Lecture10 - Cost of Capital

FINA1310EFG CORPORATE FINANCE
Lecture 10. Cost of Capital
Instructor: Dr. Mingzhu TAI

Faculty of Business and Economics
The University of Hong Kong
Spring semester, 2018-2019

Capital Budgeting
• Investment criteria
(Techniques to identify valuable investments)
‒ Lecture 7 (Chapter 9)
• Cash flows
‒ Lecture 8 (Chapter 2 & 10)
• Project analysis
• Cost of Capital
FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 2

Review of Lecture 9
• Problems with NPV
• What-if Analysis
‒ Scenario analysis
‒ Sensitivity analysis
‒ Simulation analysis
• Break-even analysis
‒ Accounting break-even
‒ Cash break-even
‒ Financial break-even
• Operating Leverage
• Capital Rationing
• Textbook Reading: Chapter 11

Today’s Roadmap
• Preliminary Discussions
• Detailed Discussions
‒ Cost of Equity (common stocks)
‒ Cost of preferred stocks
‒ Costs of debt
• The Weighted Average Cost of Capital (WACC)
• Divisional and Project Costs of Capital
• Flotation Costs

Today’s Roadmap
‒ Costs of debt
• Flotation Costs

Cost of Capital: the Big Picture

• In the discounted cash flow valuation:
𝑪𝑪𝑭𝑭𝟏𝟏 𝑪𝑪𝑭𝑭𝟐𝟐 𝑪𝑪𝑭𝑭𝑻𝑻
𝑵𝑵𝑵𝑵𝑵𝑵 = 𝑪𝑪𝑭𝑭𝟎𝟎 + + 𝟐𝟐
+ ⋯+ 𝑻𝑻
(𝟏𝟏 + 𝒓𝒓) 𝟏𝟏 + 𝒓𝒓 𝟏𝟏 + 𝒓𝒓
The discount rate 𝒓𝒓:
• For investors: the required return
‒ The required compensation for the pure time value of money, risk, …
‒ The return the investor could otherwise earn from another similar investment
• For firms: the cost of capital
‒ The extra money the firm needs to pay to raise the capital for the investment
‒ The firm is willing to put money on the project only when the actual return is
higher (NPV>0 or IRR> 𝒓𝒓)

The cost of capital:
• For investors: the required return
‒ Compensation for the pure time value of money:
 Compensation for the lost purchasing power (due to inflation)
 Real value from investment required by investors
‒ Risk premium:
 Compensation for bearing risk due to uncertainties with the future cash flows
• For firms: the cost of capital
‒ Cost of equity: expected return of the stock
(percentage return from dividend payment = stock investors’ required return)
‒ Cost of debt: yield to maturity (YTM)
(return from coupon and principal payment = bond investors’ required return)
• In the market:
Cost of Capital = Required Return

• What determines the cost of capital:
Required return on the project:
‒ Compensation for the pure time value of money (same for all investments)
‒ Risk premium (depending on the risk of the investment)
• How to estimate the cost of capital:
Inferring from the market:
‒ Cost of equity + Cost of debt
‒ Costs of financial assets are determined by investors’ required returns on
assets with the same level of (systematic) risk
• Important principle:
The cost of capital depends primarily on the use of the funds (cash flows of the
investment), not the source of funding (equity or debt)

Firm A: high-risk investments Firm B: low-risk investments
High-risk cash flows Low-risk cash flows
Creditors Shareholders Creditors Shareholders

(Debt investors) (Equity investors) (Debt investors) (Equity investors)
High required returns by investors Low required returns by investors

(high risk premium) (low risk premium)

Firm A: high-risk investments Firm B: low-risk investments
What determine the risk

High-risk cash flows Low-risk cash flows premium & required return
Creditors Shareholders Creditors Shareholders

(Debt investors) (Equity investors) (Debt investors) (Equity investors)
What we observe from
High required returns by investors Low required returns by investors the capital market
(high risk premium) (low risk premium)

