# COST OF CAPITAL

Key Concepts and Skills
»Know how to determine a firm¶s cost of equity capital »Know how to determine a firm¶s cost of debt »Know how to determine a firm¶s overall cost of capital »Understand pitfalls of overall cost of capital and how to manage them

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Chapter Outline
»The Cost of Capital: Some Preliminaries »The Cost of Equity »The Costs of Debt and Preference shares »The Weighted Average Cost of Capital »Divisional and Project Costs of Capital »Flotation Costs and the Weighted Average Cost of Capital

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Why Cost of Capital Is Important »We know that the return earned on assets depends on the risk of those assets »The return to an investor is the same as the cost to the company »Our cost of capital provides us with an indication of how the market views the risk of our assets »Knowing our cost of capital can also help us determine our required return for capital budgeting projects 15-4 .

Required Return »The required return is the same as the appropriate discount rate and is based on the risk of the cash flows »We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment »We need to earn at least the required return to compensate our investors for the financing they have provided 15-5 .

COST OF EQUITY 6 .

Cost of Equity »The cost of equity is the return required by equity investors given the risk of the cash flows from the firm » Business risk » Financial risk »There are two major methods for determining the cost of equity » Dividend growth model » CAPM* (capital asset pricing method) *A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities 15-7 .

The Dividend Growth Model Approach »Start with the dividend growth model formula and rearrange to solve for KE D1 P0 ! KE  g K E P0 : market price of equity share KE : cost of equity D1 : dividend g : Growth D1 !  g P0 15-8 .

The current price is Rs 25.1% per year and the market expects that to continue.1 % 25 15-9 .Dividend Growth Model Example »Suppose that your company is expected to pay a dividend of 1. What is the cost of equity? 1 . There has been a steady growth in dividends of 5.50 KE !  .051 ! .111 ! 11 .50 per share next year.

9) / 4 = 5.30) / 1.36) / 1.30 1.30 = 4.43 1.23 1.30 ± 1.6 + 5.1% (1.6% (1.1 + 4.23 = 5.50 ± 1.7 + 4.36 = 5.36 ± 1.50 Percent Change - Example: Estimating the Dividend Growth Rate (1.1% 15-10 .23) / 1.»One method for estimating the growth rate is to use the historical average » Year » 2000 » 2001 » 2002 » 2003 » 2004 Dividend 1.36 1.43 = 4.43) / 1.9% Average = (5.7% (1.43 ± 1.

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 aren¶t growing at a reasonably constant rate » Extremely sensitive to the estimated growth rate ± an increase in g of 1% increases the cost of equity by 1% » Does not explicitly consider risk 15-11 .

The CAPM Approach »Use the following information to compute our cost of equity » Risk-free rate. F KE ! Rf  FE (RM  Rf ) 15-12 . RM ± Rf » Systematic risk of asset. Rf » Market risk premium.

»Rf .This is the amount obtained from investing in securities considered free from credit risk.Risk-Free Rate . such as government bonds. 13 . The interest rate of Treasury bills or the long-term bond rate is frequently used as a proxy for the risk-free rate.

the share is exaggerating the market's movements.»ß .Beta . if a stock's beta is 1. 14 . less than one means the share is more stable. indicates that the company moves in line with the market. a company may have a negative beta (e. Occasionally. which means the share price moves in the opposite direction to the broader market. A beta of one. it's theoretically 20% more volatile than the market. a gold mining company). For example.This measures how much a company's share price moves against the market as a whole. for instance. If the beta is in excess of one.g.2.

It is a highly contentious figure. to compensate them for taking extra risk by investing in the stock market. over and above the risk-free rate. In other words.»Rm ± Rf) = Equity Market Risk Premium The equity market risk premium (EMRP) represents the returns investors expect. Many commentators argue that it has gone up due to the notion that holding shares has become riskier 15 . it is the difference between the risk-free rate and the market rate.

adjustments can be made to take account of risk factors specific to the company.»Once the cost of equity is calculated. which may increase or decrease the risk profile of the company. concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment and they vary from company to company. Such factors include the size of the company. 16 . pending lawsuits.

