Cost of Capital

Chapter 11
 Learning Objectives
1. Describe the concepts underlying the firm’s cost of
capital (its weighted average cost of capital) and
the purpose for its calculation.
2. Calculate the after-tax cost of debt, preferred
stock, and common equity.
3. Calculate a firm’s weighted average cost of
capital.
4. Describe the procedure used by PepsiCo to
estimate the cost of capital for a multidivisional
firm. Keown, Martin, Petty - Chapter 11 2
Learning Objectives
7. Use the cost of capital to evaluate new
investment opportunities.
8. Compute the economic profit earned by the
firm and use this quantity to calculate
incentive-based compensation.
9. Calculate equivalent interest rates for
different countries.

Keown, Martin, Petty - Chapter 11 3

Slide Contents
1. Principles Used in this Chapter
2. Cost of Capital: Key Definitions and Concepts
3. Computing the Cost of Individual Sources of Capital
4. The Weighted Average Cost of Capital
5. Calculating cost of capital for PepsiCo, Inc.
6. Cost of Capital and New Investment
7. Shareholder Value-Based Management
8. Multinational Firms and Interest Rates

Keown, Martin, Petty - Chapter 11 4

1. Principles Used in this Chapter
 Principles Used in this Chapter
◼ Principle 1:
◼ The Risk-Return Trade-Off – We Won’t Take on Additional
Risk Unless We Expect to Be Compensated with Additional
Return.

◼ Principle 2:
◼ The Time Value of Money – A Dollar Received Today is Worth
More Than a Dollar Received in the Future.

◼ Principle 3:
◼ Cash-Not Profits-Is King

Keown, Martin, Petty - Chapter 11 6

 Principles Used in this Chapter
◼ Principle 6 :
◼ Efficient Capital Markets – The Markets Are Quick and the
Prices Are Right.
◼ Principle 7 :
◼ The Agency Problem –Managers Won’t Work for the Owner
Unless It’s in Their Best Interest.
◼ Principle 8 :
◼ Taxes Bias Business Decisions.
◼ Principle 9 :
◼ All Risk Is Not Equal – Some Risk Can Be Diversified Away
and Some Cannot.
Keown, Martin, Petty - Chapter 11 7
2. Cost of Capital: Key
Definitions and Concepts
Capital
◼ Capital represents the funds used to finance a
firm's assets and operations. Capital
constitutes all items on the right hand side of
a balance sheet i.e. liabilities and common
equity.

◼ Main sources: Debt, Preferred stock, Retained

earnings and Common Stock

Keown, Martin, Petty - Chapter 11 9

Cost of Capital
◼ Cost of capital is the return/interest the
investors/lenders require on their capital (for example,
a corporation has to pay interest on bonds).
◼ Cost of capital can also be regarded as the hurdle rate
that must be achieved by an investment before it will
increase shareholder wealth.
◼ Cost of capital provides the basis for evaluating division
or firm performance.

Keown, Martin, Petty - Chapter 11 10

Cost of Capital

Cost of Capital is also called:

◼ Hurdle rate for new investment

◼ Discount rate
◼ Opportunity cost of funds
◼ Required rate of return

Keown, Martin, Petty - Chapter 11 11

Investor’s Required Rate of Return

◼ Investor’s Required Rate of Return – the

minimum rate of return necessary to attract
an investor to purchase or hold a security.

◼ Investor’s required rate of return is not the

same as cost of capital due to taxes and
transaction costs.
◼ For example, a firm may pay 8% interest on debt
but due to tax benefit on interest expense, the net
cost to the firm will be lower than 8%.
Keown, Martin, Petty - Chapter 11 12
◼ Impact of transaction costs on cost of capital:
For example, If a firm sells new stock for
$50.00 a share and incurs $5 in flotation
costs, and the investors have a required rate
of return of 15%, what is the cost of capital?
◼ The firm has only $45.00 to invest after
transaction cost.
◼ .15 x $50.00 = $7.5
k= $7.5 / ($45.00)
= .1667 or 16.67% (rather than 15%)
Keown, Martin, Petty - Chapter 11 13
Financial Policy
◼ A firm’s financial policy indicates the
desired sources of financing and the
particular mix in which it will be used.

