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**CHAPTER 10 The Cost of Capital
**

Capital Components & Costs WACC Adjusting for Risk Segmented Markets

z z z

Value = ∑

CFt t t = 0 (1 + WACC)

N

Value depends on reliably estimating risk and the cost of capital. Failure to properly assess risk leads to valuation errors. WACC is used to value corporations, projects, etc.

**Sources of long-term capital
**

z Debt z Preferred

z z

**Weighted average cost of capital
**

WACC = wdrd(1 − T) + wpsrps + wsrs

z z z z

**stock z Common stock
**

Retained earnings New common stock

The required return on all of a firm’s securities. A marginal, after-tax cost of capital. Weighted average of the component costs of capital. Weights are determined by each component’s contribution to the capital structure.

**Should our analysis focus on historical costs?
**

z No,

**How are weights determined?
**

WACC = wdrd(1 − T) + wpsrps + wsrs

z z

WACC is used for decisions about raising new capital and making new investments. z WACC focuses on marginal costs of raising an additional dollar of capital.

Weights are decided by a firm’s target capital structure. Usually based on market values of securities, rather than book values.

1

so it is expected to earn its YTC.000 7.00 $1. Many firms are now choosing to issue finite sinking fund preferred stock. Calculating rps z Cost of equity (rs) WACC = wdrd(1 − T) + wpsrps + wsrs z rs z Preferred stock pays a perpetual $6 dividend and currently sells for $94.02)) = 6. interest-bearing debt to finance its fixed assets. New preferred shares will incur a 2% flotation cost. then a shortterm debt component should be included.50%. z The appropriate component cost of debt is: rd(1 − T) = 6.29 $1.121.” Bond #1 Yrs to mat Yrs to call Coupon rate Price Maturity value YTM YTC Most likely yield 20 4 6. rps = Dps / Pps = $6 / ($94. z This second bond is selling at a premium and is likely to be called.85% 6. Retained earnings have a cost because investors could earn returns on alternative investments. The rate of return investors require on preferred stock. z z Should be greater than rd(1 − T).20. YTM on outstanding debt is usually used as a measure of rd.000 6. because interest is a tax-deductible expense. There are two callable bonds outstanding. z is the marginal cost of equity using retained earnings.20 x (1 − 0. Three common estimation methods: z z z Bond-yield-plus-risk-premium approach DCF approach CAPM approach 2 .0%. MRI’s preferred stock is non-callable and perpetual.67% Bond #2 20 4 8.50% $1. If the firm uses short-term. Relevant component cost is rd(1 − T). so no tax adjustments should be necessary. so it is expected to earn its YTM.67% 9.67% 6.67% Calculating rd z The Cost of preferred stock (rps) WACC = wdrd(1 − T) + wpsrps + wsrs z rps z z first bond is selling at a discount and is not likely to be called. The YTM and YTC of each bond is calculated and the lowest yield for each bond is its “Most likely yield.67%(1 − T) = 4. is the marginal cost of preferred stock.Cost of debt (rd) WACC = wdrd(1 − T) + wpsrps + wsrs z rd is z The z Calculating rd z z the marginal cost of debt capital.34% 6. because preferred stock is riskier than debt and its dividends are not taxdeductible. Preferred stock dividends are not taxdeductible.00% $926.

95%.15% 8.1 1.85% 3 .W (RPW) = 4.25% 11.95% 11. A common stock has a beta of 1.3 3% 4% 5% 6% 7% 7. rs = 10.05% 9. Dividend stream: 0.75% 8.95% 13. 0. Calculating rs (DCF) z CAPM approach (rs) z z A common stock. The firm’s beta with respect to global index returns is 1.35% 7.67%.67%. World Risk Premium (RPW) Beta 0. and is expected to be 3%.60 4 g = 20% The capital asset pricing model (CAPM) uses a stock’s exposure to market risk to find rs. solving for rs is extremely difficult and usually requires a spreadsheet.75% and the domestic market risk premium (RPM) is 6%. If a firm does not currently pay a dividend or pays a sporadic dividend. The discounted cash flow (DCF) approach uses the consensus future dividend estimates with the stock price to determine the marginal investor’s required return (rs) for a stock. The risk premium for this firm ranges from 2% to 4%. currently trading at $21 per share.0 1.67% and 10.75% 11.00% = 9.9 1. 15% in the fifth year.Bond-yield-plus-risk-premium approach (rs) z DCF approach (rs) z The bond-yield-plus-risk-premium approach adds a subjective equity risk premium to provide a ballpark estimate of rs. but the world risk premium (RPW) is 5%.45% 8.1.35% 9.2 1. but is expected to pay a $0. The risk-free rate is still 4.75% + 1. The dividend is expected to grow 20% in the fourth year.69 5 g = 15% g = 8% 0.55% 10.75%.25% 12. z z z z The range of rs estimates is between 8.75% + 1.35% 12. does not currently pay a dividend.75% 11. If a firm’s dividend experiences a period of non-constant growth. Using any version of the CAPM.15% 10. and at a constant rate of 8%. it is expected to fall into a long-run state of constant growth at some point in the future.50 0 P0 = $21 Using Microsoft Excel.75% 8. The risk-free rate is 4.15% 11.30% 1 2 3 0.45% 8. rs = rd + RP = 6.2 (6%) = 11. you must be aware of how sensitive estimates are to the inputs used.50 dividend three years from now. rs = rRF + bi. the CAPM parameters should reflect global risk parameters.2 with respect to the domestic stock index.1 (5%) = 10.25%.25% 10.67% + 3.745 6 Global CAPM approach (rs) z Global CAPM estimates z z If a firm operates in integrated international markets.75% 9.65% 9. rs = rRF + bi (RPM) = 4. thereafter.55% 13.75% 10.05% 9.

