6-1

CHAPTER 6
The Cost of Capital

Most important business decisions require

capital.
A company want to build a new plant to
produce a sports car, they will estimate the
total investment that would be required and
the cost of the required capital. If the
expected rate of return exceeded the cost of
capital, they will go for the project.
 6-2

The Cost of Capital

 Mergers and acquisitions often require enormous

amounts of capital.
Vodafone spent $60 billion to acquire
AirTouch Communications.
Vodafone estimated the incremental cash flows
that would result from the acquisition, then
discounted those cash flows at the estimated
cost of capital.
The resulting values were greater than the
targets’ market prices, so Vodafone made the
offer.
 6-3

The Cost of Capital

The cost of capital is a key factor in

choosing the mixture of debt and equity.
What precisely do the terms “Cost of
capital” and “weighted average cost of
capital” mean?
It is possible to finance a firm entirely with
common equity, but most firms employ
several types of capital that is called capital
components.
 6-4

The Cost of Capital

 Cost of Capital Components

Debt
Preferred
Common Equity
 Why WACC?
If a firm’s only investors are common stock
holders, then the cost of capital would be the
required rate of return on equity. But…………
 6-5

The Cost of Capital

 Most firms employ different types of capital and

due to differences in risk, these different securities
have different required rates of return.
 The required rate of return on each capital
component is called its component cost and the
cost of capital used to analyze capital budgeting
decisions should be a weighted average of the
various components’ costs.
 We call this weighted average the weighted
average cost of capital or WACC.
 6-6
What types of long-term capital do
firms use?
 Long-term debt
 Preferred stock
 Common equity
 Most firms set target percentages for the different
financing sources.
NCC plans to raise 30% of its required capital as
debt, 10% as preferred stock and 60% as common
stock.
This is its Target Capital Structure
 6-7
What types of long-term capital do
firms use?
 Although NCC and other firms try to stay close to
their target capital structures, they frequently
deviate in the short run for several reasons:
First, market conditions may be more favorable
in one market than another market i.e. if stock
market is extremely strong, a company may
decide to issue common stock.
Second, flotation costs i.e. the costs that firm
must incur to issue securities which is to a large
extent fixed.
 6-8
What types of long-term capital do
firms use?
 It is expensive to issue small amounts of debt,
preferred stock and common stock.
 Therefore, a company might issue common stock one
year, debt in the next year and preferred stock the
following year, thus fluctuating around its target
capital structure rather than staying right on it all the
time.
 This situation can cause managers to make a serious
errors in selecting projects, a process called capital
budgeting.
 6-9
What types of long-term capital do
firms use?
 Suppose NCC borrows heavily at 8% during 2003 to
finance long-term projects that yield 10%.
 In 2004, it has new long-term projects available that
yield 13%, well above the return on the 2003 projects.
 However, to return to its target capital structure, it must
issue equity which costs 15.3%. Therefore, the
company might incorrectly reject these 13% projects
because they would have to be financed with funds
costing 15.3%.
 However, this reasoning would be incorrect.
 6 - 10
What types of long-term capital do
firms use?
 Why should a company accept 10% long-term projects
one year and then rejects 13% long-term projects the
next?
 If NCC reversed the order of its financing, raising
equity in 2003 and debt in 2004, it would have
reversed its decisions, rejecting all projects in 2003
and accepting them all in 2004.
 Does it make sense to accept or reject projects just
because of the more or less arbitrary sequence in
which capital is raised?
 The answer is no. But how?
 6 - 11
What types of long-term capital do
firms use?

To avoid such errors, managers should view

companies as ongoing concerns and calculate
their cost of capital as weighted averages of the
various types of funds they use regardless of the
specific sources of financing employed in a
particular year.
 6 - 12

Cost of Debt rd (1-T)

 The first step in estimating the cost of debt is determine

the rate of return debt holders require (rd).
 Companies use both fixed and floating rate debt, straight
and convertible debt, debt with and without sinking
funds and each form has somewhat different cost.
 Suppose NCC’s treasurer is estimating the WACC for
the coming year. How should he/she calculate the
component cost of debt? So he/she will discuss current
and prospective interest rates with their investment
bankers.
 6 - 13

Cost of Debt rd (1-T)

 Assume that NCC’s bankers state that a new 30-year

non-callable, straight bond issue would require an 11%
coupon rate with semiannual payments with face value
$1000. So rd is equal to 11%.
 This 11% is the cost of new or marginal debt and will
probably not the same as the average rate on NCC’s
previously issued debt (Historical or embedded rate)
 The embedded cost is important for some decision but
not for others.
 6 - 14

Cost of Debt

In financial management the WACC is used to

make investment decisions and these decisions
hinge on projects’ expected future returns versus
the cost of new or marginal capital.
Thus for our purpose, the relevant cost is the
marginal cost of new debt to be raised during
the planning period.
 6 - 15

Cost of Debt

Method 1: Ask an investment banker what

the coupon rate would be on new debt.
Method 2: Find the bond rating for the
company and use the yield on other bonds
with a similar rating.
Method 3: Find the yield on the company’s
debt, if it has any.
 6 - 16

Should we focus on before-tax or

after-tax capital costs?

