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Prepared by

Ken Hartviksen

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Chapter 20 Cost of Capital
CHAPTER 20
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 3
Lecture Agenda
Learning Objectives
Important Terms
Financing Sources
The Cost of Capital
Estimating the Component Costs
The Effect of Operating and Financial Leverage
Growth Models and the Cost of Common Equity
Risk-Based Models and the Cost of Common Equity
The Cost of Capital and Investment
Summary and Conclusions
Concept Review Questions
Appendix 1 Steep Hill Mines # 1
CHAPTER 20 Cost of Capital 20 - 4
Learning Objectives
1. How ROE and the required return by common equity investors are
related to a firms growth opportunities

2. How to apply the steps involved in estimating a firms weighted
average cost of capital, including how to estimate the market
values of the various components of capital, and how to estimate
the various costs of these components

3. How operating and financial leverage affect firms

4. The advantages and limitations of using growth models and/or risk
models to estimate the cost of common equity.
CHAPTER 20 Cost of Capital 20 - 5
Important Chapter Terms
Asset turnover ratio
Beta coefficient
Capital asset pricing model
Capital structure
Cash cow
Cost of capital
Debt-to-equity ratio
Dog
Earnings yield
Hurdle rate
Investment opportunities
schedule (IOS)
Issuing (or floatation) costs
Marginal cost of capital (MCC)
Market-to-book (M/B) ratio
Market risk premium
Multi-stage growth DDM
Operating leverage
Present value of existing
opportunities (PVEO)
Present value of growth
opportunities (PVGO)
Return on assets (ROA)
Return on invested capital
(ROIC)
Return on equity (ROE)

CHAPTER 20 Cost of Capital 20 - 6
Important Chapter Terms
Risk-based model
Risk-free rate of return
Star
Turnaround
Weighted average cost of
capital (WACC)


Weighted Average Cost of Capital
A Quick Primer on the Subject
CHAPTER 20 Cost of Capital 20 - 8
The Short Story of WACC
Purposes/Use
The weighted average cost of capital (WACC)
serves three primary purposes:
1. To evaluate capital project proposals before-the-fact.
2. To set performance targets in order for management to
sustain or grow market values, and
3. to measure management performance after-the-fact.
CHAPTER 20 Cost of Capital 20 - 9
The Short Story of WACC
What Costs are Measured?
Costs associated with financing the firms invested
capital including:
Debt Costs:
Bank loans
Long-term debt bonds/debentures
Equity Costs:
Preferred equity costs
Common equity costs
CHAPTER 20 Cost of Capital 20 - 10
The Short Story of WACC
Why the Marginal Cost?
What capital cost the firm 5 months, 5 years or 5
decades ago is irrelevant.
What is relevant is what the next dollar of capital will
cost in todays economic environment for this
particular firm.
CHAPTER 20 Cost of Capital 20 - 11
The Short Story of WACC
Steps in Solving for the WACC
1. Identify the relevant sources of capital (debt and
equity).
2. Estimate the market values for the sources of
capital and determine the market value weights.
3. Estimate the marginal, after-tax, and after-floatation
cost for each source of capital.
4. Calculate the weighted average.
CHAPTER 20 Cost of Capital 20 - 12
The Short Story of WACC
The Formula
Once you have the specific marginal costs of capital (after accounting for taxes
and floatation costs) and you have found the appropriate weights to use, the
actual calculation of a WACC is a simple matter.
) 1 (
|
.
|

\
|
+
|
.
|

\
|
= =
V
D
T K
V
S
K K WACC
d e a
The cost of equity
times the market
value weight of
equity
The cost of debt
after tax times the
market value weight
of debt
CHAPTER 20 Cost of Capital 20 - 13
The Short Story of WACC
The Spreadsheet Approach
(1) (2) (3) (4) = (2)*(3)
Type of
Capital
Specific
Marginal Cost
after tax and
floatation
costs
Market
Value
Weights
Weighted
Specific
Marginal
Cost
Long-Term Debt 5.5% 43.0% 0.02365
Preferred Stock 11.4% 11.0% 0.01254
Common Stock 12.9% 46.0% 0.05934
WACC = 9.55%
WACC is the sum of the weighted
specific marginal costs of each source of
capital.
CHAPTER 20 Cost of Capital 20 - 14
The Short Story of WACC
Frequently Asked Questions
1. Why dont we include the cost of accruals and
accounts payable in the cost of capital?
These are spontaneous liabilities that rise and fall
with the volume of business activity, and are not
subject to formal lending arrangements.
Accruals (wages and taxes), it can be argued, dont
have an explicit cost.
For major corporations, spontaneous liabilities are
often a very small part of the overall capitalization of
the firm (are immaterial for cost of capital purposes).
CHAPTER 20 Cost of Capital 20 - 15
The Short Story of WACC
Frequently Asked Questions
2. Why is the cost of capital an estimate and does this matter?
WACC is calculated based on a current estimate of what it will cost for
the next dollar of debt and equity. Since that next dollar hasnt yet
been raised, we are attempting for forecast or estimate that cost.
To estimate the cost of debt we often assume it is equal to the
required rate of return on existing debt outstanding in the markets (Of
course, when a firm actually goes to the market, conditions may have
changed, underwriting costs may be greater, etc.)
Forecasting WACC also requires estimating the cost of equity. There
may different approaches to this task, and will result in a range of
estimates.
In the end, WACC will still be an estimate. The key thing to ensure is
that the NPV of the project be positive over the range of possible
WACCs. (Graph an NPV profile and determine the range of WACCs
that will still produce a positive NPV.)
CHAPTER 20 Cost of Capital 20 - 16
The Short Story of WACC
Frequently Asked Questions
3. Why is the component cost of capital greater than the investors
required return ?
Accruals
Accounts payable
Short-term debt
Total current liabilities
Total current assets Long-term debt
Shareholders' equity
Total assets Total liabilities and shareholders' equity
Prepaid expenses
Net fixed assets
Table 20-1 Main Balance Sheet Accounts
Cash and marketable securities
Accounts receivable
Inventory
Investment
Dealer
Investor buys one
new share in a
company and pays
the investment
dealer $20 for it.
$20.00
Investment dealer
gives the issuing
firm $18.00 for the
share, and pockets
$2.00 for providing
underwriting
services.
Issuing company
receives $18.00.
$18.00
Investor requires a
10% return on her
investment of $20.
This is a $2.00
return on invested
capital.
Conclusion: The cost of external capital is greater than
the investors required return because of
floatation costs.
The company must produce
$2.00 income on an $18.00
investment to meet the
investors expectations. This is
an 11.1% return.
CHAPTER 20 Cost of Capital 20 - 17
The Short Story of WACC
Summary
WACC measures the firms cost of financing future growth today,
based on current capital market conditions, and assuming the firm
use a long-term average of financing sources.
WACC is an estimate.
WACC is used to make capital investment decisions.
WACC is used to set performance targets for sales, and ROE.
WACC is used to assess managements performance, answering
the question, has management added value?
Sources of Capital for Corporations
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 19
Financing Sources
Capital Structure
Table 20 - 1 illustrates the basic structure of a firms balance
sheet:
This is a snapshot of the firms financial position at one point in
time.
Left-hand side of the Balance Sheet
Assets the things the firm owns
Note the structure of assets (relative proportions of current assets
and net fixed assets)
Right-hand side of the Balance Sheet
Liabilities the borrowed sources of financing
Note the structure of liabilities (the relative proportions of current versus
long-term debt)
Shareholders equity owners investment in the business
Note the amount of capital invested versus the amount of earnings that
have been reinvested in the business
CHAPTER 20 Cost of Capital 20 - 20
Financing Sources
Capital Structure
Accruals
Accounts payable
Short-term debt
Total current liabilities
Total current assets Long-term debt
Shareholders' equity
Total assets Total liabilities and shareholders' equity
Prepaid expenses
Net fixed assets
Table 20-1 Main Balance Sheet Accounts
Cash and marketable securities
Accounts receivable
Inventory
The Financial
Structure
Capital Structure
CHAPTER 20 Cost of Capital 20 - 21
Important Terms
Financial Structure
The whole right-hand side of the balance sheet
Includes both short-term and long-term sources of financing
(debt and equity)
Capital Structure
How the firm finances its invested capital
Excludes accruals and accounts payable short-term liabilities
that are not strictly debt contracts, that spontaneously change in
response to the operations of the business.
Includes:
Bank Loans
Long-term debt
Common stock and retained earnings
(See Table 20 2 for a typical example)
CHAPTER 20 Cost of Capital 20 - 22
Financing Sources
Capital Structure
$50 Accruals $100
200 Accounts payable 200
250 Short-term debt 50
0 Total current liabilities 350
Total current assets 500 Long-term debt 650
1,500 Shareholders' equity 1,000
Total assets $2,000 Total liabilities and shareholders' equity $2,000
Prepaid expenses
Net fixed assets
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
Financial Structure = $2,000 Capital Structure = $1,700
CHAPTER 20 Cost of Capital 20 - 23
Financing Sources
Interpreting Balance Sheets
Balance sheets are prepared in accordance with GAAP:
Represent historical costs which may not be relevant for current
decision-making purposes.
Analysis of reported data should include ratios such as:
Debt to Equity:
Interest bearing debt to shareholders equity plus minority interest
Convert book values to market values
This is done by multiplying the market-to-book ratio times the book
value.
Interpret the ratios again.