Today’s Roadmap
‒ Costs of debt
• Flotation Costs

Cost of Equity (Common Stocks)
• Cost of equity (𝑅𝑅𝐸𝐸 ):
The return required by equity investors, given the risk of the future cash flows
• Methods of estimating the cost of equity:

1) The Dividend Growth Model (DGM)
2) The Capital Asset Pricing Model (CAPM)

Estimating the Cost of Equity
• Basic Idea
‒ Under the constant-dividend-growth assumption:
𝐷𝐷1 𝐷𝐷0 × (1 + 𝑔𝑔)
𝑃𝑃0 = =
𝑅𝑅𝐸𝐸 − 𝑔𝑔 𝑅𝑅𝐸𝐸 − 𝑔𝑔
‒ Cost of equity (Required return on the stock):
𝐷𝐷1 𝐷𝐷0 × (1 + 𝑔𝑔)
𝑅𝑅𝐸𝐸 = + 𝑔𝑔 = + 𝑔𝑔
𝑃𝑃0 𝑃𝑃0
• Implementing in practice
‒ 𝑃𝑃0 : directly observed from the stock market
‒ 𝐷𝐷1 = 𝐷𝐷0 × (1 + 𝑔𝑔): 𝐷𝐷0 is directly observable
‒ 𝑔𝑔: needs to be estimated

𝐷𝐷1 𝐷𝐷0 × (1 + 𝑔𝑔)
𝑃𝑃0 𝑃𝑃0
• Estimating 𝑔𝑔:
Method I. Use historical growth rates
Example: a firm pays the following dividends every year between 2014-2018. Its current stock
price is $10. what is the required return on the firm’s stock?
Year Dividend
2014 $1.10
2015 $1.20
2016 $1.35
2017 $1.40
2018 $1.55

𝐷𝐷1 𝐷𝐷0 × (1 + 𝑔𝑔)
𝑃𝑃0 𝑃𝑃0
Year Dividend Dividend Growth (g)
2014 $1.10
2015 $1.20 9.09%
2016 $1.35 12.50%
2017 $1.40 3.70%
2018 $1.55 10.71%

𝐷𝐷1 𝐷𝐷0 × (1 + 𝑔𝑔)
𝑃𝑃0 𝑃𝑃0
‒ Historical average growth rate:
(9.09 + 12.50 + 3.70 + 10.71)
𝑔𝑔̅ = = 9%
4
‒ Cost of equity:
𝐷𝐷0 × (1 + 𝑔𝑔) $1.10 × (1 + 0.09)
𝑅𝑅𝐸𝐸 = + 𝑔𝑔 = + 0.09 = 20.99%
𝑃𝑃0 $10

𝐷𝐷1 𝐷𝐷0 × (1 + 𝑔𝑔)
𝑃𝑃0 𝑃𝑃0
Method II. Use analysts’ forecasts
‒ Forecasts could vary depending on different resources, and we may need to collect multiple
forecast and take the average of them

𝐷𝐷1 𝐷𝐷0 × (1 + 𝑔𝑔)
𝑃𝑃0 𝑃𝑃0
‒ Advantages:
 Easy to understand and use
‒ Disadvantages:
 The model is only applicable to dividend-paying firms with steady growth
 The estimation is very sensitive to the estimated growth rate 𝑔𝑔
 The model does not explicitly consider risk (risk is implicitly incorporated in 𝑃𝑃0 )

• Basic Idea
‒ The cost of equity (required return of the stock) is determined by its
systematic risk and the market risk premium:
𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × (𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 )
 𝑅𝑅𝑓𝑓 : risk-free rate
 𝛽𝛽𝐸𝐸 : systematic risk relative to that of the market portfolio
 (𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 ): market risk premium (𝐸𝐸 𝑅𝑅𝑀𝑀 : expected return of the market portfolio)
‒ 𝑅𝑅𝑓𝑓 : YTM of the government debt, directly observable from the market
‒ 𝛽𝛽𝐸𝐸 : estimated from the historical returns
‒ (𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 ): estimated from the historical returns
‒ 𝑅𝑅𝑓𝑓 : YTM of the government debt, directly observable from the market
 For US, use the YTM of the three-month treasury bill (sometimes we use the YTM of the
one-month treasury bill)
 For major Asian markets, use the YTM of the 10-year government bonds in the local
market (Mainland China, Hong Kong, Singapore, …)

