Cost of Capital: Concept

Cost of capital, required return, discount rate

We need to earn at least the required return to compensate
our investors for the financing they have provided.
From an investors point of view, it is the required return.
The return to investors is a cost to the firm. So, from the firms
point of view, it is the cost of capital.
The required return is the rate of return we use to discount
cash flows, which presents the opportunity cost of capital.

Cost of Capital & Capital Structure 1

Cost of Capital: Concept

The companys assets (left-hand side of BS) as a portfolio
of, typically, equity and debt (right-hand side):
Assets (A) = Debt (D) + Equity (E)
The overall cost of capital depends on the average riskiness of the
firms total assets.

Calculate the cost of capital

Determine the cost of equity capital, ke
Determine the cost of debt capital, kd
Determine the overall cost of capital, as a weighted average of ke
and kd, or the weighted average cost of capital (WACC)

Cost of Capital & Capital Structure 2

Estimating the Cost of Equity, ke

Estimating ke using CAPM
k e = R F + E R M R F
Equityholders expected return is the cost of equity capital.

Estimating the (default) risk-free rate, RF

It is the expected rate of return obtained by investing in a defaultfree security, e.g., T-bills, T-notes and T-bonds in US.
Matching duration: the maturity of the risk-free rate is matched for
investment horizon (and hence cash flows).
Using current-time return rates.

Cost of Capital & Capital Structure 3

Estimating the Cost of Equity, ke

Estimating the market risk premium (MRP), RM RF
Estimating MRP by looking at the historical premium earned by
stocks over default-free securities over long time periods.
Time period: sufficiently long
The longer the period, the more accurate the estimate, because:
Standard error SE = Standard deviation

Sample size

But the shorter the period, the more updated the estimate.

It is matched for investment horizon.

10 year project: use 10 year

Tbill

Arithmetic vs. geometric average

Cost of Capital & Capital Structure 4

Estimating the Cost of Equity, ke

Potential danger with less mature markets: higher SE

1970-2010

The country premium approach: RP = Base RP + Country premium

Use mature market as base

Cost of Capital & Capital Structure 5

Estimating the Cost of Equity, ke

Estimating equity beta,

For a publicly listed company, one can determine its historical

beta using financial information resources such as Bloomberg
(one can estimate it by running a regression).
For a non-listed firm (or a listed firms division), it needs to be
derived from peer companies (to be discussed).
Important determinants of betas
Type of business, including the degree of operating leverage (i.e.,
the relationship between fixed costs and total costs)
Degree of financial leverage

Business risk!!

Cost of Capital & Capital Structure 6

Estimating the Cost of Equity, ke

Advantages of the CAPM approach

Backward thinking and need a lot estimate!!!

But it adjusts for risk!!

Explicitly adjusting for systematic risk

Applicable to all projects as long as we can estimate the beta

Disadvantages of the CAPM approach

We have to estimate the expected market risk premium and the
beta, of which both do vary over time.
By using historical return data, we use the past to predict the future,
which is not always reliable.

How useful is this approach in practices?

About 80% of firms use CAPM to estimate the cost of equity.
Less than 10% use a modified CAPM.
Others are uncertain about how to estimate the cost of equity.
Cost of Capital & Capital Structure 7

Estimating the Cost of Equity, ke

Estimate RE using the dividend growth model
Dividend growth model
D1
P0 =
RE g

D1
ke = RE =
+g
P0

Hence ke can be estimated from the following variables:

P0: current share price of common stock (publicly observed)
D1: expected dividend payment next period (when dividends do not
change greatly from year to year, historical average dividend yield
over a few previous years can be used to determine the expected
dividend yield D1/P0)
g: the constant growth rate (which is often difficult to determine)
Cost of Capital & Capital Structure 8

Estimating the Cost of Equity, ke

Advantages of the DGM approach

Forward thinking but require companies pay

dividend and have stable dividend growth
rate!

Market-driven and using current data (no need for historical data)
Easy to use and understand

Disadvantages of the DGM approach

Only applicable to companies that currently pay dividends
Dividends are assumed to grow at a reasonably constant rate.
The estimate is very sensitive to the growth rate an increase in g
of 1% increases the cost of equity by 1%.
Does not explicitly quantify risk.

Cost of Capital & Capital Structure 9

Estimating the Cost of Debt, kd

The cost of debt, kd, is the required return by creditors.
Three factors determining kd
The risk-free rate (as for cost of equity)
The default risk premium (i.e. default spread)
The tax advantage associated with debt

Can we use CAPM to estimate kd?