(Table 20 2 will be used to illustrate the adjustment process from book values
to market values)
CHAPTER 20 Cost of Capital 20 - 24
Financing Sources
Debt-to-Equity Ratio
$50 Accruals $100
200 Accounts payable 200
250 Short-term debt 50
0 Total current liabilities 350
Total current assets 500 Long-term debt 650
1,500 Shareholders' equity 1,000
Total assets $2,000 Total liabilities and shareholders' equity $2,000
Prepaid expenses
Net fixed assets
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
70 . 0
000 , 1 $
$650 $50
Ratio Equity - to - Debt =
+
=
Debt =
Equity =
CHAPTER 20 Cost of Capital 20 - 25
Financing Sources
Converting Book Value to Market Values
Book Values
$50 Accruals $100
200 Accounts payable 200
250 Short-term debt 50
0 Total current liabilities 350
Total current assets 500 Long-term debt 650
1,500 Shareholders' equity 1,000
Total assets $2,000 Total liabilities and shareholders' equity $2,000
Prepaid expenses
Net fixed assets
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
Market value of debt will be very close (if not equal) to the book
values stated on the balance sheet. This is because these are
contractual claims that are not negotiable (traded in secondary
markets). The amounts stated are the amounts that are required
to satisfy the financial claims of these creditors.
The market value of long-term debt will depend on interest rate
changes since the debt was originally issued. As the bonds
approach maturity, their market price will move progressively to
equal their par (face) value. It is the face value of the debt that is
presented here.
Equity =
The market value of equity is greatly affected by
management. It is not uncommon to see market-to-book
ratios of 2 or more, reflecting the growth prospects the
market sees for the firm. Lets convert the book value of
equity by a market-to-book ratio of 2.5.
CHAPTER 20 Cost of Capital 20 - 26
Financing Sources
Converting Book Value to Market Values
Book Values Market Values
$50 Accruals $100 $100
200 Accounts payable 200 200
250 Short-term debt 50 50
0 Total current liabilities 350 350
Total current assets 500 Long-term debt 650 650
1,500 Shareholders' equity 1,000 2,500
Total assets $2,000 Total liabilities and shareholders' equity $2,000 $3,500
Prepaid expenses
Net fixed assets
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
28 . 0
500 , 2 $
$650 $50
Ratio Equity - to - Debt ued" Market val " =
+
=
When adjusted for market value effects, the apparent
high debt to equity ratio (.7) is a much lower 0.28.
This confirms the importance of using relevant data when
making decisions.
CHAPTER 20 Cost of Capital 20 - 27
The Most Important Corporate Finance
Decisions


It is the managers job to maximize shareholders wealth.
In this and the next chapter we will address two of the most
important ways manager can add value to the firm:
Changing the mix of financing used by the firm (changing the
relative proportions of debt and equity), and
Determining the minimum rate of return needed to maintain the
current market value.
Three Ways of Using the Valuation
Equation
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 29
Valuation Equation for a Perpetuity
Three Ways of Using the Valuation Equation
In Chapter 5 you learned how to determine the present value
of an infinite stream of equal, periodic cash flows (an infinite
annuity).





Where:
S = the present value of the perpetuity
X = the forecast annual earnings
K
e
= the investors required return

e
K
X
S =
[ 20-1] $20.00
10 . 0
00 . 2 $
= = S [ 20-1]
If the annual cash
flow is
$2.00 and the
investors required
return is 10%, the
present value of the
perpetuity is $20.
CHAPTER 20 Cost of Capital 20 - 30
Valuation Equation for a Perpetuity
Three Ways of Using the Valuation Equation
The equation can be rearranged to solve for the required
return K
e
also known as the earnings yield:






The earnings yield is not normally used as the investors
required return because it simply measures forecast earnings
as a percentage of the market price, ignoring growth
opportunities.

S
X
K
e
=
[ 20-2]
10%
$20.00
$2.00
= = =
S
X
K
e
[ 20-2]
CHAPTER 20 Cost of Capital 20 - 31
Valuation Equation for a Perpetuity
Three Ways of Using the Valuation Equation
The perpetuity valuation model can be further rearranged to
solve for the forecast earnings given the current market price
and investors required return.





This helps managers determine their earnings target that must
be met to support the current market value.
If the manager knows the investor requires a 10% rate of return
and the market price is $20.00, she knows the firm must
generate $2.00 in EPS to sustain the stock price.
S K X
e
= [ 20-3]
$2.00 $20.00 0.10 = = = S K X
e
CHAPTER 20 Cost of Capital 20 - 32
Setting Performance Targets
Using Required Returns and Market Values
Given market values and required rates of return, it is possible to
establish performance targets for management to sustain market
values:

For a firm financed by bondholders and stockholders, the firm must
plan to earn sufficient returns as follows:





Working back from these requirements we can forecast the level of
sales the firm must earn in order to achieve these operating
resultsthereby setting a sales performance target for management.


(1) (2) (3) =(1)(2)
Market Value
Required
Return
Earnings
Required
Debt (D) $700 6.0% $42
Equity (S) 2500 12.0% 300
V=D+S = $3,200 $342
CHAPTER 20 Cost of Capital 20 - 33
Setting Performance Targets
Deriving the Required Income Statement
Sales ? $1,000
Variable costs 300 300
Fixed costs 158 158
EBIT ? $542
Interest 42 42
Tax (40%) #VALUE! 200
Net Income $300 $300
Table 20-3 A Forecasted Income Statement
Given the need to
earn $42 to cover
interest, and to
earn $300 after-
tax for
shareholders, and
given a fixed
corporate tax rate
and other costs,
we can determine
the Sales required
to achieve these
goals.

It is $1,000
542 $ 500 $ 42 $
.4) - (1
$300
$42
) 1 (
= + = + =

+ =
T
Income Net
Interest EBIT
$1,000 $542 $158 $300
EBIT Costs Fixed Costs Variable
= + + =
+ + = Sales
This is the very process that is used by regulators to approve regulated
utility rates based on market-determined required rates of return.
So, the cost of capital drives utility rate increases.
CHAPTER 20 Cost of Capital 20 - 34
Setting Performance Targets
How Market Value is Related to Book Value and ROE
Once you have the sales performance target you can establish other
operating targets through the application of ratios.
Since equity in this case is a perpetuity we can express the price per
share as:






Dividing both sides of Equation 20 4 by BVPS we get the basic
relationship that drives the M/B ratio:

e e
K
BVPS ROE
K
EPS
P

= = [ 20-4]
CHAPTER 20 Cost of Capital 20 - 35
Setting Performance Targets
The Relationship Between BVPS and MVPS How to Increase
Shareholder Value
Equation 20 5 tells us:
If the ROE exceeds the investors required return (K
e
)
then the price of the stock will rise above book value.





This is a crucial goal of the financial manager to add
to shareholder value.

e
K
ROE
BVPS
P
=
[ 20-5]
Weighted Average Cost of Capital
(WACC)
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 37
The Cost of Capital
Determining the Weighted Average Cost of Capital (WACC)
The overall market value of the firm is:

V = D + S

In our example V= $3,200
After-tax ROI = 19.13%
= (EBIT)(1-T) = ($542 (1-.4))
= $325.20

This is the required net income if the firm is financed 100% with
equity (no deduction for interest.)
CHAPTER 20 Cost of Capital 20 - 38
The Cost of Capital
Determining the Weighted Average Cost of Capital (WACC)
Where the value of the firm is $3,200 and EBIT (1 T) is $325.60,
we can find the discount rate that sets them equal.
First rewrite EBIT minus taxes as ROI IC and re-express the
valuation equation as:






Equation 20 6 can be rearranged to solve for K
a
for an all equity
firm:

a
K
IC ROI
V

=
[ 20-6]
CHAPTER 20 Cost of Capital 20 - 39
The Cost of Capital
Determining the Weighted Average Cost of Capital (WACC)



Using the numbers from the continuing example the WACC is:





On the following slide will show how we can now substitute in
component costs for both equity and debt to develop the general
equation for WACC (K
a
)

V
IC ROI
K
a

=
[ 20-7]
10.16%
$3,200
$325.20
= =

=
V
IC ROI
K
a
CHAPTER 20 Cost of Capital 20 - 40
The Cost of Capital
Determining the Weighted Average Cost of Capital (WACC)
1
1
V
D
-T) ( K
V
S
K
V
T)D ( K S K
V
IC ROI
K
d e
d e
a
+ =
+
=

= [ 20-8]
The WACC is simply the weighted
average of the component costs.
CHAPTER 20 Cost of Capital 20 - 41
The Cost of Capital
Determining the Weighted Average Cost of Capital (WACC)
The equation for WACC including common equity, preferred
share financing and debt is:






In this case the value of the firm equals the sum of the value
of stock, preferred and debt:
V = S + P + D
1
V
D
-T) ( K
V
P
K
V
S
K WACC
d p e
+ + = [ 20-9]
Estimating Market Values
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 43
Estimating Market Values
Market Value of Equity
The total market value of equity (market
capitalization) is the price per share times the
number of shares outstanding:
n
0
= P S [ 20-10]
CHAPTER 20 Cost of Capital 20 - 44
Estimating Market Values
Market Value of Preferred Stock
The market price for preferred is simply the annual preferred
dividend divided by the preferred shareholders required return.




