CHAPTER 13: THE COST OF

CAPITAL

FIN303 – Advanced Corporate Finance

Instructor: Do T. Thanh Huyen
Lecturer, Faculty of Business
FPT University
LEARNING OBJECTIVES
Chapter 13: The Cost of Capital

1. Explain what the weighted average cost of capital for a firm is

and why it is often used as a discount rate to evaluate projects.
2. Calculate the cost of debt for a firm.
3. Calculate the cost of common stock and the cost of preferred
stock for a firm.
4. Calculate the weighted average cost of capital for a firm,
explain the limitations of using a firm's weighted average cost
of capital as the discount rate when evaluating a project, and
discuss the alternatives to the firm's weighted average cost of
capital.

2
CHAPTER PREVIEW
Link with previous theories in FIN202:
Chapter 5 – 6 – 7 – 8 – 9

3
13.1 THE FIRM'S OVERALL
COST OF CAPITAL

FIN303 – CHAPTER 13
 LEARNING OBJECTIVES
1. EXPLAIN WHAT THE WEIGHTED AVERAGE COST OF
CAPITAL FOR A FIRM IS AND WHY IT IS OFTEN
USED AS A DISCOUNT RATE TO EVALUATE PROJECTS.

5
THE FIRM’S OVERALL COST OF CAPITAL
We have assumed that the rate used to discount the cash flows for a project reflects the risks associated
with the incremental after-tax free cash flows from that project.

Unsystematic risk can be eliminated by holding a diversified portfolio

Systematic risk the only risk that investors require compensation for bearing

where
• E(Ri) is the expected return on project i,
• Rrf is the risk-free rate of return,
• βi is the beta for project i, and
• E(Rm) is the expected return on the market.
• the risk-free rate [E(Rm) − Rrf] is known as the market risk
premium.
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THE FINANCE BALANCE SHEET
The finance balance sheet was referred to as the market-value balance sheet from Chapter 3.

The finance balance sheet: The accounting balance sheet:

is based on market values is based on book values

THE FINANCE BALANCE SHEET

• Left-hand side of the accounting balance sheet
reports the book values of a firm’s assets, while
the right-hand side reports how those assets
were financed. MV of assets = MV of liabilities +MV of equity (13.1)
• Values of the claims that investors hold must
equal the value of the cash flows that they have
a right to receive.

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THE FINANCE BALANCE SHEET
EXAMPLE:
Consider a firm whose only business
is to own and manage an apartment
building that was purchased 20
years ago for $1,000,000. Suppose
that there is currently a $300,000
mortgage on the building, the firm
has no other liabilities, and the
current market value of the building,
based on the expected free cash
flows from future rents, is Solution:
$4,000,000. MV of assets = MV of liabilities +MV of equity
What is the market value of all of the $4,000,000 = $300,000 +MV of equity
equity (stock) in this firm?  MV of equity = $4,000,000 − $300,000 = $3,700,000

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ESTIMATING A FIRM'S COST OF CAPITAL
• Purpose of calculating cost of capital
 As a benchmark for new investment opportunities LT Debt
 To value the company as a whole

We focus on the sources of capital that are funded from

investors (of debt and equity) Capital
The working capital components such as: Structure
are not sources of funding that
• accounts payable, come from investors, so they are
• accruals, deferred taxes not included in the calculation of
the cost of capital. Common Preferred
Stock Stock
Note, we do adjust for these items when calculating the cash
flows of a project, but not when calculating the cost of capital.
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ESTIMATING A FIRM'S COST OF CAPITAL
If analysts at a firm could estimate the betas for each of the firm's individual projects, they could estimate the beta for
the entire firm as a weighted average of the betas for the individual projects.

