20 - Cost of Capital

CHAPTER 20
Cost of Capital
The Short Story of WACC
• Thus far, we have been given the discount rate with

which to evaluate projects; now we consider where it
comes from.
• Recall that we do not include dividends or interest

payments in our DCF analysis because they are included
in K.
• The WACC considers the cost and weight of individual

components in the capital structure.
CHAPTER 20 – Cost of Capital 20 - 2

What Costs are Measured?
• Costs associated with financing the firm’s invested capital

including:
– Debt Costs:
• Bank loans
• Long-term debt – bonds/debentures
– Equity Costs:
• Preferred equity costs
• Common equity costs

Why the Marginal Cost?
• What capital cost the firm 5 months, 5 years or 5 decades

ago is irrelevant.
• What is relevant is what the next dollar of capital will
cost in today’s economic environment for this particular
firm.

Steps in Solving for the WACC
1. Identify the relevant sources of capital (debt and equity).

2. Estimate the market values for the sources of capital and
determine the market value weights.
3. Estimate the marginal, after-tax, and after-floatation cost
for each source of capital.
4. Calculate the weighted average.

The Cost of Capital
Determining the Weighted Average Cost of Capital (WACC)
• The equation for WACC including common equity, preferred share

financing and debt is:
S P D
WACC  K e  K p  K d ( 1-T)
[ 20-9] V V V
• In this case the value of the firm equals the sum of the value of
stock, preferred and debt: V = S + P + D
• Throughout the course, you will see me use the notation Wd for the
weight of debt instead of (D/V) – likewise with We and Wp (weight
of common and preferred equity respectively)
The Spreadsheet Approach
(1) (2) (3) (4) = (2)*(3)

Specific
Marginal Cost Weighted
after tax and Market Specific
Type of floatation Value Marginal
Capital costs Weights Cost
Long-Term Debt 5.5% 43.0% 0.02365
Preferred Stock 11.4% 11.0% 0.01254
Common Stock 12.9% 46.0% 0.05934
WACC = 9.55%
WACC is the sum of the weighted

specific marginal costs of each source of
capital.

Market Values!
• Always remember when calculating the weights of

various capital sources to use the TOTAL MARKET
VALUE of these instruments, not the book values listed
on the balance sheet.
– Recall that market capitalization is the total value of COMMON EQUITY!
• This can be tricky for debt if required yields have

changed substantially from when the debt was issued –
we have to look up (or recalculate) the market price of
bonds rather than their par value.

Estimating Market Values
Market Value of Bonds
• As per Chapter 6, knowing the term to maturity, the coupon rate and the
bondholder’s required return we can determine the market value of bonds
with equation 20 – 12
• Then simply multiply the price by the number of bonds outstanding.
 1 
1  ( 1  k )n  1
[ 20-12] B  I  b
F
 k b  ( 1  k b ) n
 

Costs of Existing Capital
• Cost of Debt = Kd = Y (1-T)
• Cost of Preferred Shares = Kp = D/P0
• Cost of Equity = Ke = (D1/P0)+ g

Cost of Equity
Constant Growth Model Caution
• The constant growth model can only be used in cases

where it is reasonable to assume that the growth rate can
be sustained in the very long term.
– This usually means, using it only for large, mature ‘blue-chip’
companies that already pay a significant dividend.
• The Gordon model SHOULD NOT be used on smaller,

more rapidly growing firms where high current growth
rates are experienced, but cannot be sustained in the long
term.

Alternate Model for the Cost of Equity
Using the CAPM to estimate Ke
• CAPM can be used to estimate the required return by common

shareholders in situations where DCF methods will perform
poorly
• CAPM estimate is a ‘market determined’ estimate:

– The RF (risk-free) rate is the benchmark return and is measured
directly, today as the yield on 91-day T-bills
– The market risk premium (MRP) is taken from current market
estimates of the overall return in the market, less RF (ERM –RF)
– Using this model requires us to think about the inputs however
as they can have a significant impact on project evaluation.

