Cost of Capital

Overview of the Cost of
Capital
The cost of capital represents the firms cost of financing, and

is the minimum rate of return that a project must earn to
increase firm value.
Financial managers are ethically bound to only invest in projects that

they expect to exceed the cost of capital.
The cost of capital reflects the entirety of the firms financing activities.
Most firms attempt to maintain an optimal mix of debt and

equity financing.
To capture all of the relevant financing costs, assuming some desired

mix of financing, we need to look at the overall cost of capital rather
than just the cost of any single source of financing.
Kevin Campbell, University of Stirling, November 2005
Overview of the Cost of

Capital
The overall cost of capital is a weighted average of

the various sources:
WACC = Weighted Average Cost of Capital
The cost of capital is normally the relevant discount

rate to use in analyzing an investment
Overview of the Cost of Capital

(cont.)
A firm is currently faced with an investment
opportunity. Assume the following:
Best project available today

Cost = $100,000
Life = 20 years
Expected Return = 7%
Least costly financing source available

Debt = 6%
Because it can earn 7% on the investment of funds
costing only 6%, the firm undertakes the opportunity.

(cont.)
Imagine that 1 week later a new investment
opportunity is available:
Best project available 1 week later

Cost = $100,000
Life = 20 years
Expected Return = 12%
Least costly financing source available

Equity = 14%
In this instance, the firm rejects the opportunity, because

the 14% financing cost is greater than the 12% expected
return.

(cont.)
What if instead the firm used a combined cost of
financing?
Assuming that a 5050 mix of debt and equity is
targeted, the weighted average cost here would be:

(0.50 6% debt) + (0.50 14% equity) = 10%
With this average cost of financing, the first
opportunity would have been rejected (7% expected
return < 10% weighted average cost), and the second
would have been accepted
(12% expected return > 10% weighted average cost).
Specific Sources of Capital
Basic sources of long-term funds for the business

firm:
Long-term debt
Preferred stock
Common stock
Retained earnings
Factors Affecting the Cost of

Capital
General Economic Conditions

Affect interest rates
Market Conditions
Affect risk premiums
Operating Decisions
Affect business risk
Financial Decisions
Affect financial risk
Amount of Financing
Affect flotation costs and market price of
security
7
Cost of Debt
The cost of debt to the firm is the effective yield to
maturity (or interest rate) paid to its bondholders
Since interest is tax deductible to the firm, the
actual cost of debt is less than the yield to
maturity:
After-tax cost of debt = yield x (1 - tax rate)
The cost of debt should also be adjusted for
flotation costs (associated with issuing new
bonds)
Example: Tax effects of

financing with debt
EBIT
- interest expense
EBT
- taxes (34%)
EAT
with stock
400,000
0
400,000
(136,000)
264,000
with debt
400,000
(50,000)
350,000
(119,000)
231,000
Now, suppose the firm pays $50,000 in dividends

to the shareholders
Example: Tax effects of

financing with debt
with stock
with debt
EBIT
400,000
400,000
- interest expense
0
(50,000)
EBT 400,000
350,000
- taxes (34%) (136,000)
(119,000)
EAT 264,000
231,000
- dividends
(50,000)
0
Retained earnings
214,000
231,000
10
Cost of Debt
After-tax cost
of Debt
33,000
Before-tax cost
of Debt
50,000
50,000 ( 1 - .34)
Tax
Savings
17,000
OR
33,000
Or, if we want to look at percentage costs:
11
Cost of Debt
After-tax
% cost of
Debt
Kd
.066
Before-tax
% cost of
Debt
Marginal
tax
rate
kd (1 - T)
=
.10 (1 - .34)
12
EXAMPLE: Cost of Debt

Prescott
Corporation issues a $1,000 par,

20 year bond paying the market rate of
10%. Coupons are annual. The bond will
sell for par since it pays the market rate,
but flotation costs amount to $50 per
bond.
What
is the pre-tax and after-tax cost of

debt for Prescott Corporation?
13
EXAMPLE: Cost of Debt

Pre-tax
cost of debt:
950 = 100(PVIFA 20, Kd) + 1000(PVIF 20, Kd)

using a financial calculator:
So a 10% bond
Kd = 10.61%
After-tax
cost of debt:
Kd
Kd (1 - T)
Kd
.1061 (1 - .34)
Kd
.07
costs the firm

only 7%
(with flotation costs)
because interest
is tax deductible
7%
14
Cost of New Preferred

Stock
Preferred stock:
has a fixed dividend (similar to debt)
has no maturity date
dividends are not tax deductible and are
expected to be perpetual or infinite
Cost of preferred stock = dividend
price - flotation cost
15
Cost of Preferred stock:

