Cost of Capital

1
Chapter 15

• Cost of Capital

2
Key Concepts and Skills

• Know how to determine a firms cost of equity
  capital
• Know how to determine a firms cost of debt
• Know how to determine a firms overall cost of
  capital
• Understand pitfalls of overall cost of capital
  and how to manage them

3
Why is the Cost of Capital Important?

• Return and risk are related
• The return to an investor is the same as the cost
  to the company
• Cost of capital
• gives an indication of how the market views the
  risk of our assets
• helps determine the required return for capital
  budgeting projects

4
Required Return

• Required return is the discount rate based on the
  risk of the cash flows
• Used to determine the NPV ? make project
  decisions
• Projects should earn at least the required return
  to compensate investors for the funds they have
  provided

5
Cost of Equity

• Return required by equity investors given the
  risk of cash flows from the firm
• Two methods for determining the cost of equity
• Dividend growth model
• SML/CAPM

6
DGM Refresher

• RBennigans D1/P0 g
• Bennigans has a dividend growth rate of 6.
  The last dividend paid was 1.00 and the stock
  currently trades for 16.20. What is the return
  on Bennigans stock?

7
CAPM Refresher

• RBennigans R RF bI (RM - RRF)
• Bennigans has a beta of 1.22. The return on
  the market is 11 and the risk free rate is 5.
  What is the return on Bennigans stock?

8
DGM vs. CAPM

• DGM
• Advantages
• Disadvantages

• CAPM
• Advantages
• Disadvantages

9
Cost of Debt

• Required return on companys debt
• Usually focused on the cost of long-term debt
• Best estimated by computing the YTM on the
  existing debt
• Cost of debt is NOT the coupon rate

10
Cost of Debt Example

• Bennigans has an outstanding bond issue with 25
  years left to maturity. The coupon rate is 9
  and coupons are paid annually. The bond
  currently sells for 915.50. What is the cost of
  debt?
• N PMT FV PV CPT I/Y

11
Cost of Preferred Stock

• Preferred stock is a perpetuity
• Constant dividend paid forever
• RBennigans Pref. D/P0
• Bennigans has preferred stock which pays a
  dividend of 1.50 per year. The current price of
  the preferred stock is 30. What is the cost of
  the preferred stock?

12
Weighted Average Cost of Capital

• Individual costs of capital are used to compute
  an average cost for the firm
• Weights are determined by how much of each type
  of financing we use

13
Capital Structure Weights

• E market value of common equity
• ( outstanding shares x price per share)
• D market value of debt
• ( outstanding bonds x current bond price)
• P market value of preferred stock
• ( outstanding shares x price per share)
• V market value of the firm D E P
• Weights
• wE E/V financed with common equity
• wD D/V financed with debt
• wP P/V financed with preferred stock

14
Capital Structure Weights Example

• Bennigans market value of equity is 500
  million, the market value of debt is 475 million
  and the market value of preferred stock is 100
  million.
• What are the capital structure weights?
• V D E P
• wE E/V
• wD D/V
• wP P/V

15
What about Taxes?

• We are concerned with after-tax cash flows
• Which cash flows are tax deductible?
• Interest - YES
• Dividends - NO
• The weighted average cost of capital is WACC
  wERE wPRP wDRD x (1 TC)

16
WACC - Example

• Find Bennigans WACC, T 35
• Bonds currently selling for 925 with annual
  coupons of 9 and 10 years to maturity
• Preferred stock pays 1 and sells for 18
• b 1.15 and RM 13, RRF 8
• D 500 million
• E 450 million
• P 100 million

17
WACC - Example

• What is the cost of preferred stock?
• RP
• What is the cost of equity?
• RE
• What is the cost of debt?
• N PV PMT FV
• CPT I/Y
• What is the after-tax cost of debt?
• RD(1-TC)

18
WACC - Example

• What are the capital structure weights?
• E
• D
• P
• V
• WE WD WP
• What is the WACC?
• WACC

19
Divisional and Project Costs of Capital

• We can only use WACC as the discount rate for
  projects that are equal in risk to the firms
  current operations
• Divisions often have different discount rates
• Projects with different risk levels need
  different discount rates

20
Pure Play vs. Subjective

• Pure Play
• Find betas for similar companies (i.e.
  TGIFridays and Applebees)
• Find the average
• Use the average beta with CAPM to find the
  appropriate return for a project of that risk

• Subjective

21
Quick Quiz

• What are the two approaches to computing the cost
  of equity?
• How do you compute the cost of debt?
• What is the WACC?