Tax effects associated with financing can be

incorporated either in capital budgeting cash
flows or in cost of capital.
Most firms incorporate tax effects in the cost
of capital. Therefore, focus on after-tax costs.
Only cost of debt is affected.
 6 - 17

Should we focus on historical

(embedded) costs or new (marginal)
costs?
The cost of capital is used primarily to make
decisions which involve raising and investing
new capital. So, we should focus on marginal
costs.
 6 - 18

A 15-year, 12% semiannual bond sells

for $1,153.72. What’s rd?

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

INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5.0% x 2 = rd = 10%
 6 - 19

Component Cost of Debt

Interest is tax deductible, so the

after tax (AT) cost of debt is:
rd AT = rd BT(1 - T)
= 10%(1 - 0.40) = 6%.
Use nominal rate.
Flotation costs are usually small for
most debt issues, so ignore.
 6 - 20

Cost of Preferred Stock (rps)

 A number of firms use preferred stock as part of their

permanent financing mix. Preferred dividends are not
tax deductible, therefore, the company bears their full
cost and no tax adjustment is used when calculating the
cost of preferred stock.
 The component cost of preferred stock used to
calculate the weighted average cost of capital, rps, is the
preferred dividend Dps divided by the net issuing price
Pn which is the price the firm receives after deducting
flotation costs
 6 - 21

Cost of Preferred Stock (rps)

rps = Dps/Pn
Flotation costs are high for preferred stock than
for debt, therefore they are incorporated into the
formula for preferred stocks’ costs.
What is the cost of preferred stock with par
value $100, current price $113.10, dividend $10
and flotation cost $2.
 6 - 22

What’s the cost of preferred stock?

PP = $113.10; 10%Q; Par = $100; F = $2.

Use this formula:

D ps 0.1 $100 
rps  
Pn $113.10  $2.00

$10
  0.090  9.0% .
$111.10
 6 - 23

Picture of Preferred

0
rps = ?
1 2 
...
-111.1 2.50 2.50 2.50

DQ $2.50
$111.10   .
rPer rPer

$2.50
rPer   2.25%; rps( Nom)  2.25%( 4)  9%.
$111.10
 6 - 24

Note:

Flotation costs for preferred are

significant, so are reflected. Use
net price.
Preferred dividends are not
deductible, so no tax adjustment.
Just rps.
Nominal rps is used.
 6 - 25

Is preferred stock more or less risky to

investors than debt?

More risky; company not required to

pay preferred dividend.
However, firms want to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to
raise additional funds, and (3)
preferred stockholders may gain
control of firm.
 6 - 26

Why is yield on preferred lower than rd?

Corporations own most preferred stock,

because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost
to the issuer are higher on preferred
than on debt, which is consistent with
the higher risk of preferred.
 6 - 27
Example:

rps = 9% rd = 10% T = 40%

rps, AT = rps - rps (1 - 0.7)(T)

= 9% - 9%(0.3)(0.4) = 7.92%
rd, AT = 10% - 10%(0.4) = 6.00%
A-T Risk Premium on Preferred = 1.92%
 6 - 28

Cost of Common Stock (rs)

 What are the two ways that companies can raise

common equity?
 Directly, by issuing new shares of common stock.
 Indirectly, by reinvesting earnings that are not paid out
as dividends (i.e., retaining earnings).
 If new shares are issued, what rate of return must the
company earn to satisfy the new stockholders.
 6 - 29

Cost of Common Stock (rs)

 Few mature firms issue new shares of common stock.

In fact, less than 2% of all new corporate funds come
from the external equity market. Reasons are:
Flotation costs can be high.
Investors perceive issuing new equity as a negative
signal with respect to the true value of the
company’s stock.
An increase in the supply of stock will put pressure
on the stock’s price, forcing the company to sell the
new stock at a lower price than existed before the
new issue was announced.
 6 - 30

Why is there a cost for reinvested

earnings?

