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CHAPTER 10
The Cost of Capital

Cost of capital components Accounting for flotation costs WACC Adjusting cost of capital for risk Estimating project risk
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What types of capital do firms use?

Debt Preferred stock Common equity: Retained earnings New common stock

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Should we focus on before-tax or after-tax capital costs?

Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e., use A-T costs in WACC. Only kd needs adjustment.

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Should we focus on historical (embedded) costs or new (marginal) costs?

The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on todays marginal costs (for WACC).

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A 15-year, 12% semiannual bond sells for $1,153.72. Whats kd?

0 i=? 1 60 2 30

...
60 60 + 1,000

-1,153.72

INPUTS OUTPUT

30
N I/YR

-1153.72 60
PV PMT

1000
FV

5.0% x 2 = kd = 10%
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Component Cost of Debt

Interest is tax deductible, so kd AT = kd BT(1 T) = 10%(1 0.40) = 6%. Use nominal rate. Flotation costs small. Ignore.
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Whats the cost of preferred stock? Pp = $111.10; 10%Q; Par = $100. Use this formula:
Dp $10 kp 0.090 9.0%. Pp $111.10

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Picture of Preferred Stock

0 -111.1

kp = ?

1 2.50

...
2.50

2.50

DQ $2.50 $111.10 = = . kPer kPer

$2.50 kPer = = 2.25%; $111.10 kp(Nom) = 2.25%(4) = 9%.
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Note: Preferred dividends are not tax deductible, so no tax adjustment. Just kp. Nominal kp is used. Our calculation ignores flotation costs.

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Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.
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Why is yield on preferred lower than kd? 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 an investor, and the A-T cost to the issuer, are higher on preferred than on debt. Consistent with higher risk of preferred.
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Example: kp = 9% kd = 10% T = 40% kp, AT = kp kp (1 0.7)(T) = 9% 9%(0.3)(0.4) = kd, AT = 10% 10%(0.4) =

7.92%.
6.00%.

A-T Risk Premium on Preferred = 1.92%.

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Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are retained.
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Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn ks, or company could repurchase its own stock and earn ks. So, ks is the cost of retained earnings.
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Three ways to determine cost of common equity, ks:

1. CAPM: ks = kRF + (kM kRF)b.

2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP.

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Whats the cost of common equity based on the CAPM? kRF = 7%, RPM = 6%, b = 1.2.

ks = kRF + (kM kRF )b. = 7.0% + (6.0%)1.2 = 14.2%.

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Whats the DCF cost of common equity, ks? Given: D0 = $4.19; P0 = $50; g = 5%.

D1 D0(1 + g) ks = +g= +g P0 P0
$4.19(1.05) = + 0.05 $50 = 0.088 + 0.05 = 13.8%.
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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?

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Retention growth rate:

g = (1 Payout)(ROE) = 0.35(15%) = 5.25%. Here (1 Payout) = Fraction retained. Close to g = 5% given earlier. Think of bank account paying 10% with payout = 100%, payout = 0%, and payout = 50%. Whats g?
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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.
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Find ks using the own-bond-yield-plusrisk-premium method. (kd = 10%, RP = 4%.)

ks = kd + RP
= 10.0% + 4.0% = 14.0% This RP CAPM RP. Produces ballpark estimate of ks. Useful check.
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Whats a reasonable final estimate of ks? Method CAPM Estimate 14.2%

DCF
kd + RP

13.8%
14.0%

Average
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14.0%
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Why is the cost of retained 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.
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Two approaches that can be used to account for flotation costs:

Include the flotation costs as part of the projects up-front cost. This reduces the projects estimated return. Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.
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New common, F = 15%:

D0 (1 g) ke g P0 (1 F)
$4.191.05 5 .0 % $501 0.15 $4.40 5.0% 15.4%. $42.50
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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.
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Whats the firms WACC (ignoring flotation costs)?

WACC = wdkd(1 T) + wpkp + wcks

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

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What factors influence a companys composite WACC? Market conditions. The firms capital structure and dividend policy. The firms investment policy. Firms with riskier projects generally have a higher WACC.
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WACC Estimates for Some Large U. S. Corporations, Nov. 1999

Company Intel General Electric Motorola Coca-Cola Walt Disney AT&T Wal-Mart Exxon H. J. Heinz BellSouth
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WACC 12.9% 11.9 11.3 11.2 10.0 9.8 9.8 8.8 8.5 8.2
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Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the hurdle rate for a typical project with average risk. Different projects have different risks. The projects WACC should be adjusted to reflect the projects risk.
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Risk and the Cost of Capital

Rate of Return (%)
Acceptance Region W ACC 12.0 10.5 10.0 9.5 8.0 L A B H Rejection Region

Risk L

Risk A

Risk H

Risk

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Divisional Cost of Capital

Rate of Return (%)
13.0 Division Hs WACC WACC

11.0 10.0 9.0 7.0 Project L Composite WACC for Firm A

Project H

Division Ls WACC

RiskL

Risk Average

RiskH

Risk

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What are the three types of project risk?

Stand-alone risk Corporate risk Market risk

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How is each type of risk used? 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.
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What procedures are used to determine the risk-adjusted cost of capital for a particular project or division? Subjective adjustments to the firms composite WACC. Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the projects beta.
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Methods for Estimating a Projects Beta

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.
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2. Accounting beta. Run regression between projects ROA and S&P index ROA. Accounting betas are correlated (0.5 0.6) with market betas. But normally cant get data on new projects ROAs before the capital budgeting decision has been made.

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Find the divisions market risk and cost of capital based on the CAPM, given these inputs: Target debt ratio = 40%. kd = 12%. kRF = 7%. Tax rate = 40%. betaDivision = 1.7. Market risk premium = 6%.
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Beta = 1.7, so division has more market risk than average. Divisions required return on equity:
ks = kRF + (kM kRF)bDiv. = 7% + (6%)1.7 = 17.2%.

WACCDiv. = wdkd(1 T) + wcks = 0.4(12%)(0.6) + 0.6(17.2%) = 13.2%.

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How does the divisions market risk compare with the firms overall market risk? Division WACC = 13.2% versus company WACC = 11.1%. Indicates that the divisions market risk is greater than firms average project. Typical projects within this division would be accepted if their returns are above 13.2%.
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