Risk-Based Models & the Cost of Equity
Using the CAPM to estimate the cost of common equity
• As a single-factor model, we estimate the common shareholder’s required

return based on an estimate of the systematic risk of the firm (measured by
the firm’s beta coefficient)
[ 20-26] K e  RF  MRP   e
• Where:
Ke = investor’s required rate of return
βe = the stock’s beta coefficient
Rf = the risk-free rate of return
MRP = the market risk premium (ERM - Rf )

Estimating the Market Risk Premium
[ 20-26] K e  RF  MRP   e
• Rf is ‘observable’ (yield on 91-day T-bills)

• Getting an estimate of the market risk premium is one of the more difficult
challenges in using this model.
– We really need a ‘forward’ looking of MRP or a ‘forward’ looking
estimate of the ERM
• One approach is to use an estimate of the current, expected MRP by
examining a long-run average that prevailed in the past.
• Table 20 -12 illustrates the % returns on S&P/TSX Composite annually for
the first five years of this century.

Using the CAPM to Estimate the Cost of Common Equity
Table 20-12 Returns on the S&P/TSX Composite Index Investors are

It would
unlikely be
to expect
Returns better
negativetoreturns
use
average
on the stock
2000 market. If they
7.5072% realized
did, no one would
2001 -12.572% returns over
hold shares!
2002 -12.438% an entire
2003 Who would have
business/mar
26.725%
guessed before
2004 14.480% ket there
hand, cycle.would
2005 24.127%
be two
consecutive years
of aggregate
market losses?
Such is the reality

of investing since
none of us are
clairvoyant.
Using the CAPM to Estimate the Cost of Common Equity
Long-run average rates of return are more reliable.
Table 20-13 Average Investment Returns and Standard Deviations (1938 to 2005)
Annual Annual Standard

Arithmetic Geometric Deviation of
Average (%) Mean (%) Annual
Returns (%)
Government of Canada Treasury Bills 5.20 5.11 4.32

Government of Canada Bonds 6.62 6.24 9.32
Canadian Stocks 11.79 10.60 16.22
U.S. Stocks 13.15 11.76 17.54
Source: Data f rom Canadian Institute of Actuaries
The risk
Average consensus
premium ofisCanadian
that the Canadian MRP over the long-term
stocks
bondover bonds
yield (anwas 5.17%
observable yield) is between 4.0 and 5.5%.

Estimating Betas
• After obtaining estimates of the two important market

rates (Rf and MRP), an estimate for the company beta is
required.
• Figure 20 -3 illustrates that estimated betas for major sub-

indexes of the S&P/TSX have varied widely over time:

Estimated Betas for Sub Indexes of the S&P/TSX Composite Index
20 - 3 FIGURE

Estimated Betas for Sub Indexes of the S&P/TSX Composite Index
• You should note:

– IT sub index shows rapidly increasing betas
– Other sub index betas show constant or decreasing trends.
• Reasons:
– The weighted average of all betas = 1.0 (by definition they are
the market)
– If one sub index is changing…that change alone affects all
others in the opposite direction.
• What Happened in the 1995 – 2005 decade?

– The internet bubble of the late 1990s resulted in rapid growth in
the IT sector till it burst in the early 2000s.

Estimating Betas
IT
Bubble
Table 20-15 S&P/TSX Sub Index Beta Estimates
Energy Materials Industrials ConsDisc ConsStap Health Fin IT Telco Utilities

1995 0.93 1.41 1.19 0.82 0.68 0.36 0.92 1.25 0.53 0.67
1996 0.93 1.28 1.10 0.83 0.66 0.39 1.02 1.36 0.61 0.65
1997 0.98 1.33 0.97 0.82 0.62 0.60 0.93 1.56 0.62 0.53
1998 0.85 1.12 0.94 0.80 0.60 1.02 1.11 1.40 0.92 0.55
1999 0.91 1.04 0.78 0.73 0.43 1.00 1.00 1.55 1.11 0.30
2000 0.67 0.74 0.73 0.69 0.23 1.10 0.79 1.78 0.92 0.14
2001 0.50 0.60 0.82 0.68 0.10 0.98 0.67 2.12 0.94 -0.03
2002 0.43 0.57 0.86 0.73 0.11 0.99 0.67 2.27 0.92 -0.06
2003 0.27 0.42 0.91 0.74 -0.04 0.85 0.39 2.75 0.82 -0.26
2004 0.17 0.42 1.04 0.81 -0.02 0.84 0.41 2.89 0.55 -0.14
2005 0.48 0.78 1.12 0.84 0.14 0.74 0.58 2.71 0.71 -0.01
Source: Data from Financial Post Corporate Analyzer Database

