Cost of Capital

Copyright 2009, FM, Prepared by Amyn Wahid
All rights reserved. 1
Cost of Capital Here we discuss the following: Overall Cost of Capital
The Capital Asset Pricing Model (CAPM)
Weighted Average Cost of Capital (WACC)
Overall Cost of Capital
Cost of Capital is the required rate of return on the various types of financing. The overall cost of capital is a weighted average of the individual required rates of return (costs).
Market Value of Long-Term Financing
Type of Financing Long-Term Debt Preferred Stock Common Stock Equity
Mkt. Val $ 35M $ 15M $ 50M $ 100M
Weight 35% 15% 50% 100%
Cost of Debt
Cost of Debt is the required rate of return on investment of the lenders of a company.
P0 =
j =1
Ij + Pj (1 + kd)j
ki = kd ( 1 - T )
Copyright 2009, FM, Prepared by Amyn Wahid All rights reserved. 5
Determination of the Cost of Debt
Assume that Basket Wonders (BW) has $1,000 par value zero-coupon bonds outstanding. BW bonds are currently trading at $385.54 with 10 years to maturity. BW tax bracket is 40%. $0 + $1,000 $385.54 = (1 + kd)10
Determination of the Cost of Debt (1 + kd)10 = $1,000 / $385.54 = 2.5938 = (2.5938) (1/10)
(1 + kd) = 1.1 kd = .1 or 10%
Interest is tax deductible, so kd AT or ki = kd BT(1 - T) = 10%(1 - 0.40) = 6%.

Cost of Preferred Stock
Cost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company.
kP = DP / P0
Determination of the Cost of Preferred Stock
Assume that Basket Wonders (BW) has preferred stock outstanding with par value of $100, dividend per share of $6.30, and a current market value of $70 per share.
kP = $6.30 / $70 kP = 9%
Cost of Equity Approaches
Dividend Discount Model Capital-Asset Pricing Model Bond-Yield-Plus-Risk-PremiumApproach
Dividend Discount Model Dividend Discount Model
The cost of equity capital, ke, is the capital discount rate that equates the present value of all expected future dividends with the current market price of the stock. D1 D2 D + +...+ P0 = (1+ke)1 (1+ke)2 (1+ke)
Constant Growth Model Constant Growth Model
The constant dividend growth assumption reduces the model to: k e = ( D 1 / P0 ) + g Assumes that dividends will grow at the constant rate g forever.
Determination of the Cost of Equity Capital
Assume that Basket Wonders (BW) has common stock outstanding with a current market value of $64.80 per share, current dividend of $3 per share, and a dividend growth rate of 8% forever.
ke ke ke
= ( D1 / P0 ) + g = ($3(1.08) / $64.80) + .08 = .05 + .08 = 0.13 or 13%

Now, lets talk about Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM) CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a securitys expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security.
CAPM Assumptions
1. Capital markets are efficient. 2. Homogeneous investor expectations over a given period. 3. Risk-free asset return is certain (e.g. treasury securities). 4. Market portfolio contains only systematic risk
The CAPM equation: kj = krf + j(km - krf)

where:
Also referred as SML
(discussed in subsequent slides)
kj = the Required Return on security j, krf = the risk-free rate of interest, j = the beta of security j, and km = the return on the market index.
Example:
Suppose the Treasury bond rate is 6%, the average return on the KSE 100 index is 12%, and OGDC has a beta of 1.2. According to the CAPM, what should be the required rate of return on OGDC stock?
kj = krf +
(km - krf)
kj = .06 + 1.2 (.12 - .06) kj = .132 = 13.2% According to the CAPM, OGDC stock should be priced to give a13.2% return.
Beta
Measures a stocks market risk, and shows a stocks volatility relative to the market. In other words, it measures the sensitivity of a stocks returns to changes in returns on the market portfolio. Indicates how risky a stock is if the stock is held in a well-diversified portfolio.Its an index of systematic risk. The beta for a portfolio is simply a weighted average of the individual stock betas in the portfolio.
Calculating betas Run a regression of past returns of a security against past returns on the market. The slope of the regression line (sometimes called the securitys characteristic line) is defined as the beta coefficient for the security.
Illustrating the calculation of beta _

