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									              CHAPTER 9
            The Cost of Capital

   Cost of Capital Components
     Common Equity

What types of long-term capital
        do firms use?

       Long-term debt
       Preferred stock
       Common equity
 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 cost of capital.
 We do adjust for these items when
 calculating the cash flows of a
 project, but not when calculating the
 cost of capital.

  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.
Should we focus on historical (embedded)
     costs or new (marginal) costs?

 The cost of capital is used primarily
 to make decisions which involve
 raising and investing new capital.
 So, we should focus on marginal

              Cost of Debt

Method 1: Ask an investment banker what
the coupon rate would be on new debt.
Method 2: Find the bond rating for the
company and use the yield on other bonds
with a similar rating.
Method 3: Find the yield on the company’s
debt, if it has any.
A 15-year, 12% semiannual bond sells for
         $1,153.72. What’s rd?

   0                1             2             30
          i=?                          ...
-1,153.72           60            60         60 + 1,000

 Solve using the YIELD function in Excel, or the
 RATE function in Excel, or using a financial

             Component Cost of Debt

       Interest is tax deductible, so the after
       tax (AT) cost of debt is:
         rd AT   = rd BT(1 - T)
                 = 10%(1 - 0.40) = 6%.

       Use nominal rate.
       Flotation costs small, so ignore.
    What’s the cost of preferred stock?
PP = $113.10; 10%Q; Par = $100; F = $2.

Use this formula:

               D ps                 0 .1 ($ 100 )
      rps =                 =
               Pn               $ 113 .10 − $ 2 .00

                                   $ 10
                            =             = 0 .090 = 9 .0 %.
                                $ 111 .10

Picture of Preferred – assuming dividends
           are paid out quarterly

         rps = ?
                        1                     2         ∞
-111.1                 2.50               2.50          2.50

                                   DQ         $2.50
                      $111.10 =           =         .
                                   rPer        rPer

   rPer =           = 2.25%; rps ( Nom ) = 2.25%(4) = 9%.

 Flotation costs for preferred are
 significant, so are reflected. Use net
 Preferred dividends are not
 deductible, so no tax adjustment.
 Just rps.
 Nominal rps is used.

 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) in some cases,
 preferred stockholders may gain control
 of firm.
  Why is yield on preferred lower than rd?

Preferred dividends are not tax deductible, so
  while they often have 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 preferred than on debt, which is
  consistent with the higher risk of preferred.

  What are the two ways that companies
       can raise common equity?
   Directly, by issuing new shares of
   common stock.
   Indirectly, by reinvesting earnings that
   are not paid out as dividends (i.e.,
   retaining earnings).
   Why is there a cost for reinvested

Earnings can be reinvested or paid out as
Investors could buy other securities, earn
a return.
Thus, there is an opportunity cost if
earnings are reinvested.

   Opportunity cost: The return
   stockholders could earn on
   alternative investments of equal
   They could buy similar stocks and
   earn rs, or company could
   repurchase its own stock and earn
   rs. So, rs, is the cost of reinvested
   earnings and it is the cost of equity.
  Three ways to determine the
       cost of equity, rs:

1. CAPM: rs = rRF + (rM - rRF)b
            = rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
          rs = rd + Bond RP.

    What’s the cost of equity
      based on the CAPM?
 rRF = 7%, RPM = 6%, b = 1.2.

  rs = rRF + (rM - rRF )b.

    = 7.0% + (6.0%)1.2 = 14.2%.
   What’s the DCF cost of equity, rs?
 Given: D0 = $4.19;P0 = $50; g = 5%.

             D1    D (1 + g )
      rs =      +g= 0         +g
             P0       P0

             =              + 0.05
             = 0.088 + 0.05

             = 13.8%.

       Estimating the Growth Rate

Use the historical earnings growth rate if
you believe the future will be like the past.
Obtain analysts’ estimates: Value Line,
Zack’s, Yahoo Finance, MSN.
Use the earnings retention model,
illustrated on next slide.
Suppose the company has been
earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout =
65%), and this situation is expected to

What’s the expected future g?

Retention growth rate:

g = ROE(Retention rate)

g = 0.15(.35) = 5.25%.

This is close to g = 5% given earlier.
 Could DCF methodology be applied
        if g is not constant?

YES, nonconstant g stocks are
expected to have constant g at some
You can use the two and three-stage
growth models we used when working
through Chapter 7 (Valuing Stocks).

  Find rs using the own-bond-yield-
     plus-risk-premium method.
        (rd = 10%, RP = 4%.)

 rs = rd + RP
    = 10.0% + 4.0% = 14.0%

Produces ballpark estimate of rs. (usually
analysts use a risk premium of 3-5%).
   What’s a reasonable final estimate
                 of rs?

   Method          Estimate
    CAPM            14.2%
     DCF            13.8%
   rd + RP          14.0%
   Average          14.0%

         Which Method is Best?

