1

CHAPTER 12
Cost of Capital
2
Topics in Chapter
Cost of Capital Components
Debt
Equity
WACC
WACC used in Capital
Budgeting
The weighted average cost of capital
(WACC) is the discount rate used in
capital budgeting to value projects (e.g.
WACC used in finding NPV).
( )
.
1
0
t
t
n
t
WACC
CF
NPV
+
=

=
NPV: Sum of the PVs of inflows and
outflows
Cost is CF
0
and is often negative.
What is Project Ls NPV?
10 80 60
0 1 2 3
WACC=10%
Project L:
-100
9.09
49.59
60.11
118.78 = PV of inflows
118.78 - 100 = 18.78 = NPV
L
Calculator Solution
If there are a finite number of cash
flows, then enter the values into the
financial calculator the same way as for
uneven cash flow problems, except put
the initial cash flow as the negative
initial outlay value.

Infinite # of Cash Flows
If there are an infinite number of cash
flows (such as in a constant growth
perpetuity), then you cannot use the
financial calculator. Find PV the other
ways that you learned and subtract off
the cost. After all, remember that
NPV = PV inflows Cost.


Rationale for the NPV Method
NPV = PV inflows - Cost

Accept project if NPV > 0;
Reject project if NPV < 0.

Internal Rate of Return: IRR
0 1 2 3
CF
0
CF
1
CF
2
CF
3
Cost Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
( )
.
1
0
NPV
WACC
CF
t
t
n
t
=
+

=
( ) t
n
t
t
CF
IRR =

+
=
0 1
0.
NPV: Enter WACC; solve for NPV.
IRR: Enter NPV = 0; solve for IRR.
Calculator Solution
Enter the cash flow values into the
financial calculators cash flow register;
then press IRR, CPT.
What is Project Ls IRR?
10 80 60
0 1 2 3
IRR = ?
-100.00
PV
3
PV
2
PV
1
0 = NPV
IRR
L
= 18.13%.
Rationale for the IRR Method
If IRR > WACC, then the projects
rate of return is greater than its
cost, and some return is left over to
boost stockholders returns --
ACCEPT.
If IRR < WACC, then REJECT.

Project L: WACC=10%, IRR=18.13%;
Profitable (accept)
Weighted Average Cost of
Capital (WACC)
Weighted Averages and the Overall
Cost of Capital
Weighted Average Cost of Capital (WACC)
Market-Value Balance Sheet
Market Value of Equity + Market Value of Debt =
Market Value of Assets
15
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 market
weights for the percentages of the firm that
will be financed with the various types of
capital.
The weights make up a firms capital
structure.
Example: Calculating the
Weights in the WACC
Problem:
Suppose ABC Corp. has debt with a book (face) value
of $100 million trading at 80% of face value. It also
has a book equity of $100 million and 10 million
shares of common stock trading at $30 per share.
What weights should ABC use in calculating its
WACC?
Example: Calculating the
Weights in the WACC
Solution:
The weights are the fractions of ABC financed with debt
and financed with equity. Furthermore, these weights
should be based on market values, because the cost
of capital is based on investors current assessment
of the value of the firm, not their assessment of
accounting-based book values. As a consequence, we
can ignore the book values of debt and equity.
Example: Calculating the
Weights in the WACC
Execute:
100 million dollars in debt trading at 80% of face
value is $80 million in market value. 10 million shares
of stock at $30 per share is $300 million in market
value. So, the total value of the firm is $380 million.
The weights are
80 380 = 21.1% for debt and 300 380 = 78.9%
for equity.
Example: Calculating the
Weights in the WACC
Evaluate:
When calculating its overall cost of capital, ABC will
use a weighted average of the cost of its debt capital
and the cost of its equity capital, giving a weight of
21.1% to its cost of debt and a weight of 78.9% to
its cost of equity.
20
What are ways in which companies
can calculate stock return (r
s
)?
CAPM (Capital Asset Pricing Model)
CDGM (Constant Dividend Growth
Model)
21
CAPM
Cost of Equity: r
RF
= 7%, MRP = 6%, | = 1.2.






