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Cost of Capital

1

Topics in Chapter

Cost of capital components

Debt

Preferred stock

Common equity

WACC

Factors that affect WACC

Adjusting cost of capital for risk

2

COST OF CAPITAL

Why? Business Application

Key to understanding cost Min Req’d return needed

of raising $ on Project

Risk Reflects blended costs of

Financing costs raising capital

Discount Rate

Relevant “i ”

Discount rate used to

determine Project’s NPV

or to disct FCFs by

Hurdle rate

3

Determinants of Intrinsic Value:

The Weighted Average Cost of Capital

−

profit after taxes in operating capital

=

(FCF)

Value = + + ··· +

(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average

cost of capital

(WACC)

Cost of debt

Market risk aversion Cost of equity Firm’s business risk

What types of long-term

capital do firms use?

Long-term debt

Preferred stock

Common equity

5

Capital Components

Cap. components are sources of funding that

come from investors.

A/P, accruals, and deferred taxes are not

sources of funding that come from investors,

& not included in the calculation of the cost of

capital.

These items are adjusted for when calculating

project cash flows, not when calculating the

cost of capital.

6

Before-tax vs. After-tax Capital

Costs

Tax effects associated with financing

can be incorporated either in capital

budgeting cash flows or in cost of

capital.

Most firms incorporate tax effects in the

cost of capital. Therefore, focus on

after-tax costs.

Only cost of debt is affected.

7

Historical (Embedded) Costs

vs. New (Marginal) Costs

The cost of capital is used primarily to

make decisions which involve raising

and investing new capital. So, focus on

marginal (incremental) costs.

8

COST of CAPITAL

Raising $ & its Costs

Debt Equity

Cost of Borrowing Internal

Interest Rate RE

External

Common Stock

Prfd Stock

9

Cost of Capital

Raising $ & its Costs

Debt & Equity

Cost Return

Int. pd. Int. recd.

Divids pd. Divids Recd

10

EQUITIES

Why? Business Application

Key to understanding For Investor:

valuations Determine value of

What is investment worth asset/business/company

today?

Value of: For Firm:

Enterprise Determine cost of

Entity attracting investors &

Company/Firm raising equity capital

Selling ownership stake to

raise $

11

Weighted Average Cost of

Capital (WACC)

WACC: Blended cost or raising capital

considering mix of debt & equity

WACC = (Wt of Debt)(After-tax cost of

Debt) + Wt of Eqty)(Cost of Eqty) +

(Wt of Prfd)(Cost of Prfd)

12

Cost of Equity

Know: = P0 = D1/ (rs –g)

So then: rs = D1/P0 + g

13

Cost of Equity

Cost of External Equity: Function of Dvids,

growth, & net proceeds after adjusting for

flotation costs

Costs of divids not pd out but retained in firm

to grow internally (no flot. req’d)

14

Cost of Preferred Stock

r = D1/P0 + g

g= 0, so cost of prfd = function of

divids pd. & flot cost to issue

15

Determining Cost of Debt

what coupon rate would be on new

debt.

Method 2: Find bond rating for the

company and use yield on similarly

rated bonds.

Method 3: Find yield on the company’s

existing debt.

16

Current vs. Historical Cost of

Debt

For cost of debt, don’t use coupon rate

on existing debt, which represents cost

of past debt.

Use the current interest rate on new

debt (think YTM).

(More…)

17

A 15-year, 13.25% semiannual bond sells

for $1,250. Tax = 40%. 60,000 Bonds

o/s. What’s rd?

0 1 2 30

rd = ?

...

1,250.00 -66.25 -66.25 <66.25 + 1,000>

N I/YR PV PMT FV

OUTPUT 5.0% x 2 = rd = 10%

18

Component Cost of Debt

Interest is tax deductible, so the after

tax (AT) cost of debt is:

rd AT = rd BT(1 – T)

rd AT = 10%(1 – 0.40) = 6%.

Use nominal rate.

