Ross4e ch17

Chapter Seventeen
Cost of Capital
Copyright 2007 McGraw-Hill Australia Pty Ltd 17-1

PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Chapter Organisation
17.1 The Cost of Capital: Some Preliminaries
17.2 The Cost of Equity
17.3 The Costs of Debt and Preference Shares
17.4 The Weighted Average Cost of Capital
17.5 Divisional and Project Costs of Capital
17.6 Flotation Costs and the Weighted Average Cost
of Capital
Summary and Conclusions

Chapter Objectives
Apply the dividend growth model approach and the
SML approach to determine the cost of equity.
Estimate values for the costs of debt and
preference shares.
Calculate the WACC.
Discuss alternative approaches to estimating a
discount rate.
Understand the effects of flotation costs on WACC
and the NPV of a project.

Cost of Capital: Preliminaries
Vocabulary the following all mean the same
thing:
required return
appropriate discount rate
cost of capital.
The cost of capital depends primarily on the use of

funds, not the source.
The assumption is made that a firms capital

structure is fixeda firms cost of capital then
reflects both the cost of debt and the cost of equity.

Cost of Equity
The cost of equity, RE , is the return required by
equity investors given the risk of the cash
flows from the firm.
There are two major methods for determining the

cost of equity:
Dividend growth model
SML or CAPM.

The Dividend Growth Model
Approach
According to the constant growth model:
D0 (1 g )
P0
RE g
Rearranging:
D1
RE g
P0

ExampleCost of Equity:
Dividend Growth Model Approach
Jumbo Co. recently paid a dividend of 20 cents
per share. This dividend is expected to grow at a
rate of 5 per cent per year into perpetuity. The
current market price of Jumbos shares is $7.00
per share. Determine the cost of equity capital for
Jumbo Co.
$0.20 1.05
RE 0.05
$7.00
0.08 or 8%

Estimating g
One method for estimating the growth rate is to use the historical
average.
Year Dividend Dollar Change % Change

2002 $4.00 - -
2003 $4.40 $0.40 10.00%
2004 $4.75 $0.35 7.95%
2005 $5.25 $0.50 10.53%
2006 $5.65 $0.40 7.62%
Average growth rate 10.00 7.95 10.53 7.62/4

9.025%

The Dividend Growth Model
ApproachEvaluation
Advantages
Easy to use and understand.
Disadvantages
Only applicable to companies paying dividends.
Assumes dividend growth is constant.
Cost of equity is very sensitive to growth estimate.
Ignores risk.

The SML Approach
Required return on a risky investment is dependent on three
factors:
the risk-free rate, Rf
the market risk premium, E(RM) Rf
the systematic risk of the asset relative to the average, .
RE R f E RM R f

ExampleCost of Equity Capital:
SML Approach
Obtain the risk-free rate (Rf) from financial press
many use the 1-year Treasury note rate, say, 6 per
cent.
Obtain estimates of market risk premium and security
beta:
historical risk premium = 7.94 per cent (Officer, 1989)
betahistorical
investment information services
estimate from historical data
Assume the beta is 1.40.

ExampleCost of Equity Capital:
SML Approach (continued)
RE R f E RM R f
6% 1.40 7.94%
17.12%

The SML Approach
Advantages
Adjusts for risk.
Applicable in a wider range of circumstances (e.g. to
companies other than just those with constant dividend
growth).
Disadvantages
Requires two factors to be estimated: the market risk
premium and the beta co-efficient.
Uses the past to predict the future, which may not be
appropriate.

The Cost of Debt
The cost of debt, RD, is the interest rate on new
borrowing.
RD is observable:
yields on currently outstanding debt
yields on newly-issued similarly-rated bonds.
The historic cost of debt is irrelevantwhy?

ExampleCost of Debt
Ishta Co. sold a 20-year, 12 per cent bond 10 years
ago at par ($100). The bond is currently priced at
$86. What is our cost of debt?
I PV NP /n
RD
PV NP /2
$12 $100 $86/10

$100 $86/2
14.4%
The yield to maturity is 14.4 per cent, so this is used

as the cost of debt, not 12 per cent.

The Cost of Preference Shares
Preference shares pay a constant dividend every
period.
Preference shares are a perpetuity, so the cost is:
D
RP
P0
Notice that the cost is simply the dividend yield.

ExampleCost of Preference
Shares
A preference share issue paying an $8 dividend per
share was was sold 10 years ago for $60 per share.
It sells for $100 per share today.
The dividend yield today is $8.00/$100 = 8 per cent,

so this is the cost of preference shares.

