2201AFE Corporate Finance

Week 10:
Cost of Capital

Readings: Chapter 17

Agenda
Last Week
Cost of Capital
Key Concepts and Skills
Real World Application
Investors Need A Good WACC
Next Week

2
Last Lecture
Expected Returns and Variances
Single asset & Portfolios
Using probabilities & Historical returns
Principle of Diversification
Systematic and Unsystematic Risk
Beta
CAPM = Capital Asset Pricing Model
SML = Security Market Line
Reward-to-Risk Ratio
Deciding if assets are undervalued or overvalued?
3



Cost of Capital

Chapter 17
4
5
1. Introduction & Financial
Statements
2. Time Value of Money
3. Valuing Shares & Bonds
7. Mid-semester Exam
8. Some Lessons from Capital
Market History
11. Financial Leverage & Capital
Structure Policy
13. Options & Revision
9. Return, Risk & the Security
Market Line
5. Making Capital Investment
Decisions & Project Analysis
12. Dividends & Dividend Policy
6. Revision for Mid-sem Exam
4. Net Present Value & Other
Investment Criteria
10. Cost of Capital
Key Concepts and Skills
Cost of Capital: Introduction
Cost of Equity
Cost of Debt
Cost of Preferred Stock
Weighted Average Cost of Capital (WACC)
Divisional and Project Costs of Capital
Flotation Costs (cost of issuing shares)
6
Why Cost of Capital Is Important
The return to an investor is the same as the cost to the
company.

Our cost of capital provides us with an indication of how
the market views the risk of our assets.

Knowing our cost of capital can also help us determine our
required return for capital budgeting projects.
7
Required Return = Cost of Capital
The Required Rate of Return = Discount Rate = Hurdle Rate
= Cost of Capital

Need to know the required return for an investment so we
can compute the NPV and decide whether or not to take
the investment.

Need to earn at least the required return to compensate
investors for their financing.

Required return from the investors point of view.
Cost of capital from the firms point of view.
8
Cost of Capital
The firm is financed by a mixture of equity and debt (i.e.
capital structure).
Cost of Capital is a mix of Cost of Equity and Cost of Debt.
These costs are determined by the market.
The firm determines the mix, Debt/Equity (D/E) reflecting
its target capital structure.

To calculate cost of capital:
Calculate cost of equity
Calculate cost of debt
Combine them

9
Cost of Equity
The cost of equity is the return required by equity
investors, the shareholders on their investment in the firm.

Since this cost is not directly observable, it must be
estimated.

There are two main methods for determining the cost of
equity:
Dividend Growth Model
CAPM
10
Cost of Equity DGM Approach
Start with the dividend growth model formula where g is
constant:


where: R
E
is the required return for shareholders, P
0
is the
current price, D
0
is the current/last dividend, D
1
is the next
dividend. Rearranging to solve for R
E
:


where D
1
/ P
0
is the dividend yield, and g is the growth rate of
dividends.
11
g R
D
g R
g) 1 ( D
P
E
1
E
0
0

+
=
g
P
D
R
0
1
E
+ =
DGM Example 1
Bentex Ltd. recently paid a dividend of 40 cents per share.
This dividend is expected to grow at 6% per year
indefinitely. If the current market price of Bentex shares is
$6 per share, estimate its cost of equity.
D
0
= $0.40, g = 6%, P
0
= $6, R
E
= ?

D
1
= D
0
(1 + g) = $0.40(1.06) = $0.424

12
equity of cost = 13.07% or 1307 0 = 06 0 +
00 6
424 0
= + =
0
1
. . g
P
D
R
E
.
.
DGM Example 2
Suppose ABC company is expected to pay a dividend of
$1.50 per share next year. There has been a steady growth
in dividends of 5.1% per year. The current price is $25.
What is the cost of equity?

D
1
= $1.50, g = 5.1%, P
0
= $25, R
E
= ?
13
% 1 . 11 111 . 0 051 . 0
25
50 . 1
g
P
D
R
g R
D
P
0
1
E
E
1
0
= = + = + =

=
Example Estimating the Dividend Growth Rate g
One method for estimating the growth rate is to use the
historical average:









Another way is use analysts forecast of growth (g).
14
Year Dividend Change Return

2000 1.23 -
2001 1.30 (1.30-1.23) / 1.23 = 5.7%
2002 1.36 (1.36-1.30) / 1.30 = 4.6%
2003 1.43 (1.43-1.36) / 1.36 = 5.1%
2004 1.50 (1.50-1.43) / 1.43 = 4.9%
Average return = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
Advantages and Disadvantages of Dividend Growth Model
Advantage:
Easy to understand and use.

