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CHAPTER 10

The Cost of Capital

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Topics

Cost of Capital Components


Debt
Preferred
Common Equity

WACC


Composite
Risk Adjustments
WACC with Flotation Costs
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Sources of Long-term Capital

rd

rs

rps

rce

re
3

10-3

WACC Weighted Average Cost of Capital WACC = wdrd(1-T) + wpsrps + wcers(10.10) Where: Weights Component costs w d = % of debt in capital structure w ps = % of preferred stock in capital structure w ce = % of common equity in capital structure rd = firm’s cost of debt rps= firm’s cost of preferred stock rs = firm’s cost of equity T = firm’s corporate tax rate 4 .

and deferred taxes ≠ sources of funding from investors   Not included in calculation of the cost of capital Adjustments made when calculating project cash flows 5 .Capital Components   Capital components = sources of funding from investors Accounts payable. accruals.

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 company’s outstanding debt 6 .

NCC’s Cost of Debt (rd)

Calculator Solution
A 22-year, 9%
44

semiannual coupon
835.42 
bond sells for
45

1000

$835.42
= 5.50%
Bond pays a
semiannual coupon:
rd = 5.5% x 2 = 11%

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Component Cost of Debt

Interest is tax deductible, so the
after tax (AT) cost of debt is:

rd AT

= rd BT(1 - T)

rd AT

= 11%(1 - 0.40) = 6.6%

Use nominal rate

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Flotation Costs on New
Debt

Flotation costs on debt usually low
Frequently ignored
“Project Financing”

Adjusts project’s cash flows for
flotation costs of debt
Debt has specific claim on the
project’s cash flows
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2) Where: M = Bond’s par value (face value) F = Flotation cost as a % N = Number of coupon payments T = Corporate tax rate INT = Dollars of interest per period rd(1-T) = after tax cost of debt adjusted for inflation 10 .Adjusting the Cost of Debt for Flotation Costs INT ( 1  T ) M M(1  F )    t N [ 1  r ( 1  T )] [ 1  r ( 1  T )] t 1 d d N (10 .

68% 11 .01) = -990 Face value = M = 1000 Calculator Solution 60  990  33  1000  = 3.40) PMT = $33 Flotation cost = 1%   N = 60 PV = -1000(1-.NCC’s Cost of Debt (rd) with Flotation Costs  NCC can issue 30-year bonds   11% annual coupon rate     Coupons paid semiannually PMT = [(.34% Nominal after-tax cost of debt with flotation costs = 6.11 x 1000)/2]*(1-.

Preferred Stock  Flotation costs for preferred are significant   Preferred dividends are not deductible    Use net price No tax adjustment Use rps Nominal rps is used 12 .

3% $100 ( 1  .3) Where: Dps = Preferred dividend PPS = Preferred stock price F = Flotation cost % r ps $10   10.025 ) 13 .NCC’s Cost of preferred stock: PP = $100 2.5% r ps  $10 Dividend D ps Pps ( 1  F ) F= (10 .

Cost of Common Equity Two Ways to raise equity financing:  Directly   Issue new shares of common stock Indirectly   Reinvesting earnings not paid out as dividends Use retained earnings 14 .

Funding with New Common Equity  Mature firms rarely issue new equity High flotation costs  Negative signal to the market  Downward pressure on stock price  15 .

there is an opportunity cost if earnings are reinvested 16 .Cost of Retained Earnings    Earnings can be reinvested or paid out as dividends Investors could buy other securities. earn a return Thus.

or company could repurchase its own stock and earn rs  rs = the cost of reinvested earnings = the cost of equity 17 .Cost for Reinvested Earnings  Opportunity cost: The return stockholders could earn on alternative investments of equal risk   They could buy similar stocks and earn rs.

rs: 1. CAPM: rs = rRF + (RM . Own-Bond-Yield-Plus-Risk Premium: rs = rd + Bond RP 18 .Three ways to determine the cost of equity. DCF: rs = D1/P0 + g 3.rRF)β = rRF + (RPM)β 2.

rRF)β = rRF + (RPM)β 2. DCF: rs = D1/P0 + g 3. CAPM: rs = rRF + (RM .Three ways to determine the cost of equity. rs: 1. Own-Bond-Yield-Plus-Risk Premium: rs = rd + Bond RP 19 .

3. 2.CAPM Cost of Equity Steps 1. 4. Estimate risk-free rate (rRF) Estimate market risk premium (RPM) or expected return on the market (RM) Estimate beta (β) Substitute into CAPM 20 .

Estimating rRF  Common stock = long-term security  T-Bills more volatile than T-Bonds  Most analysts use the rate on a long-term (10 to 30 years) government bond as an estimate of rRF 21 .

9 % geometric mean – best future estimate Ex Ante = Forward-Looking Expected Return  rˆM  If market Value Line or Reuters D1  g  rRF  RPM  R M  Required Return in equilibrium: P0 Historical or analysts’ estimates 22 .Estimating RPM or RM  Historical .if constant risk aversion 4.5% arithmetic mean .Ibbotson & Associates     1926-most recent year 6.

