The Cost of Capital

Chapter 9

1
 Agenda
• What does cost of capital mean?
• Why is it important?
• Cost of Debt, rd,, Preferred stock, rp, & Common
stock, re.
• Calculating WACC

2
 Cost of Capital: A Critical Element
in Business Decisions
• Most important capital investments require capital
– Develop new products,
– Build new factories,
– Acquire other companies, etc.

• Cost of capital is the return demanded by investors who

provide capital for these investments.
• Investments must offer this return to be worth using the
capital providers’ money.

3
 The Flow of Funds
Equity Debt
(Shareholders) (creditors and/or
bondholders)
Dividends & Investment Interests Investment
capital gain

Firm

Profits Profits Profits

Investment Investment Investment

Project A Project B Project C, …

• Cost of Capital for the firm is also the required return by the
investors (shareholders and creditors).
4
 Cost of Capital and Firm Value

A firm’s value is the present value of its FCF, discounted at its

cost of capital.
5
Defining the Weighted Average Cost of Capital
• Firms usually have three components of long-term capital
provided by investors:
– Long-term debt, rD(1 – T)
– Preferred stock, rE
– Common stock, rP

• The cost of capital thus should be a weighted average of the

various components’ costs, i.e. the weighted average cost of
capital (WACC).

• Note: Accounts payable, accruals, and deferred taxes are not

funds from investors, and are NOT included in the calculation of
the cost of capital.

6
 Question
Why is accounts payable excluded from the cost of capital
calculation?
A. Because it rises automatically as sales decrease
B. Because it is already reflected in the cash flow estimates and
if we also include it in the cost of capital calculation, we
would be double counting
C. Because the exact amount is hard to estimate
D. Because it tend to be very small in amount in comparison to
the other sources of funding for the firm

7
 Cost of Debt
• Historical (embedded) vs. new (marginal) cost of debt
– The cost of capital is primarily used to make decisions
about raising new capital for investments NOW.

• Before-tax vs. after-tax cost of debt

– Interest payments are tax deductible

• Estimating cost of debt, rd(1 – T)

8
 Before-Tax vs. After-Tax Cost of Debt
• Most firms incorporate tax effects in the cost of capital.
Only the cost of debt is affected. Why?
• Consider two otherwise identical firms: Firm A has $0 debt
and Firm B has $1,000 of debt
Firm A Firm B
EBIT 1,000 1,000
Interest (10%) 0 100
Tax (40%) _____ _____
Net Income _____ _____
Investors’ total income $600 $640

• Firm B saves $40 on the $1,000 of debt

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 Estimating the Cost of Debt
• Method 1: Ask an investment banker what the yield
would be if the company issues 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.

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Calculating the Cost of Debt, Example
• NCC Inc. has a 22-Year, 7% semi-annual bond
outstanding. The bond currently sells for $897.26. The
corporate tax rate is 30%. What’s the cost of NCC’s debt?

• Excel function RATE

• where nper =22*2 = 44, pmt = 1,000*7%/2 = 35,
pv = -897.26, and fv = 1000
• Solve for rate = 4%
• Before-tax annual rd = 4%*2 = 8%
• After-tax annual rd*(1-T) = 8%*(1-30%) = 5.6%

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 Question
Why is the cost of debt adjusted for taxes but the cost
of equity is not?
A. Because interest payments are not tax deductible but
dividend payments are
B. Because interest payments are tax deductible but
dividend payments are not
C. Because principal payments are tax deductible but
interest payments are not
D. Because capital gains are tax deductible but principal
payments are not

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 Cost of Preferred Stock
• Preferred stocks pays stable perpetual dividends, Dp.
• Preferred dividends are not tax-deductible – no tax
adjustment. Just rp.
• Cost of preferred stock
rp = Dp / Pp

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 Cost of Preferred Stock, Example
• NCC Inc. has preferred stock that pays a $1.8 dividend
per share and sells for $25 per share. What is NCC’s
cost of preferred stock?

• Dp = $1.8, Pp = $25
𝐷𝑝
• 𝑟𝑝 = = __________________ = 7.2%
𝑃𝑝

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 Cost of Common Stock
• Two ways of raising common equity:
– Directly, by selling new shares of common stock
– Indirectly, by reinvesting earnings that are not paid out as
cash dividends – retained earnings
• Shareholders require a return of re for the new
issued shares
• Is retained earnings free money or do we have to
make a return for those who own it – the
shareholders?

15
Three Methods of Estimating the Cost
of Equity
1. The CAPM approach

2. Discounted Cash Flow (DCF) method

3. Bond-yield-plus-risk-premium approach

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 1. The CAPM Approach
• CAPM Model:
re = rF + (rM – rRF)*beta = rRF +RPM*beta

• Four-step process:
1. Estimate the risk-free rate, rRF
2. Estimate the current expected market risk
premium, RPM
3. Estimate the stock’s beta
4. Apply the CAPM equation

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 Step 1: Estimating the Risk-Free Rate
• We often use the yield on a long-term federal
government bond as a proxy for rRF , because
1. The government issued bond has a low risk of
default
2. Most shareholders invest on a long-term basis
3. We should choose a term that matches the
lifetime of the project…that’s how long investors
will be investing their money for

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 Step 2: Estimating Market Risk Premium
RPM = rM – rRF
Which market return (rM) should we use?
1. Historical data: historical market index return (rM)

2. Forward-looking data: the expected market return

(rM) being the sum of the current dividend yield (on
some market index) and the expected growth rate
in dividends: rM = D1/P0 + g

Which approach makes more sense?