Earnings can be reinvested or paid out as

dividends.
Investors could buy other securities, earn a
return.
Thus, there is an opportunity cost if
earnings are reinvested.
 6 - 31

Opportunity cost: The return

stockholders could earn on
alternative investments of equal
risk.
They could buy similar stocks
and earn rs, or company could
repurchase its own stock and
earn rs. So, rs, is the cost of
reinvested earnings and it is the
cost of equity.
 6 - 32

Three ways to determine the

cost of equity, rs:

1. CAPM: rs = rRF + (rM - rRF)b

= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + RP.
 6 - 33

Using CAPM

 To estimate the cost of common stock using the

CAPM, we proceed as follow:
Step-1. Estimate the risk-free rate (rRF)
Step-2. Estimate the current expected
market risk premium (RPM)
Step-3. Estimate the stock’s beta
coefficient (bi)
Step-4. Substitute all these values in CAPM
equation to estimate the required rate of
return
 6 - 34

Issues in Using CAPM

Most analysts use the rate on a long-

term (10 to 20 years) government
bond as an estimate of rRF. For a
current estimate, go to
www.bloomberg.com, select “U.S.
Treasuries” from the section on the
left under the heading “Market.”

More…
 6 - 35

Issues in Using CAPM (Continued)

Most analysts use a rate of 5% to 6.5%

for the market risk premium (RPM)
Estimates of beta vary, and estimates
are “noisy” (they have a wide
confidence interval). For an estimate
of beta, go to www.bloomberg.com
and enter the ticker symbol for STOCK
QUOTES.
 6 - 36

What’s the cost of equity

based on the CAPM?
rRF = 7%, RPM = 6%, b = 1.2.

rs = rRF + (rM - rRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

 6 - 37

What’s the DCF cost of equity, rs?

Given: D0 = $4.19;P0 = $50; g = 5%.

D1 D0 1  g 
rs  g g
P0 P0
$4.19105
. 
  0.05
$50
 0.088  0.05
 13.8%.
 6 - 38

Estimating the Growth Rate

Use the historical growth rate if you

believe the future will be like the
past.
Obtain analysts’ estimates: Value
Line, Zack’s, Yahoo!.Finance.
Use the earnings retention model,
illustrated on next slide.
 6 - 39

Estimating the Growth Rate

 Most firms pay out some of their net income as

dividends and reinvest or retain the rest. The
payout ratio is the percent of net income that the
firm pays out as a dividend, defined as total
dividends divided by net income.
 The retention ratio is the complement of the
payout ration:
Retention ratio = (1 – Payout ratio)
 6 - 40

Estimating the Growth Rate

Return on equity (ROE) is defined as net income

available for common stockholders divided by
common equity.
The growth rate of a firm will depend on the
amount of net income that it retains and the rate
it earns on the retentions.
So retention growth model is:
g = ROE (Retention Ratio)
 6 - 41

Estimating the Growth Rate

 Assumptions for Retention growth Model:

Payout rate and retention rate remain constant
ROE on new investment remain constant
The firm will not issue new common stock, if it
does, the selling price will be equal to book
value
Future projects have the same degree of risk as
the firm’s existing assets.
 6 - 42

Suppose the company has been

earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout
= 65%), and this situation is
expected to continue.

What’s the expected future g?

 6 - 43

Retention growth rate:

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier.

Think of bank account paying 15% with
retention ratio = 0. What is g of
account balance? If retention ratio is
100%, what is g?
 6 - 44

Could DCF methodology be applied

if g is not constant?

YES, nonconstant g stocks are

expected to have constant g at
some point, generally in 5 to 10
years.
 6 - 45

Find rs using the own-bond-yield-

plus-risk-premium method.
(rd = 10%, RP = 4%.)

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

 This RP  CAPM RPM.

 Produces ballpark/approximate
estimate of rs. Useful check.
 6 - 46
What’s a reasonable final estimate
of rs?

Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%
 6 - 47

Determining the Weights for the WACC

The weights are the percentages of

the firm that will be financed by each
component.
If possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital.
 6 - 48
Estimating Weights for the
Capital Structure

If you don’t know the targets, it is

better to estimate the weights using
current market values than current
book values.
If you don’t know the market value of
debt, then it is usually reasonable to
use the book values of debt,
especially if the debt is short-term.
(More...)
 6 - 49

Estimating Weights (Continued)

Suppose the stock price is $50, there

are 3 million shares of stock, the firm
has $25 million of preferred stock,
and $75 million of debt.

(More...)
 6 - 50

Vce = $50 (3 million) = $150 million.

Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75 = $250
million.
wce = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3
 6 - 51

What’s the WACC?

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

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

= 1.8% + 0.9% + 8.4% = 11.1%.

 6 - 52
WACC Estimates for Some Large
U. S. Corporations
Company WACC
General Electric (GE) 12.5
Coca-Cola (KO) 12.3
Intel (INTC) 12.2
Motorola (MOT) 11.7
Wal-Mart (WMT) 11.0
Walt Disney (DIS) 9.3
AT&T (T) 9.2
Exxon Mobil (XOM) 8.2
H.J. Heinz (HNZ) 7.8
BellSouth (BLS) 7.4
 6 - 53

What factors influence a company’s

WACC?

