost of capital.

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Divisional WACC Estimation Issues and Limitations

While divisional WACC is an improvement over a single, company-wide WACC, it has a number of limitations:
1. The sample of firms in a given industry may include firms that are not good matches for the firm or one of its divisions. 2. The division being analyzed may not have a capital structure that is similar to the sample of firms in the industry data.

Divisional WACC Estimation Issues and Limitations (cont.)

3. The firms in the chosen industry that are used to proxy for divisional risk may not be good reflections of project risk. 4. Good comparison firms for a particular division may be difficult to find.

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4.6 Floatation Costs and Project NPV

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WACC, Floatation Costs and Project NPV

Floatation costs are costs incurred by a firm when it raises money to finance new investments by selling bonds and stocks. For example, these costs may include fees paid to an investment banker, and costs incurred when securities are sold at a discount to the current market price.

WACC, Floatation Costs and Project NPV (cont.)

Because of floatation costs, the firm will have to raise more than the amount it needs.

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WACC, Floatation Costs and Project NPV (cont.)

Example 4.3 If a firm needs $100 million to finance its new project and the floatation cost is expected to be 5.5%, how much should the firm raise by selling securities?

WACC, Floatation Costs and Project NPV (cont.)

= $100 million (1-.055) = $105.82 million Thus the firm will raise $105.82 million, which includes floatation cost of $5.82 million.

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Checkpoint 4.4
Incorporating Flotation Costs into the Calculation of NPV
The Tricon Telecom Company is considering a $100 million investment that would allow it to develop fiber optic high-speed Internet connectivity to its 2 million subscribers. The investment will be financed using the firms desired mix of debt and equity with 40% debt financing and 60% common equity financing. The firms investment banker advised the firms CFO that the issue costs associated with debt would be 2% while the equity issue costs would be 10%. Tricon uses a 10% cost of capital to evaluate its telecom investments and has estimated that the new fiber optic project will yield future cash flows valued at $115 million. However, to this point no consideration has been given to the effect of the costs of raising the financing for the project or flotation costs. Should the firm go forward with the investment in light of the flotation costs?
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Checkpoint 4.4

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Checkpoint 4.4

Checkpoint 4.4

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Checkpoint 4.4: Check Yourself Before Tricon could finalize the financing for the new project, stock market conditions changed such that new stock became more expensive to issue. In fact, floatation costs rose to 15% of new equity issued and the cost of debt rose to 3%. Is the project still viable (assuming the present value of future cash flows remain unchanged)?

Step 1: Picture the Problem

The NPV will be equal to the present value of the future cash flows less the initial outlay and floatation costs. NPV
= PV(inflows) Initial outlay Floatation costs

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Step 1: Picture the Problem (cont.)

Step 2: Decide on a Solution Strategy

We need to first estimate the average floatation costs that Tricon will incur when raising the funds. This can be done using equation 4-5.

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Step 2: Decide on a Solution Strategy (cont.)

Next, the grossed-up investment outlay can be estimated using equation 4-6 and subtracted from the present value of the expected future cash flows to determine whether the project has a positive NPV.

Step 3: Solve
We can use equation 4-5 to estimate the weighted average floatation cost as follows:

= .40 .03 + .60 .15 = .102 or 10.2%

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Step 3: Solve (cont.)

The grossed up initial outlay for $100 million project can be estimated using equation 4-6:

Step 3: Solve (cont.)

NPV = $115 million - $111.36 million = $3.64 million

= $100 million (1- 0.102) = $111.36 million Thus, floatation costs is equal to $11.36 million.

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Step 4: Analyze
The project is feasible even after consideration of higher floatation costs as the NPV is positive at $3.64 million. However, the problem illustrates that floatation costs can be significant and cannot be ignored while evaluating projects.

Key Terms
Cost of capital Cost of debt Cost of preferred equity Cost of common equity Divisional WACC Floatation costs Weighted Average Cost of Capital

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