‒ 𝛽𝛽𝐸𝐸 : estimated from the historical returns
 For many large publicly-traded companies, the estimated betas are available online

‒ (𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 ): estimated from the historical returns
 Many finance scholars have their estimations posted online
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#HistBenchmarks

• Example:
A US firm has an equity beta of 1.2. The current YTM on the 3-month treasury bill is
1.5% and the market risk premium is 15%. What is the cost of equity?
𝑅𝑅𝐸𝐸 = 1.5% + 1.2 × 15% = 19.5%

‒ Advantages:
 The model explicitly adjust for risk
 It is applicable to companies without steady dividend growth
(it could be applied for any companies as long as the equity beta could be estimated)
‒ Disadvantages:
 Both the beta and the market risk premium have to be estimated
• These two items vary over time
• We need to use the historical returns to predict the future

Cost of Preferred Stock
• Preferred stock:
‒ Usually pays a constant dividend every period
‒ The constant dividend payment is expected to last forever
• Preferred stock valuation:
‒ All relevant future cash flows (dividends) form a perpetuity
𝐷𝐷
𝑃𝑃0 =
𝑅𝑅𝑃𝑃
• Cost of preferred stock (𝑅𝑅𝑃𝑃 ):
𝐷𝐷
𝑅𝑅𝑃𝑃 =
𝑃𝑃0

Cost of Debt
• Cost of Debt (𝑅𝑅𝐷𝐷 ):
‒ The return required by creditors (debt investors) for them to be willing to lend
to the firm
‒ Similar to the cost of equity, the cost of debt is also determined by the
relevant cash flows (coupon and principal payments) and risk (credit risk)
• Estimating the cost of debt:
‒ YTM of the firm’s existing debt
(a direct cash-flow based estimation)
‒ YTM of other debts with the same maturity and credit rating
(a risk-based estimation)
‒ Warning: coupon rate is NOT relevant!
 It tells us something about the cost of the existing debt when they are issued
 It does not tell anything about the cost of debt today (the cost of new borrowing)

Estimating the Cost of Debt
• Example:
Assume a firm’s outstanding bond has 20 years to maturity and a 10% coupon rate
with semiannual payment. The bond currently sells at $919.77. What is the cost of
debt for this firm?
20×2
10% 1 − 1/ 1 + 𝑌𝑌𝑌𝑌𝑌𝑌/2 1
𝑃𝑃𝐷𝐷 = $1,000 × × + $1,000 × 20×2
= $919.77
2 𝑌𝑌𝑌𝑌𝑌𝑌/2 𝑌𝑌𝑌𝑌𝑌𝑌/2
‒ Using the trial-and-error method,

𝑌𝑌𝑌𝑌𝑌𝑌 = 11%
‒ The cost of debt is 11%

After-Tax Cost of Debt
• Interest payment is tax-deductible:
‒ Every $1 of interest payment reduces tax by $1×T
• Total interest payment:
‒ 𝑅𝑅𝐷𝐷 × 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
• Interest tax shield:
‒ (𝑅𝑅𝐷𝐷 × 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) × 𝑇𝑇𝐶𝐶
• Interest payment net of tax shield:
‒ (𝑅𝑅𝐷𝐷 × 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) × (1 − 𝑇𝑇𝐶𝐶 )
• After-tax cost of debt:

𝑅𝑅𝐷𝐷 × (1 − 𝑇𝑇𝐶𝐶 )

After-Tax Cost of Debt
• After-tax cost of debt:
𝑅𝑅𝐷𝐷 × (1 − 𝑇𝑇𝐶𝐶 )
‒ 𝑇𝑇𝐶𝐶 : corporate tax rate

 Ideally, we should use the marginal tax rate (the tax rate on the last dollar of net income)
 In practice, marginal tax rate may not be easily found and sometimes we use the average
tax rate
• Tax and cost of equity:

