1

CHAPTER 9
Cost of Capital
2
Topics in Chapter
Cost of capital components
Debt
Preferred stock
Common equity
WACC
Factors that affect WACC
Adjusting cost of capital for risk
COST OF CAPITAL
Why?
Key to understanding cost
of raising $
Risk
Financing costs
Discount Rate
Business Application
Min Reqd return needed
on Project
Reflects blended costs of
raising capital
Relevant i
Discount rate used to
determine Projects NPV
or to disct FCFs by
Hurdle rate

3
Value = + + +
FCF
1
FCF
2
FCF

(1 + WACC)
1
(1 + WACC)

(1 + WACC)
2
Free cash flow
(FCF)
Market interest rates
Firms business risk
Market risk aversion
Firms debt/equity mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital

=
Determinants of Intrinsic Value:
The Weighted Average Cost of Capital
5
What types of long-term
capital do firms use?
Long-term debt
Preferred stock
Common equity
6
Capital Components
Cap. components are sources of funding that
come from investors.
A/P, accruals, and deferred taxes are not
sources of funding that come from investors,
& not included in the calculation of the cost of
capital.
These items are adjusted for when calculating
project cash flows, not when calculating the
cost of capital.

7
Before-tax vs. After-tax Capital
Costs
Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
Most firms incorporate tax effects in the
cost of capital. Therefore, focus on
after-tax costs.
Only cost of debt is affected.
8
Historical (Embedded) Costs
vs. New (Marginal) Costs
The cost of capital is used primarily to
make decisions which involve raising
and investing new capital. So, focus on
marginal (incremental) costs.

COST of CAPITAL
Raising $ & its Costs
Debt
Cost of Borrowing
Interest Rate
Equity
Internal
RE

External
Common Stock
Prfd Stock


9
Cost of Capital
Raising $ & its Costs
Debt & Equity


Cost Return
Int. pd. Int. recd.
Divids pd. Divids Recd
10
EQUITIES
Why?
Key to understanding
valuations
What is investment worth
today?
Value of:
Enterprise
Entity
Company/Firm
Business Application
For Investor:
Determine value of
asset/business/company

For Firm:
Determine cost of
attracting investors &
raising equity capital
Selling ownership stake to
raise $
11
Weighted Average Cost of
Capital (WACC)
WACC: Blended cost or raising capital
considering mix of debt & equity
WACC = (Wt of Debt)(After-tax cost of
Debt) + Wt of Eqty)(Cost of Eqty) +
(Wt of Prfd)(Cost of Prfd)
12
Cost of Equity
Know: = P
0
= D
1
/ (r
s
g)

So then: r
s
= D
1
/P
0
+ g
13
Cost of Equity
Cost of External Equity: Function of Dvids,
growth, & net proceeds after adjusting for
flotation costs

Cost of Internal Equity: Function of opp.
Costs of divids not pd out but retained in firm
to grow internally (no flot. reqd)
14
Cost of Preferred Stock
r = D
1
/P
0
+ g
g= 0, so cost of prfd = function of
divids pd. & flot cost to issue
15
16
Determining Cost of Debt
Method 1: Ask an investment banker
what coupon rate would be on new
debt.
Method 2: Find bond rating for the
company and use yield on similarly
rated bonds.
Method 3: Find yield on the companys
existing debt.
17
Current vs. Historical Cost of
Debt
For cost of debt, dont use coupon rate
on existing debt, which represents cost
of past debt.
Use the current interest rate on new
debt (think YTM).
(More)
18
A 15-year, 13.25% semiannual bond sells
for $1,250. Tax = 40%. 60,000 Bonds
o/s. Whats r
d
?
-66.25 <66.25 + 1,000> -66.25
0 1 2 30
r
d
= ?
1,250.00
...
30 1250 -66.25 -1000

5.0% x 2 = r
d
= 10%
N I/YR PV FV PMT
INPUTS
OUTPUT
19
Component Cost of Debt
Interest is tax deductible, so the after
tax (AT) cost of debt is:
r
d
AT = r
d
BT(1 T)
r
d
AT = 10%(1 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.
20
Cost of preferred stock: P
ps
= $125;
10.26% Div; Par = $100; F = 8.8%
Use :
r
ps
=
D
ps
P
ps
(1 F)
=
.0126($100)
$125.00(1 0.088)
=
$10.26
$114.
= 0.090 = 9.0%
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Time Line of Preferred
10.26
10.26
10.26
0 1 2