Flotation costs small, so ignore.

19

Cost of Debt - Practice

The Heuser Company’s currently

outstanding bonds have a 10 percent

coupon and a 12 percent yield to

maturity. Heuser believes it could issue

new bonds at par that would provide a

similar yield to maturity. If its marginal

tax rate is 35 percent, what is Heuser’s

after-tax cost of debt?

20

Cost of Debt - Practice

rd(1 – T) = 0.12(0.65)

= 7.80%.

21

Component cost of preferred

stock

WACC = wdkd(1-T) + wpkp + wcks

stock.

The rate of return investors require on

the firm’s preferred stock.

What is the cost of preferred

stock?

The cost of preferred stock can be

solved by using this formula:

kp = Dp / Pp

= $10 / $111.10

= 9%

Component cost of preferred

stock

Preferred dividends are not tax-

deductible, so no tax adjustments

necessary. Just use kp.

Nominal kp is used.

Our calculation ignores possible

flotation costs.

Cost of preferred stock: Pps = $125;

10.26% Div; Par = $100; F = 8.8%

Use :

Dps

rps = =

Pps (1 – F)

25

Cost of preferred stock: Pps = $125;

10.26% Div; Par = $100; F = 8.8%

Use :

Dps .0126($100)

rps = =

Pps (1 – F) $125.00(1 – 0.088)

$10.26

= = 0.090 = 9.0%

$114.

26

Note:

Flotation costs for preferred are

significant, so are reflected. Use net

price.

Preferred dividends are not deductible,

so no tax adjustment. Just rps.

Nominal rps is used.

27

Cost of Preferred Stock -

Practice

Tunney Industries can issue

perpetual preferred stock at a price

of $47.50 a share. The stock would

pay a constant annual dividend of

$3.80 a share.

What is the company’s cost of

preferred stock, rp?

28

Cost of Preferred Stock -

Practice

Pp = $47.50; Dp = $3.80; rp = ?

Dp $3.80

rp = = = 8%.

Pp $47.50

29

Cost of Preferred Stock -

Practice

Trivoli Industries plans to issue

perpetual preferred stock with an

$11.00 dividend. The stock is

currently selling for $97.00; but

flotation costs will be 5% of the

market price, so the net price will

be $92.15 per share. What is the

cost of the preferred stock,

including flotation? 30

Cost of Preferred Stock -

Practice

$11

rp = = 11.94%.

$92.15

31

Is preferred stock more or less

risky to investors than debt?

More risky; company not required to

pay preferred dividend.

However, firms want to pay preferred

dividend. Otherwise, (1) cannot pay

common dividend, (2) difficult to raise

additional funds, and (3) preferred

stockholders may gain control of firm.

32

Why is yield on preferred

lower than rd?

Corporations own most preferred stock,

because 70% of prfd divids nontaxable to

corps.

T/4, prfd often has a lower

B-T yield than the B-T yield on debt.

The A-T yield to investors and A-T cost to the

issuer are higher on prfd than on debt, which

is consistent w/ higher risk of prfd.

33

Example:

rps = 9%, rd = 10%, T = 40%

34

Example:

rps = 9%, rd = 10%, T = 40%

= 9% – 9%(0.3)(0.4) = 7.92%

rd, AT = 10% – 10%(0.4) = 6.00%

A-T Risk Premium on Preferred =

35

Example:

rps = 9%, rd = 10%, T = 40%

= 9% – 9%(0.3)(0.4) = 7.92%

rd, AT = 10% – 10%(0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%

36

Component cost of equity

WACC = wdkd(1-T) + wpkp + wcks

equity using retained earnings.

The rate of return investors require on

the firm’s common equity using new

equity is ke.

What are the two ways that

companies can raise common equity?

common stock.

Indirectly, by reinvesting earnings that

are not paid out as dividends (i.e.,

retaining earnings).

38

Why is there a cost for

reinvested earnings?

Earnings can be reinvested or paid out

as dividends.