Disadvantages:
Only applicable to companies currently paying dividends.
Assumes dividend growth is constant.
Cost of equity is sensitive to growth estimate.
Does not explicitly consider risk.
15
Cost of Equity CAPM or SML Approach
Recall CAPM for any asset i is:
E(R
i
) = R
f
+
i
[E(R
m
) R
f
]

The CAPM cost of equity (R
E
) is:
R
E
= R
f
+
E
[E(R
m
) R
f
]

Where:
R
E
= Required return for shareholders
R
f
= Risk-free rate
E(R
M
) R
f
= Market risk premium
|
E
= Systematic risk of firms equity relative to the market
16
CAPM Example
Suppose our ABC company has an equity beta of 0.58 and
the current risk-free rate is 6.1%. If the expected market
risk premium is 8.6%, what is the cost of equity capital?

E
= 0.58, R
f
= 6.1%, E(R
M
) R
f
= 8.6%

R
E
= R
f
+
E
[E(R
m
) R
f
]
R
E
= 0.061 + 0.58(0.086) = 11.1%

What if the expected market return E(R
m
) is 8.6%?
R
E
= 0.061 + 0.58(0.086 0.061) = 7.55%
17
Advantages and Disadvantages of CAPM
Advantages:
Explicitly adjusts for risk.
Applicable to all companies.

Disadvantages:
Have to estimate the expected market risk premium, which
does vary over time.
Have to estimate beta, which also varies over time.
We are using the past to predict the future, which is not
always reliable.
18
Example Cost of Equity
Suppose our company has a beta of 1.5. The market risk
premium is expected to be 9% and the current risk-free
rate is 6%. The market believes our dividends will grow at
6% per year and our last dividend was $2. The stock is
currently selling for $15.65. What is the cost of equity?
Using CAPM:
R
E
= R
f
+
E
[E(R
m
) R
f
]

Using DGM:



19
g
P
g D
R
E
+
+ 1
=
0
0
) (
Cost of Preferred Stock
Reminders:
Preferred stock pays a constant dividend.
Dividends are expected to be paid forever.
Preferred stock return = Perpetuity = R
P


P
0
= D / R
p
R
P
= D / P
0

Example: Your company has preferred stock that has an
annual dividend of $3. If the current price is $25, what is
the cost of preferred stock?
25 = 3 / R
p
therefore, R
P
= 3 / 25 = 12%
20
Cost of Debt
The cost of debt is the required return on our companys
debt.

We usually focus on the cost of long-term debt or bonds.

The required return is best estimated by computing the
yield-to-maturity or YTM.

The cost of debt is NOT the coupon rate.
For publicly listed debt use YTM.
If the firm has no publicly traded debt, use YTM on similar
debt that is traded.

21
YTM of Bond
In general:




Where:
C = coupon interest payment
R
D
= required market return or YTM
T = the number of periods left until repayment
F

= face value
Need to solve for R
D
22
T
D D
T
D
0
) R 1 (
F
R
) R 1 (
1
1
C P
+
+
(
(
(
(

=
Example Cost of Debt
Gloss Ltd issued a 20-year, 12% bond 10 years ago. The
bond is currently priced at $86, and pays interest annually.
What is its cost of debt?





Excel solution gives R
D
= 0.1476, meaning that Glosss cost
of debt is 14.76%.
Excel formula =rate(nper,pmt,pv,fv) =rate(10,12,-86,100)
23
10
D D
10
D
) R 1 (
100 $
R
) R 1 (
1
1
12 $ 86 $
+
+
(
(
(
(

=
Example Cost of Debt
Suppose a firm has a bond issue currently outstanding that
has 25 years left to maturity and pays coupons semi-
annually. The coupon rate is 9% per year. The bonds
current price is $90.87 per $100 bond. What is the cost of
debt?
t = 25 years 2 = 50; C = $9 / 2 = 4.5;
F = $100; Bond Price or P = $90.87;
R
D
or YTM = ?

By trial and error semiannual yield = 5%
YTM = R
D
= 5% 2 = 10%
24
Weighted Average Cost of Capital
We can use the individual costs of capital that we have
computed to get our average cost of capital for the firm.

WACC is the required return on our assets, based on the
markets perception of the risk of those assets

The weights are determined by how much of each type of
financing we use:
WACC = w
E
R
E
+ w
P
R
P
+ w
D
R
D

WACC = (E/V) R
E
+ (P/V) R
P
+ (D/V) R
D

where V = E + P + D
25
Weighted Average Cost of Capital
Notations:
E = market value of equity
no. of outstanding shares price per share

P = market value of preference shares
no. of outstanding preference shares price per share

D = market value of debt
no. of outstanding bonds bond price

V = market value of the firm = E + P + D


26
Capital Structure Weights
Weights:
w
E
= E/V = percent financed with equity
w
P
= P/V = percent financed with preference stock
w
D
= D/V = percent financed with debt

w
E
+ w
P
+ w
D
= 1
27
Example Weights & WACC
Cost of debt = 5.7 %, Cost of equity = 14.0 %
Cost of preference shares = 9.0 %






