# Chapter 13

COST OF CAPITAL

Alex Tajirian

Cost of Capital

13-2

**1 OBJECTIVE # # Managing the right-hand-side of the B/S By now, for valuation analysis, we know:
**

! ! ! ! criteria: NPV, IRR, payback what the relevant CFs are how to compute net CFs how to introduce forecast error in CFs (WHAT IF,. . . )

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Sources of financing:

Debt, equity, retained earnings, preferred stock, warrants, venture capital, and bank loans, strategic alliances. ! ! Bank loans, venture capital, and warrants not discussed To simplify, we concentrate only on debt, equity, and retained earnings.

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**Cost of financing = cost of capital = ?
**

! ! ! Definition: The rate that must be earned to satisfy the required rate of return of the firm's investors.

What is the cost of each source of financing? What is a project's cost of capital?

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Why might cost of capital in Japan be lower than in U.S.?

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Alex Tajirian

1997
Alex Tajirian
.2 SOME PRELIMINARIES ! Minimum required return / cost of capital= that particular discount rate “k” that makes NPV = 0.com. the risk of the CFs.
]
cost of capital to the firm = reward to investors.Cost of Capital
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2 MOTIVATION
2. 2.. not on the source. ! The return generated by a security is the cost of that security to the company that issued it.e. Q risk of CFs (systematic risk) Q company capital structure
© morevalue.1 WHY IS COST OF CAPITAL IMPORTANT? If financing cost is reduced Y NPV increases Y more projects end up with NPV > 0 Y more wealth created to shareholders. i. ! The cost of capital depends primarily on the use of funds.

Case 2 Now suppose firm needs to issue new equity for an expansion project. But reward to investor = cost of capital to the firm.e.3 COST COMPONENTS
Case 1 Assume firm has no debt & has retained earnings.
© morevalue. 1997
Alex Tajirian
. Obviously ke > ks ] (cost of new equity) > (cost of retained earnings) ] (required return on new equity) > (required return on retained earnings) since some transactions (floatation) costs have to be paid to investment banks for assisting firm in selling the new securities. projects with return at least equal to ks . i. if the company is retaining your money. then the minimum acceptable reward to you (an average investor) is the required return on equity Y required return on retained earnings = ks / required return on equity.com.. Thus. then the firm should distribute retained earnings to shareholders as dividends.
ˆ
required return on equity = cost of retained earnings.Cost of Capital
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2. Remember from the chapter on Performance Measures: Net Income = total dividend + retained earnings If a company cannot find profitable projects.

4
OUTLINE Given a company's target capital structure. Step 1: Estimate cost of each component Step 2: Calculate the cost of the combination of financing sources.e. i. firm should consider using debt. company WACC
© morevalue.com. should it be financed using equity? Not necessarily. 1997
Alex Tajirian
.
2..Cost of Capital
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Case 3 If a company has a "good" project (NPV > 0).

based on the company’s optimal/target financing mix (capital structure). (a) It is not the source of financing that determined the cost of capital. wd ' Assets Debt % Equity Equity . Market value of the company’s debt market value of the company’s equity
the weights (proportions) of each source of capital.
© morevalue. WACC Debt Equity wi
= = = =
Weighted Average Cost of Capital. (c) Weights are based on the optimal company’s source of financing. Notes.com. the topic of next chapter. and w d % ws ' 1 ws ' Debt % Equity where. 1997
Alex Tajirian
. (b) B/S weights need not be reflective of market values.
WACC ' sum of weighted rewards to firm ) s capital providers ' w d(cost of debt) % w s(cost of equity) Debt Debt ' where.Cost of Capital
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In general.

Cost of Capital
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CALCULATING COST OF EACH COMPONENT
We first start with the cost of each source of new capital.
2. then take their weighted average. 1997
Alex Tajirian
.5 COST OF RETAINED EARNINGS.com. ks
L
Cost of retained earnings = required rate of return on equity
?
What are possible approaches to estimate ks
© morevalue. Note. the weights are given by the optimal capital structure.

