CFF 310

10 - 1
CHAPTER 10
The Cost of Capital
Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
Copyright © 2002 by Harcourt, Inc. All rights reserved.

10 - 2
What sources of long-term capital do

firms use?
Long-Term
Capital
Long-Term Preferred Stock Common Stock

Debt
Retained New Common

Earnings Stock

10 - 3
How do you calculate the weighted

average cost of capital?
WACC = wdkd(1 – T) + wpkp + wcks.
The w’s refer to the capital structure

weights.
The k’s refer to the cost of each
component.
10 - 4
Should we focus on before-tax or

after-tax capital costs?
Stockholders focus on A-T CFs.

Therefore, we should focus on
A-T capital costs, i.e., use A-T
costs in WACC. Only kd needs
adjustment, because interest is
deductible.

10 - 5
Should we focus on historical

(embedded) costs or new (marginal)
costs?
The cost of capital is used primarily

to make decisions that involve
raising new capital. So, focus on
today’s marginal costs (for WACC).

10 - 6
How do you determine the weights?
Use accounting numbers or market

value (book vs. market weights)?
Use actual numbers or target capital
structure?

10 - 7
Component Cost of Debt
kd is the marginal cost of debt

capital.
The yield to maturity on outstanding
LT debt is often used as a measure
of kd.
Why tax-adjust, i.e., why kd(1 - T)?
10 - 8
A 15-year, 12% semiannual bond sells

for $1,153.72. What is kd?
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 = kd = 10%
10 - 9
Component Cost of Debt
Interest is tax deductible, so

kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.
Use nominal rate.
Flotation costs small. Ignore.

10 - 10
Component Cost of Preferred Stock
kp is the marginal cost of preferred

stock.
The rate of return investors require
on the firm’s preferred stock.

10 - 11
What’s the cost of preferred stock?

Pp = $111.10; 10%Q; Par = $100.
Use this formula:
Dp $10
kp = = = 0.090 = 9.0%.
Pp $111 .10

10 - 12
Picture of Preferred Stock
0
kp = ?
1 2 
...
-111.1 2.50 2.50 2.50
DQ $2.50
$111.10 = = .
kPer kPer
kPer = $2.50 = 2.25%;

$111.10
kp(Nom) = 2.25%(4) = 9%.
10 - 13
Note:
Preferred dividends are not tax

deductible, so no tax adjustment.
Just kp.
Nominal kp is used.
Our calculation ignores flotation
costs.

10 - 14
Is preferred stock more or less risky to

investors than debt?
More risky; company not required to

pay preferred dividend.
However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to
raise additional funds, (3) preferred
stockholders may gain control of
firm.
10 - 15
Why is yield on preferred lower than kd?
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 an investor, and the A-T
cost to the issuer, are higher on
preferred than on debt. Consistent with
higher risk of preferred.
10 - 16
Example:
kp = 9% kd = 10% T = 40%
kp, AT = kp – kp (1 – 0.7)(T)
= 9% – 9%(0.3)(0.4) = 7.92%.
kd, AT = 10% – 10%(0.4) = 6.00%.
A-T Risk Premium on Preferred = 1.92%.

10 - 17
Component Cost of Equity
ks is the marginal cost of common

equity using retained earnings.
The rate of return investors require
on the firm’s common equity using
new equity is ke.
10 - 18
Why is there a cost for retained

earnings?
Earnings can be reinvested or paid

out as dividends.
Investors could buy other securities,
earn a return.
Thus, there is an opportunity cost if
earnings are retained.
10 - 19
Opportunity cost: The return

stockholders could earn on
alternative investments of equal
risk.
They could buy similar stocks
and earn ks, or company could
repurchase its own stock and
earn ks. So, ks is the cost of
retained earnings.
10 - 20
Three ways to determine cost of

common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.

2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.

10 - 21
What’s the cost of common equity
based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM – kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.

10 - 22
What’s the DCF cost of common

equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
D1 D0(1 + g)
ks = +g= +g
P0 P0
= $4.19(1.05) + 0.05
$50
= 0.088 + 0.05
= 13.8%.
10 - 23
Suppose the company has been

earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout =
65%), and this situation is expected to
continue.
What’s the expected future g?

10 - 24
Retention growth rate:
g = (1 – Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 – Payout) = Fraction retained.
Close to g = 5% given earlier. Think of

bank account paying 10% with payout
= 100%, payout = 0%, and payout =
50%. What’s g in each case?
10 - 25
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.

10 - 26
Find ks using the own-bond-yield-plus-

risk-premium method.
(kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%

This RP  CAPM RP.
Produces ballpark estimate of ks.
Useful check.
10 - 27
What’s a reasonable final estimate

of ks?
Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%

10 - 28
Why is the cost of retained 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.
10 - 29
Two approaches that can be used to

account for flotation costs:
Include the flotation costs as part of

the project’s up-front cost. This
reduces the project’s estimated return.
Adjust the cost of capital to include
flotation costs. This is most
commonly done by incorporating
flotation costs in the DCF model.
10 - 30
Suppose new common stock had a

flotation cost of 15%. What is ke?
D0(1 + g)
ke = +g
P0(1 – F)
$4.19(1.05)
= + 5.0%
$50(1 – 0.15)
$4.40
= + 5.0% = 15.4%.
$42.50
10 - 31
Comments about Flotation Costs
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.
10 - 32
What’s the firm’s WACC (ignoring

flotation costs)?
WACC = wdkd(1 – T) + wpkp + wcks

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.