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 Step 3: Estimating Beta
• Beta is estimated as the slope in a regression of a
company’s stock returns against market return.

• The historical beta is subject to problems such as:

– No theoretical guidance as to the correct holding
period over which to measure returns
– Statistical imprecision
– Should the future be like the past?

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 An Illustration of CAPM
• Assume rRF = 5%, RPM = 5.5%, bi = 1.3 for NCC,
what is the company’s cost of equity?

re = rRF + (RM – rRF) bi

= ___________________
= 12.2%

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 Issues In Using CAPM

• It is difficult to estimate the market risk premium.

• Most analysts use a rate of 3% to 6% for the
market risk premium (RPM).
• Estimates of beta vary (why?), and estimates are
“noisy” (they have a wide confidence interval).

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 2. Discounted Cash Flow (DCF) Approach
• Given that a company pays dividends, and that dividends
are expected to grow at a constant rate, and that we can
have a legitimate estimate of the growth rate, then:
re = (D1/P0) + expected g

• Estimating expected growth rate g

– Use the historical growth rate if you believe the future will
be like the past.
– Apply the retention growth model
– Use analysts’ forecasted earnings growth rate

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 Retention Growth Model
• If a company makes 12% return per year and pays
out 25% of the earnings in dividends, the remaining
9% should be reinvested. The company would grow
by 9% a year.

• So, g = ROE*retention rate = ROE * (1-payout rate)

• In the above example,

g = 12% * (1-25%) = 9%

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 Limitation of the Retention
Growth Model
• Assumptions:
– The retention rate is expected to be constant
– ROE is expected to remain constant
– Future investments projects are expected to
be of the same level of risk as the past projects

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 Illustration of the DCF Approach
• NCC has had an average ROE = 10% over the past 15
years. The ROE has been relatively steady. NCC’s
dividend payout rate has averaged 50% over the same
time period. Its next expected dividend is $2.4.
Suppose NCC’s stock sells for $32.
• What is NCC’s cost of common stock?

• D1 = $2.4, P0 = $32, ROE = 10%, and payout = 50%

• g = ROE*(1- payout rate) = _____________ = 5%
• re = D1/P0 + g = ___________________ = 12.5%

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 3. Bond-Yield-Plus-Risk-Premium
Approach
• re = rd + RP = the firm’s own bond yield + risk premium

• This RP  RPM (CAPM). Why not?

• This approach produces ballpark estimate of re

– The bond risk premium is often a subjective value between
3% to 5%

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 Floatation Costs
• Flotation costs: the fees paid to raise new capital,
such as underwriting and legal fees.
– Flotation costs depend on the risk of the firm and the
amount being raised.
– The flotation costs of debt is usually low, especially for
private debt.
– Flotation costs are highest for common equity.

• Use net price, i.e., P(1 – F), where F = % of price.

– Preferred stock: rp = Dp / Pp(1 – F)
– Common stock: re = D1 / P0(1 – F) + g

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 The Real Cost of Flotation Costs
• Given P0 = $32, D1 = $2.40, g = 5%, and F = 12.5%,
• Ignoring flotation costs, the firm’s shareholders require a
return of 12.5% according to DCF model.
• The firm has to earn a return of 13.6% on newly issued
equity capital.
re = D1/P0*(1-F) + g = _____________________ = 13.6%

• Flotation costs add 13.6% – 12.5% = 1.1% to the firm’s

cost of equity.
• 1.1% is similarly added to the cost of equity numbers if
using other models.

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Weighted Average Cost of Capital, WACC
• WACC = wd*rd* (1 – T) + wp*rp + we*rs (or re)

• WACC is the average cost of capital on the firm’s

existing projects and activities.
• It is calculated by weighting the cost of each source of
funds.

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 Calculating the weights in WACC
• Hostin Corp. has 1.5 million common shares
outstanding selling for $142 each.
• The firm has 0.5 million preferred shares outstanding
selling for $82 each.
• The firm also has 100,000 bonds outstanding. Each
bond has a face value of $1000, and is currently selling
for 114% of the face value.
• What is the weight of the debt in Hostin’s market value?

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 Solution
• Market value of each type of capital = market price per
share * # of shares
– Ve = ______________________ = $213m
– Vp = ______________________ = $41m
– Vd = ______________________ = $114m

• Value of the firm:

V= Ve + Vp + Vd = $213m + $41m + $114m = $368m

• Weight of the debt:

wd = Vd/V = ___________________ = 30.98%
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 WACC Calculation
• Recall: rd = 8%, rP = 7.2%, re = 12.2% (from CAPM) for
NCC
• Now suppose NCC has a capital structure of 30%
debt, 10% preferred stocks, and 60% common stocks.
• The corporate tax rate is 30%.
• What is NCC’s WACC?

WACC = wd*rd* (1 – T) + wp*rp + we*re

= _____________________________ = 9.7%

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 Factors That Affect WACC
• Beyond the control of the firm:
– Market conditions, especially interest rates, market risk
premium
– tax rates
• Within the control of the firm:
– Capital structure
– Dividend policy
– Investment policy
• Should firm prefer a lower or higher WACC?

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 Question
Which of the following is the most likely order from the
lowest to highest?
A. rD, rP, rE
B. rP, rE, rD
C. rE, rP, rD
D. rE, rD, rP

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