Investors could buy other securities,

earning a return.

Thus, there is an opportunity cost if

earnings are reinvested.

39

Cost for Reinvested Earnings

(Continued)

Opportunity cost: The return

stockholders could earn on alternative

investments of equal risk.

They could buy similar stocks and earn

rs, or company could repurchase its own

stock and earn rs. So, rs, is cost of

reinvested earnings and is cost of

common equity.

40

Three ways to determine

the cost of equity, rs:

= rRF + (RPM)b.

2. DCF: rs = D1/P0 + g.

3. Own-Bond-Yield-Plus-Judgmental-

Risk Premium: rs = rd + Bond RP.

41

Equity Cost Components

Risk free = 5.6%

Mrkt Risk Prem = 6%

Beta = 1.2

Div today = $3.12

Price today = $50

Growth = 5.8%

Cost of Debt = 10%

Risk prem = 3.2%

3,000,000 shs outstanding

42

CAPM Cost of Equity: rRF = 5.6%,

RPM = 6%, b = 1.2

rs = rRF + (RPM )b

43

Issues in Using CAPM

Most analysts use the rate on a

long-term (10 to 20 years)

government bond as an estimate

of rRF.

Can use Bloomberg.com to obtain

US Treasuries Quotes

(More…)

44

Issues in Using CAPM

(Continued)

Most analysts use a rate of 3.5% to

6% for the market risk premium

(RPM)

Estimates of beta vary, and

estimates are “noisy” (they have a

wide confidence interval).

45

DCF Cost of Equity, rs:

D0 = $3.12; P0 = $50; g = 5.8%

D1 D0(1 + g)

rs = +g= +g

P0 P0

= $3.12(1.058) + 0.058

$50

=

46

DCF Cost of Equity, rs:

D0 = $3.12; P0 = $50; g = 5.8%

D1 D0(1 + g)

rs = +g= +g

P0 P0

= $3.12(1.058) + 0.058

$50

= 6.6% + 5.8%

= 12.4%

47

Estimating the Growth Rate

Use historical growth rate if believe

future be like past.

Obtain analysts’ estimates: Value Line,

Zacks, Yahoo!Finance.

Use earnings retention model.

48

Earnings Retention Model

Suppose company has been earning

15% on equity (ROE = 15%) and

been paying out 62% of its earnings.

If expected to continue as is, what’s

the expected future g?

49

Earnings Retention Model

(Continued)

Growth from earnings retention model:

g = (Retention rate)(ROE)

g = (1 – Payout rate)(ROE)

g = (1 – 0.62)(15%) = 5.7%.

50

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.

51

The Own-Bond-Yield-Plus-Judgmental-Risk-

Premium Method: rd = 10%, RP = 3.2%

rs = 10.0% + 3.2% = 13.2%

This over-own-bond-judgmental-risk

premium CAPM equity risk premium,

RPM.

Produces ballpark estimate of rs.

Useful check.

52

Final estimate of rs?

Method Estimate

CAPM 12.8%

DCF 12.4%

Bond Yld + risk prem 13.2%

Average 12.8%

53

Why is the cost of retained earnings

cheaper than the cost of issuing new

common stock?

When a company issues new common

stock they also have to pay flotation costs

to the underwriter.

Issuing new common stock may send a

negative signal to the capital markets,

which may depress the stock price.

If D0 = $4.19, P0 = $50, and g = 5%,

what’s the cost of common equity based

upon the DCF approach?

D1 = D0 (1+g)

D1 = $4.19 (1 + .05)

D1 = $4.3995

ks = D1 / P0 + g

= $4.3995 / $50 + 0.05

= 13.8%

If issuing new common stock incurs a

flotation cost of 15% of the proceeds,

what is ke?

D0 (1 g)

ke g

P0 (1 - F)

$4.19(1.05)

5.0%

$50(1 - 0.15)

$4.3995

5.0%

$42.50

15.4%

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.

