COST OF CAPITAL

When we calculated NPV, we used a discount rate. In this chapter we will learn how to determine the discount
rate.

A Company has following methods to raise capital:

1. Equity shares

2. Preference shares = You get periodic coupons and in the event of liquidation, you will be paid before the
equity holders.

3. Debt holders = Hold bonds, paid periodic coupons and are repaid back the principal upon bond maturity.

They are known as capital components and the cost of each is called component cost of capital.
Cost of Debt (Kd)

• It is the rate at which the firm can issue new debt.

• It the Yield to Maturity (YTM) on existing debt.
• Coupon rate is not taken as Kd.
• YTM is the Kd.
• YTM is the IRR from the investor’s perspective. It is the return the investor will receive if he holds the bond till maturity.
• YTM is the rate that makes the PV of future cash flows equal to the current market price.
• E.g. A bond is currently trading at a price of $1020. It pays a periodic coupon of $80 and matures in 10 years. When the
bond matures, the investor is repaid the Face Value (FV) $1000. Calculate the i/y (YTM).
Interest Expense
• In case of perpetual (lifetime) debt, Kd 
Market Price of Debt

• If the YTM is not directly given or cannot be determined using the market information of the Co’s bond or if your bond
is not publicly traded, we determine the Kd using Matrix Pricing. The analyst will use the rating and maturity of the
firm’s existing debt and compare it with a similar publicly traded bond to determine the YTM.
• E.g. Your bond is a single-A rated bond with a maturity of 15 years. The analyst will compare it with a bond with similar
characteristics and use its market price to determine the YTM.
• If the Co issues a Floating-rate debt, the analyst must estimate the longer-term cost of firm’s debt using the current
Yield Curve for the debt with similar ratings. Estimating the cost of a floating rate security is difficult because the rate of
interest is fluctuating over the life of the debt – it depends not only on the current yields but also on future yields.
Interest paid is a tax deductible expense i.e. it reduces the taxes you pay. So issuing debt offers some tax-saving advantages.

Hence we have to reduce the marginal tax rate from the Kd and determine the After-tax Kd.

Therefore, After-tax cost of debt = Kd(1 - t)

Examples:

1. The company is planning to issue net debt at an interest rate of 9%. The marginal tax rate is 30%. Find the after-tax cost
of debt for the Co.

2. If the tax rate goes up to 40%, what is the new Kd.

3. A company has issued perpetual-coupon paying bonds with a coupon rate of 8%. The bonds have a par value of $100
and currently are trading at a market price of $102. What is Kd?

4. The debt of the Co is privately held. The bond matures in 20 years and is rated AA. Its competitor has recently issued a
20 year AA rated bond with a YTM of 7%. The company has a marginal tax rate of 25%. What should be taken as the
after-tax cost of debt?

5. A 10-year 6% corporate bond is trading at a price of $95. What should be the Kd?
Cost of Preferred stock (Kp)
Preferred Dividends
• Preference shares are usually paid a fixed dividend. K ps 
Market Price of Preferred Stock
• For simplicity, we assume that these preference share are non-convertible, non-callable and non-participating.
• Preference dividends do not provide the Co. with any tax benefits, as these dividends are paid after paying the
corporate taxes. So we don’t make any adjustment for tax savings.

E.g. Determine Kp in the following cases:

1. The Co has issued 10% Preference shares and these shares are trading at par in the market.

2. The current market price of the preference share is $110. These shares are paid a dividend of $15 every year.
 COST OF EQUITY (Ke)

Ke can be calculated by three Approaches:

1. Capital asset pricing model (CAPM)
2. Dividend discount model (DDM)
3. Bond yield plus risk premium

The answers will vary for all 3 approaches.

Equity dividends are also paid after paying the corporate taxes, so there is no adjustment for tax savings.
CAPM Method


R e  R f   E ( Rm )  R f 

Rf = Risk free rate. It is the yield on a default-free bond (US T-notes). The maturity of this note is same as the project life.

