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CHAPTER 9
Determining the Cost of Capital

Debt
Preferred
Common Equity
WACC
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firms use?

Long-term debt
Preferred stock
Common equity
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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.
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Should we focus on before-tax or

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.
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Should we focus on historical

(embedded) costs or new (marginal)
costs?

The cost of capital is used primarily

to make decisions which involve
raising and investing new capital.
So, we should focus on marginal
costs.
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Cost of Debt

Method 1: Ask an investment banker

what the coupon rate would be on
new debt.
Method 2: Find the bond rating for
the company and use the yield on
other bonds with a similar rating.
Method 3: Find the yield on the
companys debt, if it has any.
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A 15-year, 12% semiannual bond sells

for \$1,153.72. Whats rd?

0 1 2 30
i=? ...
-1,153.72 60 60 60 + 1,000

INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5.0% x 2 = rd = 10%
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Interest is tax deductible, so the

after tax (AT) cost of debt is:
rd AT = rd BT(1 - T)
= 10%(1 - 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.
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Whats the cost of preferred stock?

PP = \$113.10; 10%Q; Par = \$100; F = \$2.

Use this formula:

D ps 0.1 \$100
rps
Pn \$113 .10 \$2.00

\$10
0.090 9.0%.
\$111 .10
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Picture of Preferred

0
rps = ?
1 2
...
-111.1 2.50 2.50 2.50

DQ \$2.50
\$111 .10 .
rPer rPer

\$2.50
rPer 2.25%; rps ( Nom ) 2.25%(4) 9%.
\$111 .10
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Note:

Flotation costs for preferred are

significant, so are reflected. Use
net price.
Preferred dividends are not
Just rps.
Nominal rps is used.
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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
stockholders may gain control of firm.
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Corporations own most preferred stock,

because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred 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 preferred than on
debt, which is consistent with the higher
risk of preferred.
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Example:

rps, AT = rps - rps (1 - 0.7)(T)

= 9% - 9%(0.3)(0.4) = 7.92%
rd, 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).
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earnings?

Earnings can be reinvested or paid

out as dividends.
earn a return.
Thus, there is an opportunity cost if
earnings are reinvested.
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Opportunity cost: The return

stockholders could earn on
alternative investments of equal
risk.
and earn rs, or company could
repurchase its own stock and
earn rs. So, rs, is the cost of
reinvested earnings and it is the
cost of equity.
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Three ways to determine the

cost of equity, rs:

1. CAPM: rs = rRF + (rM - rRF)b

= rRF + (RPM)b.

2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk

rs = rd + RP.
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Whats the cost of equity

based on the CAPM?
rRF = 7%, RPM = 6%, b = 1.2.

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Most analysts use the rate on a long-

term (10 to 20 years) government
bond as an estimate of rRF. For a
current estimate, go to
www.bloomberg.com, select U.S.
Treasuries from the section on the

More
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Most analysts use a rate of 5% to 6.5%

for the market risk premium (RPM)
Estimates of beta vary, and estimates
are noisy (they have a wide
confidence interval). For an estimate
of beta, go to www.bloomberg.com
and enter the ticker symbol for STOCK
QUOTES.
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Whats the DCF cost of equity, rs?

Given: D0 = \$4.19;P0 = \$50; g = 5%.

D1 D0 1 g
rs g g
P0 P0
\$4.19105
.
0.05
\$50
0.088 0.05

13.8%.
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Use the historical growth rate if you

believe the future will be like the
past.
Obtain analysts estimates: Value
Line, Zacks, Yahoo!.Finance.
Use the earnings retention model,
illustrated on next slide.
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Suppose the company has been

earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout
= 65%), and this situation is
expected to continue.

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Retention growth rate:

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier.

Think of bank account paying 15% with
retention ratio = 0. What is g of
account balance? If retention ratio is
100%, what is g?
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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.
But calculations get complicated.
See Ch 9 Tool Kit.xls.
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Find rs using the own-bond-yield-

(rd = 10%, RP = 4%.)

rs = rd + RP
= 10.0% + 4.0% = 14.0%
This RP CAPM RPM.
Produces ballpark estimate of rs.
Useful check.
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Whats a reasonable final estimate
of rs?

Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%
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The weights are the percentages of

the firm that will be financed by each
component.
If possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital.
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Estimating Weights for the
Capital Structure
If you dont know the targets, it is
better to estimate the weights using
current market values than current
book values.
If you dont know the market value of
debt, then it is usually reasonable to
use the book values of debt,
especially if the debt is short-term.
(More...)
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Suppose the stock price is \$50, there

are 3 million shares of stock, the firm
has \$25 million of preferred stock,
and \$75 million of debt.

(More...)
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Vce = \$50 (3 million) = \$150 million.

Vps = \$25 million.
Vd = \$75 million.
Total value = \$150 + \$25 + \$75 = \$250
million.
wce = \$150/\$250 = 0.6
wps = \$25/\$250 = 0.1
wd = \$75/\$250 = 0.3
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= 1.8% + 0.9% + 8.4% = 11.1%.

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WACC Estimates for Some Large
U. S. Corporations

Company WACC
General Electric (GE) 12.5
Coca-Cola (KO) 12.3
Intel (INTC) 12.2
Motorola (MOT) 11.7
Wal-Mart (WMT) 11.0
Walt Disney (DIS) 9.3
AT&T (T) 9.2
Exxon Mobil (XOM) 8.2
H.J. Heinz (HNZ) 7.8
BellSouth (BLS) 7.4
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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.
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Should the company use the
composite WACC as the hurdle rate 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.
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What procedures are used to determine
the risk-adjusted cost of capital for a
particular division?
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.
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Methods for Estimating Beta for a

Division or a Project

1. Pure play. Find several publicly

Use average of their betas as
proxy for projects beta.
Hard to find such companies.
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2. Accounting beta. Run regression

between projects ROA and S&P
index ROA.
Accounting betas are correlated
(0.5 0.6) with market betas.
But normally cant get data on new
projects ROAs before the capital
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Find the divisions market risk and cost
of capital based on the CAPM, given
these inputs:

rd = 12%.
rRF = 7%.
Tax rate = 40%.
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Beta = 1.7, so division has more market

risk than average.
Divisions required return on equity:
rs = rRF + (rM rRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdrd(1 T) + wcrs
= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.
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How does the divisions WACC

compare with the 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%.
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Divisional Risk and the Cost of Capital

Rate of Return
(%) Acceptance Region

WACC

WACCH H

A Rejection Region
WACCA
B
WACCL L

Risk
0 RiskL RiskA RiskH
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risk?

Stand-alone risk
Corporate risk
Market risk
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Stand-alone risk is easiest to

calculate.
Market risk is theoretically best in
most situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
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Cost of Capital
Start by calculating a divisional cost
of capital.
Estimate the risk of the project using
the techniques in Chapter 12.
Use judgment to scale up or down
the cost of capital for an individual
project relative to the divisional cost
of capital.
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Why is the cost of internal equity from
reinvested earnings cheaper than the
cost of issuing new common stock?

1. When a company issues new

common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.
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Estimate the cost of new common
equity: P0=\$50, D0=\$4.19, g=5%, and
F=15%.
D0 (1 g )
re g
P0 (1 F )
\$4.19 1.05
5 .0 %
\$50 1 0.15
\$4.40
5.0% 15.4%.
\$42.50
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Estimate the cost of new 30-year debt:
Par=\$1,000, Coupon=10%paid annually,
and F=2%.
Using a financial calculator:
N = 30
PV = 1000(1-.02) = 980
PMT = -(.10)(1000)(1-.4) = -60
FV = -1000
Solving for I: 6.15%
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Flotation costs depend on the risk of

the firm and the type of capital being
raised.
The flotation costs are highest for
common equity. However, since most
firms issue equity infrequently, the per-
project cost is fairly small.
We will frequently ignore flotation
costs when calculating the WACC.
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1. When estimating the cost of debt,

dont use the coupon rate on existing
debt. Use the current interest rate on
new debt.
2. When estimating the risk premium for
the CAPM approach, dont subtract
the current long-term T-bond rate from
the historical average return on
(More ...)
common stocks.
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For example, if the historical rM has

drives the current rRF up to 10%, the
current market risk premium is not
12.7% - 10% = 2.7%!

(More ...)
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3. Dont use book weights to estimate
the weights for the capital structure.
Use the target capital structure to determine
the weights.
If you dont know the target weights, then
use the current market value of equity, and
never the book value of equity.
If you dont know the market value of debt,
then the book value of debt often is a
reasonable approximation, especially for
short-term debt.
(More...)
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4. Always remember that 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 the cash flows of the
project, but not when calculating the
WACC.