cost
s
= r
s
= r
RF
+ |(r
M
- r
RF
)
= 7.0% + 1.2 (6.0%) = 14.2%
CDGM:
Stock Value = PV of Dividends
What is a constant growth stock?
One whose dividends are expected to
grow forever at a constant rate g
V
s
=
(1+r
s
)
1
(1+r
s
)
2
(1+r
s
)
3
(1+r
s
)

D
1
D
2
D
3
D

+
+ ++
For a constant growth stock:
D
1
= D
0
(1+g)
1
D
2
= D
0
(1+g)
2
D
t
= D
0
(1+g)
t
If g is constant and less than r
s
, then:
V
s
=
D
0
(1+g)
r
s
- g
=
D
1
r
s
- g
Projected Dividends
D
0
= 2 and constant g = 6%

D
1
= D
0
(1+g) = 2(1.06) = 2.12
D
2
= D
1
(1+g) = 2.12(1.06) = 2.2472
D
3
= D
2
(1+g) = 2.2472(1.06) = 2.3820
Valuation based on an infinite number
of dividends
Expected Dividends and PVs
(r
s
= 13%, D
1
= $2.12, g = 6%)
0 1
2.2472
2
2.3820
3
r
s
=13%,
g=6%
1.8761
1.7599
1.6508
13
%
2.12
Intrinsic Stock Value:
D
1
= 2.12, r
s
= 13%, g = 6%
Constant growth model:
= = $30.29.
0.13 - 0.06
$2.12 $2.12
0.07
V
s
=
D
0
(1+g)
r
s
- g
=
D
1
r
s
- g
Rearrange model to rate of
return form:
Then, r
s
= $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%

= 13%
V
s
=
D
1
r
s
- g
to
D
1
P
0
r
s =
+ g
28
Another example of
r
s
: V
s
=$50, D
0
=$4.19, g=5%
r
s
=

D
0
(1 + g)
V
s

+ g
=
$4.19(1.05)
$50
+ 5.0%
=
$4.40
$50
+ 5.0% = 13.8%
CDGM
g
V
g D
g
V
D
r
s s
s
+
+
= + =
) 1 (
0 1
Using CDGM for Market Return
A fundamental approach
Using historical data has two drawbacks:
Standard errors of the estimates are large.
Its backward looking, so it may not represent
current expectations.
One alternative is to solve for the discount rate
that is consistent with the current level of the
market index using CDGM for the market index to
get the market return.

g
V
D
r
s
M
+ =
1
CAPM
Then use r
M
to find the market risk
premium (r
M
-r
RF
), which is used in
CAPM:

cost
s
= r
s
= r
RF
+ |(r
M
- r
RF
)

31
Leverage
Weighted Average Cost of Capital
Calculations
Leverage
Unlevered (no debt)
Levered (debt)
12.5 A Projects Cost of Capital
(contd)
Asset (unlevered) beta

,

where
E
= equity beta and

D
= debt beta



U E D
E D
= +
E+D E+D
34
Cost of Debt
Method 1: Find the yield on the
companys debt if it has any.
Method 2: Find the bond rating for the
company and use the yield on other
bonds with a similar rating. (This is
especially used for companies that are
not publicly traded.)
Before-tax vs. After-tax Capital
Costs
Focus on after-tax costs.
Only cost of debt is affected.
Key Features of a Bond
1. Par value: Face amount; paid
at maturity; assume $1,000

2. Coupon interest rate: Multiply
by par value to get dollars of
periodic payments (INT);
generally fixed

(More)
3. Maturity: Time until bond
must be repaid

Financial Asset Valuation
( ) ( ) ( )
PV =
CF
1 + r
. . . +
CF
1 + r
1 n
1
2
2
1
CF
r
n
0 1 2 n
r
CF
1
CF
n
CF
2
Value
...
+ +
+
Whats the value of a 10-year,
10% coupon bond if r
d
= 10%?
( ) ( )
V
r
b
d
=
$100 $1 , 000
1
1 10 10
. . .
+
$100
1 + r
d
100 100
0 1 2 10
10%
100 + 1,000 V = ?
...
= $90.91 + . . . + $38.55 + $385.54
= $1,000.
+ +
+
1 r +
( ) d
10 10 100 1000
N I/YR PV PMT FV
-1,000
The bond consists of a 10-year, 10%
annuity of $100/year plus a $1,000 lump
sum at t = 10:
$ 614.46
385.54
$1,000.00
PV annuity
PV maturity value
Value of bond
=
=
=
INPUTS
OUTPUT
Value of a Bond
n
d D
n
D
b
r
value f ace
r
r
INT V
) 1 (
) 1 (
1
1
+
+
|
|
|
|
.
|

