Reading 36
FinQuiz Notes – 2 0 1 5
2.
The cost of capital is the minimum rate that must be
earned on investment of a company or it is the rate of
return that is required by the suppliers of capital i.e.
bondholders and owners as compensation for their
contribution of capital.
• Investing in projects with return > cost of capital
add value to the company.
• Riskier the investment’s cash flows, greater will be
the cost of capital.
• Sources of capital include equity, debt and hybrid
instruments (that share characteristics of debt and
equity).
• Each source selected represents a component of
the company’s funding and has a required rate of
return which is referred to as the component cost
of capital.
To evaluate investment opportunities, analysts are
primarily concerned with marginal cost of capital (i.e.
cost to raise additional funds for the potential investment
projects).
To calculate cost of capital:
1) Calculate Marginal cost of each of the various
sources of capital
2) Calculate a weighted average of these costs. This
weighted average is called the Weighted
average cost of capital (WACC). WACC is also
known as the marginal cost of capital (MCC)
because it is the cost that a company incurs to
raise additional capital.
WACC = wdrd (1 – t) + wprp + were
where,
wd = proportion of debt that the company uses when it
raises new funds
rd = before-tax marginal cost of debt
t = company’s marginal tax rate
wp = proportion of preferred stock the company uses
when it raises new funds
rp = marginal cost of preferred stock
we = proportion of equity that the company uses when
it raises new funds
re = marginal cost of equity
Practice: Example 1 & 2,
Volume 4, Reading 36.
2.2 Weights of the Weighted Average
When a company has a target capital structure and it
raises capital consistent with this target, then target
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Cost of Capital
COST OF CAPITAL
capital structure should be used to estimate weights of
the weighted average.
An outsider e.g. an analyst does not know the target
capital structure; thus, it can be estimated using
following approaches:
1. In the absence of any explicit information about
a firm’s target capital structure, the company’s
current capital structure can be assumed as the
company’s target capital structure.
• In current capital structure, each component is
assigned weight according to its market value.
2. Estimate target capital structure by examining
trends in the company’s capital structure or
statements by management regarding capital
structure policy.
3. Estimate target capital structure using the
averages of comparable companies’ capital
structure. This method uses un-weighted,
arithmetic average.
NOTE:
A debt-to-equity ratio D/E is transformed into a weight
i.e. D / (D + E) as follows:
(D/E)/(1 + D/E)
Practice: Example 3,
Volume 4, Reading 36.
Applying the Cost of Capital to Capital
2.3
Budgeting and Security Valuation
• A company’s marginal cost of capital (MCC) may
increase as additional capital is raised.
• In contrast, returns on company’s investment
opportunities may decrease as the additional
investments are made by a company.
This relationship is exhibited in the investment opportunity
schedule (IOS) below.
Source: Figure 1, CFA® Program Curriculum,
Volume 4, Reading 36.
Reading 36
• Marginal cost of capital schedule is upward
sloping.
• Investment opportunity schedule is downward
sloping.
Optimal capital budget: It refers to the amount of capital
raised and invested at which the marginal cost of
capital intersects with the investment opportunity
schedule i.e. where
MC of capital = Marginal return from investing
This implies that the firm should invest in all those projects
with IRRs>Cost of capital to maximize the value created.
• For an average-risk project, the opportunity cost
of capital is the company’s WACC. Thus, NPVs of
potential projects of firm-average risk should be
calculated using the marginal cost of capital for
the firm.
• If the systematic risk of the project is above
average, a discount rate greater than the firm’s
existing WACC should be used.
• If the systematic risk of the project is below
average, a discount rate less than the firm’s
existing WACC should be used.
3. COST OF THE DIFFERENT SOURCES OF CAPITAL
Due to differences among sources of capital, each
source of capital has a different cost. Differences
include seniority, contractual commitments and
potential value as a tax shield.
3.1 Cost of Debt
The cost of debt is the required return on company’s
debt e.g. bonds or bank loans.
Approaches to estimate cost of debt:
1) Yield-to-Maturity Approach: The required return on
debt can be estimated by computing the yield-to-
maturity on the existing debt.
For example
N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT I/Y = 5%;
YTM = 5(2) = 10%
2) Debt-rating Approach: When a reliable current
market price for a company’s debt is not available,
the cost of debt can also be estimated using the
current rates, based on the bond rating we expect
when we issue new debt e.g. based on company’s
debt rating,
• Before-tax cost of debt is estimated by using the
yield on comparably rated bonds i.e. with same
debt rating and similar maturity.
Cost of Capital FinQuiz.com
Limitations of WACC: When a company uses WACC in
the calculation of the NPV of a project, it assumes that