6%.6) = 11.1 + . we should feel pretty good about our estimate 15-17 .1%.Example .58 and the current risk-free rate is 6.CAPM »Suppose your company has an equity beta of .58(8. If the expected market risk premium is 8.1% »Since we came up with similar numbers using both the dividend growth model and the CAPM approach. what is your cost of equity capital? » KE = 6.

which also varies over time » We are using the past to predict the future. as long as we can estimate beta »Disadvantages » Have to estimate the expected market risk premium. which is not always reliable 15-18 . which does vary over time » Have to estimate beta.Advantages and Disadvantages of CAPM »Advantages » Explicitly adjusts for systematic risk » Applicable to all companies.

5.5(9%) = 19. We have used analysts¶ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was Rs 2.06 = 19.5% »Using DGM: KE = [2(1. What is our cost of equity? »Using CAPM : KE = 6% + 1.65] + .55% 15-19 .Example ± Cost of Equity »Suppose our company has a beta of 1.65. Our stock is currently selling for Rs15. The market risk premium is expected to be 9% and the current risk-free rate is 6%.06) / 15.

COST OF DEBT 20 .

Cost of Debt » The cost of debt is the required return on our company¶s debt » We usually focus on the cost of long-term debt or bonds » The required return is best estimated by computing the yield-to-maturity 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 15-21 .

cost of debt is fairly straightforward to calculate.Cost of Debt »Compared to cost of equity. 22 . If the company is not paying market rates. The rate applied to determine the cost of debt (Kd) should be the current market rate the company is paying on its debt. an appropriate market rate payable by the company should be estimated.

corporate tax rate).»As companies benefit from the tax deductions available on interest paid. the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. the after-tax cost of debt is Kd (1 . Therefore. 23 .

000 2.64.00.50.31.00.000 50.000 50.14.000 24 .000 2.00.000 2.31.36.000 1.000 With Debt 4.19.Tax effects of financing with debt With Equity EBIT Interest EBT 4.000 TAXES 34% PAT DIVIDENDS RETAINED EARNINGS 1.000 3.000 2.000 0 4.

CPT I/Y = 5%. What is the cost of debt? » N = 50. PMT = 45. The coupon rate is 9% and coupons are paid semiannually. YTM = 5(2) = 10% 15-25 .75.72 per Rs1000 bond. The bond is currently selling for Rs 908. FV = 1000.Example: Cost of Debt »Suppose we have a bond issue currently outstanding that has 25 years left to maturity. PV = -908.

86/97 or 16.15 % bond.Bo)/n) / (F + Bo) / 2 Bo= issue price of bond »INT= the amount of interest »F= Maturity Value »n = years »Example= 7 year .Short cut method to compute Kd »Cost of Debt = (INT+ (F. each bond is sold below par for Rs 94 »(15 + (100-94)/7 )/ (100+94)/2 =15.4% 26 .

COST OF PREFERENCE SHARES 27 .

»Preferred shares generally has a dividend that must be paid out before dividends to equity shareholders and the shares usually do not have voting rights.Preference Shares or Preferred stock »A class of ownership in a corporation that has a higher claim on the assets and earnings than equity shares . 28 .

Also known as "preferred shares 29 .»The precise details as to the structure of preference shares is specific to each corporation. the best way to think of preference shares is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). However.

Cost of Preferred Shares »Reminders » Preferred shares generally pays a constant dividend each period » Dividends are expected to be paid every period forever »Preferred shares is a perpetuity. so we take the perpetuity formula. rearrange and solve for kP »kP = D / P0 15-30 .

what is the cost of preferred shares? »kP = 3 / 25 = 12% 15-31 .Example: Cost of Preferred Stock »Your company has preferred shares that has an annual dividend of Rs 3. If the current price is Rs 25.

WEIGHTED AVERAGE COST OF CAPITAL 32 .

based on the market¶s perception of the risk of those assets »The weights are determined by how much of each type of financing we use 15-33 .The Weighted Average Cost of Capital »We can use the individual costs of capital that we have computed to get our ³average´ cost of capital for the firm. »This ³average´ is the required return on our assets.

Capital Structure Weights »Notation » E = market value of equity = # of outstanding shares times price per share » D = market value of debt = # of outstanding bonds times bond price » V = market value of the firm = D + E »Weights » wE = E/V = percent financed with equity » wD = D/V = percent financed with debt 15-34 .