This calculation would just be an application of Equation 7.13:

𝒏

𝜷𝒏 𝑨𝒔𝒔𝒆𝒕 𝒑𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 = ෍ 𝒙𝒊 𝜷𝒊 = 𝒙𝟏 𝜷𝟏 + 𝒙𝟐 𝜷𝟐 + 𝒙𝟑 𝜷𝟑 + ⋯ + 𝒙𝒏 𝜷𝒏
𝒊=𝟏

The analysts could then use the beta for the firm in Equation 7.12:
E(Ri) = Rrf + βi[E(Rm) − Rrf ]
Analysts do not need to estimate betas for each type of financing that the firm has. They can compute the cost of
capital for the firm using the following equation:
𝒌𝒇𝒊𝒓𝒎 = σ𝒏𝒊=𝟏 𝒙𝒊 𝒌𝒊 = 𝒙𝟏 𝒌𝟏 + 𝒙𝟐 𝒌𝟐 + 𝒙𝟑 𝒌𝟑 + ⋯ + 𝒙𝒏 𝒌𝒏 (13.2)

10
ESTIMATING A FIRM'S COST OF CAPITAL
EXAMPLE: SOLUTION:
We begin by calculating the weights for the
You are considering purchasing a rug cleaning company that
different types of financing:
will cost $2,000,000. You plan to finance the purchase with
xBofA loan = $1,500,000 / $2,000,000 = 0.75
• a $1,500,000 loan from Bank of America (BofA) that has a
xSeller loan = $300,000 / $2,000,000 = 0.15
6.5 percent interest rate,
xEquity = $200,000 / $2,000,000 = 0.10
• a $300,000 loan from the seller of the company that has an
where
8 percent interest rate, and $200,000 of your own money.
xBofA loan + xSeller loan + xEquity = 0.75 + 0.15 +
• You will own all of the equity (stock) in the firm. You estimate 0.10 = 1.00.
that the opportunity cost of your $200,000 investment—that
We can then calculate the WACC using
is, what you could earn on an investment of similar risk in the
Equation 13.2:
capital market—is 12 percent with that much debt.
WACC = kFirm = (0.75)(0.065) + (0.15)(0.08)
What is the cost of capital for this investment? + (0.10)(0.12)
= 0.728, or7.28%
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13.2 THE COST OF DEBT

FIN303 – CHAPTER 13
 LEARNING OBJECTIVES
2. CALCULATE THE COST OF DEBT FOR A FIRM.

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KEY CONCEPTS FOR ESTIMATING THE COST OF DEBT
Firms use these three general types of debt financing:

Lines of credit Private fixed-term Sell bonds

• to finance working loans • to the public to finance
capital items • such as bank loans ongoing operations or
• such as inventories or the purchase of long-
accounts receivable term assets

When we estimate the cost of capital for a firm, we are particularly interested in the cost of the firm’s
long-term debt. Firms generally use long-term debt to finance their long-term assets, and it is the long-
term assets that concern us when we think about the value of a firm's assets.

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ESTIMATING THE CURRENT COST OF A BOND
This cost is estimated using the yield to maturity calculation.

Recall that in Chapter 8 we defined the yield to maturity as the discount rate that makes the present
value of the coupon and principal payments equal to the price of the bond.

• YTM is the discount rate that makes the

present value of the coupon and principal
YTM payments equal the price of bond

1
1− 𝑌𝑇𝑀
(1 + 𝑚 )𝑚𝑛 Quoted rate 𝒎
𝐶 1,000 EAY = (1 + ) −1
𝑃𝐵 = × + 𝑚∗𝑛 m
𝑚 𝑌𝑇𝑀 𝑌𝑇𝑀
𝑚 1 +
𝑚

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THE CURRENT COST OF AN OUTSTANDING LOAN
Conceptually, calculating the current cost of long-term bank or other
private debt is not as straightforward as estimating the current cost of
a public bond because financial analysts cannot observe the market
price of private debt.

 Method 1: Call their banker and ask what rate the bank would charge
if they decided to refinance the debt today.
 Method 2: Find the bond rating for the company and use the yield on
other bonds with a similar rating.

 Method 3: Find the yield on the company’s debt, if it has any.