when additional capital is raised to finance new
projects, the cost of capital will be unchanged, i.e.:
• The proportion of debt and equity remain
unchanged i.e. a company will have a constant
target capital structure throughout its useful life.
• The operating risk of the firm is unchanged.
• The financing is not project specific i.e. it has the
same risk as the average-risk of the company.
Marginal cost of capital is used by analysts in security
valuation using different discounted cash flow valuation
models i.e.
• If cash flows are cash flows to the company’s
suppliers of capital (i.e. free cash flow to the firm),
the analyst uses WACC to find the PV of these
flows.
• If cash flows are cash flows to the company’s
owners (i.e. free cash flow to equity or dividends),
the analyst uses the cost of equity capital to find
the PV of these flows.
• In bond markets, this approach is referred to as
matrix pricing.
Important: The cost of debt is NOT the coupon rate of a
bond.
• Interest expense on a firm’s debt is tax-deductible,
so the pre-tax cost of debt must be reduced by
the firm’s marginal tax rate to get an after-tax cost
of debt capital.
After-tax cost of debt = kd(1 – firm’s marginal tax rate)
• The pre-tax and after-tax capital costs are equal
for both preferred stock and common equity
because dividends paid by the firm are not tax-
deductible.
• Debt rating and yields are also affected by debt
seniority and security.
Practice: Example 4,
Volume 4, Reading 36.
3.1.3) Issues in Estimating the Cost of Debt
In case of fixed rate security, analysts can easily observe
yields of the company’s existing debt or market yields of
debt of similar risk. However, for a floating-rate security, it
is quite difficult to estimate cost of debt because cost of
Reading 36
floating-rate security depends on both current yields and
future yields.
• In this case, average cost can be estimated using
the current term structure of interest rates and term
structure theory.
3.1.3.2 Debt with Option-like Features
To estimate cost of debt with option-like features,
• If the company already has debt outstanding with
option-like features, the analyst may simply use the
YTM on such debt.
• If it is believed that the future debt will include or
exclude few option features, the analyst can
make market value adjustments to the current YTM
to reflect the value of such additions and/or
deletions.
3.1.3.3 Nonrated Debt
When the company has nonrated debt, cost of debt
can be estimated using a company’s “synthetic” debt
rating based on financial ratios. However, this method is
inaccurate because debt ratings are based on
• Financial ratios, and
• Information regarding particular bond issue and
the issuer.
3.1.3.4 Leases
If the company uses leasing as a source of capital, the
cost of these leases should be included in the cost of
capital. The cost of leasing is similar to that of the
company’s other long-term debt.
3.2 Cost of Preferred Stock
In the case of nonconvertible, noncallable preferred
stock:
• Preferred stock generally pays a constant dividend
each period.
• Dividends are expected to be paid every period
forever (i.e. fixed rate perpetual preferred stock).
PP = Dp / rp
where,
Pp = current preferred stock price per share
Dp = preferred stock dividend per share
rp= cost of preferred stock
Thus,
rP = Dp/Pp
NOTE:
Preferred dividends are not tax-deductible, so there is no
tax adjustment for the cost of preferred equity.
Cost of Capital FinQuiz.com
Practice: Example 5 & 6,
Volume 4, Reading 36.
3.3 Cost of Common Equity
The cost of common equity (re) (or the cost of equity), is
the rate of return required by company’s common
shareholders on the equity capital that is retained by a
company. Common equity can be increased in two
ways:
i. Through retained earnings.
ii. Through the issuance of new shares of stock.
Estimating the cost of equity capital is more difficult than
estimating the cost of debt capital due to uncertainty of
future cash flows with respect to the amount and timing.
The cost of equity can be estimated using the following
methods:
• Capital asset pricing model
• Dividend discount model
• Bond yield plus risk premium method
NOTE:
The pre-tax and after-tax capital costs are equal for
common equity because dividends paid by the firm or
the return on equity capital are not tax-deductible.
3.3.1) Capital Asset Pricing Model Approach
E (Ri) = RF + βi [E (RM) – RF]
where,
RF = Risk-free asset *
βi = sensitivity of stock return to changes in the
market return**
E (RM) = expected return on the market
E (RM) – RF = expected market risk premium
NOTE:
* A risk free asset refers to an asset that has no default
risk. A common proxy for the risk-free rate is the yield
on a default-free government debt instrument.
Generally, risk-free rate should be selected according
to the duration of projected cash flows e.g. for a
project with an estimated useful life of 10 years, rate
on the 10-year Treasury bond can be used as risk-free
rate.
** beta is estimated relative to an equity market index;
therefore, market premium estimate used here
represents an estimate of the equity risk premium
(ERP).
• This approach involves estimating average rate of
return of a company’s market portfolio and the
average rate of return for the risk-free asset in that
country using historical data.
Reading 36 Cost of Capital FinQuiz.com