The market value of all preferred stock is simply the price per share
times the number of shares outstanding.

0
p
p
k
D
P =
[ 20-11]
n
0
= P S [ 20-10]
CHAPTER 20 Cost of Capital 20 - 45
Estimating Market Values
Market Value of Bonds
As previously mentioned, the market value of bonds will differ from
their book value only if required rates of return in the market have
changed since the bonds original issue.
Knowing the term to maturity, the coupon rate and the bondholders
required return we can determine the market value of bonds with
equation 20 - 12:

1
1 1
1
1
n
b b
n
b
) k (
F
k
) k (
I B
+
+
(
(
(
(

=
[ 20-12]
CHAPTER 20 Cost of Capital 20 - 46
Estimating Market Values
Market Value of Bonds
Once you know the market value of the bonds, you multiply their
price by the number of bonds outstanding to determine total market
value.
n =
b
P B [ 20-10]
A Simple Exercise in Determining
Market Value Weights
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 48
Market Value Weights
An Example
Given:
Market price for common stock = $21.50
Bonds are trading for 95% of face value

In order to calculate market value (MV) weights, you will need to
know the total market value of debt, and common stock (and
preferred stock if the company uses it.)
To calculate total MV you need to know the current price of the
security in each class, as well as the total number of securities
outstanding:

Total Market Capitalization = Price Quantity

The following balance sheet date, when combined with market price data, will allow you to calculate MV weights.
CHAPTER 20 Cost of Capital 20 - 49
Market Value Weights
An Example
XYZ Company Limited
Balance Sheet
as at January 30, 2xxx

ASSETS LIABILITIES:
Current Assets $147,000 Current Liabilities $75,250
Net Fixed Assets 15,000,250 8.5% 2020 Mortgage Bonds 4,000,000

Common stock (1,000,000 outstanding) 7,155,000
Retained earnings 3,917,000

TOTAL ASSETS $15,147,250 TOTAL LIABILITIES AND O. EQUITY $15,147,250
Number of common shares
outstanding is read from the
balance sheet.
Face value of bonds are
$1,000, therefore there must
be 4,000 bonds outstanding.
CHAPTER 20 Cost of Capital 20 - 50
Market Value Weights
An Example Continued
Total MV of Equity = Price per share times number of shares = 1M $21.50 = $21.5M
Total MV of Bonds = Price per bond times number of bonds = $950 4,000 = $3,800,000
Type of
Capital
Market
price Number
Total Market
Value
Market
Value
Weight
Bonds $950.00 4,000 $3,800,000 15.02%
Stock $21.50 1,000,000 $21,500,000 84.98%
TOTAL= $25,300,000 100.00%
These weights could now be used to calculate WACC.
CHAPTER 20 Cost of Capital 20 - 51
Bond Value
General Formula

) k (
F
k
) k (
I B
n
b b
n
b
+
+
(
(
(
(

=
1
1 1
1
1
[ 20-12]
Where:
I = interest (or coupon ) payments
k
b
= the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
In the example, you didnt have to calculate the bond value because you
were given the fact that it was trading at 95% of par.
In the event that you do, however, simply use equation 20 -12.
Estimating the Component Costs
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 53
Estimating the Component Costs
Floatation Costs
Issuing or floatation costs are incurred by a firm when it raises
new capital through the sale of securities in the primary
market.
These costs include:
Underwriting discounts paid to the investment dealer
Direct costs associated with the issue including legal and
accounting costs
The result:
Net proceeds on the sale of each security is less than what the
investor invests, and
The component cost of capital > investors required return.

Table 20 4 illustrates average issuing costs for different forms of capital.

CHAPTER 20 Cost of Capital 20 - 54
Estimating the Component Costs
Floatation Costs and the Marginal Cost of Capital (MCC)
Commercial paper 0.125%
Medium-term notes 1.0%
Long-term debt 2.0%
Equity (large) 5.0%
Equity (small) 5.0% - 10.0%
Equity (private) 10.0% and up
Table 20-4 Average Issuing Costs
What issue costs mean is that there is a financing wedge between what the
investor pays and what the firm receives, the difference being the money
that is lost to these costs. Issue costs are responsible for the component
cost of capital being greater than the investors required return.
Floatation costs for
debt securities is
lowest because debt is
normally privately
placed with large
institutional investors
not requiring
underwriting costs and
because debt is either
issued by high quality
issuers or sits at the
top of the priority of
claims list in the case
of default.

CHAPTER 20 Cost of Capital 20 - 55
WACC versus MCC
Floatation Costs and the Marginal Cost of Capital (MCC)
The Marginal Cost of Capital (MCC) is the weighted average
cost of the next dollar of financing to be raised.
At low levels of financing the WACC = MCC
As a firm raises more and more capital in a given year, it will
exhaust the supply of lower cost sources, and then have to
access marginally higher cost sources.
Therefore MCC increases with the amount of capital to be
raised.


The following figure illustrates the MCC concept.

CHAPTER 20 Cost of Capital 20 - 56
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000
(%)
Dollars of Capital to be Raised
15


10


5
The Marginal Cost of Capital MCC
MCC
1
=WACC= 9.44%
MCC
2
= 10.64%
There is only one break in the MCC curve. It
occurs at $5,500,000. At this point the firm has
exhausted its internal equity and to raise more
equity capital will mean accessing external
equity using the services of an underwriter.
% 64 . 10 % 24 . 2 % 4 . 8
) 4 %(. 6 . 5 ) 6 %(. 14
100
40
) 3 . 1 %( 8
100
60
% 14
) 1 (
2
= + =
+ =
+ =
+ =
V
D
t K
V
S
K MCC
d e
% 44 . 9 % 24 . 2 % 2 . 7
) 4 %(. 6 . 5 ) 6 %(. 12
100
40
) 3 . 1 %( 8
100
60
% 12
) 1 (
1
= + =
+ =
+ =
+ =
V
D
t K
V
S
K MCC
d e
2.24%
Each dollar of capital invested is financed 40% by debt. (40% after-tax cost = 2.24%)
Each dollar of capital invested up to
$5.5 million is financed 60% by
internal equity (R/E). (60% cost
of retained earnings = 7.2%)
Each dollar of capital invested
beyond $5.5 million is financed
60% by new equity. (60%
cost of new equity = 8.4%)
CHAPTER 20 Cost of Capital 20 - 57
The Component Cost of Debt
The cost of debt is a function of:
The investors required rate of return
The tax-deductibility of interest expense
The floatation costs incurred to issue new debt
CHAPTER 20 Cost of Capital 20 - 58
The Component Cost of Debt
% 19 . 6
97 . 0
% 6
.03 - 1
0.4) - (1.0 10%


f - 1
T) - (1 Return Required s Investor'
Debt of Cost
d
= =

=
If you know the debt investors required rate of return K
d
, the corporate tax
rate and the floatation cost percentage for debt, you can estimate the cost of
debt in the following manner:

Assume:
K
d
= 10% (debt investors required return)
T = 40% (corporate tax rate)
f
d
= 3% (floatation cost percentage)
The after tax cost of
debt is lower than the
investors required
return because of the
tax shield on interest
expense.
CHAPTER 20 Cost of Capital 20 - 59
Estimating the Component Costs
Debt
Alternatively you can adjust the bond valuation formula for the tax-
deductibility of interest expense and the net proceeds the firm would
receive on the sale of one bond (after floatation costs) and solve for
the rate (K
i
) that causes the formula to become and equality:








K
i
= the after-tax and after-floatation cost of debt.