Cost of Common Equity -

Practice

The future earnings, dividends, and common stock price of

Carpetto Technologies Inc. are expected to grow 7% per year.

Carpetto’s common stock currently sells for $23.00 per share;

its last dividend was $2.00; and it will pay a $2.14 dividend at

the end of the current year.

a) Using the DCF approach, what is its cost of common equity?

b) If the firm’s beta is 1.6, the risk-free rate is 9%, and the

average return on the market is 13%, what will be the firm’s

cost of common equity using the CAPM approach?

c) If the firm’s bonds earn a return of 12%, based on the bond-

yield-plus-risk-premium approach, what will be rs? Use the

midpoint of the risk premium range

d) If you have equal confidence in the inputs used for the three

approaches, what is your estimate of Carpetto’s cost of

common equity?

58

Cost of Common Equity -

Practice

D1 $2.14

rs = +g= + 7% = 9.3% + 7% = 16.3%.

P0 $23

= 9% + (13% – 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

d. rs = = 15.9%.

3 59

Cost of Common Equity -

Practice

The Evanec Company’s next expected

dividend, D1, is $3.18; its growth rate is 6%;

and its common stock now sells for $36.00.

New stock (external equity) can be sold to net

$32.40 per share.

a) What is Evanec’s cost of retained earnings, rs?

b) What is Evanec’s percentage flotation cost, F?

c) What is Evanec’s cost of new common stock,

re?

60

Cost of Common Equity -

Practice

D1

a. rs = +g

P0

$3.18

= + 0.06

$36

= 14.83%.

61

Cost of Common Equity -

Practice

F = ($36.00 – $32.40)/$36.00

= $3.60/$36.00

= 10%.

62

Cost of Common Equity -

Practice

re = D1/[P0(1 – F)] + g

= $3.18/$32.40 + 6%

= 9.81% + 6%

= 15.81%.

63

Cost of Common Equity -

Practice

Ballack Co.’s common stock currently sells for

$46.75 per share. The growth rate is a constant

12%, and the company has an expected dividend

yield of 5%. The expected long-run dividend

payout ratio is 25%, and the expected return on

equity (ROE) is 16%. New stock can be sold to the

public at the current price, but a flotation cost of

5% would be incurred. What would be the cost of

new equity?

64

Cost of Common Equity -

Practice

If the firm's dividend yield is 5% and its stock price is

$46.75, the next expected annual dividend can be

calculated.

Dividend yield = D1/P0

5% = D1/$46.75

D1 = $2.3375.

Next, the firm's cost of new common stock can be

determined from the DCF approach for the cost of equity.

re = D1/[P0(1 – F)] + g

= $2.3375/[$46.75(1 – 0.05)] + 0.12

= 17.26%

65

Cost of Common Equity -

Practice

The Bouchard Company’s EPS was $6.50 in 2008, up

from $4.42 in 2003. The company pays out 40% of its

earnings as dividends, and its common stock sells for

$36.00.

a) Calculate the past growth rate in earnings. (Hint:

This is a 5-year growth period.)

b) The last dividend was D0 = 0.4($6.50) = $2.60.

Calculate the next expected dividend, D1, assuming

that the past growth rate continues.

c) cWhat is Bouchard’s cost of retained earnings, rs?

66

Cost of Common Equity -

Practice

a)With financial calculator, Inputs:

N = 5,

PV = -4.42,

PMT = 0,

FV = 6.50,

and then solve for

I/YR = g

= 8.02% 8%. 67

Cost of Common Equity -

Practice

b. D1 = D0(1 + g)

= $2.60(1.08)

= $2.81.

c. rs = (D1/P0 ) + g

= ($2.81/$36.00) + 8%

= 15.81%.

68

Cost of Common Equity -

Practice

Sidman Products’ common stock currently sells

for $60.00 a share. The firm is expected to

earn $5.40 per share this year and to pay a

year-end dividend of $3.60, and it finances

only with common equity.

a) If investors require a 9% return, what is the

expected growth rate?

b) If Sidman reinvests retained earnings in

projects whose average return is equal to the

stock’s expected rate of return, what will be

next years’ EPS?