• Assuming an unchanged distribution of returns Ways to estimate growth rate:

through time, the arithmetic mean represents an
unbiased estimate of the expected single-period
equity risk premium; but for multiple periods,
geometric mean is preferred to use.
Limitations of the historical premium approach:
1) Using forecasted growth rate from a published source
or vendor.
2) Using a relationship between growth rate, retention
rate and ROE i.e.
g = (1 - dividend payout ratio) × Historical return on
equity

1) Stock index’s risk level may change over time.
2) Risk aversion of investors may change over time.
3) Estimates are sensitive to the method of
estimation and the historical period used.
CAPM is a single factor model; thus, it does not take into
account all risks e.g. inflation, business-cycle, interest
rate, exchange rate, and default risks. Thus, we can use
Multifactor model that incorporates factors that
represent other sources of price risk i.e. macroeconomic
factors and company-specific factors. In general, it is
expressed as:
E (Ri) = RF + βi1 (Factor risk premium)1 + βi2 (Factor risk
premium)2+…..+βij (Factor risk premium)j
where,
βij = stock i’s sensitivity to changes in the jth factor
(Factor risk premium)j = expected risk premium for the jth
factor

g = (1 - ) × ROE

g = retention rate × ROE
Survey Approach to estimate equity risk premium: In this
approach, equity risk premium is estimated by asking a
panel of finance experts for their estimates and taking
the mean response.
3.3.3) Bond Yield plus Risk Premium Approach
This approach is based on the fact that cost of capital of
riskier cash flows > cost of capital of less risky cash flows.
Thus,
re =rd + Risk Premium
• Risk premium represents compensation for
additional risk associated with stock of the
company relative to bonds of the same company.
• Unlike equity risk premium (cost of equity – risk-free
rate), here

Risk premium = cost of equity – company’s cost of debt

Practice: Example 7 & 8,

Volume 4, Reading 36. • This premium can be estimated by using historical
spreads between bond yields and stock yields.
• In developed country markets, it is in the range of
3%-5%.
3.3.2) Dividend Discount Model Approach



 

where,
re = cost of equity
D1 = expected dividend for the next period
P0 = current market value of the stock
g = expected growth rate of dividends
D1/ P0 = forward annual dividend yield