2%
© morevalue.19 kM .5% P0 = $50 $ = 0. 1997
Alex Tajirian
.com.847) ' 14.kRF = 8.1 CAPM Approach
ks ' k RF % (k M & k RF)$s ' 7.0% % (8.5.847 g = 5% ks = ? Solution:
L
#
Two approaches when company stock is trading on an exchange: 2.5%)(.Cost of Capital
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Example: Calculating Cost of Retained Earnings Given: kRF = 7% Dividend0 = $4.

g = 5%.05) % .8%
ˆ
You can use the average of these two approaches = 14%. 1997
Alex Tajirian
.19 × (1. p0 = $50 ks = ? Solution:
From equation (4) chapter 7.5.Cost of Capital
13-9
#
2. we have: Dividend1 P0
ks '
% g
7
'
Dividend0 × (1 % g) P0 4.05 $50
% g
'
' 0.com.
© morevalue.19.088 % 0.05 ' 13.2
DCF Approach:
Given: Dividend0 = $4.

If P0 = $50 and F = 15% of issue price.6 COST OF NEWLY ISSUED COMMON STOCK.com. then additional cost per share = (50)(15%) = $7. Thus. ke
# Floatation costs (F) are not part of capital budgeting CFS. if existing shareholders finance projects using new equity. 1997
Alex Tajirian
.5.
#
© morevalue. they require a higher return to cover this cost Y ke > ks .Cost of Capital
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2.

g = 5% .05) % .15)
© morevalue. Chapter 7. P0 = $50 ke = ? Solution: Using equation (4).19 .Cost of Capital
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Example: Calculating Component Cost of New Equity Given: F = 15% of issue price. 1997
Alex Tajirian
. and including F. Financial/Economic Valuation Dividend1 net value of new equity per share Dividend1 issue price & floatation cost Dividend1 P0 & (P0)(F) P0(1& F) % g % g % g
ke ' '
'
'
Dividend0 × (1% g)
% g
'
$4. we have:
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Accounting vs. Dividend0 = 4.05 ' 15.4% $50(1& .com.19 × (1.

0% ' $113. and including F.1 No tax adjustment is needed since preferred dividends are paid from after-tax income. kps Given: Dividendps = $10 annually.1 per share (market price) F = floatation cost = $2.09 ' 9.
Note.7 COST OF PREFERRED STOCK.00 $111. from Chapter 7.1& 2. 1997
Alex Tajirian
. perpetually paid price (Pps) = $113.com. we have: kps ' Dividend ps P ps& F $10 $10 ' ' 0.00 per share Solution: Using equation (3).Cost of Capital
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2.
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Cost of Capital
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2.T) Example: Calculating Component Cost of Debt
Given: Semiannual bond. 1997
Alex Tajirian
.tax benefit = kd .com.72.T × kd = kd(1 .8 COST OF DEBT = kd (1-T)
kd is the interest paid to new bond holders. coupon rate = 12%. T = 40% kd(1-T) = ?
© morevalue. price of a similar bond = $1. years to maturity = 15. But since interest is tax deductible Y
effective cost of debt = after-tax cost of debt = before tax cost .153.

1741) ' 825.35 > price
2 2
If you try kd/2 = 5%.98 < price ' $1.30)
2 2
Try k d ' 6% Y 60(PVIFA6.153.30) % 1.7648) % 1.
ˆ kd = 5% x 2 = 10% Y kd(1-T) = 10%(0.2920)% 1.72 You have to try a number < 6%.153. you will get it right.346.com. 1997
Alex Tajirian
. say k d ' 4% Y 60(17.000 ' ' 60 2 2
PV ' SUM of discounted CFs Y $1.6) = 6%
© morevalue.30) ' 60(13.000(PVIF6.30 ) % $1.000(.3083) ' 1.000(.1 ' 999.75 ' 60(PVIFAk d .000(PVIFk d .88 % 174.Cost of Capital
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Solution: Based on formula for PV of bonds Step 1: Calculate semi-annual coupon Step 2: Use Trial & Error methods Trial & Error Method: coupon ' coupon interest × par value 12% × $1.