132)]+0.4.20% rM=[0.42% 16. Spring 2008) D (1  g ) Dividend yield on S&P500 = 2.15% Long-term T-Bond rate = 4.15% .73% Problems:   Past = future? Growth rates sensitive to period measured 23 .RPM Estimate – #1 RPM = 11.42% = 11.61% rˆM  0 g P0 Dividend growth rate = 13.73%  rM Estimate     Forward-looking RPM:    (Reuters.0261(1+.132=16.

42% = 17.79%  rM Estimate     Forward-looking RPM:   (Spring 2008) Reuters S&P500 dividend yield = 2.1% rM=[0.79% rˆM  D0 ( 1  g ) g P0 Problems:     Earnings growth ≠ dividend growth 1-year growth rate ≠ long-term growth Analysts’ accuracy Differing analysts’ opinions 24 .RPM Estimate – #2 RPM = 17.21% 22.0261(1+.61% Yahoo Earnings growth rate = 19.191=22.21% .191)]+0.4.

5] 25 .5% for the market risk premium S&P500 index return =proxy for the market return RPM=RM.rRF Brigham-Daves →RPM = [3.5.Estimating RPM (or RM)  RPM = Equity risk premium   RM    Most analysts use a rate of 5% to 6. 6.

Estimating Beta .β   Beta estimates vary Beta estimates are “noisy”   Historical Beta     Wide confidence interval 4-5 years/monthly or 1-2 years/weekly Adjusted Beta Fundamental Beta Multinational issues 26 .

NCC’s CAPM Cost of Equity rRF = 8% RPM = 6% β= 1.1 = 14.rRF )β = 8.0% + (6.1 rs = rRF + (RM .0%)1.6% 27 .

CAPM: rs = rRF + (RM .Three ways to determine the cost of equity.rRF)β = rRF + (RPM)β 2. Own-Bond-Yield-Plus-Risk Premium: rs = rd + Bond RP 28 . DCF: rs = D1/P0 + g 3. rs: 1.

Growth rate (g) 29 . Current dividend (D0) 3.DCF Approach: Inputs Pˆ0  D1 rs  g (10 . Current stock price (P0) 2.5) D1 rs  rˆ s   expected g Po 1.

Finance 30 . Zack’s. Yahoo.Estimating the Growth Rate The historical growth rate   If you believe future = past The earnings retention model Analysts’ estimates:    Value Line.

5%) x 0.5% Dividend payout ratio = 52% Retention rate = 100% .48 = 7% 31 .dividend payout   ROE = 14.52% = 48% Retention growth rate:   g = ROE x (Retention rate) g = (14.Earnings Retention Model  NCC Data:    Retention ratio = 100% .

Retention rate is constant ROE on new investments is constant No new common stock will be issued The risk of future projects is very close to the risk of the overall firm 32 . 2. 3. 4.Earnings Retention Assumptions 1.

4% annual growth for 5 years 6.5% growth after 5 years Analysts’ estimates usually best source g = 6.9% 33 .Using Analysts’ Forecasts  Analysts’ estimate earnings growth   = proxy for dividend growth Sometimes involve non-constant growth   Analysts’ Estimates for NCC:    Develop a proxy constant rate 10.

07 = 14.5% 34 .40 D0(1+g) P0 g = 7% +g + 0. rs D1 = $2.40 rs = = D1 P0 P0 = $32 +g= $2.07 $32 = 0.075 + 0.NCC’s DCF Cost of Equity.

DCF: rs = D1/P0 + g 3.rRF)β = rRF + (RPM)β 2. rs: 1. Own-Bond-Yield-Plus-Risk Premium: rs = rd + Bond RP 35 .Three ways to determine the cost of equity. CAPM: rs = rRF + (RM .

7% = 14.7%  rs = rd + RP  rs = 11.The Own-Bond-Yield-Plus-RiskPremium Method: rd = 11%.0% + 3. RP = 3.7%  This RP  CAPM RPM  Produces ballpark estimate of rs  Useful check 36 .

85% DCF 14.Final Estimate of rs Method CAPM Estimat Used by e 14.7% Non-public Average 14.5% 16% rd + RP 14.6% 74% .6% 37 .

40 P0 = $32 (10 .40 re  rˆe   .125 ) 38 .6% $32 ( 1  .9) F = 12.5% $2.Flotation Costs for Equity re = Cost of New Equity D1 re  rˆe  g P0 ( 1  F ) NCC: D1 = $2.07  15.

Topics  Cost of Capital Components     Debt Preferred Common Equity WACC    Composite Risk Adjusted WACC with Flotation Costs 39 .

WACC Weighted Average Cost of Capital WACC = wdrd(1-T) + wpsrps + wcers(10.10) Where: Weights Component costs w d = % of debt in capital structure w ps= % of preferred stock in capital structure w ce= % of common equity in capital structure rd = firm’s cost of debt rps= firm’s cost of preferred stock rs= firm’s cost of equity T = firm’s corporate tax rate 40 .