Example: Capital Structure Weights »Suppose you have a market value of equity equal to Rs 500 million and a market value of debt = Rs 475 million. » What are the capital structure weights? » V = 500 million + 475 million = 975 million » wE = E/V = 500 / 975 = .4872 = 48.72% 15-35 .5128 = 51.28% » wD = D/V = 475 / 975 = .

36 .

so there is no tax impact on the cost of equity »WACC = wEKE + wDKD(1-TC) 15-37 .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 = KD(1-TC) »Dividends are not tax deductible.

I »Equity Information » 50 million shares » Rs 80 per share » Beta = 1.15 » Market risk premium = 9% » Risk-free rate = 5% »Debt Information » Rs 1 billion in outstanding debt (face value) » Current quote = 1100 » Coupon rate = 9%. semiannual coupons » 15 years to maturity »Tax rate = 40% 15-38 .Extended Example ± WACC .

CPT I/Y = 3.854% »What is the after-tax cost of debt? » KD(1-TC) = 7. PMT = 45.927(2) = 7.712% 15-39 . PV = -1100. FV = 1000.9268 » KD = 3.15(9) = 15.854(1-.II »What is the cost of equity? » KE = 5 + 1.35% »What is the cost of debt? » N = 30.4) = 4.Extended Example ± WACC .

10) = 1.Extended Example ± WACC .7843(15.1 / 5.35%) + .7843 » wD = D/V = 1.1 = .2157 »What is the WACC? » WACC = .712%) = 13.1 = .1 billion » V = 4 + 1.2157(4.06% 15-40 .1 billion » wE = E/V = 4 / 5.III »What are the capital structure weights? » E = 50 million (80) = 4 billion » D = 1 billion (1.1 = 5.

000 100 41 .000 3.000 1.IV Lohia chemicals Ltd has the following book value capital structure on 31st March 2004 Source of finance Share capital Reserve and surplus Preference share capital Debt Amount Rs¶000 4.000 1.Example ± WACC .50.00.00.000 Proportion (%) 45 15 10 30 Total 1.50.000.

The expected after tax component of the various sources of finance for lohia chemicals Ltd are as follows : Source Equity Reserve and surplus Cost % 18 18 Preference share capital 11 Debt 8 42 .

3 43 .000.1 2.000 10 11 1.50.00.50.7 Share capital Reserve and surplus Preference share capital Debt Total 4.000 1.Source 1 Amount 2 Proportion 3 After tax cost Weighted 4 cost % 5= 3X4 18 18 8.4 14.000 45 15 1.000 1.000 30 100 8 WACC 2.1 3.00.

PROBLEM The servex Company has the following capital structure on 30th June 2009 (Rs µ000) Ordinary shares (200. It is expected that company will pay next year a dividend of Rs 2/. which will grow at 7% forever.per share .000 shares) 10% Preference shares 14 % Debentures 4000 1000 3000 8000 The shares of the company sells for Rs 20/-. Assume 50 % tax rate 44 .

000 debt by issuing 15 % debentures.You are required to : (a) Compute the WACC on the existing capital structure (b) Compute the new WACC if the company raises an additional Rs 2.and leave the growth rate unchanged .000. but the share will fall to Rs 15/per share. This will result in increasing the expected dividend to Rs 3/. (c) Compute the cost of capital if in (b) above the growth rate increase to 10% 45 .

5% 10% 1.5 % 10% Preference shares 1000 12. 07 Rs 20 .Weights Ordinary shares 4000 50% After tax cost 17% WACC 8.5)= 7% 46 .37% K E ! Rs 2  .5% 7% 2.10+.62% 8000 100 % 12.17=17% Kd= 14 %( 1-.07=.25% 14 % Debentures 3000 37.

5% 2.4% KE Rs 3 !  .1% 1.20+. 07 Rs 15 .07= 27% 47 .8 % 1% 3000 2000 10000 30% 20% 100 % 7% 7.5% 15.Weights Ordinary shares 10% Preference shares 14 % Debentures 15% Debentures 4000 1000 40% 10% After tax cost WACC 27% 10% 10.

Weights Ordinary shares 10% Preference shares 14 % Debentures 15% Debentures 4000 1000 40% 10%

After tax cost WACC 30% 10% 12 % 1%

3000 2000 10000

30% 20% 100 %

7% 7.5%

2.1% 1.5% 16.6%

K

E

!

