FINA 2303 Chapter 13 Cost of Capital Spring 2023

FINA 2303 Spring 2023
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Cost of Capital
Ekkachai Saenyasiri Page 1 2/26/2023

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Why is Cost of Capital Important?
 The return to an investor is the same as the cost to the company
 Cost of capital provides us with an indication of how the market views the
risk of our assets
 Knowing cost of capital can also help us determine our required return for
capital budgeting projects

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The investment decision The financing decision

(where to invest) (where to get the money)
Assets Liabilities & Equity
Current Assets Current Liabilities
Fixed Assets Long-term Debt

Preferred Stock
Common Equity
To create value, manager should invest in assets that yield higher returns than cost of
funds (weighted average cost of bond, preferred stock, and common stock).
Example: if investor requires 10% rate of return, to create value, manager must invest in
assets that give more than 10% rate of return.

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Required Return
 The required return is the same as the appropriate discount rate and is based
on the risk of the cash flows from the project
 We need to know the required return for an investment before we can

compute the NPV and make a decision about whether or not to take the
investment
 We need to earn at least the required return to compensate our investors for
the financing they have provided
 Higher systematic risk  Higher required return

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Source of Capital
 Long-term debt
 Preferred stock
 Common Stock

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Cost of Common Stock

The cost of equity is simply the stockholders’ required rate of return.
Because in equilibrium, expected return and required return on common stock are the
same, we can find cost of equity from either one of the equations below.
 Constant Dividend Growth Model
D1
RE  g
P0
 Capital Asset Pricing Model (CAPM)  3/4 of U.S. Companies use CAPM
RE  R f   ( Rm  R f )

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Example: Use constant dividend growth model to compute cost of equity
Blair Brothers’ stock currently has a price of $50 per share and is expected to pay a year-end
dividend of $2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant
rate of 4 percent per year. What is the company’s cost of equity?
D1 2 .5
RE  g   0.04  0.09  9%  Cost of equity
P0 50

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Example: Use CAPM to compute cost of equity
The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the
market risk premium (Rm - Rf) is 6 percent. What is the company’s cost of equity?
RE  R f   ( Rm  R f ) = 5% + 1.2 (6%) = 12.2% Cost of equity
Key assumption
The systematic risk (beta) of the new project is the same as the systematic risk of the firm

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Estimating the Cost of Equity

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Example: Estimating the cost of equity

 The equity beta for Johnson & Johnson is 0.67. The yield on ten-year
treasuries is 3%, and you estimate the market risk premium to be 6%.
 Johnson & Johnson issues dividends at an annual rate of $2.16. Its current
stock price is $60.50, and you expect dividends to increase at a constant rate
of 4% per year.
 Estimate J&J’s cost of equity -- two ways.
CAPM  Cost of equity = 3% + 0.67 * 6% = 7%

.
Constant Dividend Growth Model  Cost of equity = 4% 7.6%
.
Because of the different assumptions we make when using each method, the two
methods do not have to produce the same answer.
We must examine the assumptions we made for each approach and decide which
set of assumptions is more realistic.
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Cost of Preferred Stock
 Reminders
 Preferred stock generally pays a constant dividend each period
 Dividends are expected to be paid every period forever
 A preferred stock can usually be valued like a perpetuity.
D D D D D D D D D
| | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12
D D
P R ps =
R ps P
Rps = Investor’ s required return for preferred stock = Cost of preferred stock

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Example: If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per
year and the preferred stock should be valued at $75 per share. What is the cost of
preferred stock for Prescott?
preferred stock dividend

Cost of preferred stock = = = 10.67%
Preferred stock price
Dividends on preferred stock are not tax deductible. Dividends are paid after tax.

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Cost of Debt
For the issuing firm, the cost of debt is the rate of return required by investors,
adjusted for taxes
Note that
 Dividends on common stock and preferred stocks are not tax deductible, so
no tax adjustments necessary.
 Interests paid on debt are tax deductible (good for investors), stockholders
focus on after-tax cash flows. Therefore, we should focus on after-tax cost of
debt.

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Example: Tax effects of financing with debt

No corporate
All equity With debt tax on this
Earnings Before Interest and Tax 400,000 400,000 $50,000
Interest expense 0 (50,000)
Earnings Before Tax 400,000 350,000
Tax (34%) (136,000) (119,000)
Earnings After Tax 264,000 231,000
For each $1 of interest payment, the firm reduces tax by 34 cents.

