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Cost of Capital

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1. 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 making

by companys management and also its valuation by investors

Cost of capital estimation is a complex undertaking which requires many

assumptions and, factors that need to be taken into account.

Investments that alter a companys capital structure require project specific cost of

capital adjustments

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2. Cost of Capital

Lenders/Bondholders

return that the suppliers of

capital require as compensation

for their contribution of capital

Invest if return > cost of capital

higher cost of capital

Marginal cost of capital (MCC)

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WACC = wd rd (1-t) + wp rp + were

wd = proportion of debt that the company uses when it raises new funds

rd = before tax marginal cost of debt

t = companys marginal tax rate

wp= proportion of preferred stock the company uses when it raises new funds

rp= marginal cost of preferred stock

we= proportion of equity that the company uses when it raises new funds

re = the marginal cost of capital

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Example

IFT has the following capital structure: 30 percent debt, 10 percent preferred stock

and 60 percent equity. The before tax cost of debt is 8 percent, cost of preferred stock

is 10 percent and cost of equity is 15 percent. If the marginal tax rate is 40%, what is

the WACC?.

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Example

Machiavelli Co. has an after tax cost of debt capital of 4%, a cost of preferred stock of

8%, a cost of equity capital of 10% and a weighted average cost of capital of 7%. MC

intends to maintain its current capital structure as it raises additional capital. In

making its capital budgeting decisions for the average risk project the relevant cost of

capital is

A. 4%

B. 7%

C. 8%

Answer: B

The WACC using weights derived from the current capital structure, is the best estimate of the cost of capital

for the average risk project of a company.

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Payments to owners (dividends) are not tax deductible

Interest costs are tax deductible, which means that they provide tax savings

Example: Debt = 100, interest rate = 10%, tax rate = 40%

Calculation of net income assuming

interest is tax deductible

interest is NOT tax deductible

Revenue

Operating Expenses

Interest

EBT

Tax Expense (40%)

Net Income

Revenue

Operating Expenses

EBT

Tax Expense (40%)

Interest expense

Net Income

100

50

10

40

16

24

100

50

50

20

10

20

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Example 2

Weights 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

Example 3

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Example

You gather the following information about the capital structure and before-tax

component costs for a company. The companys marginal tax rate is 40 percent.

What is the cost of capital?

Capital component

Component cost

Debt

$100

$90

8%

Preferred stock

$20

$20

10%

Common stock

$100

$300

14%

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For average risk projects use WACC to compute NPV

Adjustments to the cost of capital are necessary when a project differs

in risk from the average risk of a firms existing projects

The discount rate should be adjusted upward for higher risk projects

and downwards for lower risk projects

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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

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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

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The yield to maturity (YTM) is the annual return that an investor earns if he

purchases the bond today and holds it until maturity

Example: A company issues a 10-year, 8% semi-annual coupon bond. Upon issue, the

bond sells for $980. If the marginal tax rate is 30%, what is the after-tax cost of

debt?

Example 4

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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

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The cost of preferred stock is the cost that a company has committed to pay

preferred stockholders and preferred dividend

Cost of preferred stock = preferred dividend / current price

Example: A company issues preferred stock with a par value = 100 and preferred

dividend = 5 per share. The current share price is 125 and the marginal tax rate is

33%. What is the cost of preferred stock?

Examples 5 and 6

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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 future

cash flows

Commonly used approach for estimating cost of equity are:

Capital asset pricing model

Dividend discount model

Bond yield plus risk premium method

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Expected 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 premium

is 6%. The equity beta for a given company is 2. What is the cost of equity using the

CAPM approach?

Equity risk premium can be calculated using historical returns

Examples 7 and 8

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Present value of a perpetuity

present value of future cash flows (dividends)

Gordon growth model is one example of a DCF

model

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P0= D1 / (re- g)

re = D1 / P0 + g

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

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Example

You 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 of

retained earnings?

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Add 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 to

be 5%. What is the cost of equity?

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Estimating Beta and Determining Project Beta

Country Risk

Marginal Cost of Capital Schedule

Flotation Costs

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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 overall

market returns

At times we need to estimate the beta for a company or project

that is not publicly traded

Use the pure-play method. Terminology: comparable, equity

beta, levered beta, asset beta, unlevered beta

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Example: AA Corp. is a large conglomerate and wants to determine the equity beta of

its food division. This division has a D/E ratio of 0.7. The tax rate is 40%. A comparable

publicly traded food company has an equity beta of 1.2 and a D/E ratio of 0.5. What is

the equity beta of AAs food division?

1. Identify comparable publically traded company and estimate its beta

2. 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]}

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Examples 9, 10 and 11

26

For 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 of

developing country/annualized standard deviation of sovereign bond market in terms of

developed market currency)

Sovereign yield spread = developing country government bond yield (denominated in the

developed market currency) developed country bond yield

Example 12

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A companys target capital structure is 60 percent equity and 40 percent debt. The cost and

availability of raising various amounts of new debt and equity capital is shown below:

Amount of new debt

(in millions)

Cost of debt

(after tax)

(in millions)

Cost of

equity

4.0

14%

9.0

20%

> 4.0

16%

> 9.0

22%

WACC(%)

following amounts of capital:

5

10

15

20

Capital

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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

WACC(%)

Debt = 40% and Equity = 60%

Debt

Rd

Equity

re

4.0

14%

9.0

20%

> 4.0

16%

> 9.0

22%

Capital

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To calculate borrowing rates use Table 4

Spreads over LIBOR for Alternative Debt/Capital Ratios

LIBOR is given as 4.5%

debt/capital

Tax rate is given: 36%

If Debt / Capital = 0.1 what is D/E?

equity= asset {1+[(1-t) D/E]}

Use CAPM

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Floatation cost are the fees charged by investment bankers when a company raises

external capital; two approaches for dealing with flotation costs

Approach 1: Incorporate flotation costs

into cost of capital

Do not adjust discount rate:

re = D1 / P0 + g

re = D1 / (P0 F) + g

A higher discount rate reduces the

present value of future cash flows; is this

appropriate?

costs

Recommended approach

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Summary

WACC concept and calculation

Cost of debt

Cost of preferred shares

Cost of equity

Other topics: pure-play, CRP, MCC schedule, flotation costs

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32

Conclusion

Read summary

Review learning objectives

Examples are good

Practice problems: good but not enough

Practice questions from other sources

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33

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