‒ Dividend payment is not tax deductible for corporations
‒ Tax does not affect cost of equity

Today’s Roadmap
‒ Costs of debt
• Flotation Costs

The Weighted Average Cost of Capital (WACC)
• Basic idea of WACC:
The cost of capital reflects the mix of the cost of equity and the cost of debt
 Notice that the cost of capital is determined by the risk of the firm’s cash flows, not by
the costs of equity and debt
 But the costs of equity and debt tell us: given the risk, what are investors’ required
returns on this firm’s equity and debt
 We can therefore infer the cost of capital based on the market perception of the risk on
the firm’s equity and debt (which is determined by the market returns)
• Steps of WACC calculation:
1) Estimating the capital structure weights
 By how much the firm uses equity and debt financing

Estimating the capital structure weights
• Basic idea:
‒ For the total value of the firm, how much is claimed by equity investors (shareholders) and
how much is claimed by debt investors (creditors)
‒ All estimations should be based on the market values
• Market value of equity (E):
‒ Number of shares outstanding multiplied by the market price per share
• Market value of debt (D):
‒ Long-term debt that is publicly traded: market price per bond multiples by the number of
bonds
‒ Long-term debt that is not publicly traded: market value estimated based on YTM of similar
publicly traded debt
‒ Short-term debt: use the book value as a proxy for the market value

• Market value of equity (E):
‒ Number of shares outstanding multiplied by the market price per share
• Market value of debt (D):
‒ Long-term publicly traded debt: market price per bond multiples by the number of bonds
‒ Long-term privately held debt: market price estimated based on YTM of similar publicly
traded debt
‒ Short-term debt: use the book value as a proxy for the market value
• Total value of the firm (V):
V=E+D
• Capital Structure Weights:
100% = E/V + D/V
‒ E/V: equity weight
‒ D/V: debt weight

• Example:
A firm has 100 million shares of stock outstanding, and each share sells for $5. It also has 250,000
bonds, each with principal value $1,000 and current market price $960. what are the firm’s capital
structure weights?
‒ Total equity value:
𝐸𝐸 = $5 × 100𝑚𝑚 = $500 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
‒ Total debt value:
𝐷𝐷 = $960 × 250,000 = $240 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
‒ Total firm value:
𝑉𝑉 = 𝐸𝐸 + 𝐷𝐷 = $500 + 240 = $740 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
‒ Equity weight:
𝐸𝐸 $500
= = 67.57%
𝑉𝑉 740
‒ Debt weight:
𝐷𝐷 $240
= = 32.43%
𝑉𝑉 740

The Weighted Average Cost of Capital (WACC)
• Basic idea of WACC:
The cost of capital reflects the mix of the cost of equity and the cost of debt
 Notice that the cost of capital is determined by the risk of the firm’s cash flows, not by
the costs of equity and debt
 But the costs of equity and debt tell us: given the risk, what are investors’ required
returns on this firm’s equity and debt
 We can therefore infer the cost of capital based on the market perception of the risk on
the firm’s equity and debt (which is determined by the market returns)
• Steps of WACC calculation:
1) Estimating the capital structure weights
 By how much the firm uses equity and debt financing
2) Calculating the “average” costs based on the mix of equity and debt
 If the firm uses more equity than debt, then the cost of equity tells us more about the
overall cost of capital, vice versa
(we need to calculate the “weighted average”)

Calculating WACC
• The Weighted Average Cost of Capital (WACC):
‒ WACC is the costs of equity and debt, weighted by the corresponding capital
structure weights, and then added up:
𝑬𝑬 𝑫𝑫
𝑾𝑾𝑾𝑾𝑾𝑾𝑾𝑾 = × 𝑹𝑹𝑬𝑬 + × 𝑹𝑹𝑫𝑫 × (𝟏𝟏 − 𝑻𝑻𝑪𝑪 )
𝑽𝑽 𝑽𝑽
𝐸𝐸
 : equity weight
𝑉𝑉
 𝑅𝑅𝐸𝐸 : cost of equity
𝐷𝐷
 : debt weight
𝑉𝑉
 𝑅𝑅𝐷𝐷 : cost of debt (before tax)
 𝑇𝑇𝐶𝐶 : corporate tax rate
 𝑅𝑅𝐷𝐷 × (1 − 𝑇𝑇𝐶𝐶 ): after-tax cost of debt