WACC Weights   Weights =percentages of the firm that will be financed by each component If possible. 60% Equity 41 . always use the target weights for the percentages of the firm that will be financed with the various types of capital  NCC: 30% debt. 10% Preferred.

6%) WACC = 11.NCC’s WACC Weighted Average Cost of Capital Component Debt (before tax) Preferred Stock Common equity w r 0.10 10.0% 0.60 14.3%) +0.6% WACC = wDrD (1.3% 0.40)+0.T)+ wPsrPs + wcrs WACC =0.3(11%)(1-.77% 42 .30 11.6(14.1(10.

After-tax Capital Costs     Long.and short-term debt affected Historical Costs vs. Book Values 43 . Annual Financing Choices Target Weights vs. Marginal Costs Target Weights vs.Cost of Capital Issues  Before-tax vs.

especially if the debt is short-term 44 .Estimating Weights for the Capital Structure   Estimate the weights using current market values rather than current book values If market value of debt is not known:  Usually reasonable to use the book values of debt.

Estimating Weights  Given: The stock price is $50  There are 3 million shares of stock  $25 million of preferred stock  $75 million of debt  45 .

Estimating Weights   Vce = $50 x (3 million) = $150 million Vps = $25 million  Vd = $75 million  Total value = $150 + $25 + $75 = $250 million 46 .

Estimating Weights 47 .

WACC 48 .

Factors that influence a company’s WACC  Market conditions       Interest rates The market risk premium Tax rates Firm’s capital structure Firm’s dividend policy Firm’s investment policy  Firms with riskier projects generally have a higher WACC 49 .

Topics  Cost of Capital Components     Debt Preferred Common Equity WACC    Composite Risk Adjusted WACC with Flotation Costs 50 .

Risk-Adjusted WACC    The composite WACC reflects the risk of an average project undertaken by the firm Different divisions/projects may have different risks The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structure 51 .

Divisional Risk and the Cost of Capital Rate of Return (%) Acceptance Region WACC WACC H Acceptance Region Rejection Region WACC F Rejection Region WACC L 0 Risk L Risk H Risk 52 .

Using WACC for All Projects Example   What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15% 53 .

The Risk-Adjusted Divisional Cost of Capital   Estimate the cost of capital that the division would have if it were a stand-alone firm Requires estimating the division’s beta. cost of debt. and capital structure  CAPM frequently used 54 .

Pure Play Method for Estimating Beta for a Division or a Project    Find several publicly traded companies exclusively in project’s business Use average of their betas as proxy for project’s beta Hard to find such companies 55 .

Huron Steel Example 56 .

Subjective Approach  Consider the project’s risk relative to the firm overall  If project risk > firm risk   Project discount rate > WACC If project risk < firm risk  Project discount rate < WACC 57 .

Subjective Approach Example Risk Level Very Low Risk Discount Rate WACC – 8% 7% Low Risk WACC – 3% Same Risk as Firm WACC High Risk Very High Risk WACC + 5% WACC + 10% 12% 15% 20% 25% 58 .

Topics  Cost of Capital Components     Debt Preferred Common Equity WACC    Composite Risk Adjusted WACC with Flotation Costs 59 .

Flotation Costs   Flotation costs depend on the risk of the firm and the type of capital being raised Flotation costs:    Highest for common equity Most firms issue equity infrequently Flotation costs frequently ignored when calculating WACC 60 .

6(14.68%)+0.36% = 11.60 WACC = wdrATd + wpsrps + wcre equity r 6.03% + 9.10 New Common c 0.1(10.004% + 1.6% WACC = 0.3% 14.3%) +0.NCC’s WACC With New Debt Component w New Debt (afterd 0.794% 61 .68% 10.30 tax) Preferred Stock ps 0.3(6.6%) WACC = 2.

3% 15.10 New Common c 0.6% WACC = 0.03% + 9.60 WACC = wdrATd + wpsrps + wcre equity r 6.6%) WACC = 2.36% = 12.394% 62 .30 tax) Preferred Stock ps 0.NCC’s WACC With New Debt & New Equity Component w New Debt (afterd 0.6(15.3%) +0.004% + 1.68%)+0.1(10.3(6.68% 10.

394 % 63 .794 % 12.NCC’s WACC WACC Description No New Issues With New Debt With New Debt & New Equity WACC 11.770 % 11.

then the NPV of all projects should be estimated using this higher marginal cost of capital 64 .Increasing Marginal Cost of Capital  Externally raised capital  flotation costs   Investors often perceive large capital budgets as being risky   Increases the cost of capital Drives up the cost of capital If external funds will be raised.

394% 13 12 WACC1 = 11.Increasing Marginal Cost of Capital % 16 15 14 WACC2 = 12.77% External debt & equity 10 9 No external funds 8 500 700 Capital Required 61 .

historical (Coupon rate) cost of debt Mixing current and historical measures to estimate the market risk premium Book weights vs. Market Weights     Use Target weights Use market value of equity Book value of debt is a reasonable proxy for market value Incorrect cost of capital components  Only investor provided funding 66 .Four Mistakes to Avoid    Current (YTM) vs.

CHAPTER 10 The Cost of Capital 67 .