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CFA Level I Corporate FinanceCost of Capitalwww.irfanullah.co

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Contents and Introduction1. Introduction

2. Cost of Capital

3. Costs of the Different Sources of Capital

4. Topics in Cost of Capital Estimation

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1. Introduction A company grows by investing in projects that are profitable and survives by its

revenue streams.

All investments have associated costs and the most critical is the cost of capital.

The cost of capital is an important ingredient in both investment decision makingby companys management and also its valuation by investors

Cost of capital estimation is a complex undertaking which requires manyassumptions and, factors that need to be taken into account.

Investments that alter a companys capital structure require project specific cost ofcapital adjustments

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2. Cost of Capital

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Lenders/Bondholders

Owners/ Equity holders

Cost of capital is the rate ofreturn that the suppliers ofcapital require as compensationfor their contribution of capital

Invest if return > cost of capital

Riskier projects will have ahigher cost of capital

Marginal cost of capital (MCC)

Weighted average cost of capital (WACC)WACC = wd rd (1-t) + wp rp + were

wd= proportion of debt that the company uses when it raises new fundsrd = before tax marginal cost of debtt = companys marginal tax ratewp= proportion of preferred stock the company uses when it raises new fundsrp= marginal cost of preferred stockwe= proportion of equity that the company uses when it raises new fundsre = the marginal cost of capital

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ExampleIFT has the following capital structure: 30 percent debt, 10 percent preferred stockand 60 percent equity. The before tax cost of debt is 8 percent, cost of preferred stockis 10 percent and cost of equity is 15 percent. If the marginal tax rate is 40%, what isthe WACC?.

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WACC = (0.3)(0.08)(1-0.40) + (0.1)(0.1) + (0.6)(0.15) = 11.44 percent

ExampleMachiavelli Co. has an after tax cost of debt capital of 4%, a cost of preferred stock of8%, a cost of equity capital of 10% and a weighted average cost of capital of 7%. MCintends to maintain its current capital structure as it raises additional capital. Inmaking its capital budgeting decisions for the average risk project the relevant cost ofcapital isA. 4%B. 7%C. 8%

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Answer: BThe WACC using weights derived from the current capital structure, is the best estimate of the cost of capitalfor the average risk project of a company.

Taxes and Cost of CapitalPayments to owners (dividends) are not tax deductibleInterest costs are tax deductible, which means that they provide tax savingsExample: Debt = 100, interest rate = 10%, tax rate = 40%

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Revenue 100Operating Expenses 50Interest 10EBT 40Tax Expense (40%) 16Net Income 24

Calculation of net income assuminginterest is tax deductible

Calculation of net income assuminginterest is NOT tax deductible

Revenue 100Operating Expenses 50EBT 50Tax Expense (40%) 20Interest expense 10Net Income 20

After-tax cost of debt = Before-tax cost of debt (1- tax rate)Example 2

Weights of the Weighted AverageWeights should be based on: Market values Target capital structure

In the absence of explicit information about a firms target capital structure, use: Current capital structure based on market values Trend in the firms capital structure Average of comparable companies

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Example 3

ExampleYou gather the following information about the capital structure and before-taxcomponent costs for a company. The companys marginal tax rate is 40 percent.What is the cost of capital?

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Capital component Book Value (000) Market Value (000) Component costDebt $100 $90 8%Preferred stock $20 $20 10%Common stock $100 $300 14%

MCC and IOS


Role of WACC (MCC) For average risk projects use WACC to compute NPV

Adjustments to the cost of capital are necessary when a project differsin risk from the average risk of a firms existing projects

The discount rate should be adjusted upward for higher risk projectsand downwards for lower risk projects

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3. Costs of the Different Sources of Capital Each source of capital has a different cost because of differences in

seniority, contractual commitments, and potential value as a tax shield

Three primary source of capital are: Debt Preferred equity Common equity


3.1 Cost of Debt Cost of debt is the cost of debt financing to a company

when it issues a bond or takes out a bank loan

Two methods of estimating before tax cost of debt:

The yield to maturity approach

Debt rating approach


Yield to Maturity ApproachThe yield to maturity (YTM) is the annual return that an investor earns if hepurchases the bond today and holds it until maturity

Example: A company issues a 10-year, 8% semi-annual coupon bond. Upon issue, thebond sells for $980. If the marginal tax rate is 30%, what is the after-tax cost ofdebt?

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Example 4

Debt Rating Approach Use the debt rating approach when a reliable current market price for

a companys debt is not available can be use

Estimate before-tax cost of debt based on comparable bonds Similar rating Similar maturity

Use the companys marginal tax rate to determine after-tax cost

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3.2 Cost of Preferred StockThe cost of preferred stock is the cost that a company has committed to paypreferred stockholders and preferred dividend

Cost of preferred stock = preferred dividend / current price

Example: A company issues preferred stock with a par value = 100 and preferreddividend = 5 per share. The current share price is 125 and the marginal tax rate is33%. What is the cost of preferred stock?