Adjusting Beta Estimates and Establishing a Range
• When betas are measured over the period of a sector

bubble or crash, it is necessary to adjust the beta estimates
of firms in other sectors.
• Take the industry grouping as a major input, plus the
individual company beta estimate.
– Using current MRP and Rf Develop estimates of Ke
using the range of Company betas prior to the bubble
or crash

Costs of Existing Capital
• Cost of Debt = Kd = Y (1-T)
• Cost of Preferred Shares = Kp = D/P0
• Cost of Equity = Ke = (D1/P0)+ g

= Rf + β (Rm – Rf)

Cost of Equity Capital
• It is extremely rare that the Gordon model and the CAPM

will give you the same cost of equity.
• THIS IS OK!
– Recall that the cost of equity capital is an estimate
which tries to approximate what shareholders require
as a return compensating them for the risks they face.
• When you have enough information to calculate both, do

so and then use their average as the cost of equity.

Estimating the Component Costs
Floatation Costs
• Issuing or floatation costs are incurred by a firm when it raises new

capital through the sale of securities in the primary market.
• These costs include:
– Underwriting discounts paid to the investment dealer
– Direct costs associated with the issue including legal and
accounting costs
• The result:
– Net proceeds on the sale of each security is less than what the
investor invests, and
– The component cost of capital > investor’s required return.
Table 20 4 – illustrates average issuing costs for different forms of capital.

Floatation Costs and the Marginal Cost of Capital (MCC)
Floatation costs for

debt securities is
Table 20-4 Average Issuing Costs lowest because debt is
normally privately
placed with large
Commercial paper 0.125% institutional investors
Medium-term notes 1.0% not requiring
Long-term debt 2.0% underwriting costs
and because debt is
Equity (large) 5.0%
either issued by high
Equity (small) 5.0% - 10.0% quality issuers or sits
Equity (private) 10.0% and up at the top of the
priority of claims list
in the case of default.
What issue costs mean is that there is a financing wedge between what the
investor pays and what the firm receives, the difference being the money
that is lost to these costs. Issue costs are responsible for the component
cost of capital being greater than the investor’s required return.

Floatation Cost Calculation
• There are two approaches to factoring in floatation costs:

– % Floatation Method
– Net Proceeds Method
• The % Floatation method uses the initial cost of capital estimates we saw
earlier, but divides them by (1-floatation %) to account for the financing
wedge.
– Kx new = Kx / (1-fl%)
• The Net Proceeds method scales the cost of capital by replacing the “price”
in those same equations with the actual amount of funds received from the
public.

Floatation Cost Calculation
• These two forms give identical results except in the case of

common equity where there is a minor distortion introduced
by using % Float.
• Since the cost of capital calculation only gives us an estimate,

and real world market frictions introduce much larger errors
in estimation, the % float method can be used equivalently to
the net proceeds method
– % Float estimates are slightly lower than Net Proceeds
estimates for Ke
– If precision is ESSENTIAL, use the net proceeds method (its not
in this course so % float method is fine to use in all cases)

The Component Cost of Debt
• If you know the debt investor’s required rate of return Kd , the corporate tax rate and
the floatation cost percentage for debt, you can estimate the cost of debt in the
following manner:
The after tax cost of
debt is lower than the
• Assume: investor’s required
Kd = 10% (debt investor’s required return) return because of the
tax shield on interest
T = 40% (corporate tax rate) expense.
fd = 3% (floatation cost percentage)
Investor's Required Return  (1 - T)

KDnew 
1 - %fld
10%  (1.0 - 0.4) 6%
   6.19%
1 - .03 0.97

Debt
• Alternatively you can adjust the bond valuation formula for the tax-
deductibility of interest expense and the net proceeds the firm would
receive on the sale of one bond (after floatation costs) and solve for the
rate (Ki ) that causes the formula to become and equality:
Coupon interest times 1 minus corporate

tax rate = after tax cost of interest
 1 
1 
 (1 K n 
) 1
[ 20-13] NP  I  (1  T )   Dnew
F
 KDnew  ( 1  K Dnew )n
 
Net proceeds on the sale of the bond = Selling price –

floatation cost per bond.
• Ki = the after-tax and after-floatation cost of debt.

