Chapte

r 14

Cost of Capital

14-1

Chapter Outline
The Cost of Capital Overview
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Flotation Costs relative to WACC
14-2

Why the Cost of

Capital
Is Important
1. We know that the return
earned on assets depends on
the risk of those assets
2. The return to an investor is the
same as the cost to the
company

14-3

Capital
Is Important
3. The cost of capital provides us
with an indication of how the
market views the risk of firms
assets
4. Knowing the cost of capital
can also help determine the
required return for capital
budgeting projects
14-4

The Cost of Equity

There are two major methods for
determining the cost of equity:

1. Dividend growth
model (aka: the
Gordon Model)
14-5

2.

SML, or the

The Dividend Growth

Model
(The Gordon Model)
Start with the dividend growth
model formula and rearrange to
solve for RE

D1
P0
RE g

D1
RE
g
P0
14-6

Dividend Growth
Model Example
Suppose that your company is
expected to pay a dividend of $1.50
per share next year.
There has been a steady growth in
dividends of 5.1% per year and the
market expects that to continue. The
current price is $25.

RE
14-7

1.50 is the cost of equity?

What

.051 .111 11.1%

25

Example: Estimating
the Dividend Growth
Rate
One method for estimating the growth rate is
to use the historical average:
Year Dividend Percent Change
2005 1.23
2006 1.30
(1.30 1.23) / 1.23
2007 1.36
(1.36 1.30) / 1.30
2008 1.43
(1.43 1.36) / 1.36
2009 1.50
(1.50 1.43) / 1.43

14-8

=
=
=
=

5.69%
4.62%
5.15%
4.90%

Average = (5.7 + 4.6 + 5.1 + 4.9) /

4 = 5.087%

Advantages and
Disadvantages of the
Dividend Growth Model
Advantage: Disadvantages:
Easy to
understan
d and use

14-9

Only applicable to
companies currently
paying dividends
Not applicable if
dividends arent
growing at a
reasonably constant
rate
Extremely sensitive to
the estimated growth
rate an increase in g

The SML Approach

Use the following
information to compute
our cost of equity:
Risk-free rate, Rf
Market risk premium, E(RM)
Rf

(
E
(
R
)

R
)
E
f
E
M
f
Systematic risk of asset,
14-10

Example - SML
Suppose your company has:
an equity beta of .58
the current risk-free rate is
6.1%
What
the expected
market
riskusing
is the cost
of equity
premium
is 8.6% technique?
the
SML valuation

RE = 6.1 + .58(8.6) = 11.1%

14-11

How Did We Do?

Since we came up
with similar
numbers using
both the dividend
growth model
(11.1%) and the
SML approach
(11.1%), we should
feel good about our

14-12

Advantages and
Disadvantages of
SML
Advantages:
Explicitly
adjusts for
systematic risk
Applicable to
all companies,
as long as we
can estimate
beta
14-13

Disadvantages:
Have to estimate
the expected
market risk
premium, which
does vary over time
Have to estimate
beta, which also
varies over time
Have to use the
past to predict the

Example Cost of
Equity
Our company has a beta of 1.5.
The market risk premium is expected to be
9%, and the current risk-free rate is 6%.
We have used analysts estimates to
determine that the market believes our
dividends will grow at 6% per year and our
last dividend was $2.
Our stock is currently selling for $15.65.

What is our cost of equity using the

SML?

14-14

RE = 6% + 1.5(9%) =
19.5%

Example Cost of
Equity
Our company has a beta of 1.5.
The market risk premium is expected to be
9%, and the current risk-free rate is 6%.
We have used analysts estimates to
determine that the market believes our
dividends will grow at 6% per year and our
last dividend was $2.
Our stock is currently selling for $15.65.

What is our cost of equity using the

DGM?

14-15

RE= [2(1.06) / 15.65] + .06 =

19.55%

Cost of Debt
The cost of debt is the
required return on our
companys debt
We usually focus on the cost
of long-term debt or bonds
(as opposed to short-term
debt like notes payable)
14-16

Cost of Debt
The required return is best
estimated by computing the
yield-to-maturity on the
existing long-term debt (the
YTM).

14-17

Example: Cost of
Debt: computing the
YTM
Suppose we have a corporate bond
issue currently outstanding that has
25 years left to maturity.
The coupon rate is 9%, and coupons
are paid semiannually.
The bond is currently selling at
90.872% of Par.

14-18

What is the cost of

debt?
YTM = 10%

Cost of Preferred
Stock
Preferred stock is a
perpetuity, so we take
the perpetuity
formula:
and then rearrange the
terms to solve for RP

P0 =
Rps
14-19

D_

Rps =
P0

D_

Example: Cost of
Preferred Stock
Your company has
preferred stock that has
an annual dividend of
$3.00
The current price is $25
What is the cost of preferred
stock?