r
ps
= ?
-114.
...
$114.00 =
D
Q
r
Per
=
$10.26

r
Per
r
Per
=

$10.26

$114.00
= 9%
22
Note:
Flotation costs for preferred are
significant, so are reflected. Use net
price.
Preferred dividends are not deductible,
so no tax adjustment. Just r
ps
.
Nominal r
ps
is used.
23
Is preferred stock more or less
risky to investors than debt?
More risky; company not required to
pay preferred dividend.
However, 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.
24
Why is yield on preferred
lower than r
d
?
Corporations own most preferred stock,
because 70% of prfd divids nontaxable to
corps.
T/4, prfd often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost to the
issuer are higher on prfd than on debt, which
is consistent w/ higher risk of prfd.
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Example:
r
ps
= 9%, r
d
= 10%, T = 40%
r
ps, AT
= r
ps
r
ps
(1 0.7)(T)
= 9% 9%(0.3)(0.4) = 7.92%
r
d, AT
= 10% 10%(0.4) = 6.00%
A-T Risk Premium on Preferred = 1.92%
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What are the two ways that
companies can raise common equity?
Directly, by issuing new shares of
common stock.
Indirectly, by reinvesting earnings that
are not paid out as dividends (i.e.,
retaining earnings).
27
Why is there a cost for
reinvested earnings?
Earnings can be reinvested or paid out
as dividends.
Investors could buy other securities,
earning a return.
Thus, there is an opportunity cost if
earnings are reinvested.
28
Cost for Reinvested Earnings
(Continued)
Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
They could buy similar stocks and earn
r
s
, or company could repurchase its own
stock and earn r
s
. So, r
s
, is cost of
reinvested earnings and is cost of
common equity.
29
Three ways to determine
the cost of equity, r
s
:
1. CAPM: r
s
= r
RF
+ (r
M
r
RF
)b
= r
RF
+ (RP
M
)b.
2. DCF: r
s
= D
1
/P
0
+ g.
3. Own-Bond-Yield-Plus-Judgmental-
Risk Premium: r
s
= r
d
+ Bond RP.
Equity Cost Components
Risk free = 5.6%
Mrkt Risk Prem = 6%
Beta = 1.2
Div today = $3.12
Price today = $50
Growth = 5.8%
Cost of Debt = 10%
Risk prem = 3.2%
3,000,000 shs outstanding
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CAPM Cost of Equity: r
RF
= 5.6%,
RP
M
= 6%, b = 1.2
r
s
= r
RF
+ (RP
M
)b
= 5.6% + (6.0%)1.2 = 12.8%.
32
Issues in Using CAPM
Most analysts use the rate on a
long-term (10 to 20 years)
government bond as an estimate
of r
RF
.
Can use Bloomberg.com to obtain
US Treasuries Quotes
(More)
33
Issues in Using CAPM
(Continued)
Most analysts use a rate of 3.5% to
6% for the market risk premium
(RP
M
)
Estimates of beta vary, and
estimates are noisy (they have a
wide confidence interval).

34
DCF Cost of Equity, r
s
:
D
0
= $3.12; P
0
= $50; g = 5.8%
r
s
=
D
1
P
0
+ g =
D
0
(1 + g)
P
0
+ g
=
$3.12(1.058)
$50
+ 0.058
= 6.6% + 5.8%
= 12.4%
35
Estimating the Growth Rate
Use historical growth rate if believe
future be like past.
Obtain analysts estimates: Value Line,
Zacks, Yahoo!Finance.
Use earnings retention model.
36
Earnings Retention Model
Suppose company has been earning
15% on equity (ROE = 15%) and
been paying out 62% of its earnings.
If expected to continue as is, whats
the expected future g?
37
Earnings Retention Model
(Continued)
Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 Payout rate)(ROE)
g = (1 0.62)(15%) = 5.7%.

Close to g = 5.8% given earlier.
38
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.
39
The Own-Bond-Yield-Plus-Judgmental-Risk-
Premium Method: r
d
= 10%, RP = 3.2%
r
s
= r
d
+ Judgmental risk premium
r
s
= 10.0% + 3.2% = 13.2%

This over-own-bond-judgmental-risk
premium CAPM equity risk premium,
RP
M
.
Produces ballpark estimate of r
s
.
Useful check.

40
Final estimate of r
s
?
Method Estimate
CAPM 12.8%
DCF 12.4%
Bond Yld + risk prem
13.2%
Average 12.8%
41
Determining Weights for WACC
Wts are % of firms capital to be
financed by each component.
If possible, always use the target wts
for % financed by each type of
capital.
42
Estimating Weights for the
Capital Structure
If dont know targets, better to estimate
wts using current market values than
current book values.
If dont know MV of debt, then
reasonable to use BV of debt, especially
if S/T debt.
(More)
43
Estimating Weights
(Continued)
Suppose the common stock price is $50
with 3 million shares outstanding; the
firm has 200,000 shs of preferred stock
trading at $125; and 60,000 bonds
outstanding trading at quoted price of
125% of par.
(More)
44
Estimating Weights
(Continued)
V
s
= $50(3 million) = $150 million.
V
ps
= $25 million.
V
d
= $75 million.
Total value = $150 + $25 + $75
= $250 million.
45
Estimating Weights
(Continued)
w
s
= $150/$250 = 0.6
w
ps
= $25/$250 = 0.1
w
d
= $75/$250 = 0.3