67%)(0. 4 . rs must be adjusted for flotation costs (e.32% + 7. and vice versa.g. and 70% common stock. You can determine the flotation cost using DCF.25%) = 1.67% to 10.7(10. which is what we will do. policy (dividends and repurchases vs. underwriting and legal costs).50%..08%).00% + 0.25(6. z Distribution WACC= 0.30%) and Global CAPM (10. If the firm issues new common stock. z z Our estimate of rs is the cost of retained earnings. 5% preferred stock.Making a cost of equity estimate z Flotation costs z z z z Don’t expect the different rs estimates to be equal. but some prefer to use the appropriate CAPM estimate (10.05(6. z If the company will only use retained earnings this year … z The firm should use the WACC to evaluate projects because we would expect the firm to issue securities in the future to keep from straying too much from the target capital structure. z If book value weights are used instead. Can use an average of the three estimates (10.6) + 0. and therefore it reflects the risk of the average project. The DCF (10.67%. If evaluating different capital budgeting projects of different risk … z The WACC used to evaluate a project should reflect the project’s risk. retained earnings) z Investment policy Using WACC z WACC Should you always use the WACC? z reflects the average risk of all of the firm’s operating assets. Market value weights are preferred to book value weights.25%).5%) + 0. the more WACC will be underestimated. and add it to the CAPM estimate. Easiest way to determine the cost is to adjust the price used in the DCF method to reflect the net price (after flotation costs) and solve for rs.18% = 8.25%) estimates agree with the range for rs. but they should not be radically different either. z WACC should be used to evaluate projects of average risk. the higher a firm’s M/B ratio. z Above-average projects should be treated with a higher risk-adjusted WACC. Calculating WACC WACC = wdrd(1 − T) + wpsrps + wsrs z The Factors affecting WACC z Choice z of capital structure firm’s target capital structure calls for 25% debt. The bond-plus-risk-premium approach establishes a “ballpark” range of 8. No direct way to do this in the CAPM.

S. This method works especially well in Latin America.1 + (10%) 0. Segmented CAPM z Calculating segmented CAPM z z z z Global CAPM uses RPW and a firm/project’s risk exposure to find the cost of capital. rs = rRF + RPM[0. but it assumes integrated international markets. 5 . Country-spread approach z Calculating the country-spread approach z The z z Low returns correlations between emerging and developed markets cause Global CAPM estimates to be too low. Treasury yields to the standard (domestic) CAPM.0.598 Forward exchange rate (VEB/$) = 1.45%. The segmented premium is estimated to be 10%.38/0.27%.0.016615 = 2. The segmented component (SRPM) can represent either a specific country or geographic region’s risk. and the Venezuelan project has a beta of 0. Adds the spread between a specific country’s U.38/0. Segmented CAPM adds an additional parameter to account for the risk due to the segmentation of markets.W + (SRPM) bi.625 z Note: Must convert to direct quotations z The appropriate cost of debt to the firm is: Cost of debt (rd) = rd(1−T)(1 + ∆FXe) + ∆FXe = 6.67% in Venezuela. The firm is estimating the cost of capital for a project in Venezuela.Seg = 4.5% and the ratio of market standard deviation in Venezuela to market standard deviation in the U.75% + (6%)[ 0. z New approaches are available to estimate the costs of capital.6) (0.016615 z z Spot exchange rate (VEB/$) = 1. The firm’s bolivar-denominated debt is expected to yield 6.7 with respect to the segmented risk premium.7 = 17. Consulting firms developed the country-spread approach to handle this problem. is 0.25%.75% + (5%)1.19 = 2. z If the firm operates or is appraising a project in a developing nation. dollar-denominated sovereign bond yields and U.983385) . rs = rRF + (RPW) bi. the firm is operating in a partially segmented market. country credit spread for Venezuela is 6.5% = 18.International effects on WACC z Global Foreign-denominated debt z z CAPM works only if the firm is operating in countries that have access to integrated international markets.S.6(σj/σM)] + CC spread = 4.67% (0.S.19) ] + 6. ∆FXe = -0.6 (0.

06 ln(40) = 8.45% 17.81%. Foreign cost of equity z z z Foreign WACC z All estimates fall into a reasonable range.73%. Many political and economic risk factors affect the country-risk rating. dcr = -0. z Differences usually due to different interest rates.1(2. WACC = wd(A-T rd) + wsrs = 0. z Operations are often financed with different debt/equity mixes in different countries. We will use an average: Segmented CAPM Country-spread approach Country-risk-rating approach rs = 17. exchange rates.81%) = 0. z Therefore.31 – 0.25% 18. A higher country-risk rating means a higher required return for investments in that country.87% x 2 = 17.06. Raising capital overseas z Firms often guarantee subsidiaries’ debt in order to keep interest rates down. the annual rs = 8.31.23% + 16. The following regression model determines semiannual return for U.73% Venezuelan project will use a capital structure of 10% debt and 90% equity. and tax situations. The latest survey indicates that Venezuela’s country-risk rating is 40.9(17.S.03% = 16.Country-risk-rating approach z z z z Calculating the country-riskrating approach z z Estimates country level risk using bi-annual country risk ratings. 17. rsj/2 = a + dcr ln(country-risk ratingj) = 0. dollars in Country j. Could use any of the individual estimates or an average of estimates. 6 .87%. rsj/2 = a + dcr ln(country-risk ratingj) A regression across all countries yields the following parameters: a = 0.26%.27%) + 0.

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