Market conditions, especially interest

rates and tax rates.
The firm’s capital structure and
dividend policy.
The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.
 6 - 54
Should the company use the
composite WACC as the hurdle rate for
each of its divisions?

NO! The composite WACC reflects the

risk of an average project undertaken
by the firm.
Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk
and capital structure.
 6 - 55
What procedures are used to determine
the risk-adjusted cost of capital for a
particular division?

Estimate the cost of capital that

the division would have if it were a
stand-alone firm.
This requires estimating the
division’s beta, cost of debt, and
capital structure.
 6 - 56

Methods for Estimating Beta for a

Division or a Project

1. Pure play. Find several publicly

traded companies exclusively in
project’s business.
Use average of their betas as
proxy for project’s beta.
Hard to find such companies.
 6 - 57

2. Accounting beta. Run regression

between project’s ROA and S&P
index ROA.
Accounting betas are correlated
(0.5 – 0.6) with market betas.
But normally can’t get data on new
projects’ ROAs before the capital
budgeting decision has been made.
 6 - 58
Find the division’s market risk and cost
of capital based on the CAPM, given
these inputs:

Target debt ratio = 10%.

rd = 12%.
rRF = 7%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.
 6 - 59

Beta = 1.7, so division has more market

risk than average.
Division’s required return on equity:
rs = rRF + (rM – rRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdrd(1 – T) + wcrs
= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.
 6 - 60

How does the division’s WACC

compare with the firm’s overall WACC?

Division WACC = 16.2% versus

company WACC = 11.1%.
“Typical” projects within this division
would be accepted if their returns are
above 16.2%.
 6 - 61

Divisional Risk and the Cost of Capital

Rate of Return
(%) Acceptance Region

WACC

WACCH H

A Rejection Region
WACCA
B
WACCL L

Risk
0 RiskL RiskA RiskH
 6 - 62

What are the three types of project

risk?

Stand-alone risk
Corporate risk
Market risk
 6 - 63

How is each type of risk used?

Stand-alone risk is easiest to
calculate.
Market risk is theoretically best in
most situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
 6 - 64
A Project-Specific, Risk-Adjusted
Cost of Capital
Start by calculating a divisional cost
of capital.
Estimate the risk of the project using
the techniques in Chapter 8.
Use judgment to scale up or down
the cost of capital for an individual
project relative to the divisional cost
of capital.
 6 - 65
Why is the cost of internal equity from
reinvested earnings cheaper than the
cost of issuing new common stock?

1. When a company issues new

common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.
 6 - 66
Estimate the cost of new common
equity: P0=$50, D0=$4.19, g=5%, and
F=15%.
D0 (1  g )
re  g
P0 (1  F )
$4.191.05 
  5 .0 %
$501  0.15 
$4.40
  5.0%  15.4%.
$42.50
 6 - 67
Estimate the cost of new 30-year debt:
Par=$1,000, Coupon=10%paid annually,
and F=2%.

Using a financial calculator:

N = 30
PV = 1000(1-.02) = 980
PMT = -(.10)(1000)(1-.4) = -60
FV = -1000
Solving for I: 6.15%
 6 - 68

Comments about flotation costs:

Flotation costs depend on the risk of

the firm and the type of capital being
raised.
The flotation costs are highest for
common equity. However, since
most firms issue equity infrequently,
the per-project cost is fairly small.
We will frequently ignore flotation
costs when calculating the WACC.
 6 - 69

Four Mistakes to Avoid

1. When estimating the cost of debt,

don’t use the coupon rate on existing
debt. Use the current interest rate on
new debt.
2. When estimating the risk premium for
the CAPM approach, don’t subtract
the current long-term T-bond rate from
the historical average return on
common stocks. (More ...)
 6 - 70

For example, if the historical rM has

been about 12.7% and inflation
drives the current rRF up to 10%, the
current market risk premium is not
12.7% - 10% = 2.7%!

(More ...)
 6 - 71
3. Don’t use book weights to estimate
the weights for the capital structure.
Use the target capital structure to determine
the weights.
If you don’t know the target weights, then
use the current market value of equity, and
never the book value of equity.
If you don’t know the market value of debt,
then the book value of debt often is a
reasonable approximation, especially for
short-term debt.
(More...)
 6 - 72

4. Always remember that capital

components are sources of funding
that come from investors.
Accounts payable, accruals, and
deferred taxes are not sources of
funding that come from investors, so
they are not included in the
calculation of the WACC.
We do adjust for these items when
calculating the cash flows of the
project, but not when calculating the
WACC.