Target wts for this co. are same as these MV
wts, but often MV wts temporarily deviate
from targets due to changes in stock prices.
46
Whats the WACC using the
target weights?
WACC = w
d
r
d
(1 T) + w
ps
r
ps
+ w
s
r
s

WACC = 0.3(10%)(1 0.4) + 0.1(9%)
+ 0.6(12.8%)

WACC = 10.38%
47
What factors influence a
companys WACC?
Uncontrollable factors:
Market conditions, especially interest rates.
The market risk premium.
Tax rates.
Controllable factors:
Capital structure policy.
Dividend policy.
Investment policy. Firms with riskier projects
generally have higher financing costs.
48
Should firm-wide WACC be
used for each of its divisions?
NO! Composite WACC reflects risk of
an average project undertaken by the
firm.
Different divisions may have different
risks. Divisions WACC should be
adjusted to reflect divisions risk and
cap structure.
49
The Risk-Adjusted Divisional
Cost of Capital
Estimate cost of capital division
would have if it were a stand-alone
firm.
This requires estimating divisions
beta, cost of debt, and capital
structure.
50
Pure Play Method for Estimating
Beta for a Division or a Project
Find several publicly traded companies
exclusively in projects business.
Use average of their betas as proxy for
projects beta.
Hard to find such companies.
51
Accounting Beta Method for
Estimating Beta
Run regression between projects
ROA and S&P Index ROA.
Accounting betas correlated (0.5
0.6) with market betas.
But normally cant get data on new
projects ROAs before capital
budgeting decision made.
52
Divisional Cost of Capital
Using CAPM
Target debt ratio = 10%.
r
d
= 12%.
r
RF
= 5.6%.
Tax rate = 40%.
beta
Division
= 1.7.
Market risk premium = 6%.
53
Divisional Cost of Capital
Using CAPM (Continued)
Divisions required return on equity:
r
s
= r
RF
+ (r
M
r
RF
)b
Div.
r
s
= 5.6% + (6%)1.7 = 15.8%.
WACC
Div.
= w
d
r
d
(1 T) + w
s
r
s
= 0.1(12%)(0.6) + 0.9(15.8%)
= 14.94% 14.9%
54
Divisions WACC vs. Firms Overall
WACC?
Division WACC = 14.9% versus
company WACC = 10.4%.
Typical projects within this division
would be accepted if its returns above
14.9%.
55
What are the three types of
project risk?
Stand-alone risk
Corporate risk
Market risk
56
How is each type of risk used?
Stand-alone risk easiest to calculate.
Market risk theoretically best in most
situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
A Project-Specific, Risk-Adjusted
Cost of Capital
Start by calculating a divisional cost of
capital.
Use judgment to scale up or down the
cost of capital for an individual project
relative to the divisional cost of capital.
57
Costs of Issuing New Common
Stock
When a company issues new common
stock they also have to pay flotation
costs to the underwriter.
Issuing new common stock may send a
negative signal to the capital markets,
which may depress stock price.
58
59
Cost of New Common Equity: P
0
= $50,
D
0
= $3.12, g = 5.8%, and F = 15%
r
e
=

D
0
(1 + g)
P
0
(1 F)
+ g
=
$3.12(1.058)
$50(1 0.15)
+ 5.8%
=
$3.30
$42.50
+ 5.8% = 13.6%
60
Cost of New 30-Year Debt: Par = $1,000,
Coupon = 10% paid annually, and F = 2%
Using a financial calculator:
N = 30
PV = 1,000(1 0.02) = 980
PMT = -(0.10)(1,000)(1 0.4) = -60
FV = -1,000
Solving for I/YR: 6.15%
61
Comments about flotation
costs:
Flot costs depend on risk of firm & type of
capital being raised.
Flot costs highest for common equity.
However, most firms issue equity
infrequently, the per-project cost is fairly
small.
We will frequently ignore flotation costs when
calculating the WACC.
62
Four Mistakes to Avoid
Current vs. historical cost of debt
Mixing current and historical measures
to estimate the market risk premium
Book weights vs. Market Weights
Incorrect cost of capital components

(More)
63
Current vs. Historical Cost of
Debt
When estimating the cost of debt, dont
use the coupon rate on existing debt,
which represents the cost of past debt.
Use the current interest rate on new
debt.
(More)
64
Estimating the Market Risk
Premium
When estimating the risk premium for the
CAPM approach, dont subtract the current
long-term T-bond rate from the historical
average return on common stocks.
For example, if the historical r
M
has been
about 12.2% and inflation drives the current
r
RF
up to 10%, the current market risk
premium is not 12.2% 10% = 2.2%!
(More)
65
Estimating Weights
Use target cap structure to determine wts.
If dont know target wts, use MV of equity.
If dont know MV of debt, then use BV of
debt.

(More)
66
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 project cash flows, but not when
calculating the WACC.