69

Cost of Common Equity -

Practice

D1

a. rs= +g

P0

$3.60

0.09 = +g

$60.00

0.09 = 0.06 + g

g = 3%.

70

Cost of Common Equity -

Practice

EPS1

= EPS0(1 + g)

= $5.40(1.03)

= $5.562.

71

Determining Weights for WACC

financed by each component.

If possible, always use the target wts

for % financed by each type of

capital.

72

Estimating Weights for the

Capital Structure

If don’t know targets, better to estimate

wts using current market values than

current book values.

If don’t know MV of debt, then

reasonable to use BV of debt, especially

if S/T debt.

(More…)

73

Estimating Weights

(Continued)

Suppose the common stock price is $50

with 3 million shares outstanding; the

firm has 200,000 shs of preferred stock

trading at $125; and 60,000 bonds

outstanding trading at quoted price of

125% of par.

(More…)

74

Estimating Weights

(Continued)

Vs = $50(3 million) = $150 million.

Vps = $25 million.

Vd = $75 million.

Total value = $150 + $25 + $75

= $250 million.

75

Estimating Weights

(Continued)

ws = $150/$250 = 0.6

wps = $25/$250 = 0.1

wd = $75/$250 = 0.3

wts, but often MV wts temporarily deviate

from targets due to changes in stock prices.

76

What’s the WACC using the

target weights?

+ 0.6(12.8%)

WACC = 10.38%

77

WACC - Practice

Patton Paints Corporation has a target capital

structure of 40% debt and 60% common

equity, with no preferred stock. Its before-tax

cost of debt is 12%, and its marginal tax rate

is 40%. The current stock price is P0 = $22.50.

The last dividend was D0 = $2.00, and it is

expected to grow at a 7% constant rate. What

is its cost of common equity and its WACC?

78

WACC - Practice

Debt = 40%, Common equity = 60%.

D1 $2.14

rs = +g= + 7% = 16.51%.

P0 $22.50

= 0.0288 + 0.0991 = 12.79%.

79

WACC - Practice

Klose Outfitters Inc. believes that its optimal capital

structure consists of 60% common equity and 40%

debt, and its tax rate is 40%. Klose must raise

additional capital to fund its upcoming expansion.

The firm will have $2 million of new retained

earnings with a cost of rs= 12%. New common stock

in an amount up to $6 million would have a cost of re

= 15%. Furthermore, Klose can raise up to $3

million of debt at an interest rate of rd = 10% and

an additional $4 million of debt at rd = 12%. The

CFO estimates that a proposed expansion would

require an investment of $5.9 million. What is the

WACC for the last dollar raised to complete the

expansion? 80

WACC - Practice

If the investment requires $5.9 million, that

means that it requires $3.54 million (60%) of

common equity and $2.36 million (40%) of debt.

In this scenario, the firm would exhaust its $2

million of retained earnings and be forced to

raise new stock at a cost of 15%. Needing $2.36

million in debt, the firm could get by raising debt

at only 10%. Therefore, its weighted average

cost of capital is: WACC = 0.4(10%)(1 – 0.4) +

0.6(15%) = 11.4%.

81

WACC Practice

Kahn Inc. has a target capital structure of 60%

common equity and 40% debt to fund its $10

billion in operating assets. Furthermore, Kahn Inc.

has a WACC of 13%, a before-tax cost of debt of

10%, and a tax rate of 40%. The company’s

retained earnings are adequate to provide the

common equity portion of its capital budget. Its

expected dividend next year (D1) is $3, and the

current stock price is $35.

a. What is the company’s expected growth rate?

b. If the firm’s net income is expected to be $1.1

billion, what portion of its net income is the firm

expected to pay out as dividends? 82

WACC Practice

Step 1: Determine WACC

13.0% = 0.4(10%)(1 – 0.4) + 0.6(rs)

10.6% = 0.6rs

rs = 0.17667 or 17.67%.

