Cost of Capital

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• Cost of Capital
• What is cost of capital
• The Cost of Equity
• The Costs of Debt and Preferred Stock
• The Weighted Average Cost of Capital

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Why Cost of Capital Is Important

• We know that the return earned on assets depends
  on the risk of those assets
• Cost of capital provides us with an indication of
  how the market views the risk of our assets

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What Is Cost of Capital

• The cost of capital is the same as the required
  return to an investor.
• We need to know the required return for an
  investment before we can compute the NPV and make
  a decision about whether or not to take the
  investment
• We need to earn at least the required return to
  compensate our investors for the financing they
  have provided

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2. Cost of Equity

• The return that equity investors require on their
  investment in the firm
• Two ways to estimate the cost of equity
• the dividend growth model
• the security market line approach (SML or CAPM)

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The Dividend Growth Model

• Estimating the cost of equity the dividend
  growth model approach
• According to the constant growth model,
• D1
• P0
• RE - g
• Rearranging
• RE __________

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Dividend Growth Model Example

• Suppose that your 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 and the market expects that to continue. The
  current price is 25. What is the cost of equity?

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Exercise

• ABC company just paid dividend of 2 per share,
  and the dividend is expected to grow at 8 percent
  indefinitely. The stock currently sells for 30.
  What is ABCs cost of equity capital?

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The SML Approach

• Use the following information to compute our cost
  of equity
• Risk-free rate, Rf
• Market risk premium, E(RM) Rf
• Systematic risk of asset, ?

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Example

• Suppose ABC stock has a beta of 1.2. The market
  risk premium is 8 percent, and the risk-free rate
  is 6 percent. What is ABCs cost of equity
  capital?

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Cost of debt

• The cost of debt, RD, is the return that lenders
  require on the firms debt.
• Is coupon rate the cost of debt?
• The cost of debt is observable
• a. Yield to maturity on currently outstanding
  debt.
• b. Yields to maturity on newly-issued
  similarly-rated bonds.

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Cost of Debt

• ABC company sold a 20-year, 12 bond 10 years ago
  at par. The bond pays annual coupon and its
  currently priced is 86. What is the cost of debt
  of ABC company?

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Cost of Preferred Stock

• Preferred stock is a perpetuity, so the cost is
• RP D/P0
• The cost is simply the dividend yield.
• We sold an 8 preferred issue 10 years ago. It
  sells for 120/share today. What is the cost of
  preferred stock?

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Weighted Average Cost of Capital (WACC)

• We can use the individual costs of capital that
  we have computed to get our average cost of
  capital for the firm.
• This average 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 that we use

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Capital Structure Weights

• Notation
• E market value of equity outstanding shares
  times price per share
• D market value of debt outstanding bonds
  times bond price
• V market value of the firm D E
• Weights
• wE E/V percent financed with equity
• wD D/V percent financed with debt

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Example Capital Structure Weights

• Suppose you have a market value of equity equal
  to 500 million and a market value of debt 475
  million.
• What are the capital structure weights?

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Taxes and the WACC

• We are concerned with after-tax cash flows, so we
  need to consider the effect of taxes on the
  various costs of capital
• Interest expense reduces our tax liability
• This reduction in taxes reduces our cost of debt
• After-tax cost of debt RD(1-TC)
• Dividends are not tax deductible, so there is no
  tax impact on the cost of equity
• WACC wERE wDRD(1-TC)

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Example of WACC

• Equity Information
• 50 million shares
• 80 per share
• Beta 1.15
• Market risk premium 9
• Risk-free rate 5

• Debt Information
• 1 billion in outstanding debt (face value)
• Current quote 110
• Coupon rate 9, semiannual coupons
• 15 years to maturity
• Tax rate 40

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Exercise Find the WACC

• Given the following information for Dunhill Power
  Co., find the WACC of the firm and NPV of the new
  project.
• 1. The companys tax rate is 35 percent
• 2. Debt 3,000 shares, 8 percent coupon bonds
  outstanding, 1,000 par value, 20 years to
  maturity, selling for 103 percent of par the
  bonds make semiannual payments
• 3. Common stock 90,000 shares outstanding,
  selling for 45 per share the beta is 1.20
• 4. Preferred stock 13,000 shares preferred
  stock outstanding, it pays 7 constant dividend
  per share annually and its price is 108 per
  share
• 5. Market 8 percent market risk premium and 6
  percent risk-free rate
• 6. Suppose a new project has a cost of 50
  million and expected aftertax cash flows of 12
  million per year for six year.