β = Beta measures the riskiness of the stock compared to the market.

• If the stock is more risky than the overall market, it will have a Beta > 1.
• If it is less risky compared to the market, β will be < 1.
• If the risk is same as the market, β = 1.

E(Rm) is the expected return on the market.

E(Rm)– Rf is the expected Market Risk Premium (compensation for extra risk taken).
E.g. Calculate Ke in the following situations:

1. Beta of the stock is 1.2 RFR is 5% Market return is 10%

2. Beta of the stock is 1.5 RFR is 6% Market risk premium is 6%.

3. Using the data in Q1,

• What happens to ke if Beta is increased to 2
• What happens if the MRP is reduced to 5%
• What happens if the RFR is increased to 7%
Dividend Discount Model Approach:

If the stock is currently paying dividends, the dividends are expected to grow at a constant rate (g) each year and the
current price of the share is given, we can determine Ke.

 D1 
R e     G
We always consider the next year’s dividend.

D1 = D0 (1+g)
 P0 
Growth rate (g) is determined using the formula:
G = (Retention Rate) x (Return on Equity)
= (1 - payout rate) x (RoE)

Retention rate is the % of earnings left with the Company after paying dividends to the equity shareholders. E.g. The
company had total earnings of $100 and it distributed $40 as dividends (40% is the payout rate).

So the remaining $60 or (1 – 0.4 = 0.6) 60% in this case is the retention rate.

Estimating the firm’s future growth rate is difficult.

Calculate Ke for the following:

1. The stock is currently trading at $100 and will pay a dividend of $5 at the end of the year. The estimated
growth rate is 8%

2. Currently the stock is paid $10 as dividends. Estimated growth rate is 10%. The stock is trading at a price of
$250.

3. The company paid 50% of its earnings as dividends last year. The expected dividend is $4 and the current
share price is $60. ROE is 10%

4. The ROE was 18% and the Company is expected to retain 40% of its earnings. Last years dividend was $1 and
the current share price is $30.
Bond Yield plus Risk Premium Approach:

• Equities are considered to be more risky than bonds. If a bond is giving you a return of 8%, the equity must give you a
higher return for the additional risk that you are taking.
• Analysts therefore add a risk premium to the market yield of the firm’s long-term debt and determine Ke.

Re  bond yield  Equity risk premium

• Bond yield used is Before-tax (if After-tax cost of debt is given, convert it to before-tax).

E.g. Calculate Ke

1. The YTM of the Co’s bond is 7%. The analyst assume an ERP of 4%.

2. A Co’s bond is trading at a price of $108 and it pays a coupon of $6 each year. The equity risk premium is 9%.

3. The ERP is 4% and the after-tax cost of debt is 6%. The marginal tax rate is 40%.
The Co’s capital structure is made up of Equity, Preference share and Debt. Any increase in the firm’s total assets will have to
be financed through an increase in at least one of these capital accounts.

Now that we know how to calculate Kd, Kp and Ke, we have to adjust them with the respective weights of their capital
components.

If a Co’s capital structure is made up of 40% Equity, 30% Debt and 30% Preference shares, the weights are 0.4 for Equity, 0.3
for Debt and 0.3 for Preference shares.
• WACC is also referred to as the Marginal Cost of Capital (MCC).
• WACC is based on the target capital structure of the Company i.e. based on market values of all components.
• In the absence of target capital structure, use current capital structure based on market values.
• Alternatively, we can also use the industry average capital structure as the target capital structure.
• It reflects the risk of the projects that make up the firm.
• It has to be adjusted upward for projects with greater-than-average risk.
• If the target capital structure is not given, and there is a noticeable trend that the Co is reducing its proportion of debt
financing each year, we have to assign less weights for Debt when estimating WACC.

A Co creates value by producing a return that is higher than the required rate of return (WACC) on the capital needed to
fund the projects or assets.

E.g.