83

WACC Practice

Step 2: Determine Growth rate

rs = D1/P0 + g

0.17667 = $3/$35 + g

g = 0.090952 9.10%.

84

WACC Practice

b. From the formula for the long-run growth

rate:

g = (1 – Div. payout ratio) ROE

= (1 – Div. payout ratio) (NI/Equity)

0.090952 = (1 – Div. payout ratio)

($1,100

million/$6,000 million)

0.090952 = (1 – Div. payout ratio)

0.1833333

0.496104 = (1 – Div. payout ratio) 85

What factors influence a

company’s WACC?

Uncontrollable factors:

Market conditions, especially interest rates.

The market risk premium.

Tax rates.

Controllable factors:

Capital structure policy.

Dividend policy.

Investment policy. Firms with riskier projects

generally have higher financing costs.

86

Should firm-wide WACC be

used for each of its divisions?

NO! Composite WACC reflects risk of

an average project undertaken by the

firm.

Different divisions may have different

risks. Division’s WACC should be

adjusted to reflect division’s risk and

cap structure.

87

The Risk-Adjusted Divisional

Cost of Capital

Estimate cost of capital division

would have if it were a stand-alone

firm.

This requires estimating division’s

beta, cost of debt, and capital

structure.

88

Pure Play Method for Estimating

Beta for a Division or a Project

Find several publicly traded companies

exclusively in project’s business.

Use average of their betas as proxy for

project’s beta.

Hard to find such companies.

89

Accounting Beta Method for

Estimating Beta

Run regression between project’s

ROA and S&P Index ROA.

Accounting betas correlated (0.5 –

0.6) with market betas.

But normally can’t get data on new

projects’ ROAs before capital

budgeting decision made.

90

Divisional Cost of Capital

Using CAPM

Target debt ratio = 10%.

rd = 12%.

rRF = 5.6%.

Tax rate = 40%.

betaDivision = 1.7.

Market risk premium = 6%.

91

Divisional Cost of Capital

Using CAPM (Continued)

rs = rRF + (rM – rRF)bDiv.

rs = 5.6% + (6%)1.7 = 15.8%.

WACCDiv. = wd rd(1 – T) + wsrs

= 0.1(12%)(0.6) + 0.9(15.8%)

= 14.94% ≈ 14.9%

92

Division’s WACC vs. Firm’s Overall

WACC?

company WACC = 10.4%.

“Typical” projects within this division

would be accepted if its returns above

14.9%.

93

What are the three types of

project risk?

Stand-alone risk

Corporate risk

Market risk

94

How is each type of risk used?

Stand-alone risk easiest to calculate.

Market risk theoretically best in most

situations.

However, creditors, customers,

suppliers, and employees are more

affected by corporate risk.

Therefore, corporate risk is also

relevant.

95

A Project-Specific, Risk-Adjusted

Cost of Capital

Start by calculating a divisional cost of

capital.

Use judgment to scale up or down the

cost of capital for an individual project

relative to the divisional cost of capital.

96

Finding a divisional cost of capital:

Using similar stand-alone firms to

estimate a project’s cost of capital

Comparison firms have the following

characteristics:

Target capital structure consists of 40%

debt and 60% equity.

kd = 12%

kRF = 7%

RPM = 6%

βDIV = 1.7

Tax rate = 40%

Calculating a divisional cost of capital

ks = kRF + (kM – kRF)β

= 7% + (6%)1.7 = 17.2%

Division’s weighted average cost of capital

WACC = wd kd ( 1 – T ) + wc ks

= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%

Typical projects in this division are

acceptable if their returns exceed 13.2%.

Costs of Issuing New Common

Stock

When a company issues new common

stock they also have to pay flotation

costs to the underwriter.