In this case, with debt this firm pay tax 50,000 * 0.34 = $17,000
less than without debt.

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Now suppose the firm with all equity pays $50,000 in dividends to stockholders.
All Equity With debt

Earnings Before Interest and Tax 400,000 400,000
Interest expense 0 (50,000)
Earnings Before Tax 400,000 350,000
Tax (34%) (136,000) (119,000)
Earnings After Tax 264,000 231,000
Dividends (50,000) 0
Retained Earnings 214,000 231,000
Firm’s value is higher when using debt. Notice that both of them pay out $50,000 to investors.
Bottom line is that both firms generate equal income from operation, but
With all equity (no debt), government gets $136,000. Investors get
Shareholder gets 50000 + 214,000 = $264,000 $264,000
With debt, government gets $119,000

Debt holder gets $50,000 Investors get $281,000
Shareholder gets $231,000

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Example: Suppose a bond pays 10% coupon on $1,000 par value. And assume that
investors' required return = 10%.
Cost of debt  pay coupon $100 each year
Benefit of debt  reduce tax $34 each year
Net cost of debt = $100 - $34 = $66  6.6 %  10% (1- 0.34)  Rd (1- tax rate)
After tax cost of debt = Before tax cost of debt * (1 – Marginal Tax Rate)
Example: Suppose that before-tax cost of debt = 10%, what is after-tax cost of
debt? Assuming that marginal tax rate = 34%.
After-tax cost of debt = 10% (1- 0.34) = 6.6%

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Example: Prescott Corporation issues a 20-year bond paying 10% coupon rate
on $1,000 face value. Coupons are semiannual. Assume that the bond will be
sold for $950. What is the pre-tax cost of debt for Prescott Corporation?
  1 
 1  
n 
  (1  Rd )   Par
 C  
 
Bond Price =  Rd
 1  Rd n
 
 
Rb = interest rate for half year.
C = 10% * 1,000 = $100 per year = $50 every six months.
  1 
 1  
40 
  (1  Rd )   1000
 50  
 
950 =  R d  1  Rd 40
 
 

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  1 
 1  
40 
  (1  Rd )   1000 Solve for Rd
 50  
 1  R 40
Rd
950 =   d
 
 
Calculator Input: PV = -950, PMT = 50, n = 40, FV = 1000, COMPUTE I/Y  Rd
Rd = 5.3% per half year
Before-tax Cost of debt = 5.3% * 2 = 10.6% per year  YTM

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What is the after-tax cost of debt for Prescott Corporation? Assume marginal tax
rate = 34%.
After tax cost of debt = Before tax cost of debt * ( 1- tax rate)
= 10.6% * (1 - 0.34)
= 7%
So, a 10% bond costs the firm only 7% since the interest is tax deductible.

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The Weight Average Cost of Capital (Rwacc)
The weighted average cost of capital is the weighted average cost of all the
financing sources.
Rwacc  wd  Rd (1  Tc )  w ps  R ps   wE  RE 
D% = wd = weight of bond Rd = before tax cost of debt
P% = wps = weight of preferred stock Rps = cost of preferred stock
E% = wE = weight of equity RE = cost of equity
wd + wps + wE = 1
Note that these weights are computed using market values

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Calculating the Weights in the WACC

Example: Suppose Kenai Corp. has debt with a book (face) value of $10 million,
trading at 95% of face value. It also has book equity of $10 million, and 1
million shares of common stock trading at $30 per share.
What weights should Kenai use in calculating its WACC?
Ten million dollars in debt trading at 95% of face value is $9.5 million in market
value.
One million shares of stock at $30 per share is $30 million in market value.
The total value of the firm is $39.5 million.
The weights are

 For debt: 9.5/39.5 = 24.1%
 For equity: 30/39.5 = 75.9%

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Example: A company wants to invest in a new project. This project will be financed by
$140 million of retained earnings, $40 million of new debt and $20 million of new
preferred stock. Given the information in the table below, find the weighted average cost
of capital for this project.
Source of Capital Weights Before tax cost of capital
Debt ($40 million) 40/200 = 20% 9.09% YTM
Preferred Stock ($20 million) 20/200 = 10% 10% Rps = D/P