Calculating WACC
• Example (continued):
The same firm we just discussed has an equity beta of 0.8. Its bond has 20 years to maturity and 8%
coupon rate with semiannual payment. Assume the market risk premium is 15% and the risk-free
rate is 2%. The corporate tax rate is 40%. What is the firm’s weighted average cost of capital?
• Cost of equity:
𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × 𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 = 2% + 0.8 × 15% = 14%
• Cost of debt:
𝑅𝑅𝐷𝐷 = 8.4%
8% 1−1/ 1+𝑅𝑅𝐷𝐷 /2 20×2 1
‒ Solution for: $960 = $1,000 × × + $1,000 ×
2 𝑅𝑅𝐷𝐷 /2 1+𝑅𝑅𝐷𝐷 /2 20×2
• WACC:
𝐸𝐸 𝐷𝐷
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = × 𝑅𝑅𝐸𝐸 + × 𝑅𝑅𝐷𝐷 × 1 − 𝑇𝑇𝐶𝐶
𝑉𝑉 𝑉𝑉
= 67.57% × 14% + 32.43% × 8.4% × 1 − 40% = 11.09%

Calculating WACC
• The Weighted Average Cost of Capital (WACC):
‒ WACC is the costs of equity (common stock and preferred stock) and debt,
weighted by the corresponding capital structure weights, and then added up:
𝑬𝑬 𝑷𝑷 𝑫𝑫
𝑾𝑾𝑾𝑾𝑾𝑾𝑾𝑾 = × 𝑹𝑹𝑬𝑬 + × 𝑹𝑹𝑷𝑷 + × 𝑹𝑹𝑫𝑫 × (𝟏𝟏 − 𝑻𝑻𝑪𝑪 )
𝐸𝐸
𝑽𝑽 𝑽𝑽 𝑽𝑽
 : common stock weight
𝑉𝑉
 𝑅𝑅𝐸𝐸 : cost of common stock
𝐸𝐸
 : preferred stock weight
𝑉𝑉
 𝑅𝑅𝐸𝐸 : cost of preferred stock
𝐷𝐷
 : debt weight
𝑉𝑉
 𝑅𝑅𝐷𝐷 : cost of debt (before tax)
 𝑇𝑇𝐶𝐶 : corporate tax rate
 𝑅𝑅𝐷𝐷 × (1 − 𝑇𝑇𝐶𝐶 ): after-tax cost of debt

Use of WACC
• Investment evaluation
The weighted average cost of capital is the discount rate when we evaluate
investments under the discounted cash flow method (e.g. NPV analysis)
WARNING:
‒ WACC reflects the risk of the entire firm’s overall cash flows (those generated from existing
assets/investments), not any specific project’s
‒ In specific project evaluation, WACC is the appropriate discount rate only when the project
has the same risk as the entire firm’s existing business
‒ In practice, if we are evaluating a project that is an integral part of the overall existing
business (e.g. renovation of the distributional system, cost-cutting plan, etc.) usually we
assume a project is in the same risk class as the entire firm

Use of WACC
• Performance Evaluation
‒ Basic idea:
If the operating profits exceed the cost of capital, then the firm is making money in an
ECONOMIC sense (the economic profit is positive)
‒ Economic Value Added (EVA):
Net Operating Profit After Taxes (NOPAT) - Invested Capital × WACC
 Invested Capital = Total Assets– Current Liabilities
‒ Evaluation criterion:
When EVA > 0, the firm increases value of shareholders, as it creates more value than the
costs of raising money (or the return required by investors)