as in this example.8% % 0.1(9%) % 0. 10% Preferred.000 ! T = 40% ! Value of k from above examples is used. 1997
Alex Tajirian
.1%
?
What is the amount raised of each component?
© morevalue.4% ' 11.6(14%) % 0 ' 1.Cost of Capital
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Example: Calculating Company WACC
Given: ! optimal proportions are: 30% Debt.6) % 0. WACC ' w dk d(1& T) % w psk ps % w sk s % w ek e ' 0. 60% common equity ! Retained Earnings = $300.com.9% % 8.3(10%)(0.000 Solution: If retained earnings are to be used to finance projects. ! $ financing needed = $200.

1997
Alex Tajirian
.com.Cost of Capital
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?
What is the maximum amount of financing that can be sustained without issuing new equity?
© morevalue.

Cost of Capital
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Where do the weights come from?
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Possibilities include: ! proportional current book value of each component
!
proportional current market value of each component
!
target capital structure
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Should short-term debt be included in wd?
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Alex Tajirian
.

kRF)$project
© morevalue.com. If company has no debt. then kproject = kRF + (km . 1997
Alex Tajirian
. Should firm use ks? If you use ks. then you are implicitly assuming that the risk of projects = risk of company
?
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Remember: discount rate reflects risk of CFs.Cost of Capital
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3
WHAT IS A PROJECT'S COST OF CAPITAL
Suppose debt = 0 and project is financed through 100% equity.

com. Project k
k
Project risk < firm’s Project risk > firm’s
firm’s k riskReject good projects free
Accept Bad Projects
Beta
© morevalue.Cost of Capital
13-19
USING COMPANY k Vs. 1997
Alex Tajirian
.

1 Project Required Return (k project) and NPV.WACC) + + and NPVproject + + NPVWACC + + implication of using NPVWACC accepting bad projects no problem rejecting good projects no problem
NPVproject = NPV using k project as the discount rate NPVWACC = NPV using company WACC as the discount rate
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use k = kproject to appropriately incorporate project CF-risk
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Alex Tajirian
.com.Cost of Capital
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3.
if project risk $ Company risk yes yes No No Y (kproject .

companies have adopted a "crude" way of calculating kproject.Cost of Capital
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3. 1997
Alex Tajirian
.com. hurdle rate = company WACC ± risk premium
!
Assume company WACC = 15%.2 PROJECT COST OF CAPITAL IN PRACTICE. It reflects both project risk and cost of capital. known technology discount rate (k) 30% 25% 15% 10% risk premium 15% 10% 0 -5%
© morevalue.
!
To incorporate risk of CFS. The "hurdle rate" is one such method.
hurdle rates
project category speculative venture new product expansion of existing business cost of improvement.

com.Cost of Capital
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PROJECT COST OF CAPITAL
Does Firm Have Debt?
No Yes
Is Project Same Risk As Firm? Yes No
Is Project Same Risk As Firm? Yes No
Use Firm K
Use k Reflecting Project Beta
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Use Firm WACC
Use “Hurdle Rate”
Alex Tajirian
.

S.S. thus.com. debt and equity financing has increased. Japanese firms have traditionally relied more on bank loans as a source of financing.Cost of Capital
13-23
4
COST OF CAPITAL (k) IN JAPAN & U. k is lower
! Floatation cost is low
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Government loans and subsidies. firms. This has enhanced firm monitoring by creditors (banks). especially for R&D. ? Why might the cost be lower in Japan?
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Keiretsu (Companies aligned with financial giants) ! Agency problem lower.
© morevalue.?
Unlike U. German firms have also traditionally relied more heavily on bank loans. Recently. 1997
Alex Tajirian
.