4. TOPICS IN COST OF CAPITAL ESTIMATION

where,
4.1 Estimating Beta and Determining a Project Beta
 = estimated intercept
Company’s stock beta can be estimated using a market
= estimated slope of the regression, represents an
model regression where company’s stock returns (Ri) are estimate of beta.
regressed against market returns (Rm) over T periods.
Issues with estimated beta:
   


• Estimated beta is sensitive to the method of
t = 1, 2, …T. estimation and data used.
• Estimated beta is sensitive to estimation period
used. There is trade-off between data precision
Reading 36 Cost of Capital FinQuiz.com

obtained by using longer estimation period and estimate the project’s required return. Pure-play method
company-specific changes which are better involves the following steps:
reflected using shorter estimation periods.
o Longer estimation periods can be used for 1) Estimate the beta for a comparable company or
companies with long and stable operating companies i.e. company with similar business risk.
history.
o Shorter estimation periods can be used for • This beta is referred to as levered beta βL, comparable .
companies experiencing significant structural
changes in the recent past. 2) Un-lever the beta to get the asset beta using the
• Periodicity of return interval (i.e. daily, weekly or marginal tax rate and debt-to-equity ratio of the
monthly): It has been observed that beta comparable company.
estimated using smaller return intervals (i.e. daily
returns) have smaller standard errors.
• This beta is referred to as un-levered beta βU,
• Selection of an appropriate market index: Beta
comparable.
estimate is affected by the choice of market
• This beta represents the company’s asset risk.
index.
, 

• Use of a smoothing technique: Historical beta is
adjusted by some analysts to reflect tendency of , 
 
1  1  
  
೎೚೘೛ೌೝೌ್೗೐
beta to revert to 1.
೎೚೘೛ೌೝೌ್೗೐
• Adjustments for small-capitalization stocks: Small-
capitalization stocks are considered to have
greater risk and generate greater returns relative 3) Re-lever the beta using the marginal tax rate and
to larger capitalization stocks over the long-run. debt-to-equity ratio of the firm considering the project
Therefore, betas of small-capitalization companies to incorporate project’s financial risk.
should be adjusted upward.
• This beta is referred to as levered beta βL, project.
Stock return data for publicly traded companies is

,   , 
 1  1    
readily and easily available; therefore, beta for publicly
traded companies can be easily estimated. 

It is difficult to estimate beta for:

NOTE:
a) Companies that are not publicly traded.
 
b) Projects that are not average or typical project of  
1  1   
a publicly traded company. 




    1  1   

Factors affecting beta of a company or project: 
1) Business risk include:

i. Sales risk i.e. risk related to uncertainty of

revenues of a company. It is affected by elasticity
of demand for the product, cyclicality of
revenue, competition structure in the industry.
ii. Operating risk i.e. risk related to operating cost
structure of a company. It is affected by relative
mix of fixed and variable operating costs i.e.
greater the fixed operating costs, greater the
uncertainty of income and cash flows from
operations.
2) Financial risk: It is related to uncertainty of net income
and net cash flows associated with use of financing
that has a fixed cost i.e. debt and leases.
Practice: Example 9, 10 & 11,
Volume 4, Reading 36.
4.2 Country Risk
Beta does not accurately incorporate country risk of
companies in developing nations. Thus, to reflect the
increased risk associated with investing in a developing
country, a country equity premium or country spread is
added to the market risk premium when using the
CAPM.

• Greater the use of financial leverage, greater the Approaches to estimate country spread:
financial risk. 1) Country spread can be estimated using a sovereign
yield spread i.e.
Pure-play method: When a project’s risk is different from
that of the firm’s average project, the beta of a Sovereign yield spread = Government bond yield of the
company or group of companies that are exclusively in country denominated in the
the same business as the project can be used to currency of a developed
Reading 36 Cost of Capital FinQuiz.com

country – Treasury bond yield NOTE:

on a similar maturity bond in
When a company that is solely financed with common
the developed country
equity raises additional capital via debt, then due to tax
advantages, company’s WACC will decrease as
2) Another approach to estimate country spread is as
additional capital is raised.
follows:
As more and more capital is raised by a company, cost
Country equity premium =Sovereign yield spread ×
of different sources of financing increases. Hence,
(Annualized S.D of Equity
typically, MCC schedule is upward sloping.
index / Annualized S.D of
sovereign bond market in
Break point: It is the amount of capital at which cost of
terms of the developed
one of the components of the capital changes. A break
market currency)
point is calculated as:

• Greater the S.D (or volatility) of equity market Breakpoint =

index, greater the country equity premium, all else  !"# $ %&'(#&) &# *+(%+ #+, - !.%,/- % -# $ %&'(#&) %+&"0,-
constant. . ' .#( " $ ",* %&'(#&) .&(-,1 $.  #+, - !.%,

Cost of equity = Ke= RF + β[(E(RM)-RF) + CRP]

Practice: Example 13,
where,
Volume 4, Reading 36.
CRP = Country Risk Premium

3) Using country credit ratings to estimate the expected

rates of returns for countries that have credit ratings 4.4 Flotation Costs
but do not have equity markets. It involves following
steps:
Investment banks assist companies in raising new equity
capital. They assist in
• Estimating reward to credit risk measures for a
large sample of countries which have both credit
• Setting the price of the issue, and
ratings and equity markets.
• Selling the issue to the public.
• Applying this ratio to countries without equity
markets based on country’s credit rating.
The costs of these services provided by the investment
banks are referred to as “flotation costs”.

Practice: Example 12, • The amount of flotation costs is generally quite low
Volume 4, Reading 36. for debt and preferred stock (often 1% or less of
the face value).
• For common stock, flotation costs can be as high
as 25% for small issues, for larger issue they will be
4.3 Marginal Cost of Capital Schedule much lower.

The marginal cost of capital (MCC) refers to the cost of These costs must be accounted for in the company’s
the last new dollar of capital (additional capital) raised WACC. There are two ways to do so:
by a company. Cost of capital (WACC) increases as
more and more capital is raised i.e. a) By adjusting the cost of capital of a firm i.e.
When flotation costs are in monetary terms or per share
• As a firm raises additional debt, the cost of debt basis:
increases to reflect additional financial risk e.g. 
!  " $
due to restriction in a bond covenant regarding   #
issuing additional debt with similar seniority as
existing debt, a company have to issue less senior where,
debt (e.g. subordinated bonds) or have to issue f = flotation cost in monetary terms or per share basis.
equity which would have a higher cost.
• Issuing new equity is more expensive than using When flotation costs are in terms of % of the share price:

retained earnings due to flotation costs.
• MCC also increases due to deviation from the !  " $
target capital structure.  1  %
where, f = flotation cost as % of issue price.
Reading 36 Cost of Capital FinQuiz.com

Limitation of method: Example: Suppose

This method is inaccurate because it involves adjusting
PV of the future cash flows by a fixed percentage. • Initial cash outlay = $60,000
• Cash inflows each year = $1,000
Advantages: • Tax rate = 40%
• rd before tax = 5%
• re = 10%
• This method is useful when specific project
• Wd = 40% and We = 60%.
financing cannot be easily identified.
• Debt =24,000 and Equity = 36,000.
• It helps to demonstrate how costs of financing a
• Flotation costs = 5% of new equity capital = 5% ×
company change as its internally generated
(36,000) = $1,800.
equity (R/E) exhaust and a company needs to
raise externally generated equity (new stock
issues). Thus,
WACC= 7.2%
b) By adjusting the initial project cost: The correct way to PV of cash inflows = $69,591
account for flotation costs is by adjusting initial project
cost. It involves: If flotation costs are not tax deductible:
NPV = $69,591 – $60,000 – $1,800 = $7,791
i. Estimating the dollar amount of the flotation cost
associated with the project, and If flotation costs are tax deductible:
ii. Adding that cost to the initial cash outflow for the
project. NPV = $69,591 – $60,000 – $1,800 (0.60) = $8,511

Practice: End of Chapter Practice

Problems for Reading 36.