WACC: A More Comprehensive Example
Equity Debt
• Common stock: • Long-term public debt (bond):
‒ 1 billion shares of common stock ‒ 1 million bonds with 10 years to maturity
outstanding, $5 per share now and 5% coupon rate with semiannual
‒ Beta is 1.5 and the market risk premium payment, currently sells at $980
is 12%; risk-free rate is 2% • Private debt
‒ Dividend growth is expected to be 2% ‒ Total face value of 1 billion and same
and this year’s dividend payment is $1 maturity and risk as the public debt
• Preferred stock: (assume pure discount loan)
‒ 100 million shares of preferred stock • Short-term debt
outstanding, $10 per share now ‒ Book value of $500 million and 4%
‒ A constant dividend of $1.5 is expected to interest rate
be paid annually forever
• Corporate tax rate: 40%

• Value of common stock:
𝐸𝐸 = $5 × 1𝑏𝑏 = $5 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
• Cost of common stock:
‒ Using CAPM:
𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × 𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 = 2% + 1.5 × 12% = 20%
‒ Using DGM:
𝐷𝐷0 × (1 + 𝑔𝑔) $1 × (1 + 0.02)
𝑅𝑅𝐸𝐸 = + 𝑔𝑔 = + 2% = 22.4%
𝑃𝑃0 $5
‒ Taking the average of two estimations:
20% + 22.4%
𝑅𝑅𝐸𝐸 = = 21.2%
2

• Value of preferred stock:
𝑃𝑃 = $10 × 100𝑚𝑚 = $1 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
• Cost of preferred stock:

𝐷𝐷 $1.5
𝑅𝑅𝑃𝑃 = = = 15%
𝑃𝑃0 $10

• Value of long-term public debt (𝐷𝐷1 ):
𝐷𝐷1 = $980 × 1𝑚𝑚 = $0.98 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
• Cost of long-term public debt (𝑅𝑅𝐷𝐷𝐷 ):
5% 1−1/ 1+𝑅𝑅𝐷𝐷1 /2 10×2 1
𝑅𝑅𝐷𝐷𝐷 solves for: $980 = $1,000 × × + $1,000 × 1+𝑅𝑅𝐷𝐷1 /2 10×2
2 𝑅𝑅𝐷𝐷1 /2
𝑅𝑅𝐷𝐷𝐷 = 5.26%
• Value of long-term private debt (𝐷𝐷2 ):
$1𝑏𝑏
𝐷𝐷2 = 10×2
= $0.595 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
1 + 𝑅𝑅𝐷𝐷𝐷 /2
• Cost of long-term public debt (𝑅𝑅𝐷𝐷2 ):
𝑅𝑅𝐷𝐷2 = 𝑅𝑅𝐷𝐷𝐷 = 5.26%
• Value of short-term debt (𝐷𝐷3 ):
𝐷𝐷3 = $0.5 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
• Cost of short-term debt (𝑅𝑅𝐷𝐷3 ):
𝑅𝑅𝐷𝐷𝐷 = 4%

• Total value of debt:
𝐷𝐷 = 𝐷𝐷1 + 𝐷𝐷2 + 𝐷𝐷3 = $0.98 + $0.595 + $0.5 = $2.075 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
• Overall cost of debt:

(Weighted average across all debt instruments)
𝐷𝐷1 𝐷𝐷2 𝐷𝐷3

𝑅𝑅𝐷𝐷 = × 𝑅𝑅𝐷𝐷𝐷 + × 𝑅𝑅𝐷𝐷2 + × 𝑅𝑅𝐷𝐷3
𝐷𝐷 𝐷𝐷 𝐷𝐷
$0.98 $0.595 $0.5
= × 5.26% + × 5.26% + × 4%
$2.075 $2.075 $2.075
𝑅𝑅𝐷𝐷 = 4.96%

• Total value of the firm:
𝑉𝑉 = 𝐸𝐸 + 𝑃𝑃 + 𝐷𝐷 = $5 + $1 + $2.075 = $8.075 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
• Weighted Average Cost of Capital (WACC):
𝐸𝐸 𝑃𝑃 𝐷𝐷
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = × 𝑅𝑅𝐸𝐸 + × 𝑅𝑅𝑃𝑃 + × 𝑅𝑅𝐷𝐷 × 1 − 𝑇𝑇𝐶𝐶
𝑉𝑉 𝑉𝑉 𝑉𝑉
$5 $1 $2.075
= × 21.2% + × 15% + × 4.96% × 1 − 40%
$8.075 $8.075 $8.075
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 16.26%