20 15 10 5
ki
.
5 10
Year 1 2 3
kM 15% -5 12
ki 18% -10 16
-5
0 -5 -10
15
20
_
kM
Regression line: ^ = -2.59 + 1.44 ^ ki kM

Characteristic Lines and Different Betas

Beta =
Rise Run REQUIRED RETURN ON STOCK
Beta > 1 (aggressive) Beta = 1 Beta < 1 (defensive)
Each characteristic line has a different slope.
REQUIRED RETURN ON MARKET PORTFOLIO
Characteristic Line
Comments on beta
If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5.
Can the beta of a security be negative? Yes, if the correlation between Stock i and the market is negative (i.e., i,m < 0). If the correlation is negative, the regression line would slope downward, and the beta would be negative. However, a negative beta is highly unlikely.
Beta coefficients for HT, Coll, and T-Bills

40
_ ki
HT: = 1.30
20 T-bills: = 0
-20
20
40 Coll: = -0.87
_ kM
-20
Comparing expected return and beta coefficients Security HT Market USR T-Bills Coll. Exp. Ret. 17.4% 15.0 13.8 8.0 1.7 Beta 1.30 1.00 0.89 0.00 -0.87
Riskier securities have higher returns, so the rank order is OK.

The Security Market Line (SML): As discussed before in slide # 17
Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j, Rf is the risk-free rate of return, j is the beta of stock j (measures systematic risk of stock j), RM is the expected return for the market portfolio.
The Security Market Line (SML): Calculating required rates of return
SML: ki = kRF + (kM kRF) i Assume kRF = 8% and kM = 15%. The market (or equity) risk premium is RPM = kM kRF = 15% 8% = 7%.
The Security Market Line (SML):
Rj = Rf + j(RM - Rf)
Required Return
RM Rf
= 1.0
Risk Premium Risk-free Return

M
Systematic Risk (Beta)
Beta Coefficients for Selected Companies
Example - Portfolio Beta Calculations

Amount Share (1) ABC Company LMN Company XYZ Company Portfolio Invested (2) $ 6 000 4 000 2 000 $12 000 Portfolio Weights (3) 50% 33% 17% 100% Beta (4) 0.90 1.10 1.30 (3) (4) 0.450 0.367 0.217 1.034
Example - Portfolio Expected Returns and Betas

Assume you wish to hold a portfolio consisting of asset A and a riskless asset. Given the following information, calculate portfolio expected returns and portfolio betas, letting the proportion of funds invested in asset A range from 0 to 125%. Asset A has a beta of 1.2 and an expected return of 18%. The risk-free rate is 7%. Asset A weights: 0%, 25%, 50%, 75%, 100% and 125%.
Example - Portfolio Expected Returns and Betas

Proportion Invested in Asset A (%) 0 25 50 75 100 125 Proportion Invested in Risk-free Asset (%) 100 75 50 25 0 -25 Portfolio Expected Return (%) 7.00 9.75 12.50 15.25 18.00 20.75 Portfolio Beta 0.00 0.30 0.60 0.90 1.20 1.50
Determination of the Required Rate of Return
Lisa Miller at Basket Wonders is attempting to determine the rate of return required by their stock investors. Lisa is using a 6% Rf and a long-term market expected rate of return of 10%. A stock analyst following the firm has calculated that the firm beta is 1.2. What is the required rate of return on the stock of Basket Wonders?
BWs Required Rate of Return
RBW = Rf + j(RM - Rf) RBW = 6% + 1.2(10% - 6%) RBW = 10.8%

The required rate of return exceeds the market rate of return as BWs beta exceeds the market beta (1.0).
Determination of the Intrinsic Value of BW

Lisa Miller at BW is also attempting to determine the intrinsic value of the stock. She is using the constant growth model. Lisa estimates that the dividend next period will be $0.50 and will grow at a constant rate of 5.8%. The stock is currently selling for $15.
What is the intrinsic value of the stock? Is the stock over or underpriced?
Determination of the Intrinsic Value of BW
Intrinsic Value
= =
$0.50 10.8% - 5.8% $10
The stock is OVERVALUED as the market price ($15) exceeds the intrinsic value ($10).
Refer to the next slide
UNDERPRICED AND OVERPRICED STOCKS If the expected return is more than the required rate of return stock , the stock is UNDERPRICED If the expected return is less than the required rate of return stock , the stock is OVERPRICED
What is the market risk premium? Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. Its size depends on the perceived risk of the stock market and investors degree of risk aversion. Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year.
Calculating required rates of return
kHT
= 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30) = 8.0% + 9.1% = 17.10% kM = 8.0% + (7.0%)(1.00) = 15.00% kUSR = 8.0% + (7.0%)(0.89) = 14.23% kT-bill = 8.0% + (7.0%)(0.00) = 8.00% kColl = 8.0% + (7.0%)(-0.87) = 1.91%
Expected vs. Required returns