\
|
+

=
Whats yield to maturity?
YTM is the rate of return earned on a
bond held to maturity.
Whats the YTM on a 10-year,
9% annual coupon, $1,000 par
value bond that sells for $887?
90 90 90
0 1 9 10
r
d
=?
1,000
PV
1

.
.
.
PV
10

PV
M
887 Find r
d
that works!
...
10 -887 90 1000
N I/YR PV PMT FV
10.91
( ) ( ) ( )
V
INT
r
M
r
B
d
N
d
N
=
1 1
1
...
+
INT
1 + r
d
( ) ( ) ( )
887
90
1
1 000
1
1 10 10
=
r r
d d

+
90
1 + r
d
,
Find r
d
+ +
+ +
+ +
+ +
INPUTS
OUTPUT
...
Semiannual Bonds
1. Multiply years by 2 to get periods = 2n.
2. Divide nominal rate by 2 to get periodic
rate = r
d
/2.
3. Divide annual coupon rate (%) by 2
(times face value) to get PMT.
2n r
d
/2 OK CRx1K/2 OK
N I/YR PV PMT FV

INPUTS
OUTPUT
46
A 15-year, 12% semiannual bond
sells for $1,153.72. Whats r
d
(YTM)?
60 60 + 1,000 60
0 1 2 30
r
D
= ?
-1,153.72
...
30 -1153.72 60 1000

5.0% x 2 = r
d
= 10%
N I/YR PV FV PMT
INPUTS
OUTPUT
Par Bond
If the value of a bond is the par (face
value), then you can see from doing the
calculation that the coupon rate = YTM.
Basically, if V
b
= par value, then
coupon rate = YTM.
The bond in this particular case is called a
PAR BOND.
48
Cost of Debt
Interest is tax deductible, so the after-
tax (effective) cost of debt is

cost
d
= r
d
(1 - T)

Therefore, from previous example,
cost
d
= 10%(1 - 0.40) = 6%.
Use nominal rate.
49
Whats the WACC?



WACC = w
s
cost
s
+ w
d
cost
d


50
What factors influence a
companys WACC?
Market conditions, especially interest
rates and tax rates
The firms capital structure and dividend
policy
The firms investment policy; firms with
riskier projects generally have a higher
WACC.
51
Is the firms 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 divisions WACC should be
adjusted to reflect the divisions risk
and capital structure.
52
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 divisions
beta, cost of debt, and capital structure.
53
Divisional Cost of Capital
Using CAPM
Target debt ratio = 10%
r
d
= 12%
r
RF
= 7%
Tax rate = 40%
|
Division
= 1.7
Market risk premium = 6%
No preferred stock
54
Divisional Cost of Capital
Using CAPM (Continued)
Divisions required return on equity:
r
s
= r
RF
+ |
Div
(r
M
r
RF
)

r
s
= 7% + 1.7 (6%) = 17.2%
WACC
Div.
= w
d
r
d
(1 T) + w
s
r
s
= 0.1(12%)(1-0.4) + 0.9(17.2%)
= 16.2%
55
Divisions WACC vs. Firms Overall
WACC?
Division WACC = 16.2% versus
company WACC = 11.1%.
Typical projects within this division
would be accepted if their returns are
above 16.2%.
56
Mistakes to Avoid
Mixing current and historical measures
to estimate the market risk premium
Using non-target capital structure
Incorrect cost of capital components

(More ...)
Market Risk Premium
Do not mix the historical market return
and the current risk-free return when
calculating the market risk premium.
58
Estimating Weights
Use the target capital structure to
determine the weights.

59
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 capital.