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CFA Level I Corporate Finance

Cost of Capital
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Contents and Introduction


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

Cost of capital is the rate of


return that the suppliers of
capital require as compensation
for their contribution of capital
Invest if return > cost of capital

Owners/ Equity holders

Riskier projects will have a


higher cost of capital
Marginal cost of capital (MCC)

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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 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?.

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


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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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Taxes and Cost of Capital


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

Calculation of net income assuming


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

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


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Example 2

Weights of the Weighted Average


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

Book Value (000)

Market Value (000)

Component cost

Debt

$100

$90

8%

Preferred stock

$20

$20

10%

Common stock

$100

$300

14%

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MCC and IOS

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Role of WACC (MCC)


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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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

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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

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Yield to Maturity Approach


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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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 Stock


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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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 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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Capital Asset Pricing Model


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?

Risk free rate: use long term government bonds


Equity risk premium can be calculated using historical returns
Examples 7 and 8
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Pre-Requisites for Understanding the DDM


Present value of a perpetuity

Present value of a growing perpetuity

Value of a financial asset, such as a stock, is the


present value of future cash flows (dividends)
Gordon growth model is one example of a DCF
model
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Dividend Discount Model


P0= 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
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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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Bond Yield Plus Risk Premium Approach


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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4. Topics in Cost of Capital Estimation


Estimating Beta and Determining Project Beta
Country Risk
Marginal Cost of Capital Schedule
Flotation Costs

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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 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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Pure Play Method


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

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4.2 Country Risk


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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4.3 Marginal Cost of Capital Schedule


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)

Amount of new equity


(in millions)

Cost of
equity

4.0

14%

9.0

20%

> 4.0

16%

> 9.0

22%

WACC(%)

What is the WACC for raising the


following amounts of capital:
5
10
15
20

Capital
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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
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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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 of


debt/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
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4.4 Flotation Costs


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

Approach 2: Adjust cash flows


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?

Adjust cash flow by amount of flotation


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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Conclusion
Read summary
Review learning objectives
Examples are good
Practice problems: good but not enough
Practice questions from other sources
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