◼ For example, a firm may choose to raise

capital by issuing stocks and bonds in
the ratio of 6:4 (60% stocks and 40%
bonds).

Keown, Martin, Petty - Chapter 11 14

Weighted Average Cost of Capital
(WACC)
◼ Combined costs of all the sources of
financing used by the firm. The weighted
average of the after-tax costs of each of
the sources of capital used by a firm to
finance a project where the weights
reflect the proportion of total financing
from each source.

Keown, Martin, Petty - Chapter 11 15

3. Computing the Cost of
Individual Sources of Capital

Cost of Debt, Preferred stock and

Common equity
The Cost of Debt

◼ The investor’s required rate of return on debt

is simply the return that creditors demand on
new borrowing.

Keown, Martin, Petty - Chapter 11 17

Cost of Debt
◼After tax cost of debt = kd(1-Tc)
= Before tax cost of capital less the effect
of tax savings

Example: Debt at 9.75% and tax rate of 34%

◼ After-tax cost of debt = .0975(1-.34)

= 6.435%
Keown, Martin, Petty - Chapter 11 18
Cost of Preferred Stock
◼ Cost of Preferred Stock:
K ps = Dp/Pn
◼ Pn = net price (i.e. Issue price – Floatation costs)
◼ Dp = Preferred stock dividend per share

Example: Determine the cost for a preferred stock

that pays an annual dividend of $4.25, has a current
stock price of $8.50 and incurs flotation costs of
$1.375 per share.
Cost = $4.25/(8.50 -1.375) = .074 or 7.44%

Keown, Martin, Petty - Chapter 11 19

Common Equity
◼ Sources:
◼ Retained earnings
◼ Sale of new shares

◼ There is no flotation cost on retained

earnings.
◼ Retained earnings are not a free source of
capital.

Keown, Martin, Petty - Chapter 11 20

Cost estimation challenges
◼ Cost of equity is more challenging to estimate
than cost of debt or cost of preferred stock
because common stockholder’s rate of return
is not fixed. Furthermore, the costs will vary
for two sources of equity (i.e. retained
earnings and new issue).

Keown, Martin, Petty - Chapter 11 21

Cost estimation techniques
◼ Two commonly used methods for
estimating common stockholder’s required
rate of return are:
1. Dividend Growth Model
2. Capital Asset Pricing Model

Keown, Martin, Petty - Chapter 11 22

Dividend Growth Model

◼ Investors’ required rate of return (For

Retained Earnings):
Kcs = D1/Pcs+ g

◼ D1 = Dividends expected one year hence

◼ Pcs = Price of common stock
◼ g= growth rate
Keown, Martin, Petty - Chapter 11 23
Dividend Growth Model
◼ Investors’ required rate of return (For
new issues)
Kpcs = D1/NPcs + g

◼ D1 = Dividends expected one year hence

◼ Pcs = Net proceeds per share
◼ g= growth rate
Keown, Martin, Petty - Chapter 11 24
Dividend Growth Model
Example: A company expects dividends this year to be
$2.20, based upon the fact that $2 were paid last year.
The firm expects dividends to grow 10% next year and
into the foreseeable future. Stock is trading at $50 a
share.
Cost of retained earnings:
Kcs = D1/Pcs+ g
2.20/50 + .10 = .144 or 14.4%
Cost of new stock:
Kncs = D1/NPcs +g
2.20/(50-7.50) + .10 = .1518 or 15.18%
Keown, Martin, Petty - Chapter 11 25
Dividend Growth Model
◼ Dividend growth model is simple to use but
suffers from the following drawbacks:

◼ It assumes a constant growth rate.

◼ The growth rate is then not easy to

forecast.