WACC = (E/V) R
E
+ (P/V) R
P
+ (D/V) R
D

= (0.5)0.14 + (0.1)0.09 + (0.4)0.057
= 0.1018 or 10.18% (Unadjusted for taxation effects)
28
Source of Capital Market Value Weight
Long term debt $40m 40%
Preference shares $10m 10%
Equity $50m 50%
Total $100m 100%
WACC Adjusted
The company gets a tax deduction for interest on debt,
reducing the effective cost of debt.
If T
C
is the corporate tax rate then the after tax cost of debt
is R
D
(1 T
C
), and the WACC adjusted for taxation effects
is given by:
WACC = w
E
R
E
+ w
P
R
P
+ w
D
R
D
(1T
c
)

or
WACC = (E/V) R
E
+ (P/V) R
P
+ (D/V) R
D
(1T
c
)

Previous example: If tax rate is 30%, then
WACC = (0.5)0.14 + (0.1)0.09 + (0.4)0.057(10.3)
= 0.0950 or 9.5%.
29
WACC Extended Example (1)
Equity Information:
50 million shares
$80 per share
Beta = 1.15
Market risk premium = 9%
Risk-free rate = 5%


Step 1: Calculate cost of equity and cost of debt.
Step 2: Calculate the market value of each source of financing and
the weights.
Step 3: Calculate the WACC adjusting for tax.

30
Debt Information:
$1 billion in outstanding
debt (face value)
Current quote = 110%
Coupon rate = 9%,
semiannual coupons
15 years to maturity
Tax rate = 40%
WACC Extended Example (2)
What is the cost of equity?

E
= 1.15; R
f
= 5%; R
M
R
f
= 9%; R
E
= ?
R
E
= 5% + 1.15(0.09) = 0.1535 or 15.35%

What is the cost of debt?
t = 15 years 2=30; Price = $110; C = $9 / 2 = 4.5;
F = $100; by trial & error semi yield = 3.9268%
R
D
= 0.03927 2 = 0.07854 or 7.854%

What is the after-tax cost of debt?
R
D
(1 T
C
) = 7.854(1 0.4) = 0.04712 or 4.712%
31
WACC Extended Example (3)
What are the capital structure weights?
E = 50 million $80 = $4 billion
D = $1 billion 110% = $1.1 billion or
$1 billion / 100 = 10 million bonds issued
10 million bonds $110 = $1.1 billion
V = 4 + 1.1 = 5.1 billion

w
E
= (E / V) = (4 / 5.1) = 0.7843
w
D
= (D / V) = (1.1 / 5.1) = 0.2157

What is the WACC?
WACC = w
E
R
E
+ w
D
R
D
(1T
c
)

WACC = 0.7843(0.1535) + 0.2157(0.04712)
= 0.1336 or 13.06%
32
Finding the Weights from D/E
Suppose Belo Corp has a target D/E ratio of 0.33. Cost of Debt is
10% and cost of equity is 20%. If tax is 34%, what is WACC?
First calculate W
E
and W
D
.
If D / E = 0.33 what is E = ? D = ?
Assign any value to equity, E = 1
D / 1= 0.33 then D = 0.33 and V = 1.33
E / V = 1 / 1.33 = 0.7519 and
D / V = 0.33 / 1.33 = 0.2481

WACC = w
E
R
E
+ w
D
R
D
(1T
c
)

WACC = 0.750.20 + 0.250.10(10.34) = 0.1665 or 16.65%
33
Finding D/E
If BHP has a WACC of 21.67% and the cost of equity is 29.2%,
cost of debt is 10%, what is its target D/E ratio? Assume tax is
34%.

We know that:
E + D = V or W
E
+ W
D
= 1

We express one in terms of another:
W
E
= 1 - W
D

And insert in WACC equation:
0.2167 = W
E
0.292 + W
D
0.10 (10.34)
0.2167 = (1-W
D
) 0.292 + W
D
0.10 (10.34)
34
Finding D/E
0.2167 = (1-W
D
) 0.292 + W
D
0.10 (1-0.34)

Solve for W
D
the only unknown variable:
0.2167 = 0.292 W
D
0.292 + W
D
0.066
0.2167 0.292 = -W
D
0.292 + W
D
0.066
-0.0753 = -W
D
(0.292 - 0.066)
0.0753 = W
D
0.226
W
D
= 0.0753/0.2260 = 0.333

Therefore W
E
= 1 W
D
, W
E
= 1 0.333 = 0.667
D/E = 0.333/0.667 = 0.5
35
Divisional and Project Costs of Capital
Using the WACC as our discount rate is only appropriate for
projects that have the same risk as the firms current
operations.