Preferred Shares
Floatation
• If you know the preferred share costs cause
investor’s required rate of return Kp , the component
and the floatation cost percentage for cost to be
greater than
preferred share financing, you can the investor’s
estimate the cost of preferred shares required
in the following manner: return.
• Assume:
Investor' s Required Return
Kp = 14% (preferred investor’s KPnew 
1 - %fl p
required return)
14% 14%
F = 5% (floatation cost percentage)    14.74%
1 - .05 0.95
NOTE: Preferred dividends are paid out of after-tax

earnings, therefore there are no taxation effects on
the preferred share component cost of capital.
Preferred Shares
• Alternatively, the component cost of preferred shares can be

found using equation 20 -14, where NP is the selling price per
preferred share less the floatation costs per share.
Dp
[ 20-14] K Pnew 
NP

Constant Growth Model
The Cost of New Equity
• The model can be modified to solve for the cost of new

equity by using NP (net proceeds the firm receives for
each new share sold after floatation costs)
D1
[ 20-17] K Enew  g
NP

Risk-Based Models and the Cost of Common
Equity
Using CAPM to Estimate Kne
• We can scale our estimate of the equity holder’s required

return when accessing new equity and incurring floatation
costs.
KE
[ 20-27] K Enew 
(1  % fle)

A note of new vs. existing capital
• UNDER NO CIRCUMSTANCES can a firm use existing

debt or existing preferred shares to finance a project!
– There is no such thing as KD or KP except when using
it to calculate KDnew and KPnew .
– Money raised from these sources but not spent end
up as common equity.
• Only in the case of existing common equity can we use

KE otherwise we use KEnew.
– example after the break

WACC versus MCC
Floatation Costs and the Marginal Cost of Capital (MCC)
• The Marginal Cost of Capital (MCC) is the weighted average

cost of the next dollar of financing to be raised.
• At low levels of financing the WACC = MCC
• As a firm raises more and more capital in a given year, it will
exhaust the supply of lower cost sources, and then have to
access marginally higher cost sources.
– Therefore MCC increases with the amount of capital
to be raised.
The following figure illustrates the MCC concept.

The Marginal Cost of Capital MCC
S D S D
(%) MCC1  K e  K Dnew (1  t )
V V MCC2  K Enew  K Dnew (1  t )
V V
60 40 There is only one break in the MCC curve. It
 12%  8%(1  .3) 60 40
100 100 occurs at $5,500,000. At this point the firm has  14%  8%(1  .3)
100 100
15  12%(.6)  5.6%(.4) exhausted its internal equity and to raise more
 14%(.6)  5.6%(.4)
 7.2%  2.24%  9.44% equity capital will mean accessing external  8.4%  2.24%  10.64%
equity using the services of an underwriter.
MCC2= 10.64%
10 MCC1=WACC= 9.44%
Each dollar of capital invested up Each dollar of capital invested
to $5.5 million is financed 60% by beyond $5.5 million is financed
internal equity (R/E). (60% × cost 60% by new equity. (60% ×
5 cost of new equity = 8.4%)
of retained earnings = 7.2%)
2.24%
Each dollar of capital invested is financed 40% by debt. (40% × after-tax cost = 2.24%)
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000
Dollars of Capital to be Raised

