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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
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
1. Dividend growth
model (aka: the
Gordon Model)
14-5
2.
SML, or the
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
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%
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
(
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
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.
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.
14-15
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
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
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%
14-28
W
This
is one of the most
Ps RPs
powerful relationships in
finance.
14-30
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%
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
= 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
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
14-38
1 D
(1 E)
flotation costs
14-39
Formulas
Cost of Equity (Dividend
Growth Model)
D1
P0
RE g
D1
RE
g
P0
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
14-44