THE BASICS OF COST

OF CAPITAL

PGP TERM III

IIM INDORE

THE AGENDA

WACC
Cost of Capital Components
Debt
Preferred
Common Equity

Component Weights

CAPITAL COMPONENTS
Capital components are sources of funding that come
from investors.
Accounts payable & accruals are not sources of
funding that come from investors, so they are not included
in the calculation of the cost of capital.

We do adjust for these items when calculating the

cash flows of a project, but not when calculating the cost
of capital.

SHOULD WE FOCUS ON BEFORE-TAX

OR AFTER-TAX CAPITAL COSTS?
Tax effects associated with financing can be incorporated
either in capital budgeting cash flows or in cost of capital.
Most firms incorporate tax effects in the cost of capital.
Therefore, focus on after-tax costs.

Only cost of debt is affected.

Preferred Dividends are not tax-deductible

SHOULD WE FOCUS ON HISTORICAL

(EMBEDDED) COSTS OR NEW
(MARGINAL) COSTS?
The cost of capital is used primarily to make decisions
which involve raising and investing new capital. So, we
should focus on marginal costs.

WACC
WACC = [(D/V) kd (1-t)] + [(E/V) ke]

D = Proportion of Debt in the total Value

E = Proportion of Equity in the total Value
V=E+D
kd = Cost of Debt
t = Coporate Tax Rate
Ke = Cost of Equity
Weights in WACC are market value weights

COST OF DEBT
Expected return on a traded, long-term fixed-rate obligation of a
credit quality that corresponds to the capital structure ratios built
into the WACC Formula
Method 1: Ask an investment banker what the coupon rate would be
on new debt.
Note It will not be the same as the embedded / historical rate

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.
Method 4: Synthetic Ratings

A 15-YEAR, 12% SEMIANNUAL BOND SELLS

FOR $1,153.72. WHATS R D?
0

i=?
-1,153.72

30

...
60

60

60 + 1,000

n = 30 PV = -1153.72 Coupon -60 FV= 1000

5.0% x 2 = rd = 10%

COMPONENT COST OF DEBT

Interest is tax deductible, so the after tax (AT) cost of debt is:
rd AT = rd BT * (1 - T) = 10% *(1 - 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.

COST OF EQUITY

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).
Why is there a cost for reinvested earnings?
Earnings can be reinvested or paid out as dividends.
Investors could buy other securities, earn a return.

Thus, there is an opportunity cost if earnings are reinvested.

OPPORTUNITY COST
Opportunity cost: The return stockholders could earn on alternative
investments of equal risk.
They could buy similar stocks and earn rs
So, rs, is the cost of reinvested earnings and it is the cost of equity.

THREE WAYS TO DETERMINE THE

COST OF EQUITY, RS:
1. CAPM
rs = rRF + b(rM - rRF)

2. DCF
rs = D1/P0 + g.

3. Own-Bond-Yield-Plus-Risk Premium
rs = rd + RP.

APPROACH 1: THE CAPM

COST OF EQUITY: CAPM

Req. returns = Riskless rate + Risk-premium

CAPM defines expected returns as:

Expected returns = Riskless rate + Beta x (Market risk premium)

Marginal investor: A well diversified investor that is most likely to

trade next
the only risk that he or she perceives in an investment is risk that cannot be
diversified away (i.e, market or non-diversifiable risk)
The only risk for which she earns a risk premium for: systematic risk

Not-so-well diversified / Non-diversified investors?

WHATS THE COST OF EQUITY

BASED ON THE CAPM?

rRF = 7%, RPM = 6%, b = 1.2.

rs = rRF + (rM - rRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

RISK FREE RATE

Risk free: actual return = expected return
No default risk
No reinvestment risk

Returns on Government Security

Yield to Maturity on a long term Treasury bond

Long-term for a going concern, else the maturity should meet the
projected cash flow period
Match the duration of the analysis to the duration of the risk free rate

Most analysts use the rate on a long-term (10 to 20 years)

government bond as an estimate of rRF.
Currency choices, and nominal vs. real rates consistent with cash
flows

MARKET RISK PREMIUM

Risk Premium:

Measures extra returns for making an average risk investment rather than riskfree investment
Function of risk aversion of an investor volatility and risk associated with
underlying economy

Pratt and Grabowski (2008)

Range for MRP of 3.5% to 6 %, point estimate of 5 % as of 2007

Fernandez, Aguirreamalloa and Linares (2013)

MRP in India based on a survey as on June 2013 8.5%
Risk free rate 6.9 % for India
Survey on MRP for other countries as well in the same paper

Some analysts derive estimates from historical data on US Stock and

bond returns published by Ibbotson Intl.