Issuing new common stock may send a

negative signal to the capital markets,

which may depress stock price.

99

Cost of New Common Equity: P0 = $50,

D0 = $3.12, g = 5.8%, and F = 15%

D0(1 + g)

re = +g

P0(1 – F)

$3.12(1.058) + 5.8%

=

$50(1 – 0.15)

$42.50

100

Cost of New 30-Year Debt: Par = $1,000,

Coupon = 10% paid annually, and F = 2%

N = 30

PV = 1,000(1 – 0.02) = 980

PMT = -(0.10)(1,000)(1 – 0.4) = -60

FV = -1,000

Solving for I/YR: 6.15%

101

WACC Practice

Midwest Electric Company (MEC) uses only debt and

common equity. It can borrow unlimited amounts at an

interest rate of Rd = 10% as long as it finances at its

target capital structure, which calls for 45% debt and 55%

common equity. Its last dividend was $2, its expected

constant growth rate is 4%, and its common stock sells

for $20. MEC’s tax rate is 40%. Two projects are available:

Project A has a rate of return of 13%, while Project B’s

return is 10%. These two projects are equally risky and

about as risky as the firm’s existing assets.

a. What is its cost of common equity?

b. What is the WACC?

c. Which projects should Midwest accept? 102

WACC Practice

40%.

rs = $2(1.04)/$20 + 4% = 14.40%.

103

WACC Practice

10.62%.

c. Since the firm’s WACC is 10.62% and each of

the projects is equally risky and as risky as

the firm’s other assets, MEC should accept

Project A. Its rate of return is greater than

the firm’s WACC. Project B should not be

accepted, since its rate of return is less than

MEC’s WACC.

104

WACC Practice

Hook Industries’ capital structure consists

solely of debt and common equity. It can issue

debt at rd = 11%, and its common stock

currently pays a $2.00 dividend per share (D0

= $2.00). The stock’s price is currently $24.75,

its dividend is expected to grow at a constant

rate of 7% per year, its tax rate is 35%, and

its WACC is 13.95%. What percentage of the

company’s capital structure consists of debt?

105

WACC Practice

rs = (D1/P0 )+ g

= [$2(1.07)/$24.75] + 7%

= 8.65% + 7%

= 15.65%.

106

WACC Practice

wc = 1 – wd

107

WACC Practice

wc = 1 – wd

wd)(15.65%)

0.1395 = 0.0715wd + 0.1565 – 0.1565wd

-0.017 = -0.085wd

wd = 0.20 or 20%.

108

Comments about flotation

costs:

Flot costs depend on risk of firm & type of

capital being raised.

Flot costs highest for common equity.

However, most firms issue equity

infrequently, the per-project cost is fairly

small.

We will frequently ignore flotation costs when

calculating the WACC.

109

Four Mistakes to Avoid

Current vs. historical cost of debt

Mixing current and historical measures

to estimate the market risk premium

Book weights vs. Market Weights

Incorrect cost of capital components

(More…)

110

Current vs. Historical Cost of

Debt

When estimating the cost of debt, don’t

use the coupon rate on existing debt,

which represents the cost of past debt.

Use the current interest rate on new

debt.

(More…)

111

Estimating the Market Risk

Premium

When estimating the risk premium for the

CAPM approach, don’t subtract the current

long-term T-bond rate from the historical

average return on common stocks.

For example, if the historical rM has been

about 12.2% and inflation drives the current

rRF up to 10%, the current market risk

premium is not 12.2% – 10% = 2.2%!

(More…)

112

Estimating Weights

Use target cap structure to determine wts.

If don’t know target wts, use MV of equity.

If don’t know MV of debt, then use BV of

debt.

(More…)

113

Capital components are sources of

funding that come from investors.

Accounts payable, accruals, and deferred

taxes are not sources of funding that come

from investors, so they are not included in

the calculation of the WACC.

We do adjust for these items when

calculating project cash flows, but not when

calculating the WACC.

114