Cost of Capital & Capital Structure 10

Estimating the Cost of Debt, kd

For firms with publicly traded bonds
Obtain the yield-to-maturity (YTM) and use it as kd .
The required return on a bond is the YTM, determined as below:

Bond price =

Coupon
Coupon
+
(1+YTM)
1+YTM 2

Coupon + Face value

1+YTM T

Bond issues information available from Internet

You can obtain bond issues information for companies listed in US from
the Financial Industry Regulatory Authority (FINRA) site:
http://finra-markets.morningstar.com/MarketData/Default.jsp
Go to the bond section and search the company name or ticker symbol.

Cost of Capital & Capital Structure 11

Estimating the Cost of Debt, kd

For firms without bond information (or with private debt)
kd = Risk-free rate + Spread
Estimate the risk-free rate as we do for cost of equity.
Estimate the default-risk spread (i.e., default risk premium) from
its bond rating (when its bonds are rated but not traded), or from
a related financial ratio such as interest coverage ratio (when
bond rating information is unavailable). See next slide.

Current borrowing rates information is also useful.

Cost of Capital & Capital Structure 12

Estimating the Cost of Debt, kd

Cost of Capital & Capital Structure 13

Estimating the Cost of Debt, kd

The after-tax cost of debt
Because interest expenses are tax deductible, we have
After-tax cost of debt = kd (1 Tax rate)
Using the marginal tax rate
In contrast to the effective tax rate (i.e., the average rate at
which the firms pre-tax profits are taxed), the marginal tax rate is
the rate at which the firms last dollar of income is taxed.
Interest expenses save the firm taxes at the margin, so the
marginal tax rate should be used.

Cost of Capital & Capital Structure 14

The Cost of Preferred Stock, kps

Estimating the cost of preferred stock, kps
Preferred stock shares some of the characteristics of debt
(prespecified dividend, before common dividend) and some of
the characteristics of equity (no tax advantage and pay not
guaranteed).

With perpetual preferred dividend, :

Pps,0 =

Dps
Rps

k ps = R ps =

Dps
Pps,0

where Pps,0 is the current market price per preferred share.

The formula applies to preferred stocks with no special features

(e.g., convertibility, callability, etc.)

Cost of Capital & Capital Structure 15

Weighted Average Cost of Capital (WACC)

Capital structure weights
Determine the market value based weights
Value of debt, D
Use total debt rather than total liabilities (for operating leases, treat
them as debt).
Use the market value of total debt; use the book value as an
approximation when market value is difficult to obtain.
If you need to estimate the market value of a bond portfolio, treat the
entire debt on the books as one coupon debt, with a coupon set
equal to the interest expenses on all debt and the maturity set equal
to the face-value weighted average maturity of all debt, using current
interest rates.

Cost of Capital & Capital Structure 16

Weighted Average Cost of Capital (WACC)

Value of equity, E
It is the market cap: Number of stock shares Price per share
Add the market value of other equity claims such as convertible
preferred stock and management stock options, if you can.

Weights with E and D: wE = E/ (E+D), wD = D/ (E+D)

The firms target capital structure
A firms target capital structure is long-run oriented.
A firms current capital structure may be unstable.
When a firm is acquired, its capital structure is often changed
through the process of acquisition.

Use the firms target capital structure when it is known.

Cost of Capital & Capital Structure 17

Weighted Average Cost of Capital (WACC)

Example
Charlie Co. has 15,000 shares of common stock outstanding at a
market price of $21 a share. The firm has a bond issue outstanding
with a face value of $200,000 which is selling at 98 percent of face
value. What weights should be given to the common stock when
computing the WACC for this company?
E = $21(15,000) = $315,000; D=$200,000(98%) = $196,000;

wE =315,000/511,000 = 61.64%; wD=196,000/511,000=38.36%

Determine capital structure weights using the D/E ratio. For example,
if D/E = 1.5 is given, then:
wE = E/(E+D) = 1/(1+D/E) = 1/(1 + 1.5) = 40%
wD = D/(E+D) = (D/E) / (1+D/E) = 1.5/(1 + 1.5) = 60%

Cost of Capital & Capital Structure 18

Weighted Average Cost of Capital (WACC)

Determining WACC
WACC is the firms overall cost of capital, which is the
required return on the firms total assets.
WACC depends on the after-tax expenses.
The after-tax cost of debt: kd (1-TC)
Dividends are not tax deductible, and hence: ke , kps
E

With E and D: WACC = E+D k e + E+D k d 1 TC

With E, D and PS:
WACC =

E
k
E+D+PS e

D
k
E+D+PS d

1 TC +

PS
k
E+D+PS PS

Cost of Capital & Capital Structure 19

Capital Structure
Capital restructuring
Capital restructuring involves changing the amount of leverage a
firm has without changing the firms long-term assets.
A firm can increase its financial leverage by issuing debt and buying
back outstanding shares.
A firm can decrease its financial leverage by retiring outstanding
debt and issuing new shares.