MARKET RISK PREMIUM

Estimating Risk premium:
Historical premium
Time period used: Estimation as back as 1926, 50 yrs, 20 yrs, 10 yrs
Longer term rates are better, however, investor risk aversion might have
changed
Choice of risk-free security
Geometric averages Vs. arithmetic averages

Implied premiums
Value = Expected dividends next period / (Required return on equity
Exp. Growth rate in dividends)

Mistake to avoid: Historical data for market returns, and

current long-term bond yield

BETA
Betas:
Risk that an investment adds to a market portfolio

Regression method
Historical data
Estimation period, observation frequencies
Market Index

Consistency between the target capital structure in the

WACC and the degree of leverage present in the estimate
period used for computing equity beta
Un-lever the historical beta and re-lever using target capital structure

BETA (CONTD.)
Fundamental Beta: Intuitive underpinnings of betas
Type of business; operating leverage; financial leverage
Financial Leverage:

L U (1 (1 t ).

D
)
E

Estimates of beta vary, and estimates are noisy (they have a wide
confidence interval).

BETA
Using betas from a sample of comparable publicly traded firms

Estimation of Bottom-up betas:

Identify the business lines
Estimate unlevered (asset) beta for comparable public firms in each line
Estimate weighted average of unlevered betas
Estimate levered beta by current market value of debt and equity

COST OF EQUITY FOR NONDIVERSIFIED INVESTORS

Marginal investor non diversified
Bottom-up beta using public firms will understate risk
Adjust for total risk rather than market risk

Total Beta

Market Beta
R squared

APPROACH 2: THE DCF APPROACH TO

DETERMINING THE COST OF EQUITY

WHATS THE DCF COST OF EQUITY, RS?

GIVEN: D 0 = $4.19;P 0 = $50; G = 5%.

rs

D 1 g
D1
g 0
g
P0
P0

$4.19105
.

0.05
$50
0.088 0.05
13.8%.

DCF APPROACH: ESTIMATING THE

GROWTH RATE
1.

Use the historical growth rate if you believe the future will be like
the past.

2.

Obtain analysts estimates: Thomson Reuters, Bloomberg, Value

Line

3.

Use the earnings retention model, illustrated on next slide.

4.

An approach used for calculating the cost of new equity (Using

Price per share net of floatation costs)

EXPECTED FUTURE GROWTH

Suppose the company has been earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout = 65%), and this situation is
expected to continue.
Whats the expected future g?

RETENTION GROWTH RATE

g = ROE * (Retention rate)
g = 0.35* (15%) = 5.25%.
This is close to g = 5% given earlier.

COULD DCF METHODOLOGY BE APPLIED IF G

IS NOT CONSTANT?

YES, non-constant g stocks are expected to have constant g at some

point, generally in 5 to 10 years.
But calculations get complicated.

APPROACH-3 TO ESTIMATING
THE COST OF EQUITY

FIND RS USING THE OWN-BOND-YIELDPLUS-RISK-PREMIUM METHOD.

rd = 10%, RP = 4%.
This RP CAPM RPM.
Produces ballpark estimate of rs. Useful check.

rs = rd + RP
= 10.0% + 4.0% = 14.0%

WHATS A REASONABLE FINAL

ESTIMATE OF RS?
Method

Estimate

CAPM

14.2%

DCF

13.8%

rd + RP

14.0%

Average

14.0%

NOTE ON WACC
Weights in WACC
Market value weights
Target Capital Structure -Weights should represent the long-term target
capital structure rather than current capital structure
Consistent rates to be used in deriving cost of equity and WACC

Tax Rate
Marginal vs. Effective Tax rates
Firms that are non-taxpayers for extended periods, appropriate tax rate
could be low or zero

WEIGHT FOR DEBT

Market value of debt

If you dont know the market value of debt

Approach A: It is usually reasonable to use the book values of debt
Approach B: Convert book value debt into market Value Debt
Treat the entire debt as one coupon instrument;
Coupon = interest expenses on all debt;
FV= total debt; maturity= weighted average maturity of debt;
discount rate= current cost of debt

ESTIMATING WEIGHTS CONTD.

Suppose the stock price is $50, there are 3 million shares of stock,
the firm has $25 million of preferred stock, and $75 million of debt.
Vce = $50 (3 million) = $150 million.
Vps = $25 million.

Vd = $75 million.
Total value = $150 + $25 + $75 = $250 million.
wce = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3

WHATS THE WACC?

WACC = wdrd(1 - T) + wpsrps + wcers

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.

COST OF PREFERRED STOCK

WHATS THE COST OF PREFERRED STOCK?

Current price of Perpetual Pref. Stock = $113.10

10% Quarterly dividend, Par = $100; F = $2.
rps

D ps

0.1 $100
$113.10 $2.00

Pn

$10
0.090 9.0%.
$111.10

PICTURE OF PREFERRED
0
-111.1

rps = ?

...
2.50

2.50

$111.10

rPer

DQ
rPer

2.50

$2.50

.
rPer

$2.50

2.25%; rps( Nom) 2.25%(4) 9%.

$111.10

NOTE:
Flotation costs for preferred are significant: Use net price.

Preferred dividends are not deductible, so no tax adjustment.

Just rps.
Nominal rps is used.

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

WHY IS YIELD ON PREFERRED LOWER THAN R D?

