TOPIC 8

INVESTMENT ANALYSIS IV: COST OF CAPITAL

DR. DUNG THI THUY NGUYEN
 CRITICAL CONCEPTS
❑ Cost of equity capital
◼ Derived from Dividend Growth Model (DGM)
◼ Derived from Capital Asset Pricing Model (CAPM)
❑ Cost of debt capital (accounting for tax benefits)

❑ Capital structure weights

❑ Overall weighted average cost of capital (WACC)

Readings: Chapter 9- Textbook, (pp. 228)

INVESTMENT DECISION IN THE BIG PICTURE

Maximize value of the business(firm)

The Financing
The Investment Working Capital
Decision:
Decision Management
• Debt
(Capital Budgeting) Decision
• Equity

3
 RECAP: NPV, MEASURING VALUE CREATION
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑛
NPVof project = 𝐶𝐹0 + + + +….+
1+𝑟 1 1+𝑟 2 1+𝑟 3 1+𝑟 𝑁

There are two main ingredients to conduct NPV valuation:

1. Cash flows:

2. Cost of capital:
THE COST OF CAPITAL IS EVERYWHERE IN
FINANCE
➢ The cost of capital (hurdle rate, required rate of return) helps to determine
whether and where a business should invest, how much it should borrow and
how much it should return to stockholders.
➢ The required return on an asset depends upon the risk of the cash flflows
generated by the asset.
➢ We think of interest rates as the cost of money.
➢ The required return to a supplier of capital (a stockholder or bond holder) is
cost of capital expected to be met by the company.
➢ Required return and cost of capital are two sides of the same coin.
➢ The cost of capital measures how the market assesses the risk of the assets
➢ The cost of capital is the required return for investment projects.
➢ We shall think of the project as a mini firm. The cost of capital is a composite
cost to the firm of raising financing to fund its projects.
SOURCE OF LONG-TERM CAPITAL
.
Cost of capital: Cost of Equity ( R) E

The cost of equity capital is the return required by equity

investors given the risk of the cash flows that flow to holders of
equity.

To compute cost of equity capital:

Option 1: using Dividend Growth Model (topic 4)
Option 2: using CAPM (topic 7)
 EXAMPLE 1. COST OF EQUITY (RE). DGM
Apple is expected to pay a dividend of $2.29 per share one year from now
(t=1). There has been a steady growth in dividends of 6% per year and the
market expects this to continue into the indefinite future. The current Apple
share price is $101.81. Infer Apple’s cost of equity ( RE). (Chec k topic
4)
𝑫𝟏 𝐷1
𝑃0 = ; 𝑟=𝑔+
𝑟−𝑔 𝑃𝑉0
EXAMPLE 2. COST OF EQUITY (RE). CAPM
Suppose, Apple common stock β is estimated at 0.83, the risk free
rate (R f ) is 1.6% per annum (US short-term treasury bill), and
the expected market risk premium [E(R m)- Rf] is 8% per annum.
Estimate Apple’s cost of equity (RE). (Check topic 7)

E (R i )= R f +  i [E(R m)- Rf]

COST OF EQUITY (RE)
Graham and Harvey 2001 say CFOs always/often use the
following for cost of equity:
¤ CAPM(70/100)
◼ Standard CAPM (35/100)
◼ Multiple factor CAPM (35/100)
¤ Historical average stock returns (40/100)
¤ Dividend growth model (16/100)

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COST OF CAPITAL: COST OF DEBT ( RE)

➢ The cost of debt capital is the return required by debt investors given the
risk of the cash flows that flow to holders of debt. We will use the after-
tax cost of debt in the WACC.
➢ The before-tax required return is best estimated by the yield-to-maturity
(YTM) on the existing long-term debt.
➢ We may also use estimates of yields based on the bond rating we expect
when we issue new debt.
MEASURING AFTER-TAX COST OF DEBT (RD)
➢ The before –tax cost of debt:
Option 1: use spreadsheet / financial calculator
𝐶 1 FV
P = YTM × 1 − + (1+YTM)𝑡
1+YTM t

Option 2: use approximate formula

$1, 000 − N d Where:
I+ –I = Annual interest in dollars
rd = n (9.1)
N d + $1, 000 –Nd = Net proceeds from the sale of debt (bond)
–n = Number of years to the bond’s maturity
2

➢ The after-tax cost of debt = (1-Tax) * Before-tax cost of

debt
 EXAMPLE 3. COST OF DEBT (RD)-
1. ABC Co. Ltd. Has 5,000 annual bonds outstanding. Each bond
has a par value of $1,000, coupon rate is 5% p.a, 12 years to maturity,
selling for 110 percent of par. Find the before/after-tax cost of debt.

2. ABC Co. Ltd. Has 5,000 semiannual bonds outstanding. Each

bond has a par value of $1,000, coupon rate is 5% p.a, 12 years to
maturity, selling for 110 percent of par. Find the before/after-tax cost of
debt.
EXAMPLE 4. COST OF DEBT (RD)- ZERO
COUPON BONDS
1. Suppose that the Geneva Electronics Co. issues a $1,000 face
value, eight-year zero coupon bond. What is the yield to maturity
on the bond if the bond is offered at $627? Assume annual
compounding.
A. Find the before tax cost of debt
B. Find the after-tax cost of debt
2. Suppose the Eight-Inch Nails (EIN) Company issues a $1,000
face value, five-year zero-coupon bond. The initial price is set at
$508.35. What is the yield to maturity using semiannual
compounding?
A. Find the before tax cost of debt
B. Find the after-tax cost of debt
Measuring Cost of Preferred Equity, (REP)

Preferred dividends are a fixed dividend amount promised to

shareholders at regular interval for an indefinite period of time.
The cost of preferred stock is the preferred dividend yield.
EXAMPLE 5. COST OF PREFERRED EQUITY

In 2014, Green Cross Health issued preferred stocks that currently

trade on the NZX. The company pays $ 0.20 dividend per share.
The current share price is $1.84. What is the cost of perpetual
preference equity ( R p ) ?

