5 - Cost of Capital

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e

Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-1
Chapter 5
Cost of Capital
18-2
18.1 The Cost of Capital: Some Preliminaries
18.2 The Cost of Equity
18.3 The Costs of Debt and Preference Shares
18.4 The Weighted Average Cost of Capital
18.5 Divisional and Project Costs of Capital
18.6 Flotation Costs and the Weighted Average Cost
of Capital
18.7 Summary and Conclusions
Chapter Organisation
18-3
The Cost of Capital: Preliminaries
Vocabularythe following all mean the same thing:
required return
appropriate discount rate
cost of capital.
The cost of capital is an opportunity costit depends on
where the money goes, not where it comes from.
The assumption is made that a firms capital structure is
fixeda firms cost of capital then reflects both the cost of
debt and the cost of equity.
18-4
Chapter Objectives
Apply the dividend growth model approach and the SML
approach to determine the cost of equity.
Estimate values for the costs of debt and preference shares.
Calculate the WACC.
Discuss alternative approaches to estimating a discount rate.
Understand the effects of flotation costs on WACC and the
NPV of a project.
18-5
Cost of Equity
The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm.
There are two major methods for determining the
cost of equity:
Dividend growth model
SML or CAPM.
18-6
The Dividend Growth Model
Approach
According to the constant growth model:

Rearranging:

g R
g D
P
E

) (1

0
0
+
=
g
P
D
R
E

0
1
+ =
18-7
ExampleCost of Equity Capital:
Dividend Approach
Reno Co. recently paid a dividend of 15 cents per
share. This dividend is expected to grow at a rate
of 3 per cent per year into perpetuity. The current
market price of Renos shares is $3.20 per share.
Determine the cost of equity capital for Reno Co.
( )
7.8% or 0.078
0.03
$3.20
1.03 $0.15

=
+ =
E
R
18-8
Estimating g
( )
9.025%
/4 7.62 10.53 7.95 10.00 rate growth Average
=
+ + + =
One method for estimating the growth rate is to use the historical
average.
18-9
The Dividend Growth Model
Approach

Advantages
Easy to use and understand.

Disadvantages
Only applicable to companies paying dividends.
Assumes dividend growth is constant.
Cost of equity is very sensitive to growth estimate.
Ignores risk.
18-10
The SML Approach
Required return on a risky investment is dependent on three
factors:

the risk-free rate, R
f
the market risk premium, E(R
M
) R
f
the systematic risk of the asset relative to the average, |
| |
f M E f E
R R R R + = |
18-11
SML Approach
Obtain the risk-free rate (R
f
) from financial press
many use the 1-year Treasury note rate, say, 6 per cent.
Obtain estimates of market risk premium and security beta:
historical risk premium = 7.94 per cent (Officer, 1989)
betahistorical
investment information services
estimate from historical data
Assume the beta is 1.40.
18-12
SML Approach (continued)
| |
( )
% .
% . . %
R R R R
f M E f E
12 17
94 7 40 1 6
=
+ =
| + =
18-13
The SML Approach
Advantages
Adjusts for risk.
Accounts for companies that dont have a constant dividend.

Disadvantages
Requires two factors to be estimated: the market risk
premium and the beta co-efficient.
Uses the past to predict the future, which may not be
appropriate.
18-14
The Cost of Debt

The cost of debt, R
D
, is the interest rate on new borrowing.

R
D
is observable:
yields on currently outstanding debt
yields on newly-issued similarly-rated bonds.

The historic cost of debt is irrelevantwhy?
18-15
ExampleCost of Debt
Ishta Co. sold a 20-year, 12 per cent bond 10 years
ago at par. The bond is currently priced at $86.
What is our cost of debt?
( )
( )
( )
( )
14.4%
/2 $86 $100
/10 $86 $100 $12

/2 NP PV
/ NP PV

=
+
+
=
+
+
=
n I
R
D
The yield to maturity is 14.4 per cent, so this is used
as the cost of debt, not 12 per cent.
18-16
The Cost of Preference Shares
Preference shares pay a constant dividend every period.
Preference shares are a perpetuity, so the cost is:

Notice that the cost is simply the dividend yield.
0

P
D
R
p
=
18-17
ExampleCost of Preference Shares

An $8 preference share issue was sold 10 years ago. It sells
for $120 per share today.

The dividend yield today is $8.00/$120 = 6.67 per cent, so
this is the cost of the preference share issue.
18-18
The Weighted Average Cost of Capital
Let: E = the market value of equity = no.
of outstanding shares share
price
D = the market value of debt = no. of
outstanding bonds price
Then: V = E + D
So: E/V + D/V = 100%
That is: The firms capital structure weights
are E/V and D/V.
18-19
The Weighted Average Cost of
Capital
Interest payments on debt are tax deductible, so the after-tax
cost of debt is:

Dividends on preference shares and ordinary shares are not
tax-deductible so tax does not affect their costs.
The weighted average cost of capital is therefore:
( )
C D
T R 1 debt of cost tax - After =
() () ( )
C D E
T R
V
D
R
V
E
1 WACC + =
18-20
ExampleWeighted Average Cost of
Capital
Zeus Ltd has 78.26 million ordinary shares on
issue with a book value of $22.40 per share and a
current market price of $58 per share. The
market value of equity is therefore $4.54 billion.
Zeus has an estimated beta of 0.90. Treasury
bills currently yield 4.5 per cent and the market
risk premium is assumed to be 7.94 per cent.
Company tax is 30 per cent.
18-21
ExampleWeighted Average Cost of
Capital (continued)
The firm has four debt issues outstanding:
18-22
ExampleCost of Equity
(SML Approach)
| |
( )
% .
% . . % .
R R R R
f M E f E
65 11
94 7 90 0 5 4
=
+ =
| + =
18-23
ExampleCost of Debt
The weighted average cost of debt is 7.15 per cent.
18-24
ExampleCapital Structure Weights
Market value of equity = 78.26 million $58 = $4.539 billion.
Market value of debt = $1.474 billion.
( ) ( )
9.32% or 0.0932
0.30 1 0.0715 0.245 0.1165 0.755 WACC
75.5% or 0.755
$6.013b
$4.539b

24.5% or 0.245
$6.013b
$1.474b

billion $6.013 billion $1.474 billion $4.539
=
+ =
= =
= =
= + =
V
E
V
D
V
18-25
WACC

The WACC for a firm reflects the risk and the target capital
structure to finance the firms existing assets as a whole.

WACC is the return that the firm must earn on its existing
assets to maintain the value of its shares.

WACC is the appropriate discount rate to use for cash flows
that are similar in risk to the firm.
18-26
Divisional and Project Costs of
Capital

When is the WACC the appropriate discount rate?
When the projects risk is about the same as the firms
risk.

Other approaches to estimating a discount rate:
divisional cost of capitalused if a company has more
than one division with different levels of risk
pure play approacha WACC that is unique to a
particular project is used
subjective approachprojects are allocated to specific
risk classes which, in turn, have specified WACCs.
18-27
The SML and the WACC
Expected
return (%)
Beta
SML
WACC = 15%
= 8%
Incorrect
acceptance
Incorrect
rejection
B
A
16
15
14
R
f
=7
A
= .60
firm
= 1.0
B
= 1.2
If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a
tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky
projects.
18-28
ExampleUsing WACC for all
Projects
What would happen if we use the WACC for all
projects regardless of risk?
Assume the WACC = 15 per cent

Project Required Return IRR Decision
A 15% 14% Reject
B 15% 16% Accept

Project A should be accepted because its risk is low (Beta =
0.60), whereas Project B should be rejected because its risk
is high (Beta = 1.2).
18-29
The SML and the Subjective
Approach
Expected
return (%)
Beta
SML
20
WACC = 14
10
R
f
= 7
Low risk
(4%)
Moderate risk
(+0%)
High risk
(+6%) A
With the subjective approach, the firm places projects into one of several risk classes. The discount
rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk)
an adjustment factor to or from the firms WACC.
= 8%
18-30
Flotation Costs
The issue of debt or equity may incur flotation costs such as
underwriting fees, commissions, listing fees.

Flotation costs are relevant expenses and need to be
reflected in any analysis.
D E A
f
V
D
f
V
E
f + =
18-31
ExampleProject Cost including
Flotation Costs
Saddle Co. Ltd has a target capital structure of 70
per cent equity and 30 per cent debt. The
flotation costs for equity issues are 15 per cent of
the amount raised and the flotation costs for debt
issues are 7 per cent. If Saddle Co. Ltd needs
$30 million for a new project, what is the true
cost of this project?
( )( )
12.6%
0.07 0.30 0.15 0.70
=
+ =
A
f
The weighted average flotation cost is 12.6 per
cent.
18-32
ExampleProject Cost including
Flotation Costs (continued)
( )
( )
million $34.32
0.126 1
$30m
project of cost True
million $30 costs flotation ignoring cost Project
=
=
=
18-33
ExampleFlotation Costs and NPV
Apollo Co. Ltd needs $1.5 million to finance a new project
expected to generate annual after-tax cash flows of $195 800
forever. The company has a target capital structure of 60 per
cent equity and 40 per cent debt. The financing options
available are:
An issue of new ordinary shares. Flotation costs of equity
are 12 per cent of capital raised. The return on new
equity is 15 per cent.
An issue of long-term debentures. Flotation costs of debt
are 5 per cent of the capital raised. The return on new
debt is 10 per cent.

Assume a corporate tax rate of 30 per cent.
18-34
ExampleNPV (No Flotation Costs)
( ) ( )
322 $159
000 500 $1
0.118
800 $195
NPV
11.8% or 0.118
0.30 1 0.1 0.4 15% 0.6 WACC
=
=
=
+ =
18-35
ExampleNPV (With Flotation Costs)
( ) ( )
( )
$7340
982 651 $1 -
0.118
800 $195
NPV
982 651 $1
0.092 1
000 500 $1
cost True
9.2% or 0.092
0.05 0.4 0.12 0.6
=
=
=
=
=
+ =
A
f
Flotation costs decrease a projects NPV and
could alter an investment decision.

5 - Cost of Capital

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Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Fundamentals of Corporate Finance 3e

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