Example
Baker Corporation has preferred stock that sells for $100 per share and pays an annual
dividend of $10.50. If the flotation costs are $4 per share, what is the cost of new
preferred stock?
KP
$10.50
.1094 10.94%
$100 - 4
16
Cost of Equity:
Retained
Earnings
Why is there a cost
for retained earnings?
Earnings
can be reinvested or paid out as
dividends
Investors could buy other securities, and
earn a return.
Thus, there is an opportunity cost if
earnings are retained
17
Cost of Equity:
Retained
Earnings
Common stock equity
is available through
retained earnings (R/E) or by issuing new

common stock:
Common equity = R/E + New common stock
18
Cost of Equity:
New Common Stock
The
cost of new common stock is higher

than the cost of retained earnings
because of flotation costs
selling and distribution costs (such as
sales commissions) for the new
securities
19
Cost of Equity
There
are a number of methods used to

determine the cost of equity
We will focus on two
Dividend
growth Model
CAPM
20
The Dividend Growth Model

Approach
Estimating the cost of equity: the dividend growth model

approach
According to the constant growth (Gordon) model,
D1
P0 =
RE - g
Rearranging
D1
RE =
+g
P0
21
Example: Estimating the

Dividend Growth Rate
Percentage
Year
Dividend
Dollar Change
Change
1990
$4.00
--
1991
4.40
$0.40
10.00%
1992
4.75
0.35
7.95
1993
5.25
0.50
10.53
1994
5.65
0.40
7.62
Average Growth Rate

(10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%
22
Dividend Growth Model

This model has drawbacks:
Some firms concentrate on growth and do not

pay dividends at all, or only irregularly
Growth rates may also be hard to estimate
Also this model doesnt adjust for market risk
Therefore many financial managers prefer the
capital asset pricing model (CAPM) - or security
market line (SML) - approach for estimating the
cost of equity
23
Capital Asset Pricing Model (CAPM)
kj Rf ( Rm Rf )
Cost of
capital
Risk-free
return
Co-variance
of returns against
the portfolio
(departure from the average)
Average rate of return

on common stocks
(WIG)
B < 1, security is safer than WIG average

B > 1, security is riskier than WIG average
24
The Security Market Line (SML)
Required rate
of return
Percent
20.0
SML = Rf + (Km Rf)
18.0
16.0
14.0
12.0
10.0
Rf
Market risk premium
8.0
5.5
0.5
1.0
1.5
2.0
Beta (risk)
25
Finding the Required Return on

Common Stock using the Capital
Asset Pricing Model
The Capital Asset Pricing Model (CAPM) can be used to estimate the
required return on individual stocks. The formula:
K j R f j K m R f
where
Kj
Required return on stock j
Rf
j
=
=
Risk-free rate of return (usually current rate on Treasury Bill).

Beta coefficient for stock j represents risk of the stock
Km
Return in market as measured by some proxy portfolio (index)
Suppose that Baker has the following values:

=
5.5%
Rf
j
=
1.0
Km
12%
.
26
Finding the Required Return on

Common Stock using the Capital
Asset Pricing Model
Then, using the CAPM we would get a required return of
K j 5.5 1.0 12 - 5.5 12%
27
CAPM/SML approach
Advantage:
Evaluates risk, applicable

to firms that dont pay dividends
Disadvantage:
Need to estimate
Beta
the risk premium (usually based on past data,
not future projections)

use an appropriate risk free rate of interest
28
Estimation of Beta: Measuring

Market Risk
Market
Portfolio - Portfolio of all assets in

the economy
In practice a broad stock market index,
such as the WIG, is used to represent the
market
Beta - sensitivity of a stocks return to the
return on the market portfolio
29
Estimation of Beta
Theoretically, the calculation of beta is

straightforward:
Cov ( Ri , RM ) iM
2
Problems
Var ( RM )
M
1. Betas may vary over time.

2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.
Solutions
Problems 1 and 2 (above) can be moderated by more sophisticated statistical

techniques.
Problem 3 can be lessened by adjusting for changes in business and financial
risk.
Look at average beta estimates of comparable firms in the industry.
30
Stability of Beta
Most
analysts argue that betas are generally

stable for firms remaining in the same industry
Thats not to say that a firms beta cant
change
Changes in product line

Changes in technology
Deregulation
Changes in financial leverage
31
What is the appropriate riskfree rate?
Use the yield on a long-term bond if you are

analyzing cash flows from a long-term investment
For short-term investments, it is entirely

appropriate to use the yield on short-term
government securities
Use the nominal risk-free rate if you discount

nominal cash flows and real risk-free rate if you
discount real cash flows
32
Survey evidence: What do you

use for the risk-free rate?
Corporations
Financial Advisors
90-day T-bill (4%)
90-day T-bill (10%)
3-7 year Treasuries (7%)
10-year Treasuries (33%)
N/A (10%)
10-years or 90-day; depends