CAPM or Constant
Retained Earnings ($140 million) 140/200 = 70% 16% Dividend Growth Model
Total Capital = $200
Assume tax rate = 34%. Note that after tax cost of debt = 9.09% * (1-0.34) = 6%
Do not adjust for tax for both preferred and common stock.
Rwacc  0.2  0.0909  (1  0.34)  0.1  0.1  0.7  0.16 = 0.134 = 13.4%
To create value, this new project has to yield return at least 13.4% to satisfy all investors
who bought bonds, preferred stocks and common stocks.
The firm should not invest in this project if it yields return less than 13.4%.
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WACC for Real Companies
Before tax
Assume tax rate = 35%

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Using WACC to compute PV

The appropriate cost of capital for a project should reflect the risk of that investment.
We can use the firm's WACC to estimate a project's NPV only when the level of risk of
that project is similar to the level of risk of the firm.
If project risk differs from that of the firm, then
 The firm’s WACC is no longer appropriate cost of capital for the project. For this
reason, firms that invest in multiple divisions or business unites that have different
risk characteristics should calculate a different cost of capital for each division.
 We can use WACC of competitors whose business are similar to the new project
 We may also compute the new project's WACC by adjusting the firm's WACC
upward/downward depend on whether the new project is more or less risky than the
firm
By using the firm's WACC for a new project, we also implicitly assume that the firm will
keep the debt-equity ratio constant

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Example
 Heineken is considering introducing a new ultra-light beer with zero calories to be

called BeerZero.
 The cost of bringing the beer to market is $200 million, but Heineken expects first-
year incremental free cash flows from BeerZero to be $100 million and to grow at
3% per year thereafter.
 If Heineken’s WACC is 5.7%, should it go ahead with the project?
NPV of the project = 200 $3,503.7 million  Accept the project

. .

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Project-Based Costs of Capital
The cost of capital of the new project must depend on the risk of the new project
To use the firm's WACC, we have to assume that the new project is as risky as
the firm overall.
McDonald’s (food & restaurant)'s WACC = 10%

Boeing (aerospace business)'s WACC = 12%
With discount rate 10%  NPV = 500,000
With discount rate 12%  NPV = -1,000,000
If McDonald’s wants to invest in an aerospace project, what should be the

discount rate for the new project?
Answer: McDonald’s must evaluate this project based on 12% cost of capital 
reject this project

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When Raising External Capital is Costly

Issuing new equity or bonds carries a number of costs
- Cost of filing and registration with the Securities and Exchange Commission
- Fees charged by investment bankers, accountants and lawyers
We should treat the issuing costs as negative cash flow in the NPV analysis

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Example: Costly External Financing
DuPont plans to offer $23 billion as the purchase price for firm X. To do so,
Dupont will need to issue additional debt and equity to finance such a large
acquisition.
You estimate that the issuance costs will be $0.8 billion and will be paid as soon
as the transaction closes.
You estimate the incremental free cash flows from the acquisition will be $1.4
billion in the first year and will grow at 3% per year thereafter.
WACC of Dupont = 9.11%

WACC of firm X = 8.8%
What is the NPV of the proposed acquisition?
1.4
𝑁𝑃𝑉 23 0.8 0.338 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
0.088 0.03

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Example WACC & Capital Budgeting
– Suppose DuPont is considering an investment that would extend the life of one
of its chemical facilities for 4 years
– The project would require upfront costs of $6.67 million plus a $24 million
investment in equipment
– The equipment will be obsolete in four years and will be depreciated via
straight-line over that period
– DuPont expects annual sales of $60 million per year from this facility
– Material costs and operating expenses are expected to total $25 million and $9
million, respectively, per year
– DuPont expects no net working capital requirements for the project, and it pays
a tax rate of 35%.
– WACC = 9.11%

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Expected Free Cash Flow from Dupont' s Facility Project
19 19 19 19
𝑁𝑃𝑉 28.34 33.07 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1.0911 1.0911 1.0911 1.0911
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Extended Example – WACC
 Equity Information
 50 million shares
 $80 per share
 Beta = 1.15
 Market risk premium = 9%
 Risk-free rate = 5%
 Debt Information
 $1 billion in outstanding debt (face value)
 Current quote = 110 (i.e., bond price is traded at 110% of face value)
 Coupon rate = 9%, semiannual coupons
 15 years to maturity
 Tax rate = 40%

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Extended Example – WACC (continued)
 What is the cost of equity?

 RE = 5 + 1.15(9) = 15.35%
 What is the cost of debt?

 N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268
 Rd = 3.927(2) = 7.854%
 What is the after-tax cost of debt?

 Rd(1-TC) = 7.854(1-.4) = 4.712%

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Extended Example – WACC (continued)
 What are the capital structure weights?