k HT USR T - bills Coll. Market 15.0 13.8 8.0 1.7
^
k 15.0 14.2 8.0 1.9
Refer Slide # 27
^
17.4% 17.1% Undervalue(k > k) d Fairly val (k = k) ued Overvalued < k) (k Fairly val (k = k) ued Overvalued < k) (k
Illustrating the Security Market Line SML: ki = 8% + (15% 8%) i

ki (%) HT kM = 15 SML
-1
Coll.
kRF = 8
. T-bills
. . .
USR
1 2
Risk, i
An example: Equally-weighted two-stock portfolio

Create a portfolio with 50% invested in HT and 50% invested in Collections. The beta of a portfolio is the weighted average of each of the stocks betas. P = wHT HT + wColl Coll P = 0.5 (1.30) + 0.5 (-0.87) P = 0.215
Calculating portfolio required returns

The required return of a portfolio is the weighted average of each of the stocks required returns. kP = wHT kHT + wColl kColl kP = 0.5 (17.1%) + 0.5 (1.9%) kP = 9.5% Or, using the portfolios beta, CAPM can be used to solve for expected return. kP = kRF + (kM kRF ) P kP = 8.0% + (15.0% 8.0%) (0.215) kP = 9.5%
Verifying the CAPM empirically
The CAPM has not been verified completely. Statistical tests have problems that make verification almost impossible. Some argue that there are additional risk factors, other than the market risk premium, that must be considered.
More thoughts on the CAPM

Investors seem to be concerned with both market risk and total risk. Therefore, the SML may not produce a correct estimate of ki. ki = kRF + (kM kRF ) i + ??? CAPM/SML concepts are based upon expectations, but betas are calculated using historical data. A companys historical data may not reflect investors expectations about future riskiness.
Lets recall from before three ways to determine the cost of equity, keor ks :
1. Capital Asset Pricing Model (CAPM)
ks = kRF + (kM - kRF )b

2. Dividend-Yield-Plus-Growth-Rate-Approach (DCF)
ks = D1/P0 + g.
3
Bond-Yield-Plus-Risk-Premium-Approach:
ks = kd + RP.
Whats the cost of 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%.
Whats the DCF cost of equity, ks? Given: D0 = $4.19 ;P0 = $50; g = 5%.
D 0 (1 + g) D1 ks = +g= +g P0 P0
$4.19(105) . = + 0.05 $50 = 0.088 + 0.05 = 13.8%.
Find ks using the own-bond-yieldplus-risk-premium method. (kd = 10%, RP = 4%.) ks = kd + RP = 10.0% + 4.0% = 14.0%
Whats a reasonable final estimate of ks?

Method CAPM DCF kd + RP Average Estimate 14.2% 13.8% 14.0% 14.0%
Generally, the three methods will not agree.

Lets turn our attention to weighted average cost of capital
x x
Weighted Cost of Capital

The weighted cost of capital is just the weighted average cost of all of the financing sources.

Capital Structure 20% 10% 70%
Source debt preferred common
Cost 6% 10% 16%

(20% debt, 10% preferred, 70% common)
Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16) = 13.4%
Whats the WACC?

(30% debt, 10% preferred, 60% common) (kd = 10%, kps = 9%, ks = 14%) (
WACC = wdkd(1 - T) + wps kps + wce ks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.
WACC Estimates for Some Large U. S. Corporations

Company Intel General Electric Motorola Coca-Cola Walt Disney AT&T Wal-Mart Exxon H. J. Heinz BellSouth
WACC 12.9% 11.9 11.3 11.2 10.0 9.8 9.8 8.8 8.5 8.2
What factors influence a companys 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.
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 projects WACC should be adjusted to reflect the projects risk.
Find the divisions required return on equity and weighted average cost of capital based on the CAPM, given these inputs:
Target debt ratio = 10%. kd = 12%. kRF = 7%. Tax rate = 40%. betaDivision = 1.7.
Market risk premium = 6%.