(4%)
N/A (15%)
Source: Bruner et. al. (1998)
33
Weighted Average Cost of Capital

(WACC)
WACC weights the cost of equity and the cost

of debt by the percentage of each used in a
firms capital structure
WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
(E/V)= Equity % of total value

(D/V)=Debt % of total value
(1-Tc)=After-tax % or reciprocal of corp tax rate Tc.
The after-tax rate must be considered because
interest on corporate debt is deductible
34
WACC Illustration
ABC Corp has 1.4 million shares common valued at $20 per
share =$28 million. Debt has face value of $5 million and trades
at 93% of face ($4.65 million) in the market. Total market value
of both equity + debt thus =$32.65 million. Equity % = .8576
and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABCs =.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18%
Tax rate is 40%
Current yield on market debt is 11%
35
WACC Illustration
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
36
Final notes on WACC
WACC should be based on market rates and

valuation, not on book values of debt or equity
Book values may not reflect the current
marketplace
WACC will reflect what a firm needs to earn on
a new investment. But the new investment
should also reflect a risk level similar to the
firms Beta used to calculate the firms RE.
In the case of ABC Co., the relatively low WACC of

8.81% reflects ABCs =.74. A riskier investment
should reflect a higher interest rate.
37
Final notes on WACC

The
WACC is not constant

It changes in accordance with the risk
of the company and with the floatation
costs of new capital
38
Marginal cost of capital and

Percent
investment
projects
16.0 A
12.0 10.0 8.0 14.0
10.77%
11.23%
Kmc
10.41%
D
E
F
4.0 2.0 0.0 -
Marginal
cost of
capital
G
H
6.0
10 15 19
39
50
70
Amount of capital ($ millions)
85
95
39

Cost of Capital

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Cost of Capital

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Overview of the Cost of

The cost of capital represents the firms cost of financing, and

Financial managers are ethically bound to only invest in projects that

Most firms attempt to maintain an optimal mix of debt and

To capture all of the relevant financing costs, assuming some desired

Kevin Campbell, University of Stirling, November 2005

Overview of the Cost of

The overall cost of capital is a weighted average of

The cost of capital is normally the relevant discount

Kevin Campbell, University of Stirling, November 2005

Overview of the Cost of Capital

Best project available today

Least costly financing source available

Because it can earn 7% on the investment of funds

costing only 6%, the firm undertakes the opportunity.

Kevin Campbell, University of Stirling, November 2005

Overview of the Cost of Capital

Best project available 1 week later

Least costly financing source available

In this instance, the firm rejects the opportunity, because

Kevin Campbell, University of Stirling, November 2005

Overview of the Cost of Capital

Assuming that a 5050 mix of debt and equity is

targeted, the weighted average cost here would be:

Kevin Campbell, University of Stirling, November 2005

Specific Sources of Capital

Basic sources of long-term funds for the business

Kevin Campbell, University of Stirling, November 2005

Factors Affecting the Cost of

General Economic Conditions

Kevin Campbell, University of Stirling, November 2005

Example: Tax effects of

Now, suppose the firm pays $50,000 in dividends

Example: Tax effects of

Or, if we want to look at percentage costs:

Kevin Campbell, University of Stirling, November 2005

Kevin Campbell, University of Stirling, November 2005

EXAMPLE: Cost of Debt

Corporation issues a $1,000 par,

is the pre-tax and after-tax cost of

EXAMPLE: Cost of Debt

950 = 100(PVIFA 20, Kd) + 1000(PVIF 20, Kd)

costs the firm

Kevin Campbell, University of Stirling, November 2005

Cost of New Preferred

Kevin Campbell, University of Stirling, November 2005

Cost of Preferred stock:

Kevin Campbell, University of Stirling, November 2005

can be reinvested or paid out as

Kevin Campbell, University of Stirling, November 2005

retained earnings (R/E) or by issuing new

Kevin Campbell, University of Stirling, November 2005

cost of new common stock is higher

Kevin Campbell, University of Stirling, November 2005

are a number of methods used to

Kevin Campbell, University of Stirling, November 2005

The Dividend Growth Model

Estimating the cost of equity: the dividend growth model

Kevin Campbell, University of Stirling, November 2005

Example: Estimating the

Average Growth Rate

Kevin Campbell, University of Stirling, November 2005

Dividend Growth Model