Investment Opportunity Schedule
A Detailed Example …
• An investment opportunity schedule is a prioritized list of

capital projects, listed by IRR from highest to lowest.
• Consider the 6 projects below:
Project A can be
eliminated at this
point because it has
Capital Annual ATCF Useful a negative NPV.
Project Initial Cost Benefits Life NPV IRR
A $1,500,000 $290,000 7 -$88,159 8.19%
B $2,300,000 $529,000 6 $3,933 10.06%
C $3,750,000 $940,000 6 $343,945 13.07%
D $180,000 $40,000 7 $14,737 12.45%
E $985,000 $318,540 5 $222,517 18.50%
F $2,154,000 $421,500 8 $94,671 11.20%

A Detailed Example …
The first step in developing an IOS is to order the projects

from highest IRR to lowest, and then to calculate the
cumulative capital cost of the projects.
Capital Cumulative Cost

Project Initial Cost of the Projects IRR
E $985,000 $985,000 18.50%
C $3,750,000 $4,735,000 13.07%
D $180,000 $4,915,000 12.45%
F $2,154,000 $7,069,000 11.20%
B $2,300,000 $9,369,000 10.06%
A $1,500,000 $10,869,000 8.19%

A Detailed Example Continued …
• The remaining projects certainly meet the first

investment screen - that is, they offer rates of return in
excess of the firm’s WACC (they have a positive NPV).
• Now we can prepare a graphical representation of the

IOS by plotting the projects’ IRR against the
cumulative dollars of capital to be raised.
• Then we overlay the MCC graph we just saw to

determine which projects provide sufficient returns

Investment Opportunity Schedule (IOS)
IRR
E The height of each cylinder is equal to the project’s IRR; the width is equal to the initial
investment for the project.
(%)
IRR = D The upper surface of
18.5% the columns is the
15 IRR = 12.45%
C IOS
IRR = 13.07%
F B
10
IRR = 11.2%
IRR = 10.06%
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000

Investment Opportunity Schedule (IOS)
IRR
E
(%)
IRR = D IOS
18.5%
15 IRR = 12.45%
C
IRR = 13.07%
10
F B
IRR = 11.2%
IRR = 10.06%
5
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000

MCC Superimposed on the IOS
The break in the MCC IRRis B <caused

MCC2
IRR by the exhaustionso ofthis
low project
cost
E retained earnings and the need Itto
is rejected.
(%)
IRR = D finance project F through willexternal
not
18.5% offering of equity,increase
incurringthe
15 IRR = 12.45%
C floatation costs.
value of the
firm.
IRR = 13.07%
MCC2= 10.64%
10
MCC1=WACC= 9.44% F B
IRR = 11.2% IRR = 10.06%
5
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000

Divisional Costs of Capital
• An overall cost of capital developed for a highly diversified conglomerate may
not be appropriate for decisions made within specific divisions of the
company.
• High-risk divisions (with high return possibilities) would have a

disproportionate share of their investment proposals accepted if they use an
overall WACC.
• The solution to this is to develop risk-adjusted discount rates that reflect the
unique risk characteristics of each division.
• Developing these estimates can sometimes be accomplished by looking at

other firms in that industry that are not highly diversified in their operations…
this is called the pure play approach.
– More on this next class

Appendix 1
Steep Hill Mines 1
An Exercise in Cost of Capital

Steep Hill Mines # 1
The Question
Steep Hill Mines Ltd. shares are publicly traded on the Toronto
Stock Exchange. The shares currently trade at a price of $30.00 per
share. Security analysts that follow the stock have estimated it's beta
coefficient to be 0.9. Steep Hill paid a dividend on its common stock
last year that totaled $1.50 per share. Dividends have been growing at
a 4% compound rate for the past six years and the expectation is that
this growth can continue into the foreseeable future.
Steep Hill also has it's long-term bonds trading on public markets.
The bonds are currently trading at a discount from their par value of
96.54%. These 5.75% bonds have ten years left until they mature.
Steep Hill Mines Ltd. has an important capital project to consider.

Project A is expected to produce annual cash flows after tax of
$100,000 for the next eight years. It is considered to be of similar risk to
the risk of the firm itself. It will cost Steep Hill $400,000 this year to get
this project up and running.

