Chapter 11

The Cost of Capital

taufikur@ugm.ac.id
What types of capital do firms use?

Debt
Preferred stock
Common equity:
Retained earnings
New common stock
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.
 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
todays marginal costs (for WACC).
 A 15-year, 12% semiannual bond, principal
$1000, sells for $1,153.72. Whats 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%
 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.
 Whats the cost of preferred stock?
Pp = $111.10; 10% Quarterly; Par = $100.

Use this formula:

Dp $10
kp 0.090 9.0%.
Pp $111 .10
 Picture of Preferred Stock
0
kp = ?
1 2
...
-111.1 2.50 2.50 2.50
$111.10 = DQ = $2.50 .
kPer kPer
kPer = $2.50 = 2.25%;
$111.10
kp(Nom) = 2.25%(4) = 9%.
Note:
Preferred dividends are not tax
deductible, so no tax adjustment. Just
kp.
Nominal kp is used.
Our calculation ignores flotation costs.
 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.
 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.
 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.
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.
Whats 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%.

Whats the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.

ks = D1 + g = D0(1 + g) + g
P0 P0
= $4.19(1.05) + 0.05
$50
= 0.088 + 0.05
= 13.8%.
Suppose the company has been
earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout =
65%), and this situation is expected to
continue.

Whats the expected future g?

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%. Whats g?
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.
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.
Whats a reasonable final estimate of ks?

Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%
 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.
 Two approaches that can be used to
account for flotation costs:

Include the flotation costs as part of the

projects up-front cost. This reduces the
projects estimated return.
Adjust the cost of capital to include flotation
costs. This is most commonly done by
incorporating flotation costs in the DCF
model.
New common, F = 15%:

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
 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.
 Whats the firms WACC
(ignoring flotation costs)?
Suppose the firm has a target capital
structure calling for 30% debt, 10%
preferred stock, and 60% common equity
(retain earnings), using the below data we
can calculate the following WACC
kd = 10%
kp = 9%
ks = 14%
 Whats the firms 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%.
 What factors influence a
companys composite WACC?
Market conditions. (Firms out of control)
Interest rate
Tax rate
Under Firms control
The firms capital structure and dividend policy.
The firms investment policy. Firms with riskier
projects generally have a higher WACC.
WACC Estimates for Some Large
U. S. Corporations, Nov. 1999
Company WACC
Intel 12.9%
General Electric 11.9
Motorola 11.3
Coca-Cola 11.2
Walt Disney 10.0
AT&T 9.8
Wal-Mart 9.8
Exxon 8.8
H. J. Heinz 8.5
BellSouth 8.2
 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.
 Risk and the Cost of Capital
Rate of Return
(%) Acceptance Region

WACC

12.0 H

10.5 A Rejection Region

10.0
9.5 B
8.0 L

Risk
0 RiskL RiskA RiskH
 Divisional Cost of Capital
Rate of Return
(%)
WACC
Division Hs WACC
13.0

Project H
11.0

10.0
Composite WACC
9.0 Project L
for Firm A

7.0 Division Ls WACC

Risk
0 RiskL RiskAverage RiskH