This firm is evaluating a cost-cutting plan which costs $50 million today and will
increase its cash flow by $10 million per year over the next 10 years. Is this a
valuable plan?
1
1− 10
1 + 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
𝑁𝑁𝑁𝑁𝑁𝑁 = −$50 + $10 × = −2.13 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊

Today’s Roadmap
‒ Costs of debt
• Flotation Costs

Divisional and Project Costs of Capital
• WACC applies to an investment evaluation if the investment has the same risk as
the entire firm’s existing business
For example:
‒ An integral part of the overall existing business: expanding production or markets
‒ Opening the same business in a new location/ market (which is similar to the existing
location/market)
• WACC does NOT apply to an investment evaluation if the investment has different
risk from the entire firm’s existing business
For example:
‒ Starting a new project (that is different from the average of the existing projects)
‒ Integral change for one division in a multi-division corporation

Problems of using WACC for projects or divisions with different risk:
Example:
Think about an all-equity firm with 𝛽𝛽𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 = 1. The firm is evaluating two new independent
projects, A and B. Project A has a systematic risk measured by 𝛽𝛽𝐴𝐴 = 0.6, while project B has
𝛽𝛽𝐵𝐵 = 1.2; after evaluating the two projects’ cash flows, we know that project A has an
expected return (IRR) of 14% and project B has an expected return of 16%. The risk-free rate is
7% and the market risk premium is 8%.
‒ For the overall firm:
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 × 𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 = 15%
‒ For project A, the required return is:
𝑅𝑅𝐴𝐴 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐴𝐴 × 𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 = 11.8%
‒ For project B, the required return is:
𝑅𝑅𝐵𝐵 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐵𝐵 × 𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 = 16.6%

Example:
For project A:
‒ If we use 𝑅𝑅𝐴𝐴 as the required return (the correct project cost of capital)
𝐼𝐼𝐼𝐼𝐼𝐼𝐴𝐴 = 14% > 𝑅𝑅𝐴𝐴 = 11.8%: project A has positive NPV
‒ If we use WACC as the required return
𝐼𝐼𝐼𝐼𝐼𝐼𝐴𝐴 = 14% < 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 15%, we mistakenly reject good investment

Example:
For project B:
‒ If we use 𝑅𝑅𝐵𝐵 as the required return (the correct project cost of capital)
𝐼𝐼𝐼𝐼𝐼𝐼𝐵𝐵 = 16% < 𝑅𝑅𝐵𝐵 = 16.6%: project B has negative NPV
‒ If we use WACC as the required return
𝐼𝐼𝐼𝐼𝐼𝐼𝐵𝐵 = 16% > 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 15%, we mistakenly accept bad investment


Solution I. The Pure Play Approach
• Basic idea:
Infer the project or divisional cost of capital from similar investments outside the firm
• A pure play:
A company that focuses on a single line of business
• The Pure Play Approach:
Estimate the costs of capital of pure plays in the same business sector, and use (the average of)
them as the project/divisional cost of capital
• Example:
If you are evaluating a project on personal computer and network server business, then Dell is
potentially a pure play, but HP is not.

Solution II. The Subjective Approach
• The Subjective Approach:
‒ Subjectively determine a few risk classes and corresponding discount rate for each class
‒ Assign each project into a specific subject risk class
• Example:
For a firm with WACC=14%, it could place all proposed projects into the following categories:

Solution II. The Subjective Approach

Today’s Roadmap
‒ Costs of debt
• Flotation Costs

Flotation Costs
• Definition:
The (transactional) costs related to issuing new bonds and stock
‒ underwriting fees, legal fees, registration fees, …
Actual amount needed = Total amount raised × (1 - %flotation cost)
• Example:
A full-equity firm needs $100 million to invest in a new project. The flotation
cost of issuing additional equity is 10%. How much new equity should the firm
issue in total?
‒ Actual amount needed = $100 million
$100 million = Total amount raised × (1-10%)
Total amount raised = $100 million / (1-10%) = $111.11 million
Dollar flotation cost = $111.11 – 100 = $11.11 million