Keown, Martin, Petty - Chapter 11 26

Capital Asset Pricing Model
kc = krf + (km – krf)

Krf = Risk Free rate

 = Beta
km – krf = Market Risk Premium or
Expected rate of return for
“average security” minus the risk
free rate, km – krf
Keown, Martin, Petty - Chapter 11 27
Capital Asset Pricing Model

Example: If beta is 1.4, risk-free rate is

3.75% and expected market rate is 12%

kc = krf + B(km – krf)

= .0375 + 1.4(.12 - .0375)

= 15.3%
Keown, Martin, Petty - Chapter 11 28
Capital Asset Pricing Model
Variable estimates
◼ CAPM is easy to apply. Also, the estimates for model
variables are generally available from public sources.
◼ Risk Free Rate: Wide range of US government
securities on which to base risk-free rate.
◼ Beta: Estimates of beta available from a wide range
of services, or can be estimated using regression
analysis of historical data.
◼ Market risk premium: It can be estimated by looking
at history of stock returns and premium earned over
risk-free rate.
Keown, Martin, Petty - Chapter 11 29
4. The Weighted Average Cost of
Capital
 Bringing it all together: WACC
◼ To estimate WACC, we need to know the
capital structure mix and the cost of each of
the sources of capital.
◼ For a firm with only two sources: debt and
equity,
WACC = (After tax cost of debt X proportion
of debt financing) + (Cost of equity X
proportion of equity financing)
Keown, Martin, Petty - Chapter 11 31
WACC Example
A firm borrows money at 7% after taxes
and pays 12% for equity. The company
raises capital in equal proportions –
50/50.

WACC = (.07 X .5) + (.12 X .5) = .095

or 9.5%

Keown, Martin, Petty - Chapter 11 32

WACC: Summary

Keown, Martin, Petty - Chapter 11 33

WACC example: Ash Inc.

Keown, Martin, Petty - Chapter 11 34

Keown, Martin, Petty - Chapter 11 35
5. Calculating Cost of Capital
for PepsiCo, Inc.
PepsiCo

◼ PepsiCo calculated divisional cost of capital for

each of its three major divisions: restaurants,
food, and beverages.
◼ The target ratios for debt/equity mix and the
pre-tax cost of debt were different for each
division.

Keown, Martin, Petty - Chapter 11 37

◼ PepsiCo estimated the WACC for each
division in a 3 step process:
◼ Estimate the cost of debt for each division
◼ Estimate the cost of equity for each
division
◼ Estimate the WACC (with target capital
structure for each division)

Keown, Martin, Petty - Chapter 11 38

Pepsi Co’s Cost of Debt
Division Pretax (1-tax rate) After-tax
Cost of cost of debt
Debt
Rest 8.93% X 0.62 = 5.54%

Snack Foods 8.43% X 0.62 = 5.23%

Beverages 8.51% X 0.62 = 5.28%

Keown, Martin, Petty - Chapter 11 39

Pepsi Co’s Cost of Equity
Division Risk Beta (Exp. Mkt ret- Cost of
Free Risk free rate) equity
Rate
Rest 7.28% X 1.17 X (11.48%-7.28%) = 12.19%

Snack 7.28% X 1.02 X (11.48%-7.28%) = 11.56%

Foods

Beverages 7.28% X 1.07 X (11.48%-7.28%) = 11.77%

Keown, Martin, Petty - Chapter 11 40

Pepsi Co’s WACC
Division Cost of After-tax cost of WACC
Equity X debt X the target
Target debt ratio
Equity
Ratio
Restaurant (12.20%) + (5.54%) = 10.20%
(0.70) (0.30)

Snack (11.56%) + (5.23%) = 10.29%

Foods (0.80) (0.20)

Beverages (11.77%) + (5.28%) = 10.08%

(0.74) (0.26)

Keown, Martin, Petty - Chapter 11 41

6. Cost of Capital and New Investment
Cost of Capital and New Investment
◼ Cost of capital can serve as the discount rate
in evaluating new investment when the
projects offer the same risk as the firm as a
whole.

◼ If risk differs, it is better to calculate a

different cost of capital for each division.

Keown, Martin, Petty - Chapter 11 43

7. Shareholder
Value-Based Management
How much value has a firm
created for its owners?
◼ Compute the Market Value added (MVA). MVA
measures the wealth created by a firm at a
particular point in time.
◼ MVA = Total market value of the firm –
Invested capital
◼ Market value of the Firm = Market value of the
firm’s outstanding debt + market value of
preferred stock + market value of the firm’s
common stock

Keown, Martin, Petty - Chapter 11 45

How to evaluate performance
over a period of time?

