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Chapter 10 Cost of Capital

Cost of Capital Components

-Debt -Preferred -Common Equity


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What types of long-term capital do firms use?

Long-term debt Preferred stock Common equity
New Issues

Retained Earnings

Cost of a source of capital for the company would be the investors required return on that investment.
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1 r


1 r


The required return r must 1. compensate our investors (common, preferred, and bonds) for the risks they bear 2. take into account what fraction of the funding is coming from each type of investor 3. take taxes into account
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Why Cost of Capital Is Important

The return earned on assets depends on the risk of those assets Our cost of capital provides us with an indication of how the market views the risk of our assets The cost of capital is our required return for capital budgeting projects

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Required Return
The required return is based on the risk of the cash flows With the required return we can compute the NPV We need to earn at least the required return to compensate our investors for the financing they have provided

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Initial Assumptions
1. The cash flows of the project are of similar risk to those of the existing firm 2. The project will use a similar mix of financing as the existing firm

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Comments about flotation costs:

Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the perproject cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.
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Why is the cost of internal equity from reinvested earnings cheaper than the cost of issuing new common stock?

1. When a company issues new common stock they also have to pay flotation costs to the underwriter. 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

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Cost of Equity
The return required by common stockholders to invest in our project given the riskiness of project cash flows. Two methods Dividend growth model

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What are the two ways that companies can raise common equity?
Directly, by issuing new shares of common stock. Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

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The Dividend Growth Model Approach

Start with the dividend growth model formula and rearrange to solve for RE
D 1 + g P 0 D0 ( 1+ g ) + g P 0
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RE = RE =

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2. Using DCF:
You are estimating the cost of retained earnings for Jax Liquor. The current stock price is $40 and the next expected dividend is $2.00. The companys dividends are expected to grow at a constant annual rate of 6%.

D0 1 g D1 rs g g P P 0 0
$2.00 0.06 $40 .00

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Estimating the Growth Rate

Use the historical growth rate if you believe the future will be like the past. Obtain analysts estimates: Value Line, Zacks, Yahoo!.Finance. Use the earnings retention model, illustrated on next slide.

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Example: Estimating the Dividend Growth Rate

One method for estimating the growth rate is to use the historical average
Year 1995 1996 1997 1998 1999
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Dividend 1.23 1.30 1.36 1.43 1.50

Percent Change
(1.30 1.23) / 1.23 = 5.7% (1.36 1.30) / 1.30 = 4.6% (1.43 1.36) / 1.36 = 5.1% (1.50 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

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Advantages and Disadvantages of Dividend Growth Model

Advantage easy to understand and use Disadvantages
Only applicable to companies currently paying dividends Not applicable if dividends arent growing at a reasonably constant rate Sensitive to the estimated growth rate Does not explicitly consider systematic risk
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Could DCF methodology be applied if g is not constant?

YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. But calculations get complicated.

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The SML Approach (CAPM)

Use the following information to compute our cost of equity

RE R f E ( E ( RM ) R f )

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Issues in Using CAPM

Most analysts use the rate on a longterm (10 to 20 years) government bond as an estimate of rRF. For a current estimate, go to, select U.S. Treasuries from the section on the left under the heading Market.
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Issues in Using CAPM (Continued)

Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM) Estimates of beta vary, and estimates are noisy (they have a wide confidence interval). For an estimate of beta, go to and enter the ticker symbol for STOCK QUOTES.

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Advantages and Disadvantages of SML

Explicitly adjusts for systematic risk Applicable to all companies

Have to estimate the expected market risk premium Have to estimate beta We are relying on the past to predict the future, which is not always reliable

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1. Using CAPM
You are trying to estimate the cost of retained earnings for Xenex CO. A 10-year treasury bond is currently yielding 7%. You estimate that the companys beta is 1.14 and that the required return on the market is 12%. The cost of retained earnings using CAPM would be:
rs 0.07 1.14 (0.12 0.07 ) 0.127 12 .7%

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Cost of Debt
The cost of debt is the required return on our companys debt We usually focus on the cost of long-term debt or bonds Estimated by computing the yield-tomaturity on the existing debt We may also use estimates of current rates based on the bond rating we expect when we issue new debt The cost of debt is NOT the coupon rate
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Cost of Debt
Method 1: Ask an investment banker what the coupon rate would be on new debt. 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 companys debt, if it has any.

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Cost of Debt
Assume that a firm has an outstanding 30year semi-annual coupon bond with a face value of $1,000 and an annual coupon rate of 14%. The bond is selling at par. If the company issues new bonds, a flotation cost of 5% would be incurred. The firms combined marginal federal and state tax rate is 40%. What is the cost of debt?
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Cost of Debt
First calculate the YTM, taking into account that the firm only receives (1-0.05)$1,000 = 950 per bond issued: 0 1 2 60


1,000 70 + 1,000

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7.37% x 2 = rd = 14.74%
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Cost of Debt
Interest is tax deductible, so the after tax (AT) cost of debt is:
rd AT = rd BT(1 - T) = 14.74%(1 - 0.40) = 8.84%.