Flotation Costs
• Calculation
When the flotation costs of issuing new bonds and stock are different (which is
usually true), we need to calculated the weighted average flotation cost:
𝐸𝐸 𝐷𝐷
𝑓𝑓𝐴𝐴 = × 𝑓𝑓𝐸𝐸 + × 𝑓𝑓𝐷𝐷
𝑉𝑉 𝑉𝑉
𝐸𝐸
 : equity weight
𝑉𝑉
 𝑓𝑓𝐸𝐸 : flotation cost of issuing new stock
𝐷𝐷
 : debt weight
𝑉𝑉
 𝑅𝑅𝐷𝐷 : flotation cost of issuing bond
𝐸𝐸 𝐷𝐷
‒ NOTICE: and should be the target weights, not the actual weights
𝑉𝑉 𝑉𝑉

Flotation Costs
• Flotation costs are financing costs:
‒ They should not be included in our original project evaluation
• Flotation costs affect our actual cash flows:
‒ We still need to think about them as an extension of our NPV analysis
Example:
A firm’s target debt-equity ratio is 1. It is considering a new investment (which has the same
risk as the entire firm’s existing business) with $500,000 initial cost and cash flows of $72,000
per year forever. The tax rate is 34% and the firm’s current capital structure is at its target. The
required return is 20% for the firm’s stock and 10% for its debt. Flotation costs of issuing new
stock and debt are 10% and 6% respectively.

Flotation Costs
Example:
‒ Project evaluation:
𝐸𝐸 𝐷𝐷
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = × 𝑅𝑅𝐸𝐸 + × 𝑅𝑅𝐷𝐷 × 1 − 𝑇𝑇𝐶𝐶 = 0.5 × 20% + 0.5 × 10% × 1 − 0.34
𝑉𝑉 𝑉𝑉
= 13.3%
$72,000
𝑁𝑁𝑁𝑁𝑁𝑁 = −$500,000 + = $41,353
0.133

Flotation Costs
Example:
‒ Percentage flotation cost:
𝐸𝐸 𝐷𝐷
𝑓𝑓𝐴𝐴 = × 𝑓𝑓𝐸𝐸 + × 𝑓𝑓𝐷𝐷 = 0.5 × 10% + 0.5 × 6% = 8%
𝑉𝑉 𝑉𝑉
‒ Dollar flotation cost:

$500,000
− $500,000 = $43,478
1 − 0.08
‒ NPV – flotation cost:

$41,353 − $43,478 = −$2,125

Flotation Costs
Example:
• NPV>0:
‒ The project itself is valuable
• NPV – flotation cost<0:
‒ With flotation cost, the project cannot add (net-of-finance-cost) value to this firm

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FINA1310EFG CORPORATE FINANCE

Lecture 10. Cost of Capital

Instructor: Dr. Mingzhu TAI

Spring semester, 2018-2019

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 2

• Textbook Reading: Chapter 11

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• Textbook Reading: Chapter 14

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• Textbook Reading: Chapter 14

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Firm A: high-risk investments Firm B: low-risk investments

High-risk cash flows Low-risk cash flows

Creditors Shareholders Creditors Shareholders

High required returns by investors Low required returns by investors

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 10

Firm A: high-risk investments Firm B: low-risk investments

What determine the risk

Creditors Shareholders Creditors Shareholders

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• Textbook Reading: Chapter 14

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 12

• Methods of estimating the cost of equity:

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𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × (𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 )

𝑅𝑅𝐸𝐸 = 1.5% + 1.2 × 15% = 19.5%

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 24

𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × (𝐸𝐸 𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 )

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 25

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‒ Using the trial-and-error method,

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 28

• After-tax cost of debt:

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 29

‒ 𝑇𝑇𝐶𝐶 : corporate tax rate

• Tax and cost of equity:

FINA1310EFG, 2018-2019 Lecture 10: Cost of Capital 30

• Textbook Reading: Chapter 14

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