 E = 50 million (80) = 4 billion
 D = 1 billion (1.10) = 1.1 billion
 E+D = 4 + 1.1 = 5.1 billion
 wE = E/(E+D) = 4 / 5.1 = .7843
 wd = D/(E+D) = 1.1 / 5.1 = .2157
 What is the WACC?

 WACC = .7843(15.35%) + .2157(4.712%) = 13.06%

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Example: A firm is considering a project that will result in after-tax cash
savings of $5 million at the end of first year. These savings will grow at the rate
of 5% per year. WD = 0.333. WE = 0.667. RD = 10%. RE = 29.2%. Should the
firm take on the project? Assume tax rate = 34%
This is an example of growing perpetuity similar to that of dividend discount

model: P = D1/(K-g)
$5,000,000
PV 
WACC  0.05
WACC  wE  RE   wD  RD (1  Tc )
WACC  0.667  29.2%  0.333 10%(1  0.34)  21.67%

$5,000,000
PV   $30,000,000
0.2167  0.05
The NPV will be positive only if the cost is less than $30 million.

FINA 2303 Chapter 13 Cost of Capital Spring 2023

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FINA 2303 Spring 2023

Ekkachai Saenyasiri Page 1 2/26/2023

Why is Cost of Capital Important?

 The return to an investor is the same as the cost to the company

Ekkachai Saenyasiri Page 2 2/26/2023

The investment decision The financing decision

Assets Liabilities & Equity

Current Assets Current Liabilities

Fixed Assets Long-term Debt

Ekkachai Saenyasiri Page 3 2/26/2023

 We need to know the required return for an investment before we can

 Higher systematic risk  Higher required return

Ekkachai Saenyasiri Page 4 2/26/2023

Ekkachai Saenyasiri Page 5 2/26/2023

Cost of Common Stock

 Constant Dividend Growth Model

Ekkachai Saenyasiri Page 6 2/26/2023

Example: Use constant dividend growth model to compute cost of equity

Ekkachai Saenyasiri Page 7 2/26/2023

Example: Use CAPM to compute cost of equity

RE  R f   ( Rm  R f ) = 5% + 1.2 (6%) = 12.2% Cost of equity

Ekkachai Saenyasiri Page 8 2/26/2023

Estimating the Cost of Equity

Ekkachai Saenyasiri Page 9 2/26/2023

Example: Estimating the cost of equity

 Estimate J&J’s cost of equity -- two ways.

CAPM  Cost of equity = 3% + 0.67 * 6% = 7%

Cost of Preferred Stock

Ekkachai Saenyasiri Page 11 2/26/2023

preferred stock dividend

Ekkachai Saenyasiri Page 12 2/26/2023

Ekkachai Saenyasiri Page 13 2/26/2023

Example: Tax effects of financing with debt

For each $1 of interest payment, the firm reduces tax by 34 cents.

Ekkachai Saenyasiri Page 14 2/26/2023

All Equity With debt

With debt, government gets $119,000

Ekkachai Saenyasiri Page 15 2/26/2023

After-tax cost of debt = 10% (1- 0.34) = 6.6%

Ekkachai Saenyasiri Page 16 2/26/2023

Ekkachai Saenyasiri Page 17 2/26/2023

Calculator Input: PV = -950, PMT = 50, n = 40, FV = 1000, COMPUTE I/Y  Rd

Rd = 5.3% per half year

Before-tax Cost of debt = 5.3% * 2 = 10.6% per year  YTM

Ekkachai Saenyasiri Page 18 2/26/2023

Ekkachai Saenyasiri Page 19 2/26/2023

Rwacc  wd  Rd (1  Tc )  w ps  R ps   wE  RE 

D% = wd = weight of bond Rd = before tax cost of debt

P% = wps = weight of preferred stock Rps = cost of preferred stock

E% = wE = weight of equity RE = cost of equity

Note that these weights are computed using market values

Ekkachai Saenyasiri Page 20 2/26/2023

Calculating the Weights in the WACC

What weights should Kenai use in calculating its WACC?

The total value of the firm is $39.5 million.

The weights are

Ekkachai Saenyasiri Page 21 2/26/2023

Debt ($40 million) 40/200 = 20% 9.09% YTM

Preferred Stock ($20 million) 20/200 = 10% 10% Rps = D/P

Total Capital = $200

WACC for Real Companies

Ekkachai Saenyasiri Page 23 2/26/2023

Using WACC to compute PV