RP = 3/25 = 12%

14-20

Capital Structure
Weights
To compute the
WACC, we first
need the weights
of each source of
funds: namely
debt, preferred
stock and equity

14-21

Capital Structure
Weights
Lets simplify with
an example of just
debt and equity.
We often use the
market value of
both debt and
equity
14-22

Capital Structure
Valuation
Debts Market Value = (# of
outstanding bonds ) x (the
market price of one bond)
Equitys Market Value = (#
shares of outstanding common
stock) x (the market price of one
share of common stock)
14-23

Capital Structure
Valuation
A firms market value is
simply the added value of
both the debt and the equity:

V=D + E

14-24

Capital Structure
Weights
WD = D/V
This is the % financed with debt
WE = E/V
This is the % financed with
equity
W D + WE = 1

14-25

Remember D/E = (D/V)/(E/V)

If D/E = 1.5, then

Student Alert!
The capital structure
weights must always add up
to 100%
WD + WPS + WE = 100%
If no preferred stocks, then
WPS =0, hence,
WD + WE = 100%
14-26

Example: Capital
Structure Weights
Suppose you have a market value
of equity equal to $500 million and
a market value of debt equal to
$475 million.
What are the capital structure
weights?
V = $500 million + $475 million =
$975 million
wD = D/V = 475 / 975 = .4872 =
48.72%
w
= E/V = 500 / 975 = .5128 =
E

14-27

51.28%

Taxes and the WACC

Wait a minute!
Debt and Equity
are not equal in
the eyes of the
firm.

14-28

Debt gets a tax

advantage and
Equity does not.

Taxes and the WACC

Interest expense reduces
our tax liability
This reduction in taxes
reduces our cost of debt
Thus, our real cost of debt
is actually the AFTER-TAX
cost of debt or
After-tax cost of debt = RD(1TC)
14-29

Taxes and the WACC

Our new equation for the
WACC is:
WACC
= WDRD(1-TC) +WE RE +

W
This
is one of the most
Ps RPs

powerful relationships in
finance.

If no Preferred shares, then

14-30

WACC = WDRD(1-TC) +WE

RE

Together WACC
Example

14-31

Equity
Information:
o 50 million
shares
o $80 per share
o Beta = 1.15
o Market risk
premium =
9%
o Risk-free rate
The firms tax
= 5%

Debt Information:
o Outstanding debt
in the form of
bonds with a face
value = $1 bn.
o Current quote =
110
o Coupon rate = 9%,
o Semiannual
coupons
rate is 40%
o 15 years to

WACC Example
1. What is the cost of debt? AT-Cost of
Debt?
If YTM (RD ) = 7.85%
After-tax cost of debt = RD(1 TC)=
7.854%(1 - .40) = 4.712%

2. What is the cost of equity (using the

CAPM)?
RE = 5% + 1.15(9%) =
15.35%
14-32

WACC Example
3. What are the capital structure
weights?
VDebt = 1 billion ($1.10) = $1.1
billion
VEquity = 50 million ($80) = $4
billion
Value of the Firm = 4 + 1.1 =
$5.1 billion
14-33

WACC Example (Plug

and Chug)
4. Compute the Weighted Average
Cost of Capital (the WACC)
WACC = WDRD(1-TC) + WE RE
WACC = 0.2157 x (4.712%) + 0.7843
(15.35%)

= 13.06%
14-34

Flotation Costs
Flotation costs are the
fees paid to issue stocks or
bonds
While the required return
for a project depends on
the risk, it should not
depend upon how the
money is raised
14-35

However, the cost of

issuing new securities

Flotation Costs
However, the cost of
issuing new securities
should not just be ignored
either.
The Basic Approach:
1. Compute the weighted
average flotation cost (fA)
2.
14-36

Use the target weights

because the firm will

Flotation Costs: An NPV

Example
Your company is considering a project
that will cost $1 million.
The project will generate after-tax cash
flows of $250,000 per year for 7 years.
The WACC is 15%, and the firms target
D/E ratio is .6
The flotation cost for equity is 5%, and
the flotation cost for debt is 3%.
14-37

Flotation Costs: An NPV

Example
What is the NPV for the project
before adjusting for flotation costs?
WACC = 15%
PV of future cash flows =
$1,040,105
NPV = 1,040,105 - 1,000,000
= $ 40,105

14-38

Flotation Costs: An NPV

Example
What is the NPV for the project
after adjusting for flotation costs?
D DE
fA = (.375)(3%) + (.625)(5%) =
V
(1 DE)
4.25%

PV of future cash flows =

1,040,105

1 D
(1 E)

NPV = 1,040,105 - 1,000,000/

The
(1-.0425)
= would have a positive
project
$ -4,281
NPV
of $40,105 without considering

flotation costs

14-39

Once we consider the cost of

Formulas
Cost of Equity (Dividend
Growth Model)
D1
P0

RE g

D1
RE
g
P0

Cost of Equity (CAPM)

RE R f E ( E ( RM ) R f )
14-40

Formulas
Cost of (continued)
Preferred Stock
Rps =

D_
P0

Cost of Debt
(approximation
Annual
Coupon
Par Price
n
rB

14-41

Par Price
2

After-tax cost of debt =

RD(1-TC)
WACC = WDRD(1-TC) +WE RE +
WPs RPs

Key Concepts and

Skills
Be able to compute a
firms cost of equity
using the CAPM and the
Dividend Growth model
Be able to compute a
firms after-tax cost of
debt
14-42

Key Concepts and

Skills
Know how to
compute the WACC
of a firm
Identify the
consequences to the
WACC of considering
floatation costs
14-43

What are the most

important topics of this
chapter?

14-44

1. There are two ways to compute the

cost of equity: DGM and CAPM.
2. The relevant cost of debt to a firm is
the after-tax cost.
3. Capital structure determines the
weights of debt, preferred stock and
equity used by the firm.
4. The WACC determines the discount
rate to be used for capital
budgeting purposes for NPV, IRR .
5. 5. All projects may not have the
identical risk classification and we
may need to adjust the WACC
accordingly.