1
1 1
1
1
) 1 (
n
i i
n
i
) K (
F
K
) K (
T I NP
+
+
(
(
(
(

= [ 20-13]
Net proceeds on the sale of the bond = Selling price
floatation cost per bond.
Coupon interest times 1 minus corporate
tax rate = after tax cost of interest
CHAPTER 20 Cost of Capital 20 - 60
Estimating the Component Costs
Preferred Shares
If you know the preferred share
investors required rate of return
K
p
, and the floatation cost
percentage for preferred share
financing, you can estimate the
cost of preferred shares in the
following manner:

Assume:
K
p
= 14% (preferred investors
required return)
F = 5% (floatation cost percentage)
% 74 . 14
95 . 0
% 14
.05 - 1
14%


f - 1
Return Required s Investor'
Preferred of Cost
p
= = =
=
NOTE: Preferred dividends are paid out of after-
tax earnings, therefore there are no taxation effects
on the preferred share component cost of capital.
Floatation
costs cause
the component
cost to be
greater than
the investors
required
return.
CHAPTER 20 Cost of Capital 20 - 61
Estimating the Component Costs
Preferred Shares
Alternatively, the component cost of preferred shares
can be found using equation 20 -14, where NP is the
selling price per preferred share less the floatation costs
per share.

NP
D
K
p
p
=
[ 20-14]
CHAPTER 20 Cost of Capital 20 - 62
Estimating the Component Costs
Common Shares
Estimating the component cost of common stock is the most
difficult because:
Promised cash flows are uncertain
Growth opportunities, their timing and magnitude will influence
the cost
The riskiness of the stock is influenced by corporate decisions
such as the use of leverage
There are numerous alternative approaches that we will
present to estimate the component cost of equity.
Before doing so, we will first address the effect of leverage on
shareholders.
Effects of Operating and Financial
Leverage
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 64
Leverage
The increased volatility in operating income over
time, created by the use of fixed costs in lieu of
variable costs.
Leverage magnifies profits and losses.
There are two types:
Operating leverage
Financial leverage
Both types of leverage have the same effect on
shareholders but are accomplished in very different
ways, for very different purposes strategically.
CHAPTER 20 Cost of Capital 20 - 65
Leverage Effects on Operating Income
Years
When a firm increases the
use of fixed costs it
increases the volatility of
operating income.
Normal volatility of
operating income
Operating
Income
+

0
-
CHAPTER 20 Cost of Capital 20 - 66
Operating Leverage
What is it? How is it Increased?
Your textbook defines operating leverage as:
The increased volatility in operating income caused by fixed
operating costs.
You should understand that managers do make decisions
affecting the cost structure of the firm.
Managers can, and do, decide to invest in assets that give
rise to additional fixed costs and the intent is to reduce
variable costs.
This is commonly accomplished by a firm choosing to become
more capital intensive and less labour intensive, thereby
increasing operating leverage.
CHAPTER 20 Cost of Capital 20 - 67
Operating Leverage
Advantages and Disadvantages
Advantages:
Magnification of profits to the shareholders if the firm is
profitable.
Operating efficiencies (faster production, fewer errors, higher
quality) usually result increasing productivity, reducing
downtime etc.
Disadvantages:
Magnification of losses to the shareholders if the firm does not
earn enough revenue to cover its costs.
Higher break even point
High capital cost of equipment and the illiquidity of such an
investment make it:
Expensive (more difficult to finance)
Potentially exposed to technological obsolescence, etc.
CHAPTER 20 Cost of Capital 20 - 68
Financial Leverage
What is it? How is it Increased?
Your textbook defines financial leverage as:
The increased volatility in operating income caused
by fixed financial costs.
Financial leverage can be increased in the firm by:
Selling bonds or preferred stock (taking on financial
obligations with fixed annual claims on cash flow)
Using the proceeds from the debt to retire equity (if
the lenders dont prohibit this through the bond
indenture or loan agreement)
CHAPTER 20 Cost of Capital 20 - 69
Financial Leverage
Advantages and Disadvantages
Advantages:
Magnification of profits to the shareholders if the firm is
profitable.
Lower cost of capital at low to moderate levels of financial
leverage because interest expense is tax-deductible.
Disadvantages:
Magnification of losses to the shareholders if the firm does not
earn enough revenue to cover its costs.
Higher break even point.
At higher levels of financial leverage, the low after-tax cost of
debt is offset by other effects such as:
Present value of the rising probability of bankruptcy costs
Agency costs
Lower operating income (EBIT), etc.
CHAPTER 20 Cost of Capital 20 - 70
Effects of Operating and Financial Leverage
Summary
Equity holders bear the added risks associated with
the use of leverage.
The higher the use of leverage (either operating or
financial) the higher the risk to the shareholder.
Leverage therefore can and does affect
shareholders required rate of return, and in turn
this influences the cost of capital.

HIGHER LEVERAGE = HIGHER COST OF CAPITAL
Growth Models and the Cost of
Common Equity
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 72
The Importance of Growth
To this point we have been valuing stock as a perpetuity:
This means that we are assuming the current dividend will be
paid each year in the future into infinity.
Table 20 8 illustrates the importance of growth opportunities
to the price of dividend paying stocks on the TSX.
On average, 62.22% of the market value of this sample of
firms could be attributed to growth opportunities and the
remaining 37.78% to the present value of the current dividend
(perpetuity value)
CHAPTER 20 Cost of Capital 20 - 73
Company Price ($) DPS ($) Dividend
Yield (%)
Perpetuity
($)
Growth
Value (%)
AGF 25.75 0.283 1.10 5.66 78.0
BC Gas 30.60 1.13 3.70 22.60 26.0
CAE 11.50 0.161 1.40 3.22 72.0
Dennings 3.50 0.102 2.90 2.04 42.0
EL Financial 285 0.570 0.20 11.40 96.0
GSW (A) 26.75 0.428 1.60 8.56 68.0
Hammersen 14.05 0.197 1.40 3.94 72.0
Intrawest 6.95 0.292 4.20 5.84 16.0
Jannock 29.60 0.148 0.50 2.96 90.0
Average 1.89 62.22
Source: Booth, Laurence, Table 1 f rom "What Drives Shareholder Value." Financial Intelligence IV-6, Spring 1999.
Table 20-8 Stock Prices and Growth Prospects
Stock Market Time Horizon
Growth Models and the Cost of Common
Equity
The Importance of Adjusting for Growth
Current
stock price
Perpetuity
value of
current
dividend
% of Current
Market Value
explained by
growth
opportunities.
CHAPTER 20 Cost of Capital 20 - 74
Growth Models and the Cost of Common
Equity
The Constant Growth Model
The Gordon model assumes constant growth in the stream of
dividends from t =1 through :





The price of a share (P
0
) today equals the expected dividend
at t =1 dividend b the required shareholder return (K
e
) minus
the long-run growth rate (g) .
This formula can be rearranged to solve for the investors
required rate of return (K
e
):

1
0

g K
D
P

= [ 20-15]
CHAPTER 20 Cost of Capital 20 - 75
Constant Growth Model
The Cost of Common Equity Using Internal Funds
Investors required rate of return consists of two
components:
1. Expected dividend yield
2. Expected long-run growth rate (g)





This is the cost of internal equity (the cost of retained
earnings where the firm does not need to incur floatation
costs)

0
1
g
P
D
K
e
+ = [ 20-16]
CHAPTER 20 Cost of Capital 20 - 76
Constant Growth Model
The Cost of New Equity
The model can be modified to solve for the cost of
new equity by using NP (net proceeds the firm
receives for each new share sold after floatation
costs)

1
g
NP
D
K
ne
+ =
[ 20-17]
CHAPTER 20 Cost of Capital 20 - 77
Constant Growth Model
Caution
The constant growth model can only be used in
cases where it is reasonable to assume that the
growth rate can be sustained in the very long term.
This usually means, using it only for large, mature
blue-chip companies that already pay a significant
dividend.
The Gordon model SHOULD NOT be used on
smaller, more rapidly growing firms where high
current growth rates are experienced, but cannot be
sustained in the long term.
CHAPTER 20 Cost of Capital 20 - 78
Growth Models and the Cost of Common
Equity
Growth and ROE
One way to estimate growth is the sustainable
growth method:
Growth rate is the product of the firms retention rate
(b), times the forecast ROE:





This definition of g can be used in the Gordon model:
ROE b g =
[ 20-18]
CHAPTER 20 Cost of Capital 20 - 79
Growth Models and the Cost of Common
Equity
Growth and ROE
Substituting the sustainable growth rate into the Gordon
model:






Now we can recognize that the expected dividend D
1
is the
expected earnings per share (X
1
) times the dividend payout
ratio (one minus the retention rate):

1
0

ROE b K
D
P
e

=
[ 20-19]
CHAPTER 20 Cost of Capital 20 - 80
Growth Models and the Cost of Common
Equity
Growth and ROE
This equation shows that the price per share is
determined by:
The firms forecast EPS
Dividend payout (1 b)
ROE
Required return by common shareholders (K
e
)





This equation shows the higher the growth rate, the higher the share price
because larger future dividends and earnings are forecast.

