6-1

The Cost of Capital

nCost of Capital Components

lDebt
lPreferred
lCommon Equity
nWACC

6-2

What types of long-term capital do

firms use?
nLong-term debt
nPreferred stock
nCommon equity

6-3

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 capital.

6-4

Should we focus on before-tax or

after-tax capital costs?
nTax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
nMost firms incorporate tax effects in
the cost of capital. Therefore, focus
on after-tax costs.
nOnly cost of debt is affected.

6-5

Should we focus on historical

(embedded) costs or 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.

6-6

Cost of Debt
nMethod 1: Ask an investment banker
what the coupon rate would be on
new debt.
nMethod 2: Find the bond rating for
the company and use the yield on
other bonds with a similar rating.
nMethod 3: Find the yield on the
companys debt, if it has any.

6-7

Component Cost of Debt

nInterest is tax deductible, so the
after tax (AT) cost of debt is:
rd AT = rd BT(1 - T)
= 10%(1 - 0.40) = 6%.
nUse nominal rate.
nFlotation costs small, so ignore.

6-8

Whats the cost of preferred stock?

PP = $113.10; 10%Q; Par = $100; F = $2.
Use this formula:
rps =

D ps
Pn

0.1 ($100 )
$113.10 $2.00

$10
= 0.090 = 9.0%.
$111.10

6-9

Picture of Preferred
0

rps = ?

-111.1

...
2.50

$111.10 =

rPer =

2
2.50

DQ
rPer

2.50

$2.50
.
rPer

$2.50
= 2.25%; rps ( Nom ) = 2.25%(4) = 9%.
$111.10

6 - 10

Note:
nFlotation costs for preferred are
significant, so are reflected. Use
net price.
nPreferred dividends are not
deductible, so no tax adjustment.
Just rps.
nNominal rps is used.

6 - 11

Is preferred stock more or less risky to

investors than debt?
nMore risky; company not required to
pay preferred dividend.
nHowever, 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.

6 - 12

Why is yield on preferred lower than rd?

nCorporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
nTherefore, preferred often has a lower
B-T yield than the B-T yield on debt.
nThe 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.

6 - 13

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%

6 - 14

What are the two ways that companies

can raise common equity?
nDirectly, by issuing new shares of
common stock.
nIndirectly, by reinvesting earnings
that are not paid out as dividends
(i.e., retaining earnings).

6 - 15

Why is there a cost for reinvested

earnings?
nEarnings can be reinvested or paid
out as dividends.
nInvestors could buy other securities,
earn a return.
nThus, there is an opportunity cost if
earnings are reinvested.

6 - 16

nOpportunity cost: The return

stockholders could earn on
alternative investments of equal
risk.
nThey 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 equity.

6 - 17

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-Risk
Premium:
rs = rd + RP.

6 - 18

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%.

6 - 19

Issues in Using CAPM

nMost analysts use the rate on a longterm (10 to 20 years) government
bond as an estimate of rRF. For a
current estimate, go to
www.bloomberg.com, select U.S.
Treasuries from the section on the
left under the heading Market.

More

6 - 20

Issues in Using CAPM (Continued)

nMost analysts use a rate of 5% to 6.5%
for the market risk premium (RPM)
nEstimates of beta vary, and estimates
are noisy (they have a wide
confidence interval). For an estimate
of beta, go to www.bloomberg.com
and enter the ticker symbol for STOCK
QUOTES.

6 - 21

Whats the DCF cost of equity, rs?

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

rs =

D (1 + g )
D1
+g = 0
+g
P0
P0
=

$4.19(105
. )
+ 0.05
$50

= 0.088 + 0.05
= 13.8%.

6 - 22

Estimating the Growth Rate

n Use the historical growth rate if you
believe the future will be like the past.
n Obtain analysts estimates: Google
Finance, Bloomberg, Yahoo! Finance.
n Use the earnings retention model,
illustrated on next slide.

6 - 23

Suppose the company has been

earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout
= 65%), and this situation is
expected to continue.
Whats the expected future g?

6 - 24

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% with
retention ratio = 0. What is g of
account balance? If retention ratio is
100%, what is g?

6 - 25

Could DCF methodology be applied

if g is not constant?

nYES, nonconstant g stocks are

expected to have constant g at
some point, generally in 5 to 10
years.

6 - 26

Find rs using the own-bond-yieldplus-risk-premium method.

(rd = 10%, RP = 4%.)
rs = rd + RP
= 10.0% + 4.0% = 14.0%
n This RP CAPM RPM.
n Produces ballpark estimate of rs.
Useful check.

6 - 27

Whats a reasonable final estimate

of rs?
Method
CAPM
DCF
rd + RP
Average

Estimate
14.2%
13.8%
14.0%
14.0%

6 - 28

Determining the Weights for the WACC

nThe weights are the percentages of
the firm that will be financed by each
component.
nIf possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital.

6 - 29

Estimating Weights for the

Capital Structure
nIf you dont know the targets, it is
better to estimate the weights using
current market values than current
book values.
nIf you dont know the market value of
debt, then it is usually reasonable to
use the book values of debt,
especially if the debt is short-term.
(More...)

6 - 30

Estimating Weights (Continued)

nSuppose 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...)

6 - 31

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

nVps = $25 million.
nVd = $75 million.
nTotal value = $150 + $25 + $75 = $250
million.
nwce = $150/$250 = 0.6
nwps = $25/$250 = 0.1
nwd = $75/$250 = 0.3

6 - 32

Whats the WACC?