Find the divisions ks and WACC :
Divisions required return on equity :
ks = kRF + (kM - kRF )b. ks = 7% + (6% )1.7 = 17.2% Divisions WACC WACC = wdkd(1 T) + wcks = 0.1(12%)(0.6) + 0.9(17.2%) = 16.2%
How does the divisions WACC compare with the firms overall WACC?
Division WACC = 16.2% versus company WACC = 11.1%. Indicates that the divisions market risk is greater than firms average project. Typical projects within this division would be accepted if their returns are above 16.2%.
Overall Cost of Capital of the Firm Recall from before (slide # 3), Cost of Capital is the required rate of return on the various types of financing. The overall cost of capital is a weighted average of the individual required rates of return (costs).
Market Value of Long-Term Financing Type of Financing Long-Term Debt Preferred Stock Common Stock Equity
Figures from Slide # 4
Mkt Val Weight $ 35M 35% $ 15M 15% $ 50M 50% $ 100M 100%
Weighted Average Cost of Capital (WACC) Cost of Capital = k x) x (W

x=1 Recall the following cost of capital figures for Basket Wonders (refer to slide # 5 onwards) n
Cost of Debt (ki) = 6% Cost of Preferred Stock (kp) = 9% Cost of Equity (ke) =13%
Weighted Average Cost of Capital (WACC) Cost of Capital = k x) x (W

x=1 n
WACC (Basket Wonders) = WACC = .35(6%) + .15(9%) + .50(13%) WACC = .021 + .0135 + .065 = .0995 or 9.95%
Hang in there! It was a great and an enjoyable ride Yeah, thats easy for you to say!
End of Chapter
End of Term

Cost of Capital

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Cost of Capital

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Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 1

Cost of Capital Here we discuss the following: Overall Cost of Capital

The Capital Asset Pricing Model (CAPM)

Weighted Average Cost of Capital (WACC)

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 2

Overall Cost of Capital

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 3

Market Value of Long-Term Financing

Type of Financing Long-Term Debt Preferred Stock Common Stock Equity

Mkt. Val $ 35M $ 15M $ 50M $ 100M

Weight 35% 15% 50% 100%

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 4

Determination of the Cost of Debt

(1 + kd) = 1.1 kd = .1 or 10%

Interest is tax deductible, so kd AT or ki = kd BT(1 - T) = 10%(1 - 0.40) = 6%.

Cost of Preferred Stock

Determination of the Cost of Preferred Stock

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 9

Cost of Equity Approaches

Dividend Discount Model Capital-Asset Pricing Model Bond-Yield-Plus-Risk-PremiumApproach

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 10

Dividend Discount Model Dividend Discount Model

Constant Growth Model Constant Growth Model

Determination of the Cost of Equity Capital

= ( D1 / P0 ) + g = ($3(1.08) / $64.80) + .08 = .05 + .08 = 0.13 or 13%

Copyright 2009, FM, Prepared by Amyn Wahid

Now, lets talk about Capital Asset Pricing Model

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 14

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 15

The CAPM equation: kj = krf + j(km - krf)

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 20

Illustrating the calculation of beta _

Regression line: ^ = -2.59 + 1.44 ^ ki kM

Copyright 2009, FM, Prepared by Amyn Wahid

Characteristic Lines and Different Betas

Beta > 1 (aggressive) Beta = 1 Beta < 1 (defensive)

Each characteristic line has a different slope.

REQUIRED RETURN ON MARKET PORTFOLIO

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 25

Beta coefficients for HT, Coll, and T-Bills

All rights reserved. 26

Riskier securities have higher returns, so the rank order is OK.

Copyright 2009, FM, Prepared by Amyn Wahid

All rights reserved. 28

The Security Market Line (SML): As discussed before in slide # 17

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The Security Market Line (SML): Calculating required rates of return

The Security Market Line (SML):

Risk Premium Risk-free Return

Copyright 2009, FM, Prepared by Amyn Wahid

Systematic Risk (Beta)

Beta Coefficients for Selected Companies

Copyright 2009, FM, Prepared by Amyn Wahid