The Question …
Cathy Jones, Steep Hill's manager of finance has collected current

data from the firm's underwriters.
– Government of Canada 91-day Treasury bills are currently yielding 4.25%.
– The expected return on the TSE 300 composite index is forecast to be 10% in
the next year
– New equity capital could be raised by the firm at the current market price, but
floatation costs would amount of 4% of the value of the issue.
– New bonds could be sold into the market, but the floatation cost percentage
would be 6%.
– The firm faces a corporate tax rate of 40%.
– The company will seek to sustain the current capital structure based on existing
market value weights.
– If the firm goes ahead with the capital project, it will have to seek external
financing since there is no internal cash flow available for reinvestment.
The firm's most recent financial statements are found below:

The Question …
Steep Hill Mines Ltd.

Balance Sheet
As at December 31, 20XX
In $ '000s
Assets: Liabilities:
Cash 100 Accruals 30
Accounts Receivable 220 Accounts Payable 312
Inventories 450 ____
Total Current Assets 770 Total Current Liabilities 342
Gross Fixed Assets 4,000 5.75% bonds 1,000
Accumulated Depreciation 1,500 Common stock
(100,000 outstanding) 1,000
Net Fixed Assets 2,500 Retained earnings 928
TOTAL ASSETS 3,270 TOTAL CLAIMS 3,270
Required:
Find the WACC using book value weights, market value weights and target capital structure weights.
Using the target capital structure weights, is the proposed project viable?

The Solution – The Equity Investor’s Required Return
Investor's Required Return on Equity Capital:

DDM Approach:
D0 (1  g ) $1.50(1.04) $1.56
KS  g  .04   .04  0.052  .04  9.2%
P0 $30 $30
CAPM Approach:
K S  RF  Bs [ ERM  RF ]  4.25%  0.9[10%  4.25%]

K S  4.25%  5.175%  9.425%

The Solution – The Cost of Equity
Investor's Required Return on Equity Capital

The average of our two estimates for the cost of retained earnings
is: (9.2 + 9.425)/2 = 9.3%
This is the returns our current shareholders are demanding on our

stock.
If we raise external capital, we will incur floatation costs

(underwriter's fees, legal costs, etc.) This represents 4%.
Investors Required Return

Cost of New Equity 
1- f
9.3% 9.3%
   9.7%
1 - .4 .96

The Solution
Investor's Required Return on Debt
 1 
1 
 ( 1  k )n 
[ 20-12] 1
B  I  b
F
 kb  ( 1  k b )n
 
 1 
1 
 (1 k )  20
1
$965.40  $28.75 b
F
 kb  ( 1  kb )20
 
k b  3.11% semiannually
k b  3.11%  2  6.22%

The Solution – The Cost of Debt
Since interest on debt is tax deductible to the firm, the after-tax and
after floatation cost of debt is:
6.22%(1  T ) 6.22%(1  .4)

Kd    3.97%
1 f 1  .06
Where:
T= 40%
f= 6%

The Solution – Determining Market Value Weights
Market Value Weights:

Market values are always found by multiplying
the number of outstanding securities times
their price per unit.
Market Value of LT Debt = 1,000 bonds outstanding times $965.40 = $965,400
Market Value of Equity = 100,000 times $30.00 = 3,000,000
TOTAL MARKET VALUE OF THE FIRM = 3,965,400
Market Value Weight of LT Debt = $965,400/$3,965,400 = 24.35%

Market Value Weight of Equity = (1 - .2435) = 75.65%

The Solution – Market Value WACC
The Cost of Capital Using Market Value Weights:
Market Specific
Source of Value Marginal Weighted
Capital Weight Cost Cost
L. T. Debt 24.4% 3.97% 0.97%
Preferred 0.0% 0.00% 0.00%
Common 75.7% 9.70% 7.34%
WACC = 8.30%

The Solution
Viability of the Capital Project
Since the project has similar risk characteristics to the

firm as a whole, we do not have to calculate a risk-adjust
discount rate…instead, we can just use the firm's WACC.
Since the market value capital structure weights will be

used by the firm in the long run, let's use that in the
WACC, and calculate the project’s NPV.