Intrinsic Value of preference shares = Preferred Dividend

R
WEIGHTED AVERAGE COST OF CAPITAL
(WACC): DEBT + EQUITY
The weighted average cost of capital (WACC) is a weighted
average of the costs of the different types of capital (debt and
equity) that have been used to finance a project; the cost of
each type of capital is weighted by the proportion of the total
capital that it represents.
Asset = Debt + Equity
Book-value of debt/equity: largely based on historical
measures (costs).
Market-value of debt/equity: fair value that is reflective of the
current worth of bonds and shares based on the PV of future cash
flows.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Step 1. Cost of capital components:

• Cost of Equity (RE)
• Cost of Debt (RD)
Step 2. Capital structure:
• Equity weight (wE )
• Debt weight (wD)

Step 3. W A C C =[wE*RE]+[wD * RD*(1-T)]

CAPITAL STRUCTURE WEIGHTS (WACC)

Market Values
E (market value of equity) = (# outstanding shares)x(price per
share)
D (market value of debt) = (# outstanding bonds)x(bond price)
V = market value of the firm
V=D+E

Weights
wE = E/V =E/(D+E)= proportion financed with equity
wD = D/V = D/(D+E) = proportion financed with debt
EXAMPLE 6. CAPITAL STRUCTURE WEIGHTS

Apple has 10,000 shares outstanding and a current share price of

$101.54; Apple also has 26 outstanding bonds and a current bond
price of $575.

1. What are the market values of Apple’s shares and bonds,

respectively?
2. What are the capital structure weights?
Example 7. WACC

Using previously calculated capital weights, calculate the cost of

capital for Apple with a cost of equity of 8.247% per annum and a
cost of debt of 1.08% per annum.
EXAMPLE 8. PULLING ALL TOGETHER
Apple has invented a new product called iCycle. The undertaken
marketing survey determined iCycle will generate the following
free cash flows (FCF).
1 year 2 year 3 year
FCF $5,500,000 $6,400,000 $7,100,000

The project requires an initial investment of $800,000.

To finance the project Apple is going to issue 1000 bonds, selling
for $600 per bond and 120,000 shares, selling for $100. The
current YTM on the outstanding bonds is 1.7 % per annum. The
expected return on equity is 8.6% per annum. Corporate tax rate
is 40%.
Using the NPV method, determine if Apple should accept or
reject the project?
 PROJECT AND DIVISIONAL COST OF CAPITAL
➢ The WACC of a firm, however, should only be used as an estimate
of the appropriate cost of capital for a new capital project if:
✓ The risk of the new project is equivalent to the risk of the existing
projects of the firm
✓ The new capital project is financed in the same proportions as the
overall firm (or in line with the firm’s target capital structure)
➢ If not, then it is appropriate to adjust for risk or financing
differences, or to calculate a project-specific or division-specific cost
of capital
✓ This may be achieved using the pure-play estimation approach
✓ Alternatively, this could be done by determining a (subjective) risk-
adjusted discount rate, or using a certainty-equivalent adjustment
for the risk associated with project or division cash flows (risk-
adjusted discount rates)
 PURE-PLAY ADJUSTMENT APPROACH
A pure-play equity beta coefficient is de-levered as:
b A = bE / (1 + (1 − t )( D / E PP ))
where:
 bA = the asset (all-equity) beta coefficient of the pure-play firm
 bE = the equity beta coefficient of the pure-play firm
 t = corporate tax rate
 D/EPP = the debt/equity ratio of the pure-play firm
The target firm’s equity beta coefficient is determined by transforming the
above equation:
Target b E = b A  (1 + (1 − t )( D / ET arget ))
where:
 D/ETarget = the debt/equity ratio of the target firm
Determining Risk-Adjusted Discount
Rates (RADRs)
The rate of return that must be earned on a given project to
compensate the firm’s owners adequately, that is, to maintain or
improve the firm’s share price

n
CFt
NPV =  − CF0 (12.2)
t =1 (1 + RADR )
t
 USE CAPM TO FIND RADRS (CONT.)
Using CAPM to Find RADRs

rproject j = RF +   project j  (rm − RF )  (12.5)

The security market line (SML) is shown in Figure 12.2

Any project having an IRR above the SML would be acceptable because
its IRR would exceed the required return, rproject; any project with an IRR
below rproject would be rejected

In terms of NPV, any project falling above the SML would have a positive
NPV, and any project falling below the SML would have a negative NPV
USE CAPM TO FIND RADRS
 KEY INSIGHTS
• The weighted average cost of capital is a weighted average of the after-tax costs of
each source of capital.
• The WACC in NPV valuation. For example, the WACC is used to value a project
using the net present value (NPV) method.
• Before-tax cost of debt is generally estimated by means of yield to maturity
method.
• The yield-to-maturity method of estimating before-tax cost of debt uses the
familiar bond valuation equation.
• Because interest payments are generally tax deductible, the after-tax cost is the
true, effective cost of debt to the company.
• The cost of perpetual preferred stock is the preferred stock dividend divided by the
current preferred stock price.
• The cost of equity is the rate of return required by a company’s common
stockholders. We estimate this cost using the CAPM (or its variants) or the
dividend discount method.
• Survey evidence indicates that the CAPM method is the most popular method used
by companies in estimating the cost of equity.