10 - 33
What factors influence a company’s

composite WACC?
Market conditions.
The firm’s capital structure and
dividend policy.
The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.
10 - 34
WACC Estimates for Some Large

U.S. Corporations, 1999
Company WACC
Intel 12.19%
General Electric 12.47
Motorola 11.65
Coca-Cola 12.31
Walt Disney 9.28
AT&T 9.22
Wal-Mart 10.99
Exxon Mobil 8.16
H. J. Heinz 7.78
BellSouth 7.41
10 - 35
Should the company use the

composite WACC as the hurdle rate for
each of its projects?
NO! The composite WACC reflects the

risk of an average project undertaken
by the firm. Therefore, the WACC only
represents the “hurdle rate” for a
typical project with average risk.
Different projects have different risks.
The project’s WACC should be adjusted
to reflect the project’s risk.
10 - 36
Risk and the Cost of Capital

Rate of Return
(%) Acceptance Region
W ACC
12.0 H
10.5 A Rejection Region

10.0
9.5 B
8.0 L
Risk
0 Risk L Risk A Risk H
10 - 37
Divisional Cost of Capital

Rate of Return
(%)
WACC
Division H’s WACC
13.0
Project H
11.0
10.0
Composite WACC
9.0 Project L
for Firm A
7.0 Division L’s WACC
Risk
0 RiskL Risk Average RiskH
10 - 38
What are the three types of project

risk?
Stand-alone risk
Corporate risk
Market risk

10 - 39
How is each type of risk used?
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.
10 - 40
What procedures are used to determine

the risk-adjusted cost of capital for a
particular project or division?
Subjective adjustments to the

firm’s composite WACC.
Attempt to estimate what the cost
of capital would be if the
project/division were a stand-alone
firm. This requires estimating the
project’s beta.
10 - 41
Methods for Estimating a Project’s Beta
1. Pure play. Find several publicly

traded companies exclusively in
project’s business.
Use average of their betas as
proxy for project’s beta.
Hard to find such companies.

10 - 42
2. Accounting beta. Run regression

between project’s ROA and S&P
index ROA.
Accounting betas are correlated
(0.5 – 0.6) with market betas.
But normally can’t get data on new
projects’ ROAs before the capital
budgeting decision has been made.

10 - 43
Find the division’s market risk and cost

of capital based on the CAPM, given
these inputs:
Target debt ratio = 40%.

kd = 12%.
kRF = 7%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.
10 - 44
Beta = 1.7, so division has more market

risk than average.
Division’s required return on equity:
ks = kRF + (kM – kRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdkd(1 – T) + wcks
= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.
10 - 45
How does the division’s market risk

compare with the firm’s overall market
risk?
Division WACC = 13.2% versus

company WACC = 11.1%.
Indicates that the division’s market risk
is greater than firm’s average project.
“Typical” projects within this division
would be accepted if their returns are
above 13.2%.

CFF 310

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFF 310

Uploaded by

Copyright:

Available Formats

10 - 1

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What sources of long-term capital do

Long-Term Preferred Stock Common Stock

Retained New Common

Copyright © 2002 by Harcourt, Inc. All rights reserved.

How do you calculate the weighted

WACC = wdkd(1 – T) + wpkp + wcks.

The w’s refer to the capital structure

Should we focus on before-tax or

Stockholders focus on A-T CFs.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Should we focus on historical

The cost of capital is used primarily

Copyright © 2002 by Harcourt, Inc. All rights reserved.

How do you determine the weights?

WACC = wdkd(1 – T) + wpkp + wcks.

Use accounting numbers or market

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Component Cost of Debt

WACC = wdkd(1 – T) + wpkp + wcks.

kd is the marginal cost of debt

A 15-year, 12% semiannual bond sells

INPUTS 30 -1153.72 60 1000

Component Cost of Debt

Interest is tax deductible, so

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Component Cost of Preferred Stock

WACC = wdkd(1 – T) + wpkp + wcks.

kp is the marginal cost of preferred

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What’s the cost of preferred stock?

Use this formula:

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Picture of Preferred Stock

kPer = $2.50 = 2.25%;

Preferred dividends are not tax

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Is preferred stock more or less risky to

More risky; company not required to

Why is yield on preferred lower than kd?

Corporations own most preferred stock,

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Component Cost of Equity

WACC = wdkd(1 – T) + wpkp + wcks.

ks is the marginal cost of common

Why is there a cost for retained

Earnings can be reinvested or paid

Opportunity cost: The return

Three ways to determine cost of

1. CAPM: ks = kRF + (kM – kRF)b.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

ks = kRF + (kM – kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What’s the DCF cost of common

Suppose the company has been

What’s the expected future g?

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Retention growth rate:

Here (1 – Payout) = Fraction retained.

Close to g = 5% given earlier. Think of

Could DCF methodology be applied if