How does a firms capital restructure affect its risk and value?

Cost of Capital & Capital Structure 20

Capital Structure
Modigliani and Miller theory of capital structure
Three cases of capital structure with respect to assumptions
regarding corporate taxes and bankruptcy costs:
Case 1: No corporate taxes; no bankruptcy costs

Case 2: With corporate taxes; no bankruptcy costs

Case 3: With both corporate taxes & bankruptcy costs

Cost of Capital & Capital Structure 21

Capital Structure
Case 1: No corporate taxes; no bankruptcy costs
M&M Proposition I (firm value): The value of the firm is not
affected by changes in the capital structure.
M&M Proposition II (cost of capital): The WACC of the firm is not
affected by capital structure.
Intuition: In the absence of market frictions, the firms cash flows do
not change when its capital structure changes. Therefore, the firms
value doesnt change (two pie models of capital structure) and its
overall cost of capital (that depends on the riskiness of the cash
flows) does not change.

Cost of Capital & Capital Structure 22

Capital Structure
Equations for the cost of capital
E
D
WACC = R A =
R +
R
D+E E D+E D
D
RE = RA + RA RD
E
RA: the cost of the firms business risk (i.e., the risk of its assets).
(RA RD)(D/E): the cost of the firms financial risk - the additional
return required by stockholders for taking the risk of leverage.

Intuition: when we increase the amount of debt financing, we

increase the fixed interest expenses and, consequently, the residual
cash flow to equityholders becomes riskier.
The cost of equity is a positive linear function of the capital structure.
Cost of Capital & Capital Structure 23

Capital Structure

Cost of Capital & Capital Structure 24

Capital Structure
Case 2: With corporate taxes, but no bankruptcy costs
The tax effect on cash flows
Interest expenses are tax deductible, so when a firm adds debt, it
reduces its income taxes, all else being equal.

The reduction in taxes increases the cash flow of the firm.

The value of interest tax shield

In general: Value = PV(all interest expense savings)
Special case of constant debt amount: Value = D Tax rate

Cost of Capital & Capital Structure 25

Capital Structure
M&M Proposition I (firm value): The value of the firm increases
by the present value of the annual interest tax shield.
Value of levered firm
= Value of unlevered firm + Value of interest tax shield
M&M Proposition II (cost of capital): WACC decreases as D/E
increases (due to government subsidy on interest payments.)

E
D
RE +
R D 1 TC
D+E
D+E
D
RE = R0 + R0 RD
1 TC
E

WACC =

Now, the cost of equity increases as debt financing increases based on

R0 (instead of RA), where R0 is the unlevered cost of capital (which is the
cost of capital when the firm is fully equity financed).
Cost of Capital & Capital Structure 26

Capital Structure

R0

R0

R0
Cost of Capital & Capital Structure 27

Capital Structure
Example
East Asia, Inc. has constant operating earnings of $550,000 every
year forever, and hence its fixed assets and working capital will
remain unchanged in the future. The company can borrow at 12%.
With no debt, East Asias cost of equity is 20%. The tax rate is 16%.
East Asia plans to borrow $400,000 and use the proceeds to
repurchase shares. Determine the WACC after recapitalization.
Unlevered firm value = 550,000(1 - 0.16)/0.20 = $2,310,000
Levered firm value = 2,310,000 + (400,000)(16%) = $2,374,000
D/V = 400,000/2,374,000 = 0.1685
D/E = 400,000/(2,374,000 - $400,000) = 0.2026
RE = 0.20 + (0.20 0.12)(0.2026)(1 - 0.16) = 21.36%
WACC = 0.2136(1 0.1685) + 0.12(0.1685) (1 - 0.16) = 19.46%
DCF and Bond and Stock Valuation 28

Capital Structure
Case 3: With both corporate taxes & bankruptcy costs
Financial distress & financial distress costs
When a firm is having significant problems in meeting its debt
obligations, we say that it is experiencing financial distress (though
such firms do not necessarily file for bankruptcy).
Financial distress costs include direct bankruptcy costs (legal and
administrative costs) and indirect bankruptcy costs associated with
going bankrupt or experiencing financial distress.

Financial leverage and bankruptcy costs

As debt increases, the probability of financial distress/bankruptcy
increases, which increases the expected bankruptcy costs.

Cost of Capital & Capital Structure 29

Capital Structure
The static theory of capital structure
At some point, the additional value of the interest tax shield will
be offset by the increase in expected bankruptcy cost. At this
point, the value of the firm will start to decrease, and the WACC
will start to increase as more debt is added.

A firm borrows up to the point where the tax benefit from an extra
dollar in debt is exactly equal to the cost that comes from the
increased probability of financial distress.