Rs 3  . 10 Rs 15

.20+.10= 30%

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Divisional and Project Costs of Capital
»Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm¶s current operations »If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project »Divisions also 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 Required Return 20% 15% 10% IRR 17% 18% 12%

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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 15-51 .

use a discount rate less than the WACC »You may still accept projects that you shouldn¶t and reject projects you should accept. but your error rate should be lower than not considering differential risk at all 15-52 . use a discount rate greater than the WACC »If the project has less risk than the firm.Subjective Approach »Consider the project¶s risk relative to the firm overall »If the project has more risk than the firm.

Example Risk Level Very Low Risk Low Risk Same Risk as Firm High Risk Very High Risk 15-53 Discount Rate WACC ± 8% WACC ± 3% WACC WACC + 5% WACC + 10% .Subjective Approach .

not how the money is raised »However. the cost of issuing new securities should not just be ignored either »Basic Approach » Compute the weighted average flotation cost » Use the target weights because the firm will issue securities in these percentages over the long term 15-54 .Flotation Costs »The required return depends on the risk.

105 » NPV = 1.1.000/(1-. the NPV becomes negative 15-55 .375)(3%) + (.6 The flotation cost for equity is 5% and the flotation cost for debt is 3%. The project will generate after-tax cash flows of \$250.000 per year for 7 years.105 .0425) = -4.625)(5%) = 4.281 » The project would have a positive NPV of 40. What is the NPV for the project after adjusting for flotation costs? » fA = (.000.040.040.NPV and Flotation Costs .105 without considering flotation costs » Once we consider the cost of issuing new securities.25% » PV of future cash flows = 1.Example » Your company is considering a project that will cost \$1 million. The WACC is 15% and the firm¶s target D/E ratio is .

Quick Quiz » What are the two approaches for computing the cost of equity? » How do you compute the cost of debt and the aftertax cost of debt? » How do you compute the capital structure weights required for the WACC? » What is the WACC? » What happens if we use the WACC for the discount rate for all projects? » What are two methods that can be used to compute the appropriate discount rate when WACC isn¶t appropriate? » How should we factor in flotation costs to our 15-56 analysis? .

have no voting rights. and should not be included in shares outstanding calculations 57 . or it may have never been issued to the public in the first place.»What Does Treasury Stock (Treasury Shares) Mean? The portion of shares that a company keeps in their own treasury. These shares don't pay dividends. Treasury stock may have come from a repurchase or buyback from shareholders.

Therefore. For example. 58 . these companies are negatively affected. As such. All they do is sell one particular type of product over the internet.»A pure play is a company that invests its resources in only one line of business. if internet buying declines even slightly. this type of stock has a performance that correlates highly to the performance of the stock's particular industry. many electronic retailers or "e-tailers" are pure plays.

Whereas Pepsi wouldn't be pure play. 59 . a startup R&D company developing a new technology would be considered pure play because its success depends upon a single product. Coca-Cola would also be considered a pure play in the beverage business. »For example. because it has activities in the food business. or a company whose stock price is highly correlated with the fortunes of a specific investing theme or strategy.»A company devoted to one line of business.

»Back ±up slides 60 .

6 per share.00. The expected dividend per share next year is 50% of the the 2003 EPS 61 .00.00.000 The Company µs share has a current market price of Rs 23.00.PROBLEM The kay Company has the following capital structure as at 31st march 2003 14% Debentures 3.00.000 Equity (1.000 11% Preference shares 1.000 20.000 Shares) 16.

46 YEAR 1999 2000 2001 2002 2003 EPS Rs 1.10 1.The following are the earnings per share figure for the company during The preceding ten years .21 1.36 62 .15 2. YEAR 1994 1995 1996 1997 1998 EPS Rs 1.95 2.77 1. The past trends are expected to continue.00 1.33 1.61 1.

»The company can issue 16% per cent new debentures . The company tax rate is 50 % »Calculate the after tax cost of (1) of new debt (2) of new preference capital (3) of ordinary equity 63 .20 paying a dividend of Rs 1. The company µs debenture is currently selling at Rs 96.1 per share . The new preference shares can be sold at a net price of Rs 9.

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