Examples 5 and 6


3.3 Cost of Common Equity Cost of equity is the rate of return required by a companys common shareholders

Estimation of cost of equity is challenging because of the uncertain nature of futurecash flows

Commonly used approach for estimating cost of equity are: Capital asset pricing model Dividend discount model Bond yield plus risk premium method


Capital Asset Pricing ModelExpected return = risk free rate + premium for stocks market risk

re = Rf + [E(Rmkt ) Rf]

Example: In a developing market the risk free rate is 10% and the equity risk premiumis 6%. The equity beta for a given company is 2. What is the cost of equity using theCAPM approach?

Risk free rate: use long term government bondsEquity risk premium can be calculated using historical returnsExamples 7 and 8


Pre-Requisites for Understanding the DDMPresent value of a perpetuity

Present value of a growing perpetuity

Value of a financial asset, such as a stock, is thepresent value of future cash flows (dividends)

Gordon growth model is one example of a DCFmodel


Dividend Discount ModelP0= D1 / (re- g)

re = D1 / P0 + g

g= (retention rate)(return on equity) = (1- payout rate) (ROE)

Cost of equity is the same as cost of retained earnings

Gordon growth model is also called the constant-growth dividend discount model


ExampleYou have gathered the following information about a company and the market Current share price = 30 Most recent dividend paid = 2 Expected dividend payout rate = 40% Expected ROE = 15% Equity beta = 1.5 Expected return on market = 15% Risk free rate = 8%

Using the DCF approach, what is the cost ofretained earnings?


Bond Yield Plus Risk Premium ApproachAdd a risk premium to the yield on the firms long term debt

re = bond yield + risk premium

A companys interest rate on long term debt is 8%. The risk premium is estimated tobe 5%. What is the cost of equity?

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4. Topics in Cost of Capital Estimation Estimating Beta and Determining Project Beta

Country Risk

Marginal Cost of Capital Schedule

Flotation Costs


4.1 Estimating Beta and Determining a Project Beta A firms beta is used to estimate its required return on equity

Beta is a measure of risk; riskier firms will have higher betas

Beta is estimated by regressing a stocks returns with overallmarket returns

At times we need to estimate the beta for a company or projectthat is not publicly traded

Use the pure-play method. Terminology: comparable, equitybeta, levered beta, asset beta, unlevered beta


Pure Play MethodExample: AA Corp. is a large conglomerate and wants to determine the equity beta ofits food division. This division has a D/E ratio of 0.7. The tax rate is 40%. A comparablepublicly traded food company has an equity beta of 1.2 and a D/E ratio of 0.5. What isthe equity beta of AAs food division?

1. Identify comparable publically traded company and estimate its beta2. Determine comparables asset (unlevered) beta asset = equity {1/1+[(1-t) D/E]}

3. Get the equity (levered) beta for the project = asset {1+[(1-t) D/E]}

www.irfanullah.co 26Examples 9, 10 and 11

4.2 Country RiskFor companies in developing countries add a country risk premium to CAPM

re = Rf + [E(rmkt) Rf + CRP]

CRP = sovereign yield spread * (annualized standard deviation of equity index ofdeveloping country/annualized standard deviation of sovereign bond market in terms ofdeveloped market currency)

Sovereign yield spread = developing country government bond yield (denominated in thedeveloped market currency) developed country bond yield

Example 12www.irfanullah.co 27

4.3 Marginal Cost of Capital Schedule


A companys target capital structure is 60 percent equity and 40 percent debt. The cost andavailability of raising various amounts of new debt and equity capital is shown below:Amount of new debt(in millions)

Cost of debt(after tax)

Amount of new equity(in millions)

Cost ofequity

4.0 14% 9.0 20%> 4.0 16% > 9.0 22%

What is the WACC for raising thefollowing amounts of capital:5101520

Capital

WACC(%)

MCC and Breakpoints As a firm raises more capital, the cost of different sources of finance will increase MCC shows the WACC for different levels of financing Breakpoint = amount of capital at which the component cost of capital changes /

weight of the component in the capital structure


Capital

WACC(%)

Debt Rd Equity re 4.0 14% 9.0 20%> 4.0 16% > 9.0 22%

Debt = 40% and Equity = 60%

Pre-Requisites for Curriculums Example 13 To calculate borrowing rates use Table 4

Spreads over LIBOR for Alternative Debt/Capital Ratios LIBOR is given as 4.5%

To calculate cost of equity fist compute beta at different levels ofdebt/capital The unleveraged (asset) beta is given: 0.9 Tax rate is given: 36% If Debt / Capital = 0.1 what is D/E? equity= asset {1+[(1-t) D/E]} Use CAPM


4.4 Flotation CostsFloatation cost are the fees charged by investment bankers when a company raisesexternal capital; two approaches for dealing with flotation costs


Approach 1: Incorporate flotation costsinto cost of capital

re = D1 / (P0 F) + g

A higher discount rate reduces thepresent value of future cash flows; is thisappropriate?

Approach 2: Adjust cash flows

Do not adjust discount rate:re = D1 / P0 + g

Adjust cash flow by amount of flotationcosts

Recommended approach

Summary WACC concept and calculation

Cost of debt

Cost of preferred shares

Cost of equity

Other topics: pure-play, CRP, MCC schedule, flotation costswww.irfanullah.co 32

Conclusion Read summary

Review learning objectives

Examples are good

Practice problems: good but not enough

Practice questions from other sourceswww.irfanullah.co 33

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