1. The target capital structure of the Co is 60% equity, 30% Debt and 10% preference shares. If the cost of each component
capital is Kd = 8% Kp = 9% Ke = 12% Tax rate is 30%determine WACC.

2. If we interchange the weights of equity and debt, what is the new WACC?
Determine WACC if the value of the capital components are as follows:

Book value of debt $200mn

Market value of Debt $250mn
Preference shares outstanding 500,000 shares
Market price of Preference Shares $100
Equity Shares outstanding 1mn shares
Book Value of Equity shares $50
Market price of Equity shares $200
Kp 10%
Kd 8%
Tax rate 30%
Expected risk premium 6%
 Marginal cost of capital is the cost of raising additional
capital. As you keep on borrowing through any source,
the cost will go up, because the risk goes up for the
financers. So the MCC is upward sloping.

Investment Opportunity schedule plots the projects with

the highest IRR to the lowest IRR.
If you have less money, you will invest in projects that
gives you the higher IRR.
When you have additional funds, you still keep investing
in projects that offer you decent returns. So the IOS is
downward sloping.

The Optimal Capital Budget is the point of intersection of

these 2 curves. It is the point where your return from the
project is equal to the cost of capital.

On points to the left of the intersection, your returns are more than the cost, and vice versa if on the right. The Co should
not accept any projects on the right of the intersection as the IRR is less than the cost of capital.
A Co’s Equity Beta is a measure of systematic or market risk (risk that cannot be eliminated or reduced).

Equity Beta is a.k.a. Levered Beta (Co. has both Debt and Equity i.e. it has some leverage). The risk arising for
equity shareholders only.

Asset Beta is a.k.a. Unlevered Beta i.e. Beta specific to a Project or Asset only. Project is financed using debt
and equity. It is the risk for the entire project i.e. risk pertaining to all contributors of capital.

Scenario:
• We neither have the Equity Beta nor the Asset Beta for our Co.
• We find a comparable Co. that engages in similar kind of projects or has similar assets.
• Information about that Comparable Co. is available - We know its Equity beta, D/E ratio, Tax rate.
• We break-down the Equity Beta of that Comparable and find out the Asset/Project Beta.
• Our Co and the Comparable Co. engage in similar Projects, so the Asset/Project Beta should be the same for
both of us. So the comparable firm’s Asset/Project beta is our Asset/Project beta.
• This Asset beta is for all contributors of capital. We make adjustment for the leverage of our Co. and find
Equity beta of our firm.
• This is Pure-play Method – We determine the Asset/Project Beta and Equity Beta for our Co. that is not
publicly traded.
To get the asset beta for a publicly traded firm (comparable Co.), use the Tax, Debt & Equity of that comparable Company.

Equity
Beta (Asset) = Beta (Equity) of
Comparable Co. Equity + Debt (I – T)

To get the equity beta of our Co’s project, use the subject firm’s (our firm’s) tax rate, Debt & Equity Values.

Equity + Debt (1 – T)
Equity Beta = Beta (Asset)
Equity

If D/E ratio is given as 0.5, Debt is 0.5 and Equity is 1.

Example:

Our Co A is considering a food distribution Project. It has:

D/E ratio 1.5
Tax rate 30%
Kd 12%

Co. B is a comparable Co and has the following data:

D/E ratio 1
Tax rate 25%
Equity Beta 0.9

RFR 5%
Erm 10%

Calculate:
• Asset Beta of B
• Equity Beta of A
• WACC of A
Issues with Beta:

• Estimated using historical data

• Time sensitive = varies depending on no. of years, daily or weekly etc.
• Mean reverting = have a tendency to revert back to 1 over a period of time.
• Beta for Small cap firms need to adjusted higher to reflect the higher risk.
Country Risk Premium

Developing countries have higher risk than Developed countries. Hence, while using CAPM for Cos operating in Developing
countries, we need to add a Country Risk Premium.