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TAXES AND THE COST OF DEBT
Firms can deduct interest payments for tax purposes

More generally, the after-tax cost of interest payments equals the pretax cost times 1 minus the tax rate.
This means that the after-tax cost of debt is:

kDebt after-tax = kDebt pretax × (1 − t) (13.3)

This after-tax cost of debt is the cost that firms actually use to calculate the WACC. The reason is that
investors care only about the after-tax cost of capital—just as they care only about after-tax cash flows.

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AFTER-TAX COST OF DEBT EXAMPLE
Example 01:
Five-year bonds of XYZ company are currently priced at $1,042.65. These bonds have a coupon rate of
7 percent and make semiannual coupon payments. If tax marginal rate of this company is 20%, what is
its after-tax cost of debt?

INPUT DATA: SOLUTION:

• Coupon rate = 7% 1
1−
 C = 1,000 * 7% = $70 𝑌𝑇𝑀 𝑚𝑛
𝐶 (1 + ) 1,000
• n=5 𝑃𝐵 = × 𝑚 +
𝑌𝑇𝑀 𝑚∗𝑛
• m=2 𝑚 𝑌𝑇𝑀
𝑚 1 +
• PB= $1,042.65 𝑚
• t = 20%  kDebt before-tax = 6.09%

 kDebt after-tax = 6.09% × (1-0.2)

= 4.875%
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AFTER-TAX COST OF DEBT EXAMPLE
Example 02: Solution:
Suppose that your pizza parlor business has grown Using Equation 8.1, find EAY for these bonds
dramatically in the past three years from a single is:
restaurant to 30 restaurants. To finance this growth, two
years ago you sold $25 million of five-year bonds.
These bonds pay interest annually and have a coupon
rate of 8 percent. They are currently selling for
$1,026.24 per $1,000 bond. Just today, you also
borrowed $5 million from your local bank at an
interest rate of 6 percent. Assume that this is all the Because the bonds are currently selling above
long-term debt that you have and that there are no their par value we know that their current
issuance costs. market value is greater than their $25 million
What is the overall average after-tax cost of your face value. In fact, it equals:
($1,026.24/$1,000) × $25,000,000
debt if your business’s marginal tax rate is 35 percent?
= $25,656,000
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AFTER-TAX COST OF DEBT EXAMPLE
Solution: (cont.)
Since the bank loan was just made today, its value simply equals the amount borrowed or $5 million. The
weights for the two types of debt are therefore:

The weighted average pretax cost of debt is:

The after-tax cost of debt is therefore:

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13.3 THE COST OF EQUITY

FIN303 – CHAPTER 13
 LEARNING OBJECTIVES
3. CALCULATE THE COST OF COMMON STOCK AND
THE COST OF PREFERRED STOCK FOR A FIRM.

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RECALL FROM CHAP 9
Stocks are equity securities - certificates of ownership in a corporation
COMMON STOCK
• Is the basic ownership claim in a corporation
• Has the right to vote on matters such as
electing a board of directors, setting a capital
budget, and proposed mergers or acquisitions
• Has the right to a firm’s residual assets after
creditors, preferred stockholders, and others
with higher priority claims have been satisfied
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PREFERRED STOCK
• Represents ownership in corporation
• Does not have the right to vote
• Has priority over common stock with respect to
dividends and liquidation of assets
• Must be paid a fixed dividend before funds
are distributed to common stockholders
ESTIMATING THE COST 13.3 The Cost of Equity

OF COMMON STOCK
 METHOD 1: USING THE CAPITAL ASSET PRICING MODEL (CAPM)
kcs = Rrf + (βcs ×Market risk premium) (13.4)