) 1 (
1
0

ROE b K
b X
P
e


= [ 20-20]
CHAPTER 20 Cost of Capital 20 - 81
Growth Models and the Cost of Common
Equity
Growth and ROE
Rearranging Equation 20 20 by substituting alternative
expressions for D
1
and g :






When this equation is used to estimate the cost of equity
capital (internal) for three different growth scenarios (10%,
12% and 14%) we get some unusual results summarized in
Table 20 9:

1
0
1
0
1
ROE b
P
b) ( X
g
P
D
K
e
+

= + =
[ 20-21]
CHAPTER 20 Cost of Capital 20 - 82
Growth Models and the Cost of Common
Equity
Growth and ROE
ROE P
0
Expected
Dividend
Yield
Sustainable
Growth Rate
K
e
10% $14.29 7% 5% 12%
12% $16.67 6% 6% 12%
14% $20.00 5% 7% 12%
Table 20-9 Growth and K
e
Stock price rises as
expected growth rate rises.
Three different sustainable
growth rates.
A lower dividend yield. As
prices rise, dividends as a
percentage of share price,
fall.
The firms retention rate, and thus its dividend payout ratio, is reflected in the
constant growth DDM as b.
Table 20 10 on the next slide gives the share price if the retention rate
changes under the three scenarios where ROE is 10, 12 and 14%.
CHAPTER 20 Cost of Capital 20 - 83
Growth Models and the Cost of Common
Equity
Growth and ROE
b 14.0% 12.0% 10.0%
0.40 $18.75 $16.67 $15.00
0.41 18.85 16.67 14.94
0.42 18.95 16.67 14.87
0.43 19.06 16.67 14.81
0.44 19.18 16.67 14.74
0.45 19.30 16.67 14.67
0.46 19.42 16.67 14.59
0.47 19.56 16.67 14.52
0.48 19.70 16.67 14.44
0.49 19.84 16.67 14.37
0.50 20.00 16.67 14.29
0.51 20.16 16.67 14.20
0.52 20.34 16.67 14.12
0.53 20.52 16.67 14.03
0.54 20.72 16.67 13.94
0.55 20.93 16.67 13.85
0.56 21.15 16.67 13.75
0.57 21.39 16.67 13.65
0.58 21.65 16.67 13.55
0.59 21.93 16.67 13.44
0.60 22.22 16.67 13.33
Table 20-10 Retention Rates, ROE, and Share Prices
ROE
Retention
rate
increases
as you go
south.
When ROE =
10%, share
price
decreases as
the firm retains
more money.
When ROE =
12%, share
price remains
the same as
the firm
increases the
retention rate.
When ROE =
14%, share
price
increases as
the firm retains
more money.
The shareholders
required return is 12%.

When a firm retains more
earnings and reinvests
them at a lower rate than
what shareholders
require, the value of the
firm falls.

Clearly, the key to share
price growth is to
reinvest earnings at rates
greater than the cost of
capital.
CHAPTER 20 Cost of Capital 20 - 84
Hurdle Rate
The Cost of Capital
Table 20 -10 tells us that the cost of capital is a
hurdle rate.
The HURDLE RATE is the return on an investment
required to create value; below this rate, an
investment will destroy value.
CHAPTER 20 Cost of Capital 20 - 85
Growing Firms Versus Growth Firms
Growing Firms
Reinvests in projects that offer rates equal to its cost
of capital:

ROE = K
e


Growth Firms
Does something that shareholders cannot do
reinvest earnings at rates higher than the cost of
capital.

ROE > K
e

CHAPTER 20 Cost of Capital 20 - 86
Growth Firms
Importance of the Reinvestment Rate of Return

Growth Firms
Does something that shareholders cannot do reinvest earnings
at rates higher than the cost of capital.

ROE > K
e

This is the reason earnings yield is not an appropriate estimate of the
firms cost of capital.
What is relevant is NOT whether dividends or earnings are growing,
but rather WHETHER THE FIRM IS INVESTING AT RATES OF
RETURN GREATER THAN THE COST OF CAPITAL.
Of course, this means, the firm should be investing in projects with
positive NPVs (IRRs > cost of capital)
Multi-Stage Growth Models and the
Cost of Capital
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 88
Growth Models and the Cost of Common
Equity
Multi-Stage Growth Models
Multi-stage DDM is a version of the DDM that
accounts for different levels of growth in earnings
and dividends.
There is no limit to the number of growth stages one
can forecast for a given company, so this is a very
flexible model.
See Chapter 7 for detailed pricing model description.
CHAPTER 20 Cost of Capital 20 - 89
Simple Two-stage Growth Model
Multi-Stage Growth Models
Equation 20 22 is a simple, two-stage growth model.
It breaks the stock price into two components:
1. PVEO present value of existing opportunities (the value of the firms
current operations assuming no new investment) and
2. PVGO present value of growth opportunities the net present value
today of the firms future investments.
) (
) 1 (
2 1
0
e
e
e e
K
K ROE

K
Inv
K
BVPS ROE
P

+
+

=
[ 20-22]
PVEO PVGO
CHAPTER 20 Cost of Capital 20 - 90
Simple Two-stage Growth Model
PVEO and PVGO








PVGO is discounted back to the present by one year because it
represents an incremental investment decision today that wont
result in the first cash flow until one year from now.
PVGO does add a perpetual amount represented by the difference
between ROE
2
earned on this added investment and K
e

) (
) 1 (
2 1
0
e
e
e e
K
K ROE

K
Inv
K
BVPS ROE
P

+
+

=
[ 20-22]
PVEO PVGO
CHAPTER 20 Cost of Capital 20 - 91
Simple Two-stage Growth Model
PVGO and ROE
2








If ROE
2
= K
e
then the future investment adds
nothing to the value of the firm
If ROE
2
> K
e
then the future investment adds
value to the firm

) (
) 1 (
2 1
0
e
e
e e
K
K ROE

K
Inv
K
BVPS ROE
P

+
+

=
[ 20-22]
PVGO
CHAPTER 20 Cost of Capital 20 - 92
Simple Two-stage Growth Model Scenarios
PVEO and PVGO








Four Scenarios:
High PVEO and High PVGO - Star
High PVEO and Low PVGO - Cash Cow
Low PVEO and High PVGO - Turnaround
Low PVEO and Low PVGO - Dog

(These four scenarios are found in matrix form in Figure 20 -1 )

) (
) 1 (
2 1
0
e
e
e e
K
K ROE

K
Inv
K
BVPS ROE
P

+
+

=
[ 20-22]
PVGO
CHAPTER 20 Cost of Capital 20 - 93
Simple Two-stage Growth Model
Growth Opportunities and Firm Type
20 - 1 FIGURE
CHAPTER 20 Cost of Capital 20 - 94
Simple Two-stage Growth Model
Growth Opportunities and Firm Type
Star Growth Company
High PVEO and high PVGO
DCF methods of valuation are unreliable due to high growth
Turnaround Growth Company
Low PVEO and high PVGO
Poor PVEO drags down stock price today
DCF methods of valuation are unreliable due to high growth
Cash Cow
High PVEO and low PVGO
DCF methods of valuation are reliable due to lack of growth we are valuing a
perpetuity
Dog
Low PVEO and low PVGO
High earnings yield forecast to lose value from future investments depressing
the current share price.

(See Table 20 -11 for earnings yield and Market-to-book ratios for each type.)

CHAPTER 20 Cost of Capital 20 - 95
Simple Two-stage Growth Model
Growth Opportunities and Firm Type
Earnings Yield (%) Market-to-Book
Star
8.84 2.26
Cash cow
12.00 1.67
Turnaround
2.63 0.76
Dog
114.29 0.02
Table 20-11 The Impact of Growth Opportunities on Share Prices
The Fed Model
U.S. Federal Reserve
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 97
Growth Models and the Cost of Common
Equity
The Fed Model
Used by the U.S. central bank to estimate whether
the stock market was over- or under-valued
Used to decide whether the Central Reserve Bank
should send signals to the market to encourage
reason in the market place (to avoid speculative
bubbles and the inevitable price collapse that follows)


Attempting to avoid irrational exuberance!