◼ Compute Economic Profit (EP)

= Accounting profit less a charge for
use of capital
= Net operating profit after tax (NOPAT)
– invested capital X cost of capital

Keown, Martin, Petty - Chapter 11 46

Kmart Example
EP = NOPAT – (Invested capital X cost of capital)

($568.979M) = 950M – ($19,727M X .0770)

Note: NOPAT represents a return of 4.82% while cost of
capital is 7.70% leading to negative economic profit.

◼ As long as Kmart continues to earn a return on invested

capital that is lower than its cost of capital, shareholder
value declines.
◼ Kmart declared bankruptcy in Jan 2002
Keown, Martin, Petty - Chapter 11 47
How to increase Economic Profit?
Economic profits will increase if:
(a) NOPAT increases without a corresponding
increase in the cost of capital.
(b) Firm invests in projects that earn more
than the firm’s cost of capital.
(c) Firm’s capital charge (cost of capital *
invested capital) is reduced.

Keown, Martin, Petty - Chapter 11 48

 Economic Profit
Domtar Corp. increased NOPAT and economic profit by
identifying the following operating efficiencies:
◼ Cutting down on waste and damaged products.
◼ Operating machinery and equipment more efficiently.
◼ Improving product mix, devising methods to save on the
purchase of raw materials.
◼ Improving health and safety performance, attracting and
retaining new customers.
◼ Making better use of time in the office and the plant,
implementing or improving preventative maintenance
programs.
◼ Developing links with suppliers.
Keown, Martin, Petty - Chapter 11 49
 How to link Pay for Performance and
Wealth Creation?

◼ Base manager’s incentive

compensation on economic profit

Actual
Economic
Incentive Base % of Incentive
= X X Profit/target
Compensation Pay Compensation
economic
profit

Keown, Martin, Petty - Chapter 11 50

Example: Base pay $100K/yr. + 30% incentive
compensation, with a target economic profit
$1M and an earned profit of $1.25M

Incentive
Compensation
= $100K X .30 X $1.2M/$1m

Incentive Compensation = $37,500

Total compensation
= $100,000 + $37,500= $137,500
Keown, Martin, Petty - Chapter 11 51
8. Multinational Firms and
Interest Rates
Multinational Firms and
Interest Rates

◼ In an international setting, there can be

different rates of inflation among different
countries.
◼ The Fisher Model indicates that the nominal
interest rate in the home or domestic country
is a function of real interest rates and
anticipated rate of inflation.

Keown, Martin, Petty - Chapter 11 53

Fisher Model and Domestic
Interest Rates
rn,h = (1 + r r,h)(1 + ih) – 1

rn,h = Nominal rate of interest at home

r r,h = real interest rate at home
Ih = inflation rate at home

Example: If real interest rate is 3% and inflation rate is

5%, nominal rate will be 8.15%

(1.03)(1.05) – 1 = 8.15%
Keown, Martin, Petty - Chapter 11 54
International or Foreign Rates
and Fisher Effect

rn,h - rn,f = ih – if

Differences in observed nominal rates of

interest between two countries should
equal the difference in expected rates of
inflation between the two countries.

Keown, Martin, Petty - Chapter 11 55

Interest Rate Parity Theorem
1+r n,h = E1
1 + rn,f E0
rn,h = Domestic one-period rate of interest
rn,f = Corresponding rate in foreign country
E0 & E1 = Exchange rates corresponding to current
period (i.e. spot exchange rate) and one-period
hence (i.e. the one-period exchange rate)
- Nominal interest rates are tied to exchange rates
- Differences in nominal interest rates are tied to
expected rates of inflation
Keown, Martin, Petty - Chapter 11 56
Interest Rates and Currency
Exchange Rates
Example: If the domestic one-period
interest rate is 15.5%, and the
Japanese rate of interest is 5%, the
spot exchange rate is $1 to 1 yen
and the forward exchange rate is
$1.10 to 1 yen.

1 + .155 / 1 + .05 = 1.1/1= 1.10

Keown, Martin, Petty - Chapter 11 57