The Solution – Project NPV
CF1 CF2 CF3

[ 13-1] NPV     ...  CF0 Using Equation
(1  k ) (1  k )
1 2
(1  k ) 3
n
13 -1 for NPV,
 CF t
and substituting
in the annual
 i 1
 CF0
(1  k ) t
cash flow
 $100,000(PVIFA n 8,k  WACC )  $400,000 benefits of
$100,000 after-
 $100,000(PVIFA n 8,k 8.3% )  $400,000
tax, initial cost,
1 useful life of 8
1-
(1.083)8 years, and
 $100,000  $400,000
.083 WACC of 8.3%
 $100,000(5.681788)  $400,000 we find the
project offers a
 $568,178  $400,000
positive NPV.
NPV  $168,178

20 - Cost of Capital

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20 - Cost of Capital

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CHAPTER 20

• Thus far, we have been given the discount rate with

• Recall that we do not include dividends or interest

• The WACC considers the cost and weight of individual

CHAPTER 20 – Cost of Capital 20 - 2

• Costs associated with financing the firm’s invested capital

CHAPTER 20 – Cost of Capital 20 - 3

• What capital cost the firm 5 months, 5 years or 5 decades

CHAPTER 20 – Cost of Capital 20 - 4

1. Identify the relevant sources of capital (debt and equity).

CHAPTER 20 – Cost of Capital 20 - 5

• The equation for WACC including common equity, preferred share

(1) (2) (3) (4) = (2)*(3)

WACC is the sum of the weighted

CHAPTER 20 – Cost of Capital 20 - 7

• Always remember when calculating the weights of

• This can be tricky for debt if required yields have

CHAPTER 20 – Cost of Capital 20 - 8

CHAPTER 20 – Cost of Capital 20 - 9

• Cost of Debt = Kd = Y (1-T)

• Cost of Preferred Shares = Kp = D/P0

• Cost of Equity = Ke = (D1/P0)+ g

CHAPTER 20 – Cost of Capital 20 - 10

• The constant growth model can only be used in cases

• The Gordon model SHOULD NOT be used on smaller,

CHAPTER 20 – Cost of Capital 20 - 11

• CAPM can be used to estimate the required return by common

• CAPM estimate is a ‘market determined’ estimate:

CHAPTER 20 – Cost of Capital 20 - 12

• As a single-factor model, we estimate the common shareholder’s required

CHAPTER 20 – Cost of Capital 20 - 13

• Rf is ‘observable’ (yield on 91-day T-bills)

CHAPTER 20 – Cost of Capital 20 - 14

Table 20-12 Returns on the S&P/TSX Composite Index Investors are

Such is the reality

Long-run average rates of return are more reliable.

Annual Annual Standard

Government of Canada Treasury Bills 5.20 5.11 4.32

Source: Data f rom Canadian Institute of Actuaries

CHAPTER 20 – Cost of Capital 20 - 16

• After obtaining estimates of the two important market

• Figure 20 -3 illustrates that estimated betas for major sub-

CHAPTER 20 – Cost of Capital 20 - 17

CHAPTER 20 – Cost of Capital 20 - 18

• You should note:

• What Happened in the 1995 – 2005 decade?

CHAPTER 20 – Cost of Capital 20 - 19

Energy Materials Industrials ConsDisc ConsStap Health Fin IT Telco Utilities

CHAPTER 20 – Cost of Capital 20 - 20

• When betas are measured over the period of a sector

CHAPTER 20 – Cost of Capital 20 - 21

• Cost of Debt = Kd = Y (1-T)

• Cost of Preferred Shares = Kp = D/P0

• Cost of Equity = Ke = (D1/P0)+ g

CHAPTER 20 – Cost of Capital 20 - 22

• It is extremely rare that the Gordon model and the CAPM

• When you have enough information to calculate both, do

CHAPTER 20 – Cost of Capital 20 - 23

• Issuing or floatation costs are incurred by a firm when it raises new

Table 20 4 – illustrates average issuing costs for different forms of capital.

CHAPTER 20 – Cost of Capital 20 - 24

Floatation costs for

CHAPTER 20 – Cost of Capital 20 - 25