The Fed Model equation is found on the next slide.
CHAPTER 20 Cost of Capital 20 - 98
Growth Models and the Cost of Common
Equity
The Fed Model
)
%) 0 . 1 /( ) (
=
TBond
actual
Fed
actual
K EPS Exp
V

V
V
[ 20-23]
Actual value of the U.S. stock a
market. (Total market
capitalization).
Estimate of the U.S. stock
market value from the Fed
model.
Expected EPS on S&P 500 index
divided by yield on long U.S.
Treasury bonds.
Aggregate valuation across the entire market is easier because
unsystematic risk attached to individual securities is eliminated as a
factor for the market as a whole.
CHAPTER 20 Cost of Capital 20 - 99
Growth Models and the Cost of Common
Equity
The Fed Model
The Feds estimate of market value = Expected EPS on S&P 500
divided by Yield on Long U.S. Treasury Bonds minus 1.0%.
All of this data is continuously, readily available so this estimate of
value is easy to produce and to track over time as illustrated in
Figure 20 2 on the following slide:
)
%) 0 . 1 (
) (

=
TBond
Fed
K
EPS Exp
V
[ 20-24]
Aggregate valuation across the entire market is easier because
unsystematic risk attached to individual securities is eliminated as a
factor for the market as a whole.
CHAPTER 20 Cost of Capital 20 - 100
The Fed Model
Feds Stock Valuation Model
20 - 2 FIGURE
CHAPTER 20 Cost of Capital 20 - 101
Growth Models and the Cost of Common
Equity
The Fed Model
If the Fed Model is rearranged it can show when the
market is fairly valued:








% . - K
P
X
TBond
S&P
0 1
500
=
[ 20-25]
CHAPTER 20 Cost of Capital 20 - 102
Growth Models and the Cost of Common
Equity
The Fed Model
When the earnings yield on the S&P 500 (market) is equal to the
long-term Treasury Bond yield minus 1.0 percent, the market is fairly
valued.
The earnings yield is the appropriate discount rate for the no-growth
case. (perpetuities), whereas we would expect the market as a
whole to grow at the nominal GDP growth rate.





Required return on the market as a whole = Long Treasury Yield +
4.0% risk premium. (5% nominal GDP 1%).


% . - K
P
X
TBond
S&P
0 1
500
=
[ 20-25]
CHAPTER 20 Cost of Capital 20 - 103
Growth Models and the Cost of Common
Equity
The Fed Model
Required return on the market as a whole = Long Treasury Yield + 4.0%
risk premium. (5% nominal GDP 1%).








The required rate of return on the market as a whole can serve as a
useful benchmark for financial managers as they attempt to estimate
their own firms cost of capital.


% . - K
P
X
TBond
S&P
0 1
500
=
[ 20-25]
Risk-Based Models and the Cost of
Common Equity
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 105
Risk-Based Models and the Cost of Common
Equity
Using the CAPM to Estimate the Cost of Common Equity
CAPM can be used to estimate the required return by
common shareholders.
It can be used in situations where DCF methods will
perform poorly (growth firms)
CAPM estimate is a market determined estimate
because:
The RF (risk-free) rate is the benchmark return and is measured
directly, today as the yield on 91-day T-bills
The market premium for risk (MRP) is taken from current market
estimates of the overall return in the market place less RF (ER
M

RF)

CHAPTER 20 Cost of Capital 20 - 106
Risk-Based Models and the Cost of Common
Equity
Using the CAPM to Estimate the Cost of Common Equity
As a single-factor model, we estimate the common shareholders required
return based on an estimate of the systematic risk of the firm (measured by
the firms beta coefficient)




Where:
K
e
= investors required rate of return

e
= the stocks beta coefficient
R
f
= the risk-free rate of return
MRP = the market risk premium (ER
M
- R
f
)
MRP R K
e F e
| + = [ 20-26]
CHAPTER 20 Cost of Capital 20 - 107
Risk-Based Models and the Cost of Common
Equity
Estimating the Market Risk Premium




R
f
is observable (yield on 91-day T-bills)
Getting an estimate of the market risk premium is one of the more
difficult challenges in using this model.
We really need a forward looking of MRP or a forward looking
estimate of the ER
M

One approach is to use an estimate of the current, expected MRP
by examining a long-run average that prevailed in the past.
Table 20 -12 illustrates the % returns on S&P/TSX Composite
annually for the first five years of this century.
MRP R K
e F e
| + = [ 20-26]
CHAPTER 20 Cost of Capital 20 - 108
Risk-Based Models and the Cost of Common
Equity
Using the CAPM to Estimate the Cost of Common Equity
Returns
2000
7.5072%
2001
-12.572%
2002
-12.438%
2003
26.725%
2004
14.480%
2005
24.127%
Table 20-12 Returns on the S&P/TSX Composite Index
Investors are
unlikely to expect
negative returns
on the stock
market. If they
did, no one would
hold shares!

Who would have
guessed before
hand, there would
be two
consecutive years
of aggregate
market losses?

Such is the reality
of investing since
none of us are
clairvoyant.
It would be
better to use
average
realized
returns over
an entire
business/mar
ket cycle.
CHAPTER 20 Cost of Capital 20 - 109
Risk-Based Models and the Cost of Common
Equity
Using the CAPM to Estimate the Cost of Common Equity
Annual
Arithmetic
Average (%)
Annual
Geometric
Mean (%)
Standard
Deviation of
Annual
Returns (%)
Government of Canada Treasury Bills 5.20 5.11 4.32
Government of Canada Bonds 6.62 6.24 9.32
Canadian Stocks 11.79 10.60 16.22
U.S. Stocks 13.15 11.76 17.54
Source: Data f rom Canadian Institute of Actuaries
Table 20-13 Average Investment Returns and Standard Deviations (1938 to 2005)
Long-run average rates of return are more reliable.
Average risk premium of Canadian
stocks over bonds was 5.17%
The consensus is that the Canadian MRP over the long-term
bond yield (an observable yield) is between 4.0 and 5.5%.
CHAPTER 20 Cost of Capital 20 - 110
Risk-Based Models and the Cost of Common
Equity
Using the CAPM to Estimate the Cost of Common Equity
Financial Forecasts Average Annual Percent Return
Bank of Canada Overnight Rate
4.50
Cash: 3-Month T-bills
4.40
Income: Scotia Universe Bond Index
5.60
Canadian Equities: S&P/TSX Composite Index
7.30
U.S. Equities: S&P 500 Index
7.80
International Non-U.S. Equities: MSCI EAFE Index
7.50
Source: TD Economics
Table 20-14 Long-Run Financial Projections
An estimate of ER
M
is very important.
TD Economics recently generated the above estimates of forward
looking rates.
The Scotia Universe Bond Index is a long-term bond index that
contains Canadas and corporate bonds with default risk.
Nevertheless, on a risk-adjusted basis, the TD forecast for MRP is
consistent with an arithmetic risk premium of 4.3%
CHAPTER 20 Cost of Capital 20 - 111
Risk-Based Models and the Cost of Common
Equity
Estimating Betas
After obtaining estimates of the two important
market rates (R
f
and MRP), an estimate for the
company beta is required.

Figure 20 -3 illustrates that estimated betas for
major sub-indexes of the S&P/TSX have varied
widely over time:
CHAPTER 20 Cost of Capital 20 - 112
Risk-Based Models and the Cost of Common
Equity
Estimated Betas for Sub Indexes of the S&P/TSX Composite Index
20 - 3 FIGURE
CHAPTER 20 Cost of Capital 20 - 113
Risk-Based Models and the Cost of Common
Equity
Estimated Betas for Sub Indexes of the S&P/TSX Composite Index
Actual data for Figure 20 -3 is presented in Table 20 -15 on
the following slide:
You should note:
IT sub index shows rapidly increasing betas
Other sub index betas show constant or decreasing trends.
Reasons:
The weighted average of all betas = 1.0 (by definition they are
the market)
If one sub index is changingthat change alone affects all
others in the opposite direction.
What Happened in the 1995 2005 decade?
The internet bubble of the late 1990s resulted in rapid growth in
the IT sector till it burst in the early 2000s.
CHAPTER 20 Cost of Capital 20 - 114
Risk-Based Models and the Cost of Common
Equity
Estimating Betas
Energy Materials Industrials ConsDisc ConsStap Health Fin IT Telco Utilities
1995 0.93 1.41 1.19 0.82 0.68 0.36 0.92 1.25 0.53 0.67
1996 0.93 1.28 1.10 0.83 0.66 0.39 1.02 1.36 0.61 0.65
1997 0.98 1.33 0.97 0.82 0.62 0.60 0.93 1.56 0.62 0.53
1998 0.85 1.12 0.94 0.80 0.60 1.02 1.11 1.40 0.92 0.55
1999 0.91 1.04 0.78 0.73 0.43 1.00 1.00 1.55 1.11 0.30
2000 0.67 0.74 0.73 0.69 0.23 1.10 0.79 1.78 0.92 0.14
2001 0.50 0.60 0.82 0.68 0.10 0.98 0.67 2.12 0.94 -0.03
2002 0.43 0.57 0.86 0.73 0.11 0.99 0.67 2.27 0.92 -0.06
2003 0.27 0.42 0.91 0.74 -0.04 0.85 0.39 2.75 0.82 -0.26
2004 0.17 0.42 1.04 0.81 -0.02 0.84 0.41 2.89 0.55 -0.14
2005 0.48 0.78 1.12 0.84 0.14 0.74 0.58 2.71 0.71 -0.01
Source: Data from Financial Post Corporate Analyzer Database
Table 20-15 S&P/TSX Sub Index Beta Estimates
IT
Bubble
CHAPTER 20 Cost of Capital 20 - 115
Risk-Based Models and the Cost of Common
Equity
Nortel Stock Price

Nortels stock price reflects the IT bubble and crash.