Use nominal rate

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Cost of Preferred Stock

Preferred generally pays a constant dividend every period, g = 0. Dividends are expected to be paid every period forever

D0 (1 g ) Rp g P0 D Rp P0
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Cost of preferred stock?

A firm can issue 8% preferred stock with a par value of $100. The flotation cost is 2% of the par value. Use this formula:
rps D ps PF

8 $100 $2.00 $8 0.0816 8.16%. $100 2

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Is preferred stock more or less risky to investors than debt?

More risky; company not required to pay preferred dividend.
However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.

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Why is yield on preferred lower than rd?

Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. Therefore, preferred often has a lower B-T yield than the B-T yield on debt. The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.
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rps = 9% rd = 10% T = 40%

rps, AT = rps - rps (1 - 0.7)(T) = 9% - 9%(0.3)(0.4) = 7.92% rd, AT = 10% - 10%(0.4) = 6.00% A-T Risk Premium on Preferred = 1.92%

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Average the returns required to attract different types of investors to get a single discount rate. This average is the overall required return on our assets, based on the markets perception of the risk of those assets The weights are determined by how much of each type of financing that we use
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The Weighted Average Cost of Capital WACC

Capital Structure Weights

Notation E = market value of equity = # outstanding shares times market price per common share D = market value of debt = # outstanding bonds times bond market price P = market value of preferred = # outstanding shares times market price per preferred share V = market value of the firm = D + E + P Capital Structure Weights wE = E/V = percent financed with equity wD = D/V = percent financed with debt wp = P/V = percent financed with preferred
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Taxes and the WACC

We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital Interest expense reduces our tax liability
This reduction in taxes reduces our cost of debt After-tax cost of debt = RD(1-TC)

Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = wERE + wDRD(1-TC) + wPRP
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Current (Optimal) Capital Structure: Debt: 25% Pref St: 15% Com St:60% NI = $17,142.86 Div pay-out ratio: 30%; tax rate = 40% D0 = $3.60; P0 = $60; g=9% rRF = 11%; rM = 14%; beta = 1.51 Flotation costs on new common stock(F) = 10% Par value of new preferred stock = $100 Dividend on new preferred stock = $11 Flotation Cost on new preferred stock = $5 per share Before-tax required return on new debt = 12%
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Find the component costs of capital

After-tax cost of new debt: Cost of Preferred Stock:
rd(1-t) = 0.12(1-0.40) = 0.072 = 7.2%
rps =D/(P-F) = 11/(100-5) = 0.1158 = 11.58%

Cost of Retained Earnings:

Cost of New Common Stock:

Method 1: rs=D1/P0+g = 3.60(1.09)/60+0.09 = 0.1554 Method 2: rs= rRF +(rM rRF) = 0.11+1.51(.14-.11) = .1553
re = D1/(P-F)+g = 3.60(1.09)/(60(1-0.1))+0.09 = 0.1627

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How much new capital could be raised before the firm needs to sell new equity? Retained Earnings available:
NI(1-div payout ratio) = 17142.86(1-.30) = 12,000

Retained Earnings Breakpoint

12,000/0.60 = $20,000

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Using retained earnings:
WACC = 0.25(0.12)(1-0.4)+0.15(0.1158)+0.60(0.1554) = 0.1286 = 12.86%

Using new common stock:

WACC = 0.25(0.12)(1-0.4)+0.15(0.1158)+0.60(0.1627) = 0.1330 = 13.30%

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13.30% 12.86%

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$ of new capital
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WACC Estimates for Some Large U. S. Corporations

Company WACC Intel (INTC) 16.0 Dell Computer (DELL) 12.5 BellSouth (BLS) 10.3 Wal-Mart (WMT) 8.8 Walt Disney (DIS) 8.7 Coca-Cola (KO) 6.9 H.J. Heinz (HNZ) 6.5 Georgia-Pacific (GP) 5.9
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wd 2.0% 9.1% 39.8% 33.3% 35.5% 33.8% 74.9% 69.9%

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What factors influence a companys WACC?

Market conditions, especially interest rates and tax rates. The firms capital structure and dividend policy. The firms investment policy. Firms with riskier projects generally have a higher WACC.

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WACC as Discount Rate




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Divisional and Project Costs of Capital

Using the WACC as our discount rate is only appropriate for projects that are the same risk and will be financed in the same way as the firms current operations If we are looking at a project that is NOT the same risk or financed in the same way as the firm, then we need to determine the appropriate discount rate for that project For example, divisions often require separate discount rates
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Using WACC for All Projects Example

What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15%
Project A B C
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IRR 17% 18% 12%

WACC 15% 15% 15%

Truth 20% 16% 10%

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The Pure Play Approach

Find one or more companies that specialize in the product or service that we are considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies
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Subjective Approach
Consider the projects risk relative to the firm overall If the project is more risky than the firm, use a discount rate greater than the WACC If the project is less risky than the firm, use a discount rate less than the WACC You may still accept projects that you shouldnt and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
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Subjective Approach Example

Risk Level Low Risk Same Risk as Firm High Risk Discount Rate WACC 4% WACC = 14% WACC + 6%

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