Ke = Rf + ß [E(Rm) – Rf + CRP]
The additional risk of the developing country is reflected in its Sovereign Yield Spread (difference between the yield of
Developed Country’s T-Bond and a Developing Country’s T-Bond with same maturity).

If 10-year U.S. T-bonds yield 4%, 10-year T-bonds of a developing country (India) will yield something more, say 7%. The
additional 3% is to compensate for country related risk.
E.g.

An analyst of a Company is estimating Ke for a project in Argentina and has gathered the following info:

Project Beta 1.5

E(Rm) 12%
RFR 5%
Country Risk Premium 4%

Calculate Ke using CAPM.

MARGINAL COST OF CAPITAL

It is the cost of the last new dollar of capital a firm raises. As the firm keeps on raising capital, the costs of different sources of
funds will increase.

If you keep on borrowing Debt, the riskiness goes up, and hence the cost of debt. The existing bond covenants will prevent
you from issuing additional senior debt (seniority refers to repayment – they will be paid off 1 st).
So the Co. will issue Subordinate Debt at a higher Kd (If you will receive payment later than others, you will demand a higher
rate of interest for the additional risk taken).

Issuing new Equity is expensive than using retained earnings due to Floatation Costs (costs paid to the Investment Bank to
help the Co issue new Equity).

As different sources of financing become more expensive as the firm raises more capital, MCC (expressed as a graph) has an
upward slope.

Break points = occur any time the cost of one of the capital component changes.
Target Capital Structure is 60% Equity and 40% Debt.

This Co. will have 4 break points:

1. Raise 100-199mn Debt or > 100mn Debt
2. Raise 200-299mn Debt or > 200mn Debt
3. Raise 200-399mn Equity or > 200mn Equity
4. Raise 400-599mn Equity or > 400mn Equity
The Break point tell us, when do we need >100mn Debt = when we are raising more than $250mn total capital.

The Capital structure is 60% Equity and 40% Debt.

So when the Co. is raising $250mn, 40% comes from Debt and 60% comes from Equity.
It will raise $100mn from Debt and $150mn from Equity.
Correct Treatment of Floating Costs

Do not add the floatation costs (%) to the cost of equity. This will increase the WACC and we will be incorrectly using a
higher discount rate to calculate NPV (NPV will be lower).
Floatation costs are one-time costs and are not an ongoing expense. So calculate the Dollar value and add it to the Initial
cash Outflow.

Example:
A Company is planning to invest in a project costing $1mn cash outlay. The project will generate a cash flow of 350,000 every
year for 4 years.
Tax rate 30%
Kd (Before tax) 7%
Current Share price 50
Dividend next year 2.5
Expected growth rate 4%
Debt Equity ratio 2/3
Floatation costs 5%

Calculate WACC and NPV.

 After-tax Kd 7% * (1-0.3) 4.90%
Cost of Equity (2.5/50) + 0.04 9.00%

Weight of Debt 40%

Weight of Equity 60%

WACC 0.4*4.9 + 0.6*9 7.36%

Project value $1,000,000

Equity Portion $600,000
Debt Portion $400,000.0

Floatation costs 0.05*600,000 $30,000

Initial Outlay 1mn + 30,000 $1,030,000

NPV -$1,030,000 $ 350,000 $ 350,000 $ 350,000 $ 350,000

(1.0736)^1 (1.0736)^2 (1.0736)^3 (1.0736)^4

$145,952.4869
Incorrect Method:

We adjust Ke with the floatation cost (%) and this results in a different WACC. The NPV calculated is also different.

After-tax Kd 7% * (1-0.3) 4.900%

Cost of Equity 2.5 +0.04 9.2632%

50(1-0.05)

WACC 0.4*4.9 + 0.6*9.2632 7.5179%

NPV -$1,000,000 $ 350,000 $ 350,000 $ 350,000 $ 350,000

(1.0752)^1 (1.0752)^2 (1.0752)^3 (1.0752)^4

$171,793