(See Figure 20 -4 on the following slide for Nortel Stock Price history)
CHAPTER 20 Cost of Capital 20 - 116
Risk-Based Models and the Cost of Common
Equity
Nortel Stock Price
20 - 4 FIGURE
CHAPTER 20 Cost of Capital 20 - 117
Risk-Based Models and the Cost of Common
Equity
IT Bubble effect on Betas of Other Companies Outside the Sector

The bubble in IT stocks has driven down the betas in other
sectors.
This is demonstrated in Rothmans beta over the 1966 2004
period.
Remember, Rothmans is a stable company and its beta
should be expected to remain constant.




(See Figure 20 -5 on the following slide for Rothmans beta history)
CHAPTER 20 Cost of Capital 20 - 118
Risk-Based Models and the Cost of Common
Equity
Rothmans Beta Estimates
20 - 5 FIGURE
CHAPTER 20 Cost of Capital 20 - 119
Risk-Based Models and the Cost of Common
Equity
Adjusting Beta Estimates and Establishing a Range
When betas are measured over the period of a
sector bubble or crash, it is necessary to adjust the
beta estimates of firms in other sectors.
Take the industry grouping as a major input, plus
the individual company beta estimate.
Using current MRP and R
f
Develop estimates of K
e

using the range of Company betas prior to the bubble
or crash

CHAPTER 20 Cost of Capital 20 - 120
Risk-Based Models and the Cost of Common
Equity
Using CAPM to Estimate K
ne

We can scale our estimate of the equity holders
required return when accessing new equity and
incurring floatation costs.
NP P K K
e ne
/
0
= [ 20-27]
The Marginal Cost of Capital and
Investment Opportunity Schedule
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 122
The Investment Opportunity Schedule
The IOS is the ranking of a firms investment
opportunities from highest to lowest profitability
according to expected IRR.
When superimposed on the MCC curve, the firm is able
to identify projects that will increase the value of the firm.
A stylized version of this for Rothmans is found in Figure
20 6.
CHAPTER 20 Cost of Capital 20 - 123
Cost of Capital and Investment
Rothmans Inc.s IOS Schedule, 2006
20 - 6 FIGURE
$11,976
Million
Rate of
Return





WACC
Internal Funds Available
OPTIMAL INVESTMENT
IOS
$177,607
Million
Projects expected to
increase the value of the
firm.
The break in the MCC at
$177,607 million
indicates that the firm
has a surplus of
internally-generated
fundsmore than
enough to fund the
$11,976 of capital
investments.
Projects
rejected.
CHAPTER 20 Cost of Capital 20 - 124
Investment Opportunity Schedule
A Detailed Example
In practice, the IOS is a detailed list, rank ordered
from highest IRR to lowest of the investment project
proposals for one year.
As you can see on the following slides:
The width of the columns indicate the capital
investment each project requires, and
The height of the columns indicates the forecast IRR
for the project
CHAPTER 20 Cost of Capital 20 - 125
Investment Opportunity Schedule
A Detailed Example
In any one year, a firm may consider a number of capital projects.

The greater the number of projects undertaken, the more money
that the firm will have to raise in order to finance them.

There is a limit to the amount of money that can be raised in any
one year (ie. the capital markets are finite ie. there is a limit to the
number of investors and their investment dollars that will consider
investing in any prospect in any given year.) hence it is important
that the capital budgeting analysis be extended to take this fact into
account.
CHAPTER 20 Cost of Capital 20 - 126
Investment Opportunity Schedule
A Detailed Example
This Investment opportunity schedule is the prioritized list of
capital projects, listed by IRR (internal rate of return) from
highest to lowest.
At the same time, the cumulative investment required is listed.
Example:
Consider a firm that has six different capital investment proposals this
year. Each project has its own IRR and capital cost.

(see the next slide)
CHAPTER 20 Cost of Capital 20 - 127
Investment Opportunity Schedule
A Detailed Example
Example:
Consider a firm that has six different capital investment
proposals this year. Each project has its own IRR and capital
cost. Each project has the same risk as the firm as a whole.
Capital
Project Initial Cost
Annual ATCF
Benefits
Useful
Life
NPV IRR
A $1,500,000 $290,000 7 -$88,159 8.19%
B $2,300,000 $529,000 6 $3,933 10.06%
C $3,750,000 $940,000 6 $343,945 13.07%
D $180,000 $40,000 7 $14,737 12.45%
E $985,000 $318,540 5 $222,517 18.50%
F $2,154,000 $421,500 8 $94,671 11.20%
Project A can be
eliminated at this
point because it has
a negative NPV.
CHAPTER 20 Cost of Capital 20 - 128
Investment Opportunity Schedule
A Detailed Example
Example:
The first step in developing an IOS is to order the projects
from highest IRR to lowest, and then to calculate the
cumulative capital cost of the projects.
Capital
Project Initial Cost
Cumulative Cost
of the Projects IRR

E $985,000 $985,000 18.50%
C $3,750,000 $4,735,000 13.07%
D $180,000 $4,915,000 12.45%
F $2,154,000 $7,069,000 11.20%
B $2,300,000 $9,369,000 10.06%
A $1,500,000 $10,869,000 8.19%
CHAPTER 20 Cost of Capital 20 - 129
Investment Opportunity Schedule
A Detailed Example Continued
Example:
It was clear at the start that project A was unacceptableit had a
negative NPV.

The remaining projects certainly meet the first investment screen (they
have positive NPVs that is, they offer rates of return in excess of
the firms WACC).

Now we can prepare a graphical representation of the IOS by plotting
the projects IRR against the cumulative dollars of capital to be raised.
CHAPTER 20 Cost of Capital 20 - 130
Investment Opportunity Schedule (IOS)
A Detailed Example Continued
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000
Dollars of Capital to be Raised
IRR
(%)
15


10


5
E
IRR =
18.5%
C
IRR = 13.07%
F
IRR = 11.2%
B
IRR = 10.06%
D
IRR = 12.45%
The height of each cylinder is equal to the projects IRR; the width is equal to the initial
investment for the project.
The upper surface of
the columns is the
IOS
CHAPTER 20 Cost of Capital 20 - 131
Investment Opportunity Schedule (IOS)
A Detailed Example Continued
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000
Dollars of Capital to be Raised
IRR
(%)
15


10


5
E
IRR =
18.5%
C
IRR = 13.07%
F
IRR = 11.2%
B
IRR = 10.06%
D
IRR = 12.45%
IOS
CHAPTER 20 Cost of Capital 20 - 132
MCC Superimposed on the IOS
A Detailed Example Continued
0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000
Dollars of Capital to be Raised
IRR
(%)
15


10


5
E
IRR =
18.5%
C
IRR = 13.07%
F
IRR = 11.2%
B
IRR = 10.06%
D
IRR = 12.45%
MCC
1
=WACC= 9.44%
MCC
2
= 10.64%
The break in the MCC is caused
by the exhaustion of low cost
retained earnings and the need to
finance project F through external
offering of equity, incurring
floatation costs.
IRR
B
< MCC
2

so this project
is rejected. It
will not
increase the
value of the
firm.
CHAPTER 20 Cost of Capital 20 - 133
The Break In the IOS
A Detailed Example Continued
The break in the IOS curve (the amount of capital investment that
exhausts retained earnings) can be estimated as:




Assuming the firm has $3.3 million in internal capital to invest and
equity represents 60% of the firms capital structure the break point
occurs at:





Structure Capital in the Up Makes Equity that Percentage
Investment for Available Earnings Retained of $
MCC in Break =
$5,500,000
60%
$3,300,000
MCC in Break = =
CHAPTER 20 Cost of Capital 20 - 134
MCC and IOS
The foregoing is consistent with economic theory
that states a firm will operate where marginal cost
equals marginal revenue.

Now the rationale for this must be clear. The value
of the firm will fall if it undertakes projects that offer a
rate of return that is less than the marginal cost of
capital used to finance them.
CHAPTER 20 Cost of Capital 20 - 135
Divisional Costs of Capital
An overall cost of capital developed for a highly diversified
conglomerate may not be appropriate for decisions made within
specific divisions of the company.

High-risk divisions (with high return possibilities) would have a
disproportionate share of their investment proposals accepted if they
use an overall WACC.

