COST OF CAPITALChapter 7

Chapter OutlineThe Cost of Capital: Introduction

The Cost of Equity (CAPM and DDM)

The Costs of Debt and Preferred Stock

The Weighted Average Cost of Capital

Divisional and Project Costs of Capital

2

Why Cost of Capital is ImportantReturn earned on assets depends on the risk

of those assets

The return to an investor is the same as the cost to the company

Cost of capital provides with an indication of how the market views the risk of assets

Knowing cost of capital can also help determine required return for capital budgeting projects

3

Required ReturnThe required return is the same as the

appropriate discount rate and is based on the risk of the cash flows

The required rate of return is used to calculate NPV

We need to earn at least the required return to compensate investors for the financing they have provided

4

Cost of EquityThe cost of equity is the return

required by equity investors given the risk of the cash flows from the firm

There are two major methods for determining the cost of equity◦Dividend growth model (Gordon

growth model)◦SML or CAPM

5

The Dividend Growth Model ApproachCan be rearranged to solve for RE

6

P0 D1

RE g

RE D1

P0

g

Example Suppose that a company is

expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity?

Solution: RE = 11.1%

7

Example: Estimating the Dividend Growth Rate

One method for estimating the growth rate is to use the historical average◦Year Dividend Percent Change◦19951.23◦19961.30 5.7%◦19971.36 4.6% Geom. = 5.0864◦19981.43 5.1%◦19991.50 4.9% Ar. Av = 5.0872

Analysts’ forecast can be used

8

Alternative Approach to Estimating GrowthIf the company has a stable ROE, a stable

dividend policy and is not planning on raising new external capital, then the following relationship can be used:

A company has a ROE of 15% and payout ratio is 35%. If management is not planning on raising additional external capital, what is its growth rate?

Solution: g= 9.75%9

g = Retention ratio x ROE

Advantages and Disadvantages of DividendGrowth Model

– easy to understand and use:

◦Only applicable to companies currently paying dividends

◦Not applicable if dividends aren’t growing at a reasonably constant rate

◦Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1%

◦Does not explicitly consider risk

10

The SML Approach (CAPM)Use the following information to

compute our cost of equity◦Risk-free rate, Rf

◦Market risk premium, E(RM) – Rf

◦Systematic risk of asset,

11

E(RA) = Rf + A(E(RM) – Rf)

SML exampleSuppose the company has an

equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is the cost of equity capital?

Solution: RE = 11.08%

Do both approaches have the same result?

12

Advantages and Disadvantages of SML:

◦ Explicitly adjusts for systematic risk◦ Applicable to all companies, as long as

beta can be computed

:◦ Have to estimate the expected market risk

premium, which does vary over time◦ Have to estimate beta, which also varies

over time◦ We are relying on the past to predict the

future, which is not always reliable

13

Cost of EquitySuppose the company has a beta of

1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. Dividends will grow at 6% per year and last dividend was $2. The stock is currently selling for $15.65. What is our cost of equity?

◦Using SML: RE = 19.5%

◦Using DGM: RE = 19.55%

14

Cost of DebtThe cost of debt is the required return on a

company’s debt

Usually the cost of long-term debt or bonds only is taken into account

The required return is best estimated by computing the yield-to-maturity on the existing debt

Estimates of current rates based on the bond rating can be used

The cost of debt is NOT the coupon rate

15

Cost of Debt exampleSuppose you have a bond issue

currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt?

Solution: RD = 10% (YTM)

16

Cost of Preferred StockPreferred stock generally pays a

constant dividend every period

Dividends are expected to be paid every period forever

Preferred stock is an annuity

17

RP = D / P0

Cost of Preferred Stock exampleA company has preferred stock

that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock?

Solution: RPE = = 12%

18

The Weighted Average Cost of Capital (WACC)Individual costs of capital are used to

find cost of capital for the firm

WACC is the required return assets, based on the market’s perception of the risk of those assets

The weights are determined by how much of each type of financing that we use – target D/E ratio

19

Capital Structure WeightsV = market value of the firm’s D

+ EWeights

◦wE = E/V = percent financed with equity

◦wD = D/V = percent financed with debt

20

Capital Structure Weights exampleSuppose you have a market

value of equity equal to $500 million and a market value of debt = $475 million.◦What are the capital structure

weights?

Solution: WD = =.4872

WE = = .5128

21

Taxes and the WACCWe are concerned with after-tax

cash flows, so the effect of taxes on the various costs of capital has to be considered

Interest expense reduces tax liability◦Reduction in taxes reduces cost of

debt◦After-tax cost of debt = RD(1-TC)

Dividends are not tax deductible, so there is no tax impact on the cost of equity 22

WACC = wERE + wDRD(1-TC)

WACC (1)Equity Information

◦ 50 million shares◦ $80 per share◦ Beta = 1.15◦ Market risk premium

= 9%◦ Risk-free rate = 5%

Debt Information◦ $1 billion in

outstanding debt (face value)

◦ Current quote = 110

◦ Coupon rate = 9%, semiannual coupons

◦ 15 years to maturity

Tax rate = 40%23

WACC (2)

What is the cost of equity? RE =15.35% (by SML)

What is the cost of debt? RD =7.85 (YTM)

What is the after-tax cost of debt? 7.85*(1-.4)=4.71

24

WACC (3)What are the capital structure

weights?E=80*50mil= 4blnD=1.1bln (110% of face)V= 5.1blnWhat is the WACC?WACC=4/5.1*15.35 +

1.1/5.1*4.71== 12.0392% + 1.0159 = 13.0551

25

Divisional and Project Costs of Capital Using the WACC as discount rate is only

appropriate for projects that have the same risk as the firm’s current operations

If we are looking at a project that has NOT the same risk as the firm, then the appropriate discount rate for that project has to be determined

Divisions also often require separatediscount rates because they have different levels of risk

26

Using WACC for All Projects exampleWhat would happen if we use the

WACC for all projects regardless of risk?

Assume the WACC = 15%Project Required Return IRRA 20% 17%B 15% 18%C 10% 12%

27

The Pure Play Approach

1. Find one or more companies that specialize in the product or service that we are considering

2. Compute the beta for each company3. Take an average4. Use that beta along with the CAPM to find the

appropriate return for a project of that risk

Often difficult to find pure play companies

28

The pure play approach = use of a WACC that is unique to a particular project

Subjective ApproachConsider the project’s risk relative to

the firm overallIf the project is more risky than the

firm, use a discount rate greater than the WACC

If the project is less risky than the firm, use a discount rate less than the WACC

You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all

29

Subjective Approach example

Risk Level Discount Rate

Very Low Risk WACC – 8%

Low Risk WACC – 3%

Same Risk as Firm WACC

High Risk WACC + 5%

Very High Risk WACC + 10%

30