• Recommended to use is the risk-free
rate on a long-term Treasury security
because the equity claim is a long-term
claim on the firm’s cash flows.
• A long-term risk-free rate better reflects
long-term inflation expectations and the
cost of getting investors to part with
their money for a long period of time
than a short-term rate.
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• For listed company: can estimate the Beta
for that stock using a regression analysis.
• For private company:
 This problem may be overcome by
identifying a “comparable” company
with publicly traded stock that is in the
same business and that has a similar
amount of debt.
 When a good comparable company
cannot be identified, it is sometimes
possible to use an average of the betas
for the public firms in the same industry.
• It is not possible to directly observe
the market risk premium since we
don’t know what rate of return
investors expect for the market
portfolio.
• For this reason, financial analysts
generally use a measure of the
average risk premium investors have
actually earned in the past as an
indication of the risk premium they
might require today.
METHOD 2: USING THE CONSTANT-GROWTH DIVIDEND MODEL
The Constant-Growth Dividend Model
• In order to solve for the cost of common
stock, we must estimate the dividend that 𝐃𝟏
𝐏𝟎 = (𝟗. 𝟒)
stockholders will receive next period, D1, as 𝐢−𝐠
well as the rate at which the market expects
dividends to grow over the long run, “g”.
• This approach is useful for a firm that pays
dividends that will grow at a constant rate. 𝐷1
• This approach might be consistent for an 𝑘𝑐𝑠 = +𝑔 (13.5)
electric utility but not for a fast growing high- 𝑃𝑜
tech firm.

26
METHOD 3: USING A MULTISTAGE-GROWTH DIVIDEND MODEL
Multistage-Growth Dividend Model
• The third approach is based upon the
supernormal-growth dividend model discussed
in Chapter 9.
• The complexity of this approach lies in
choosing the correct number of stages of
forecasted growth as well as how long each
stage will last.
• Because of the algebraic complexity in
solving for the required rate of return, the
value is generally solved for using a trial and
error method, after forecasting the different
stages of dividend growth.
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 Which
Method
COMMON STOCK – SUMMARY Should We
Use?
• Method 1: Using the Capital Asset Pricing Model (CAPM)
kcs = Rrf + (βcs ×Market risk premium) (13.4)

• Method 2: Using the Constant-Growth Dividend Model

D1
k cs = + g (13.5)
Po

• Method 3: Using a Multistage-Growth Dividend Model

D1 D2 Dt Pt
P0 = 1
+ 2
+. . . + t
+
(1 + k cs ) (1 + k cs ) (1 + k cs ) (1 + k cs )t

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ESTIMATING THE COST 13.3 The Cost of Equity

OF PREFERRED STOCK
PREFERRED STOCK
The characteristics of preferred stock allow us to use the perpetuity model, Equation 6.3 in
chapter 6, to estimate the cost of preferred equity.
Just as with common stock, we can find the cost of preferred equity by rearranging the pricing
equation for preferred shares:

D Dps
Pps = k ps = (13.6)
Pps
i

30
13.4 USING THE WACC IN
PRACTICE

FIN303 – CHAPTER 13
 LEARNING OBJECTIVES
4. CALCULATE THE WEIGHTED AVERAGE COST OF CAPITAL
FOR A FIRM, EXPLAIN THE LIMITATIONS OF USING A
FIRM'S WEIGHTED AVERAGE COST OF CAPITAL AS THE
DISCOUNT RATE WHEN EVALUATING A PROJECT, AND
DISCUSS THE ALTERNATIVES TO THE FIRM'S WEIGHTED
AVERAGE COST OF CAPITAL.

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WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC = wdkd (1  t) + wpskps + wcskcs Cost of Capital