The solution to this is to develop risk-adjusted discount rates that
reflect the unique risk characteristics of each division.

Developing these estimates can sometimes be accomplished by
looking at other firms in that industry that are not highly diversified in
their operations this is called the pure play approach.
CHAPTER 20 Cost of Capital 20 - 136
Summary and Conclusions
In this chapter you have learned:
How types of equity differ in their degree of equityness and
therefore have different costs of capital
WACC is the market value weighted average of the after-tax
costs of all securities used to finance the firm.
If a firm earns more than its WACC, the value of the firm will
rise.
Common shareholders are residual claimants hence they hold
the riskiest securities issued by the firm.
The most difficult estimate in WACC is the cost of common
equity.
DCF approaches to estimating the cost of equity is particularly
prone to errors for high growth firms.
CAPM can be used to minimize estimation errors, however,
estimation of beta can be affected by recent stock market
performance.
Concept Review Questions
Cost of Capital
CHAPTER 20 Cost of Capital 20 - 138
Concept Review Question 1
Earnings Yield
Why is the earnings yield not usually an adequate
measure of the required rate of return by equity
investors?


Appendix 1
Steep Hill Mines 1
An Exercise in Cost of Capital
CHAPTER 20 Cost of Capital 20 - 140
Steep Hill Mines # 1
The Question
Steep Hill Mines Ltd. shares are publicly traded on the Toronto
Stock Exchange. The shares currently trade at a price of $30.00 per
share. Security analysts that follow the stock have estimated it's beta
coefficient to be 0.9. Steep Hill paid a dividend on its common stock
last year that totaled $1.50 per share. Dividends have been growing at
a 4% compound rate for the past six years and the expectation is that
this growth can continue into the foreseeable future.

Steep Hill also has it's long-term bonds trading on public markets.
The bonds are currently trading at a discount from their par value of
96.54%. These 5.75% bonds have ten years left until they mature.

Steep Hill Mines Ltd. has an important capital project to consider.
Project A is expected to produce annual cash flows after tax of
$100,000 for the next eight years. It is considered to be of similar risk
to the risk of the firm itself. It will cost Steep Hill $400,000 this year to
get this project up and running.
CHAPTER 20 Cost of Capital 20 - 141
Steep Hill Mines # 1
The Question
Cathy Jones, Steep Hill's manager of finance has collected current
data from the firm's underwriters.

Government of Canada 91-day Treasury bills are currently yielding 4.25%.
The expected return on the TSE 300 composite index is forecast to be 10% in
the next year
New equity capital could be raised by the firm at the current market price, but
floatation costs would amount of 4% of the value of the issue.
New bonds could be sold into the market, but the floatation cost percentage
would be 6%.
The firm faces a corporate tax rate of 40%.
The company will seek to sustain the current capital structure based on existing
market value weights.
If the firm goes ahead with the capital project, it will have to seek external
financing since there is no internal cash flow available for reinvestment.

The firm's most recent financial statements are found below:
CHAPTER 20 Cost of Capital 20 - 142
Steep Hill Mines # 1
The Question
Steep Hill Mines Ltd.
Balance Sheet
As at December 31, 20XX
In $ '000s
Assets: Liabilities:
Cash 100 Accruals 30
Accounts Receivable 220 Accounts Payable 312
Inventories 450 ____
Total Current Assets 770 Total Current Liabilities 342
Gross Fixed Assets 4,000 5.75% bonds 1,000
Accumulated Depreciation 1,500 Common stock
(100,000 outstanding) 1,000
Net Fixed Assets 2,500 Retained earnings 928
TOTAL ASSETS 3,270 TOTAL CLAIMS 3,270

Required:
Find the WACC using book value weights, market value weights and target capital structure
weights. Using the target capital structure weights, is the proposed project viable?
CHAPTER 20 Cost of Capital 20 - 143
Steep Hill Mines # 1
The Solution The Equity Investors Required Return
Investor's Required Return on Equity Capital:
DDM Approach:





CAPM Approach:





% 2 . 9 04 . 052 . 0 04 .
30 $
56 . 1 $
04 .
30 $
) 04 . 1 ( 50 . 1 $ ) 1 (
0
0
= + = + = + = +
+
= g
P
g D
K
S
% 425 . 9 % 175 . 5 % 25 . 4
%] 25 . 4 % 10 [ 9 . 0 % 25 . 4 ] [
= + =
+ = + =
S
M s S
K
RF ER B RF K
CHAPTER 20 Cost of Capital 20 - 144
Steep Hill Mines # 1
The Solution The Cost of Equity
Investor's Required Return on Equity Capital
The average of our two estimates for the cost of retained earnings
is: (9.2 + 9.425)/2 = 9.3%

This is the returns our current shareholders are demanding on our
stock.

If we raise external capital, we will incur floatation costs
(underwriter's fees, legal costs, etc.) This represents 4%.

% 7 . 9
96 .
% 3 . 9
.4 - 1
% 3 . 9


f - 1
Return Required Investors
Equity New of Cost
= = =
=
CHAPTER 20 Cost of Capital 20 - 145
Steep Hill Mines # 1
The Solution
Investor's Required Return on Debt




% 22 . 6 2 % 11 . 3 k
% 11 . 3 k
1
1 1
1
1
$28.75 $965.40
1
1 1
1
1
b
b
20
20
= =
=
+
+
(
(
(
(

=
+
+
(
(
(
(

=
ly semiannual
) k (
F
k
) k (

) k (
F
k
) k (
I B
b b
b
n
b b
n
b
[ 20-12]
CHAPTER 20 Cost of Capital 20 - 146
Steep Hill Mines # 1
The Solution The Cost of Debt

Since interest on debt is tax deductible to the firm, the after-tax and
after floatation cost of debt is:






Where:
T = 40%
f = 6%


% 97 . 3
06 . 1
) 4 . 1 %( 22 . 6
1
) 1 %( 22 . 6
=


=
f
T
K
d
CHAPTER 20 Cost of Capital 20 - 147
Market Value Weights:
Market values are always found by multiplying
the number of outstanding securities times
their price per unit.

Market Value of LT Debt = 1,000 bonds outstanding times $965.40 = $965,400
Market Value of Equity = 100,000 times $30.00 = 3,000,000
TOTAL MARKET VALUE OF THE FIRM = 3,965,400

Market Value Weight of LT Debt = $965,400/$3,965,400 = 24.35%
Market Value Weight of Equity = (1 - .2435) = 75.65%
Steep Hill Mines # 1
The Solution Determining Market Value Weights
CHAPTER 20 Cost of Capital 20 - 148
The Cost of Capital Using Market Value Weights:
Steep Hill Mines # 1
The Solution Market Value WACC
Source of
Capital
Market
Value
Weight
Specific
Marginal
Cost
Weighted
Cost
L. T. Debt 24.4% 3.97% 0.97%
Preferred 0.0% 0.00% 0.00%
Common 75.7% 9.70% 7.34%
WACC = 8.30%
CHAPTER 20 Cost of Capital 20 - 149
Viability of the Capital Project

Since the project has similar risk characteristics to the firm as
a whole, we do not have to calculate a risk-adjust discount
rateinstead, we can just use the firm's WACC.

Since the market value capital structure weights will be used
by the firm in the long run, let's use that as the WACC, and
discount the prospective after-tax cash flows on this project
back to the present and compare that with the cost of the
project to see if there is a positive NPV.


Steep Hill Mines # 1
The Solution
CHAPTER 20 Cost of Capital 20 - 150



Steep Hill Mines # 1
The Solution Project NPV
178 , 168 $
000 , 400 $ 178 , 568 $
000 , 400 $ ) .681788 $100,000(5
000 , 400 $
083 .
(1.083)
1
- 1
$100,000
000 , 400 $ ) VIFA $100,000(P
000 , 400 $ ) VIFA $100,000(P
) 1 (
...
) 1 ( ) 1 ( ) 1 (
8
8.3% k 8, n
WACC k 8, n
0
1
0
3
3
2
2
1
1
=
=
=
=
=
=

+
=
+
+
+
+
+
+
=
= =
= =
=

NPV
CF
k
CF
CF
k
CF
k
CF
k
CF
NPV
t
n
i
t
[ 13-1]
Using Equation
13 -1 for NPV,
and substituting
in the annual
cash flow
benefits of
$100,000 after-
tax, initial cost,
useful life of 8
years, and
WACC of 8.3%
we find the
project offers a
positive NPV.
CHAPTER 20 Cost of Capital 20 - 151
Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access
Copyright (the Canadian copyright
licensing agency) is unlawful. Requests
for further information should be
addressed to the Permissions
Department, John Wiley & Sons Canada,
Ltd. The purchaser may make back-up
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not for distribution or resale. The author
and the publisher assume no
responsibility for errors, omissions, or
damages caused by the use of these files
or programs or from the use of the
information contained herein.

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