The weights are determined by the target capital structure.com.Cost of Capital
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5
From P0 '
SUMMARY
T
Dividendps Dividend Y k ps ' P ps k Dividend ps P ps& F % g Dividend1 P0(1& F)
Including Floatation costs Y kps ' T From P0 ' Dividend1 k& g Yk ' Dividend1 P0
including Floatation costs Y k e '
T
% g
Long-term financing used for long-term projects.
T WACC ' wdkd(1& T) % weke % wpskps % wsks
Note. The target proportions are not book values. Only debt is tax deductible. 1997
Alex Tajirian
. Short-term financing is used only if there is a temporary mismatch between timing of inflows and outflows.
© morevalue.

com. debt and equity. Floatation costs are irrelevant to capital budgeting. If the target (Debt/Asset) = 0. Agree/Disagree-Explain
1 If a manager. A project's cost of capital > company WACC. uses the firm's WACC as the cost of project finance. Consider the simple case of only two sources of financing. What Happens to kd(1-T) and WACC if:
a.
2 3 4
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II. 1997
Alex Tajirian
. kd is the cost of debt financing to a firm. firm incurs more debt b. interest rates increase c. with no finance background. company undertakes risky projects e. then a company's WACC = ks. tax rates are increased
© morevalue. then he/she would be accepting bad projects.Cost of Capital
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6 QUESTIONS I. inflation increases d.

000. (a) Using its balance sheet data below. 1997
Alex Tajirian
.Cost of Capital
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III. NUMERICAL.
1 WAK Inc. calculate WAK's WACC. before-tax cost of debt of 10%.
© morevalue.00 Long-term debt Equity Total liabilities and equity $500 1. has a cost of equity of 15%.com. Its equity and debt are trading at book value.500 2. Assets Cash Accounts receivable Inventories Plant and equipment Total assets $500 300 800 400 2. and a marginal tax rate of 40%.000.00 Liabilities and Equity
(b)
How would you calculate WACC if equity and debt were not trading at book values? Also assume that the firm is currently at its target capital structure.

Disagree.Cost of Capital
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ANSWERS TO QUESTIONS I. Although floatation costs are not part of the relevant CFs. they do impact capital budgeting decisions. Thus.
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II. Interest is deductible. Disagree. Agree/Disagree-Explain
1 2 3 4 Disagree. Assuming that the only two components of assets are debt and equity. Disagree. Only if the project is more risky than the company. interest rates increase c. It depends on the project's risk. tax rates are increased
© morevalue. Thus. inflation increases d. at (Debt/Asset) = 0. Agree. 1997
Alex Tajirian
. Thus cost of debt is kd(1-T). WACC = ks. company undertakes risky projects e. 20. firm incurs more debt b. they are part of the cost of capital (k). the WACC would have wd = 0 and ws = 1. What Happens to kd(1-T) and WACC if:
a.com. See p.

i. not book value proportions.000
wd '
Debt 500 ' ' .6) % .
© morevalue.10)(. the proportions have to be based on market-value proportions. 1997
Alex Tajirian
. Problems..15) ' 12. 1.25 Asset 500% 1.75 Y WACC ' wdkd(1& T) % wsks ' . Debt = Market value of Debt = sum of [(market price of each bond)(# of bonds outstanding)] Equity = Market value of Equity = (price of stock)(# of shares outstanding) Thus.75%
(b) What happens if stock is not trading at book value.com. book value is different from market value?
Calculate market values of debt and Equity.e.Cost of Capital
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III.25(.75(.500 2.500
ws ' 1& wd ' .
Step 1: Step 2: Calculate weights: proportions of each source of capital substitute in WACC equation
Capital Sources Long-term debt Equity
Amount 500 1.