Cost of Capital 1

Cost of Capital

Rate of return required by firm’s investorsCost of capital is required rate of return

for projects with same level of risk as overall firm

Required rate of return must be adjusted to reflect anticipated risk of project

Cost of Capital 2

Cost of Capital

Cost of Capital = Average cost of debt and equityFor now, assume ratio of debt to equity

constant As debt increases, required will start to

increase at some point

The Big Picture….

Cost of Capital 3

Cost of debt

After-tax YTM on debt Includes flotation costs

Cost of Capital 4

Cost of Debt

Rate of return required by firm’s investorsYTM (required return) on IBM’s bonds is 10%

(Ms. Investor demands a 10% rate of return)However, IBM’s after-tax cost of debt is 7%

Assuming IBM has a 30% tax rate $100 Interest (10%) - 30 Tax Savings = 70 After-Tax Interest Cost (7%)

Cost of Capital 5

Cost of Debt

Rate of return required by firm’s investorsCoupon rate on debt is not relevant

12% coupon bond, trading at $1,117 has a 9% YTM

Would issue additional debt at 9% (before tax)

This would be 6.3% after-tax (assume 30% tax rate)

Cost of Capital 6

Calculating Required Rate of Return (Yield to Maturity) Bond has 6.5% coupon rate, 7 years to maturity

and has net price of $870. What is yield to maturity? Required rate of return (YTM) = 9.09% After-tax rate required rate of return = 9.09% -

(38% x 9.09%) = 5.64%

Cost of Capital 7

Cost of Preferred Stock

Cost of preferred stock = annual dividend / net price of preferred stock

Net price is after flotation costs

Cost of Capital 8

Cost of Equity

Must be estimated. No stated rate like YTM on bonds or loans.

Calculate cost for both:Retained earnings Issuing new equity

Cost of Capital 9

Cost of Equity

Dividend Growth Model NP = D1 / (RR – G) RR = (D1/NP) + G Calculate cost of retained earnings

Price (P) , Dividend (D) are known.Can estimate growth rate (G).Then solve for required return (RR)

Use Net Price after flotation costs for P

Cost of Capital 10

Cost of Equity

Dividend Growth Model NP = D1 / (RR – G) RR = (D1/NP) + G P = $32, D = $2.20, G = 4%, NP =

$32.00, D1 = $2.29 RR = ($2.29/$32.00)+4% RR = 11.15%

Cost of Capital 11

Cost of Equity

Dividend Growth Model Advantage:

Simple Issues:

Must estimate growth rateSome companies don’t pay dividendsTake into account risk?

Cost of Capital 12

Cost of Equity

Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta

Risk-free rate of return (RF) is knownBeta is generally knownRequired Return for Market (RM) must

be estimated

Cost of Capital 13

Cost of Equity

Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta

Advantages Adjusts for risk Can be used for companies with no

dividends

Cost of Capital 14

Cost of Equity

Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta

Issues: Calculating Market Risk Premium (RM – RF)

One study: 9.2% for large cap stocks Another study: 9.5% for large cap stocks Another study: 4-6% for large cap stocks

Cost of Capital 15

Cost of Equity

Bond-yield plus equity risk RR = YTM + (RM – RF)

Advantage Uses YTM for company’s bonds as starting

point Can be used to compare with other two

methods

Cost of Capital 16

WACC

Market Value Company = Equity Value + Debt ValueEquity Value = Market cap

Number of shares x Price of stockDebt Value

Number of bonds x Value of Bonds

Cost of Capital 17

WACC

WACC =(Debt Value x Cost of Debt) +(Equity Value x Cost of Equity)

Due to risk premium for equity, generally equity will have a larger cost than debt

But required return on debt will increase if very little equity

Cost of Capital 18

WACC: cost of capital

Debt: usually cheapest after-tax cost Deduct interest Barclays 2006 study:

Investment grade: 4.0%; high-yield: 5.6% Preferred stock

Less risk than common stock Internal equity (retained earnings)

No flotation costs External equity (issue new stock)

Usually most expensive Barclays 2006 study: 9%

Cost of Capital 19

WACC

Value of firm maximized when WACC is minimized

Should reduce Required Return This would increase NPV of projects

WACC is not Required Return for all projects Adjust Required Return based on risk of project If use WACC for all projects, will accept risky

projects and decline safe projects Since safe projects will generally have low IRR