If we are looking at a project that does NOT have the same
risk as the firm, then we need to determine the appropriate
discount rate for that project.

Divisions also often require separate discount rates
(Divisions Overview).
36
Using WACC for All Projects Example





Assume the WACC = 15%.

If we use the WACC for all projects regardless of risk
Accept A and B, reject C

If correct required return based on specific risk is used
Accept B and C, reject A
37
Project Required Return IRR WACC

A 20% reject 17% accept 15%
B 15% accept 18% accept 15%
C 10% accept 12% reject 15%
Divisional and Project costs of capital
WACC is the appropriate discount rate only when the
project is about the same risk as the firm.

Other approaches to estimating a discount rate:
Divisional cost of capital used if a company has more
than one division with different levels of risk;

Pure play approach a discount rate that is unique to a
particular project is used;

Subjective approach projects are allocated to specific
risk classes which, in turn, have specified discount rates.
38
Other Approaches
Pure Play Approach:
Look at companies in the same line of business as the new
project.
Calculate an average WACC for all the companies and use
this rate as the discount rate of the new project.

Subjective Approach:
Consider the projects risk relative to the firm overall risk.
If the project risk > firm risk,
use a discount rate > WACC
If the project risk < firm risk,
use a discount rate < WACC
39
Flotation Costs
The required return depends on the risk, not how the money is
raised.
However, the cost of issuing new securities should not just be
ignored either.
Basic Approach:
Compute the weighted average flotation cost
Use the target weights because the firm will issue securities in
these percentages over the long term
f
A
= (E/V) f
E
+ (D/V) f
D

where f
A
is the weighted average flotation cost, f
E
is the equity
flotation cost proportion, and f
D
is debt flotation cost proportion.
True cost of project = Cost / (1 f
A
)
40
Flotation Costs Example
A firm has a target structure that is 80% equity and 20% debt.
The costs for raising equity are 20% and the cost of raising debt
are 6%.
If the firm needs $65 million for a new facility, what is the true
cost after accounting for flotation costs?
f
A
= (E/V) f
E
+ (D/V) f
D

= 0.80.2 + 0.20.06 = 0.172 or 17.2%

If the flotation cost is 17.2%, and we need to raise $65 million
net, this would be only 82.8% or (1 17.2%) of amount raised
$65m = (1 f
A
) True amount raised
True amount raised = $65 / (1 f
A
) = 65 / 0.828 = $78.50 million
41
Flotation Costs Example
The firm needs to raise
$78.5 million to account for flotation costs and to have $65
million left to invest.

Since 78.5 / 65 = 1.2077, this suggests that:
for every dollar required by the project, the firm must raise
$1.2077 to finance its projects and to cover the cost of
raising the funds.
42
Quick Quiz
What are the two approaches for computing the cost of equity?

What is the cost of debt?

How do you compute the after-tax cost of debt?

When is appropriate to use WACC as the discount rate for
projects?

What is the proportion of E and D if we have a D/E ratio of 1.2?

43



Real World Application
Investors Need A Good WACC
44
Investors Need A Good WACC
During the dotcom era, there were predictions of the Dow Jones
Index soaring to 30,000!
Around five times greater than current value.
But this was a time when the market lost itself to the hype.
Role of psychology and behavioural finance?
When investors, along with their valuations, come back down to
earth from such heights, there can be a loud thump, reminding
everyone that it's time to get back to fundamentals and take a
look at a key aspect of share valuations.
the weighted average cost of capital (WACC)

Source: http://www.investopedia.com/articles/fundamental/03/061103.asp
45
To understand WACC, think of a company as a bag of money. The money in the bag
comes from two sources: debt and equity
Money from business operations is not a third source because, after paying for debt,
any cash left over that is not returned to shareholders in the form of dividends is kept
in the bag on behalf of shareholders
If debt holders require a 10% return on their investment and shareholders require
a 20% return, then, on average, projects funded by the bag of money will have to
return 15% to satisfy debt and equity holders - the 15% is the WACC
If the only money the bag held was $50 from debt holders and $50 from
shareholders, and the company invested $100 in a project, the return from this
project, to meet expectations, would have to return $5 a year to debt holders and
$10 a year to shareholders - this would require a total return of $15 a year, or a
15% WACC
Investors use WACC as a tool to decide whether to invest. The WACC represents the
minimum rate of return at which a company produces value for its investors
Let's say a company produces a return of 20% and has a WACC of 11%. That
means that for every dollar the company invests into capital, the company is
creating $0.09 of value
By contrast, if the company's return is less than WACC, the company is shedding
value, which indicates that investors should put their money elsewhere
46
Next Week
Next week we look at the role of leverage and the Nobel
Prize winning work on selecting a capital structure.
47