where Cost of Cost of

Cost of Debt Preferred Common
wd is the proportion of debt that the company uses Equity Equity
when it raises new funds
kd is the before-tax marginal cost of debt
t is the company’s marginal tax rate Yield to Maturity Return on Capital Asset
Preferred Stock Pricing Model
wps is the proportion of preferred stock the company
uses when it raises new funds
kps is the marginal cost of preferred stock Constant-growth
Debt Rating Dividend Discount
wcs is the proportion of equity that the company uses Model
when it raises new funds
kcs is the marginal cost of equity
Multistage-growth
Dividend Discount
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Model
CALCULATING WACC: AN EXAMPLE
Assume that you are a financial analyst at a manufacturing company that has used three types of debt, preferred
stock, and common stock to finance its investments.
• Debt: The debt includes a $4 million bank loan that is secured by machinery and equipment. This loan has an
interest rate of 6 percent, and your firm could expect to pay the same rate if the loan were refinanced today.
Your firm also has a second bank loan (a $3 million mortgage on your manufacturing plant) with an interest rate
of 5.5 percent. The rate would also be 5.5 percent today if you refinanced this loan. The third type of debt is a
bond issue that the firm sold two years ago for $11 million. The market value of these bonds today is $10
million. Using the approach we discussed earlier, you have estimated that the effective annual yield on the bonds
is 7 percent.
• Preferred Stock: The preferred stock pays an annual dividend of 4.5 percent on a stated value of $100. A
share of this stock is currently selling for $60, and there are 100,000 shares outstanding.
• Common Stock: There are 1 million shares of common stock outstanding, and they are currently selling for $21
each. Using a regression analysis, you have estimated that the beta of these shares is 1.1.
The 20-year Treasury bond rate is currently 2.88 percent, and you have estimated the market risk premium to be
5.92 percent using the returns on stocks and Treasury bonds from the 1926 to 2015 period. Your firm's marginal
tax rate is 35 percent.
What is the WACC for your firm?
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CALCULATING WACC: AN EXAMPLE
Step 1: calculate the pretax cost of debt.
Market value of the firm's debt is: $17 million (=$4 million + $3 million + $10 million)

Step 2: calculate the cost of equity

• The cost of the preferred stock. WACC = 7.43%

where
Wd = $17/$44
• The cost of the common stock Wps = $6/$44
Wcs = $21/$44
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LIMITATIONS OF WACC AS A DISCOUNT RATE FOR EVALUATING PROJECTS
EXHIBIT 13.3 Potential Errors When
Using the WACC to Evaluate Projects

Two types of problems can arise when

the WACC for a firm is used to
evaluate individual projects: (i) positive
NPV projects may be rejected or (ii)
negative NPV projects may be accepted.

For the tropical beverage example, if

the expected return on that project was
below the level indicated by the SML,
but above the firm's WACC, the project
might be accepted even though it would
have a negative NPV.

37
LIMITATIONS OF WACC AS A DISCOUNT RATE FOR EVALUATING PROJECTS
Condition 1:
A firm’s WACC should be used to evaluate the cash
flows for a new project only if the level of systematic
risk for that project is the same as that of the
portfolio of projects that currently comprise the firm.

Condition 2:
A firm’s WACC should be used to evaluate a project
only if that project uses the same financing mix—the
same proportions of debt, preferred shares, and
common shares—used to finance the firm as a whole.

38
ALTERNATIVES TO USING WACC FOR EVALUATING PROJECTS
Alternative 01:
If the discount rate for a project cannot be estimated directly, a financial analyst might try to find a public
firm that is in a business that is similar to that of the project.
• This public company would be what financial analysts call a pure-play comparable because it is
exactly like the project.
• Unfortunately, this approach is generally not feasible due to the difficulty of finding a public firm that
is only in the business represented by the project. If the public firm is in other businesses as well, then
we run into the same sorts of problems that we face when we use the firm's WACC.

pure-play comparable:
a comparable company that is in exactly the same
business as the project or business being analyzed

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ALTERNATIVES TO USING WACC FOR EVALUATING PROJECTS
Alternative 02:
Financial managers sometimes
classify projects into categories
based on their systematic risks.
They then specify a discount
rate that is to be used to
discount the cash flows for all
projects within each category.
1. Efficiency projects
2. Product extension projects
3. Market extension projects
4. New product projects

40 EXHIBIT 13.4 Potential Errors When Using Multiple Discount Rates to Evaluate Projects
SUMMARY
SUMMARY OF KEY EQUATIONS

42
PRACTICE
THANK YOU FOR YOUR
ATTENTION
Instructor: Do T. Thanh Huyen
Lecturer, Faculty of Business
FPT University
Email: HuyenDTT24@fe.edu.vn