Cost of Capital & Capital Structure 30

Capital Structure

R0

R0

Cost of Capital & Capital Structure 31

Capital Structure
VLevered = VUnlevered + ITS BFDC
ITS: value of interest tax shield
BFDC: expected bankruptcy and financial-distress costs
EV

Optimal D/(D+E)

0%

D/(D+E)

Cost of Capital & Capital Structure 32

Capital Structure
Summary
Case 1: no taxes or bankruptcy costs
There is no optimal capital structure.

Case 2: corporate taxes but no bankruptcy costs

Optimal capital structure is almost 100% debt, because each
additional dollar of debt increases the cash flow of the firm.

Case 3: corporate taxes and bankruptcy costs

Optimal capital structure is part debt and part equity, which occurs
where the benefit from an additional dollar of debt is just offset by
the increase in expected bankruptcy costs.

Cost of Capital & Capital Structure 33

Further Issues about Cost of Capital

The cost of capital for a division or project
A firm makes investment decisions on various projects and might
have multiple business divisions. Can we use the firms overall
WACC for all its divisions or projects?
Using the WACC as the discount rate is only appropriate for
projects that have the same risk as the firms current operations.
For a project that does not have the same risk as the firm, we
need to estimate the appropriate discount rate for that project.
For firms of multiple business divisions, a separate discount rate
is often required for each division.

Cost of Capital & Capital Structure 34

Further Issues about Cost of Capital

Estimating WACC from comparable firms
When there is no public information on a project, we can
estimate the cost of capital for the project from the information of
comparable firms
Comparable firms are such companies that are in the same
business as our project, and publicly listed (so that there is
public information on their risk and return)
Comparable firms are useful in situations such as:
Valuation of a project
IPO valuation
Valuation of a private company in an acquisition

Cost of Capital & Capital Structure 35

Further Issues about Cost of Capital

Estimating equity beta from comparable firms
The effect of financial leverage on equity beta
Viewing assets as a portfolio of debt and equity, then

A =

E
D
E +
D
E+D
E+D

E = A +

D
A D
E

Even if comparable firms asset betas are similar, their equity

betas can vary significantly because of their different leverages.

Hence, unless your investment has the same leverage as a

comparable firm, the equity beta of your investment can be very
different from that of the comparable firm.

Cost of Capital & Capital Structure 36

Further Issues about Cost of Capital

We deal with this problem by utilizing a special equity beta: the
unlevered beta the beta when the firm was fully equity financed.
The relation between a levered beta (with leverage effect) and its
corresponding unlevered beta (without leverage effect) is:
D
E

Levered = Unlevered 1 + 1 TC
We do the following two-step adjustment:
Step 1. Apply the formula to the comparable firm to obtain the
unlevered beta, which is the same for all firms of the same
business.
Step 2. With the unlevered beta, apply the formula again (but to our
investment) to obtain the relevered beta for our investment.

Cost of Capital & Capital Structure 37

Further Issues about Cost of Capital

Example: Sun Hung Kai Properties Ltd wants to sell its fast-food division
in Los Angeles, which is non-listed. To evaluate the market value of this
division, Sun Hung Kai needs to determine the cost of capital. Three fastfood companies are identified as comparable firms. The following
information is given on these firms:

D ($bill)

E ($bill)

D/(D+E)

Churchs Chicken

0.75

0.004

0.096

0.04

McDonalds

1.00

2.300

7.700

0.23

Wendys

1.08

0.210

0.790

0.21

We also have TC = 34%, RD = Rf = 4% and RM Rf = 8.4%.

Sun Hung Kais fast-food division has a target debt-to-equity ratio of 40%.
Determine the cost of capital of this division using the comparable firms.
Cost of Capital & Capital Structure 38

Further Issues about Cost of Capital

Step 1. Estimate the unlevered beta from comparable firms
D
E

Unlevered = Levered 1 + 1 TC

Churchs Chicken:

0.75 [1+(0.004/0.096)(0.66) ]-1 = 0.73

McDonalds:

1.00 [1+(2.3/7.7)(0.66) ]-1 = 0.84

Wendys:

1.08 [1+(0.21/0.79)(0.66) ]-1 = 0.92

Taking average gives our estimated unlevered beta:

(0.73+0.84+0.92)/3 = 0.83

Cost of Capital & Capital Structure 39

Further Issues about Cost of Capital

Step 2. Relever beta using the target leverage of the fast-food division.

E = Relevered
D
E

= UnLevered 1 + 1 TC
= 0.83 1 + 0.4 1 0.34

= 1.049

Step 3. Determine WACC for the fast-food division.

ke = Rf + E (RM Rf) = 4% + 1.049(8.4%) = 12.81%
WACC = (1/(1+0.4)0.1281 + (0.4/(1+0.4)0.04(1 - 0.34) = 9.9%

Cost of Capital & Capital Structure 40