WACC = wdrd(1 - T) + wpsrps + wcers

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.

6 - 33

WACC Estimates for Some Large

U. S. Corporations
Company
General Electric (GE)
Coca-Cola (KO)
Intel (INTC)
Motorola (MOT)
Wal-Mart (WMT)
Walt Disney (DIS)
AT&T (T)
Exxon Mobil (XOM)
H.J. Heinz (HNZ)
BellSouth (BLS)

WACC
12.5
12.3
12.2
11.7
11.0
9.3
9.2
8.2
7.8
7.4

6 - 34

What factors influence a companys

WACC?
nMarket conditions, especially interest
rates and tax rates.
nThe firms capital structure and
dividend policy.
nThe firms investment policy. Firms
with riskier projects generally have a
higher WACC.

6 - 35

Should the company use the

composite WACC as the hurdle rate for
each of its divisions?
nNO! The composite WACC reflects the
risk of an average project undertaken
by the firm.
nDifferent divisions may have different
risks. The divisions WACC should be
adjusted to reflect the divisions risk
and capital structure.

6 - 36

What procedures are used to determine

the risk-adjusted cost of capital for a
particular division?
nEstimate the cost of capital that
the division would have if it were a
stand-alone firm.
nThis requires estimating the
divisions beta, cost of debt, and
capital structure.

6 - 37

Methods for Estimating Beta for a

Division or a Project
1. Pure play. Find several publicly
traded companies exclusively in
projects business.
Use average of their betas as
proxy for projects beta.
Hard to find such companies.

6 - 38

2. Consolidated method: Use the

same beta as the rest of firm.
Simple and time-saving approach,
although can be an inaccurate
assessment of project risk.
3. Accounting beta: No longer
popular and may result in widely
misleading calculations.

6 - 39

Find the divisions market risk and cost

of capital based on the CAPM, given
these inputs:
nTarget debt ratio = 10%.
nrd = 12%.
nrRF = 7%.
nTax rate = 40%.
nbetaDivision = 1.7.
nMarket risk premium = 6%.

6 - 40

nBeta = 1.7, so division has more market

risk than average.
nDivisions 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%.

6 - 41

How does the divisions WACC

compare with the firms overall WACC?
nDivision WACC = 16.2% versus
company WACC = 11.1%.
nTypical projects within this division
would be accepted if their returns are
above 16.2%.

6 - 42

Divisional Risk and the Cost of Capital

R a te o f R e tu r n
(% )

A c c e p t a n c e R e g io n
W ACC

W AC C H

H
R e je c t i o n R e g i o n

A
W AC C A
B
W AC C L

R is k L

R is k A

R isk H

R is k

6 - 43

What are the three types of project

risk?

nStand-alone risk
nCorporate risk
nMarket risk

6 - 44

How is each type of risk used?

nStand-alone risk is easiest to
calculate.
nMarket risk is theoretically best in
most situations.
nHowever, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
nTherefore, corporate risk is also
relevant.

6 - 45

A Project-Specific, Risk-Adjusted
Cost of Capital
nStart by calculating a divisional cost
of capital.
nEstimate the risk of the project using
the techniques in Chapter 8.
nUse judgment to scale up or down
the cost of capital for an individual
project relative to the divisional cost
of capital.

6 - 46

Why is the cost of internal equity from

reinvested earnings cheaper than the
cost of issuing new common stock?
1. When a company issues new
common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.

6 - 47

Estimate the cost of new common

equity: P0=$50, D0=$4.19, g=5%, and
F=15%.

D0 (1 + g)
+g
P0 (1 F )
$4.19(1.05 )
=
+ 5.0%
$50(1 0.15 )

re =

$4.40
+ 5.0% = 15.4%.
$42.50

6 - 48

Estimate the cost of new 30-year debt:

Par=$1,000, Coupon=10%paid annually,
and F=2%.
nUsing a financial calculator:
lN = 30
lPV = 1000(1-.02) = 980
lPMT = -(.10)(1000)(1-.4) = -60
lFV = -1000
nSolving for I: 6.15%

6 - 49

Comments about flotation costs:

nFlotation costs depend on the risk of
the firm and the type of capital being
raised.
nThe flotation costs are highest for
common equity. However, since
most firms issue equity infrequently,
the per-project cost is fairly small.
nWe will frequently ignore flotation
costs when calculating the WACC.

6 - 50

Four Mistakes to Avoid

1. When estimating the cost of debt,
dont use the coupon rate on existing
debt. Use the current interest rate on
new debt.
2. When estimating the risk premium for
the CAPM approach, dont subtract
the current long-term T-bond rate from
the historical average return on
(More ...)
common stocks.

6 - 51

For example, if the historical rM has

been about 12.7% and inflation
drives the current rRF up to 10%, the
current market risk premium is not
12.7% - 10% = 2.7%!

(More ...)

6 - 52

3. Dont use book weights to estimate

the weights for the capital structure.
Use the target capital structure to determine
the weights.
If you dont know the target weights, then
use the current market value of equity, and
never the book value of equity.
If you dont know the market value of debt,
then the book value of debt often is a
reasonable approximation, especially for
short-term debt.
(More...)

6 - 53

4. Always remember that 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 the cash flows of the
project, but not when calculating the
WACC.