The results of the three methods should
be reasonably consistent, however, if they
vary wildly, a financial analyst would have
to make a judgment call as to which
measure is most reasonable.
CAPM is the most widely used measure.
DCF is the next most popular method, and
the bond-yield-plus-risk-premium method
is the least popular, primarily being used
by non-public companies.
As we will see when we talk about capital
structure, each firm has an optimum
capital structure, defined as a mix of debt,
preferred, and common equity that results
in maximization of its stock price. So, a
firm will establish an optimal capital
structure and then raise new capital to
keep its capital structure on target.
Here we assume that the firm has
identified its optimal capital structure (it’s
taken as exogenous).

 Determining the Weights for the WACC

The weights are the percentages of the
firm that will be financed by each
If possible, always use the target weights
for the percentages of the firm that will be
financed with the various types of capital.
       Estimating Weights for the
            Capital Structure

 If you don’t know the targets, it is
 better to estimate the weights using
 current market values than current
 book values.
 If you don’t know the market value of
 debt, then it is usually reasonable to
 use the book values of debt, especially
 if the debt is short-term.

    Estimating Weights (Continued)

Suppose the stock price is $50, there are
3 million shares of stock, the firm has $25
million of preferred stock, and $75 million
of debt.

  Vce = $50 (3 million) = $150 million.
  Vps = $25 million.
  Vd = $75 million.
  Total value = $150 + $25 + $75 =
  $250 million.
  wce = $150/$250 = 0.6
  wps = $25/$250 = 0.1
  wd = $75/$250 = 0.3

            What’s the WACC?

WACC = wdrd(1 - T) + wpsrps + wcers

       = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

       = 1.8% + 0.9% + 8.4% = 11.1%.
    WACC Estimates for Some Large
         U. S. Corporations

Company              WACC         wd
Intel (INTC)          16.0      2.0%
Dell Computer (DELL   12.5      9.1%
BellSouth (BLS)       10.3     39.8%
Wal-Mart (WMT)         8.8     33.3%
Walt Disney (DIS)      8.7     35.5%
Coca-Cola (KO)         6.9     33.8%
H.J. Heinz (HNZ)       6.5     74.9%
Georgia-Pacific (GP)   5.9     69.9%

  What factors influence a company’s

Market conditions, especially interest rates
and tax rates.
The firm’s capital structure and dividend
The firm’s investment policy. Firms with
riskier projects generally have a higher
Should the company use the composite
WACC as the hurdle rate for each of its

NO! The composite WACC reflects the risk
of an average project undertaken by the
Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk and
capital structure.

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

  Estimate the cost of capital that the
  division would have if it were a
  stand-alone firm.
  This requires estimating the division’s
  beta, cost of debt, and capital
Methods for Estimating Beta for a Division
              or a Project

1. Pure play. Find several publicly traded
   companies exclusively in project’s
   Use average of their betas as proxy for
   project’s beta.
   Hard to find such companies.

 2. Accounting beta. Run regression
    between project’s ROA and S&P index
    Accounting betas are correlated (0.5 –
    0.6) with market betas.
    But normally can’t get data on new
    projects’ ROAs until after the capital
    budgeting decision (after the cost of
    capital is calculated) has been made.
Find the division’s market risk and cost of
 capital based on the CAPM, given these

     Target debt ratio = 10%.
     rd = 12%.
     rRF = 7%.
     Tax rate = 40%.
     betaDivision = 1.7.
     Market risk premium = 6%.

Beta = 1.7, so division has more market
risk than average.
Division’s required return on equity:
rs = rRF + (rM – rRF)bDiv.
    = 7% + (6%)1.7 = 17.2%.
WACCDiv.   = wdrd(1 – T) + wcrs
           = 0.1(12%)(0.6) + 0.9(17.2%)
           = 16.2%.
   How does the division’s WACC compare
       with the firm’s overall WACC?

  Division WACC = 16.2% versus company
  WACC = 11.1%.
  “Typical” projects within this division
  would be accepted if their returns are
  above 16.2%.

     Divisional Risk and the Cost of Capital

R a te o f R e tu r n
       (% )                                   A c c e p t a n c e R e g io n

                                                                               W ACC

W ACCH                                                     H

                                         A                      R e je c t io n R e g io n
W ACCL                        L

                                                                 R is k
          0             R is k L   R is k A          R is k H
What are the three types of project risk?

    Stand-alone risk
    Corporate risk
    Market risk

     How is each type of risk used?

  Stand-alone risk is easiest to
  Market risk is theoretically best in
  most situations.
  However, creditors, customers,
  suppliers, and employees are more
  affected by corporate risk.
  Therefore, corporate risk is also
  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

     Comments about flotation costs:

  Flotation costs depend on the risk of
  the firm and the type of capital being
  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.
           Four Mistakes to Avoid

1. When estimating the cost of debt,
   don’t use the coupon rate on existing
   debt. Use the current interest rate on
   new debt.

                                         (More ...)

2. Don’t use book weights to estimate
   the weights for the capital structure.
  Use the target capital structure to determine
  the weights.
  If you don’t know the target weights, then
  use the current market value of equity, and
  never the book value of equity.
  If you don’t know the market value of debt,
  then the book value of debt often is a
  reasonable approximation, especially for
  short-term debt.
3. Always remember that 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

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