The Cost of Capital

1
The Cost of Capital

• Cost of Capital Components
• Debt
• Preferred
• Common Equity
• WACC

2
What types of long-term capital do firms use?

• Long-term debt
• Preferred stock
• Common equity

3
Should we focus on before-tax or 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.

4
Market Based Measurement of the Cost of Capital

• Cost of capital Required rate of return by
  investors (RRR)
• Since we assume the market efficiency,
• Expected rate of return (ERR) Required rate of
  return (RRR)
• Therefore, cost of capitalRRRERR

5
A 15-year, 12 semiannual bond sells for
1,153.72. Whats YTM or kd?
0
1
2
30
i ?
...
60
60 1,000
60
-1,153.72
30 -1153.72 60 1000 5.0
x 2 kd 10
INPUTS
N
I/YR
PV
FV
PMT
OUTPUT
6

• YTMERR
• Since cost of capitalERR,
• YTM(the pre-tax) cost of debt (where we assume
  bonds are used for debt-financing)

7
Component Cost of Debt

• Interest is tax deductible, so using after-tax
  convention,
• kd AT kd BT(1 - T)
• 10(1 - 0.40) 6.
• Typically use nominal rate.
• Flotation costs small, so typically ignore.

8
Whats the cost of preferred stock?
Since cost of capitalERR The formula for the ERR
of preferred stock is
9
The cost of preferred stock is given by the
following formula Pn net proceed price
dollar flotation cost per share

10
Whats the cost of preferred stock? PP
113.10 10Q Par 100 F 2.
Use this formula
11
Note

• Flotation costs for preferred are significant, so
  are reflected. Use net price.
• Preferred dividends are not deductible, so no tax
  adjustment. Just kps.

12
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.

13
What are the two ways that companies can raise
common equity?

• Companies can issue new shares of common stock.
• Companies can reinvest earnings.

14
Why is there a cost for reinvested 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 reinvested.

15
Cost of common equity

• Cost of capitalRRRERR
• Cost of common equityRRRERR
• RRR of common equity found using the market model
  (e.g. CAPM)
• ERR of common equity found using the constant
  growth formula

16
Three ways to determine the cost of equity, ks
1. CAPM ks kRF (kM - kRF)b kRF
(RPM)b. 2. DCF ks D1/P0 g. 3. Own-Bond-Yield
-Plus-Risk Premium ks kd RP.
17
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.
18
Whats the DCF cost of equity, ks?Given D0
4.19P0 50 g 5.
19
Find ks using the own-bond-yield-plus-risk-premiu
m method. (kd 10, RP 4.)
ks kd RP 10.0 4.0 14.0

• This RP ? CAPM RPM.
• Produces ballpark estimate of ks. Useful check.

20
Whats a reasonable final estimateof ks?

• Method Estimate
• CAPM 14.2
• DCF 13.8
• kd RP 14.0
• Average 14.0

21
Since a typical firm uses some combination of
bonds, preferred stock and common stock, the
firms overall cost of capital is a weighted
average cost of components capitals (WACC), where
weights are capital structure weights (w).WACC
wdkd(1 - T) wpskps wceks
22
Whats the WACC?
WACC wdkd(1 - T) wpskps wceks
0.3(10)(0.6) 0.1(9) 0.6(14) 1.8 0.9
8.4 11.1.
23
WACC Estimates for Some Large U. S. Corporations
Company WACC Intel 12.9 General
Electric 11.9 Motorola 11.3 Coca-Cola 11.2 Walt
Disney 10.0 ATT 9.8 Wal-Mart 9.8 Exxon
8.8 H. J. Heinz 8.5 BellSouth 8.2
24
What factors influence a companys WACC?

• The firms investment policy. Firms with riskier
  projects generally have a higher WACC.
• Market conditions, especially interest rates and
  tax rates.
• The firms capital structure and dividend policy.

25
How do we measure the minimum required rate of
return (hurdle rate) for firms investments
(projects)?

• The expected rate of return from a typical
  project of a firm must be at least its overall
  cost of capital.
• Hurdle rate cost of capital

26
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.

27
What procedures are used to determine the
risk-adjusted cost of capital for a particular
project or division?

• Subjective adjustments to the firms composite
  WACC.
• Estimate what the cost of capital would be if the
  project/division were a stand-alone firm. This
  requires estimating the projects beta.

28
Methods for Estimating Beta for a Division or a
Project

• Pure play. Find several publicly traded
  companies exclusively in projects business.
• Use average of their betas as proxy for
  projects beta.
• Hard to find such companies.

29
Find the divisions market risk and 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.

30

• Beta 1.7, so division has more market risk than
  average.
• Divisions required return on equity
• ks kRF (kM kRF)bDiv.
• 7 (6)1.7 17.2.
• WACCDiv. wdkd(1 T) wcks
• 0.1(12)(0.6) 0.9(17.2)
• 16.2.

31
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.

32
Why is the cost of internal equity from
reinvested 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.
33
Estimate the cost of new common equity P050,
D04.19, g5, and F15.
34
Four Mistakes to Avoid
1. When estimating the cost of debt, use the
current interest rate on new debt, not the coupon
rate on existing debt. 2. When estimating the
market risk premium for the CAPM approach, dont
subtract the current long-term T-bond rate from
the historical average return on common stocks.
(More ...)
35

• For example, if the historical kM has been about
  12.7 and inflation drives the current kRF up to
  10, the current market risk premium is not 12.7
  - 10 2.7! We rather use the historical market
  risk premium of 5.5, which has been held steady
  for a long period of time.

(More ...)
36
3. Use the target capital structure to determine
the weights. If you dont know the target
weights, then use the current market value of
equity, and never the book value of equity. If
you dont know the market value of debt, then the
book value of debt often is a reasonable
approximation, especially for short-term debt.
(More...)
37
4. 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 the cash
flows of the project, but not when calculating
the WACC.