Corporations own most preferred stock, because 70% of preferred dividends
are nontaxable to corporations.
Therefore, preferred often has a lower Before-tax yield than the Before-Tax
yield on debt.
The After-Tax yield to investors and After-Tax cost to the issuer are higher on
preferred than on debt, which is consistent with the higher risk of preferred.

EXAMPLE:
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%

ESTIMATING HURDLE RATES FOR

FIRMS IN MULTIPLE BUSINESSES
/ DIVISIONS / PROJECTS

SHOULD THE COMPANY USE THE COMPOSITE

WACC AS THE HURDLE RATE FOR EACH OF ITS
DIVISIONS?
NO! The composite WACC reflects the risk of an average project undertaken
by the firm.
Different divisions may have different risks.
The divisions WACC should be adjusted to reflect the divisions risk and
capital structure.

WHAT PROCEDURES ARE USED TO DETERMINE

THE RISK-ADJUSTED COST OF CAPITAL FOR A
PARTICULAR DIVISION?
Estimate the cost of capital that the division would have if it were a
stand-alone firm.
This requires estimating the divisions beta, cost of debt, and
capital structure.

METHODS FOR ESTIMATING BETA FOR A

DIVISION OR A PROJECT
1.

2.

Pure play. Find several publicly traded companies exclusively in

projects business.
Use average of their betas as proxy for projects beta.
Hard to find such companies.
Follow the estimation of Bottom-up betas discussed earlier
Accounting beta. Run regression between projects ROA and S&P
index ROA.
Accounting betas are correlated (0.5 0.6) with market betas.
But normally cant get data on new projects ROAs before the
capital budgeting decision has been made.

FIND THE DIVISIONS MARKET RISK AND COST

OF CAPITAL BASED ON THE CAPM, GIVEN
THESE INPUTS:

Target debt ratio = 10%.

rd = 12%.
rRF = 7%.

Tax rate = 40%.

betaDivision = 1.7.
Market risk premium = 6%.

Beta = 1.7, so division has more market risk than average.

Divisions required return on equity:
rs = rRF + (rM rRF)bDiv.
= 7% + (6%)1.7 = 17.2%.

WACCDiv. = wdrd(1 T) + wcrs

= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.

HOW DOES THE DIVISIONS WACC COMPARE

WITH THE FIRMS OVERALL WACC?
Division WACC = 16.2% versus company WACC = 11.1%.
Typical projects within this division would be accepted if their returns are
above 16.2%.

DIVISIONAL RISK AND THE COST OF

CAPITAL
Rate of Return
(%)

Acceptance Region
WACC

WACCH

H
Rejection Region

A
WACCA
B
WACCL

RiskL

RiskA

RiskH

Risk

TO SUM UP:
COST OF EQUITY

A single business firm & project risk similar to the firm

Cost of equity of the firm

Multiple business firm, each business has different risk profile

Bottom-up beta for each business
If project risk is consistent with the corresponding business, use respective
business-line/division beta

Independent projects which are large investments compared to

the firm
And the risk profile is different from the firm
Independent cost of capital
Bottom-up beta

TO SUM UP: COST OF DEBT

Project
characteristics
1 Small; cash flows
similar to firm
2 Large; CF different
to firm
3 Large; Stand alone

Cost of Debt
Firm's CoD

Debt Ratio
Firm's D/E

CoD of comparable Avg D/E of

firms
comparables
CoD of Project (Based D/E of project
on actual or synthetic
ratings)

ADDITIONAL ISSUES

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.

ESTIMATE THE COST OF NEW COMMON

EQUITY: P 0=$50, D 0=$4.19, G=5%, AND
F=15%.

D0 (1 g )
re
g
P0 (1 F )
$4.191.05

5 .0 %
$501 0.15
$4.40

5.0% 15.4%.
$42.50

ESTIMATE THE COST OF NEW 30-YEAR DEBT:

PAR=$1,000, COUPON=10%PAID ANNUALLY,
AND F=2%.

N = 30
PV = 1000(1-.02) = 980
PMT = -(.10)(1000)(1-.4) = -60
FV = -1000

Solving for I: 6.15%

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 per-project cost is fairly small.
We will frequently ignore flotation costs when calculating the WACC.

FOUR MISTAKES TO AVOID

1. When estimating the cost of debt, dont use the
coupon rate on existing debt. Use the current
interest rate on new debt.
2. When estimating the risk premium for the CAPM
approach, dont subtract the current long-term Tbond rate from the historical average return on
common stocks.

(More ...)

For example, if the historical rM has been about 12.2% and inflation
drives the current rRF up to 10%, the current market risk premium is
not 12.2% - 10% = 2.2%!

(More ...)

3. Dont use book weights to estimate the weights for

the capital structure.

Use the target capital structure to determine the

weights.
If you dont know the target weights, then use the
current market value of equity, and never the book
value of equity.

If you dont know the market value of debt, then the

book value of debt often is a reasonable
approximation, especially for short-term debt.

(More...)

4. Always remember that capital components are

sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes
are not sources of funding that come from
investors, so they are not included in the
calculation of the WACC.
We do adjust for these items when calculating
the cash flows of the project, but not when
calculating the WACC.