The cost of equity capital

When a firm has extra-cash, it can:

pay dividends
invest in a project

Suppose the shareholder can reinvest the

dividend in a financial asset (stock/bond) with the
same risk as that of the project. Which
alternative will he prefer?
He will desire the alternative with the highest
expected return.
The project should be undertaken only if its
expected return is at least as great or greater than
that of a financial asset of comparable risk!

The discount rate of a project (cost of equity

capital) should be the expected return on a
financial asset of comparable risk
1

The cost of equity capital

Under the CAPM, the expected return on the
stock is:

ri rf i (rM rf )

It means that if an all-equity firm is seeking to

value a risky project, the required return on the
project (the cost of equity capital (rE), can be
estimated from the CAPM.
Ex. Apha is an all-equity firm with beta=1.21. The
market risk premium is 9.5% and the risk-free
rate is 5%. Determine the cost of equity capital.

rAlpha r f Alpha (rM r f )

rAlpha rE 5% 1.21(9.5%) 16.495%

2

The cost of equity capital

Suppose that Alpha is evaluating the following
projects, with each one costing initially 100$.
All projects are assumed to have the same risk as
the firm
Project

beta

Expected
CF next
year

NPV when CFs are

discounted at
16.495%

Accept or reject

1.21

140$

20.2$

Accept

1.21

120$

3$

Accept

1.21

110$

-5.6$

Reject

NPVA 100

140
20.2$
1.16495
T

NPV C0
t 1

Ct
(1 r ) t
3

Cost of equity capital for projects

If the risk of a project differs from that of the
firm, the project should be discounted at the
rate commensurate with its own beta.
The use of a firms cost of capital in discounting
all the projects might lead to incorrect capital
budgeting decisions
Projects with a high risk must be discounted at a
high rate. By using the firms cost of capital, the
firm is likely to accept too many high-risk projects
Projects with a low risk must be discounted at a
low rate. By using the firms cost of capital, the
firm is likely to reject too many low-risk projects

If the project has an identical risk to that of the

firms in the same industry, use the industry beta
or make a slight adjustment.
4

Determinants of beta
Beta is determined by the characteristics of the
firm:
Cyclical nature of revenues
Operating leverage
Financial leverage

Cyclicality of revenues:
If firms sales are largerly dependent on the
market cycle, beta will be high.

Operating leverage:
It is defined as

EBIT sales

EBIT sales

Determinants of beta
Financial leverage:
It is the extent to which a firm relies on debt
Since a levered firm must make interest payments
regardless of its sales, financial leverage is the firms fixed
cost of finance

If a firm has a capital structure with both debt and

equity and an investor owns the entire firm, we can
debt asset beta:equity
calculate
the
asset
debt
equity
debt equity
debt equity
If we assume
equity that the beta of debt is zero, we have:
asset
equity
debt equity

asset equity
Because equity/(debt+equity)
for a levered firm is below
1, it follows that

equity asset (1

debt
)
equity

Determinants of beta
Ex. Rapid C. is currently all equity and has a asset
beta of 0.8. It has decided to move to a capital
structure of debt (1) and equity (2). Since the firm is
staying in the same industry, its asset beta keeps
0.8. Assuming a zero beta for debt, which is its equity
beta?
1

equity 0.8(1 ) 1.2

2

What happens if it decides a capital structure of debt

(1) and equity (1)?

equity 0.8(1 1) 1.6

The effect of leverage is to increase the equity beta.

7

Weighted average cost of capital

Suppose a firm uses both debt and equity to finance its
investments.
The cost of capital is a weighted average of both the
cost of equity and the cost of debt

rWACC

E
D
rE
rD
ED
ED

Since interest on debt is tax-deductible:

rWACC

E
D
rE
rD (1 Tc )
ED
ED
Cost of debt after
corporate tax

Weighted average cost of capital

Ex. A firm with debt=40mln$ and equity=60mln$(3mln
outstanding shares, price per share=20$). The firm
pays a 15% interest rate on its debt. Firms beta=1.41.
Corporate tax rate is 34%. Assume that SML holds, the
risk premium is 9.5% and the Treasury bill rate is 11%.
What is the company rWACC?
The after tax cost of debt is (1-0.34)*0.15=9.9%
rThe
rcost
of(requity
r ) capital:
E

rE 11% 1.41(9.5%) 24.40%

The proportions of debt and equity are respectively 40%
and 60%

rWACC

40
60

9.9%
24.40% 18.60%
100
100

Weighted average cost of capital

Ex. A firm has both a target and a current debt/equity
ratio=0.6. The cost of debt is 15.5% and the cost of
equity is 20%. The corporate tax rate is 34%. What is
the company rWACC?
Debt to value ratio=6/(6+10)=0.375
Equity to value ratio=10/(6+10)=0.625

rWACC 0.625 20% 0.375 15.15% (1 0.34) 16.25%

Suppose the firm is considering taking an investment
of50mln$ that is expected to yield CFs of 12mln$ a year
for 6 years. Will the firm accept the project? No!
NPV 50

12
12
..
6.07$
(1 rWACC )
(1 rWACC ) 6

10