The Weighted Average Cost of
Capital
Let: E = the market value of equity = no.
of outstanding shares share price
D = the market value of debt = no. of
outstanding bonds price
V = the combined market value of debt
and equity
Then: V=E+D
So: E/V + D/V = 100%
That is: The firms capital structure weights
are E/V and D/V.

The Weighted Average Cost of
Capital
Interest payments on debt are tax deductible, so
the after-tax cost of debt is:
After - tax cost of debt RD 1 TC
Dividends on preference shares and ordinary

shares are not tax-deductible so tax does not
affect their costs.
The weighted average cost of capital is therefore:
WACC E V R D V RE D 1 TC

ExampleWeighted Average Cost
of Capital
Gidget Ltd has 78.26 million ordinary shares on
issue with a book value of $22.40 per share and a
current market price of $58 per share. Gidget has
an estimated beta of 0.90. Treasury bills currently
yield 5 per cent and the market risk premium is
assumed to be 7.94 per cent. Company tax is 30
per cent.

ExampleWeighted Average Cost
of Capital (continued)
Gidget Ltd has four debt issues outstanding:
Bond Coupon Book Market Yield to

Value Value Maturity
1 6.375% $499m $501m 6.32%
2 7.250% $495m $463m 7.83%
3 7.635% $200m $221m 6.76%
4 7.600% $296m $289m 7.82%
Total $1 490m $1 474m

ExampleCost of Equity
(SML Approach)
RE R f E RM R f
5% 0.90 7.94%
12.15%

ExampleCost of Debt
Bond Market Weight Yield to Weighted
Value Maturity YTM
1 $501m 0.3399 6.32% 2.1482%
2 $463m 0.3141 7.83% 2.4594%
3 $221m 0.1499 6.76% 1.0133%
4 $289m 0.1961 7.82% 1.5335%
$1 474m 1.0000 7.1544%
The weighted average cost of debt is 7.15 per cent.

ExampleCapital Structure
Weights and WACC
Market value of equity = 78.26 million $58 = $4.539
billion.
Market value of debt = $1.474 billion.
V $4.539 billion $1.474 billion $6.013billion
D $1.474b 0.245 or 24.5%

V $6.013b
E $4.539b 0.755 or 75.5%
V $6.013b
WACC 0.755 0.1215 0.245 0.07151 0.30
0.104 or 10.4%

WACC
The WACC for a firm reflects the risk and the target
capital structure to finance the firms existing assets
as a whole.
WACC is the return that the firm must earn on its

existing assets to maintain the value of its shares.
WACC is the appropriate discount rate to use for

cash flows that are similar in risk to the firm.

Divisional and Project Costs of
Capital
When is the WACC the appropriate discount rate?
When the projects risk is about the same as the firms
risk.
Other approaches to estimating a discount rate:

divisional cost of capitalused if a company has more
than one division with different levels of risk
pure play approacha WACC that is unique to a
particular project is used
subjective approachprojects are allocated to specific
risk classes which, in turn, have specified WACCs.

The SML and the WACC
Expected
return (%)
SML
= 8%
Incorrect
16 B acceptance
15 WACC = 15%
14 A
Incorrect
rejection
Rf =7
Beta
A = .60 firm = 1.0 B = 1.2
If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a
tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.

ExampleUsing WACC for all
Projects
What would happen if we use the WACC for all
projects regardless of risk?
Assume the WACC = 15 per cent
Project Required Return IRR Decision

A 15% 14% Reject
B 15% 16% Accept
Project A should be accepted because its risk is

low (Beta = 0.60), whereas Project B should be
rejected because its risk is high (Beta = 1.2).

The SML and the Subjective
Approach
Expected
return (%)
SML
= 8%
20
High risk
A (+6%)
WACC = 14
10
Rf = 7 Moderate risk
Low risk (+0%)
(4%)
Beta
With the subjective approach, the firm places projects into one of several risk classes. The discount
rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk)
an adjustment factor to or from the firms WACC.

Flotation Costs
The issue of debt or equity may incur flotation costs
such as underwriting fees, commissions, listing fees.
Flotation costs are relevant cash flows and need to
be included in project analysis.
To assist with this, a weighted average flotation cost
can be calculated:
fA E fE D fD
V V
where f A weighted average flotationcost
f E equity flotationcost
f D debt flotationcost

ExampleProject Cost including
Flotation Costs
Saddle Co. Ltd has a target capital structure of 70 per
cent equity and 30 per cent debt. The flotation costs
for equity issues are 15 per cent of the amount raised
and the flotation costs for debt issues are 7 per cent.
If Saddle Co. Ltd needs $30 million for a new project,
what is the true cost of this project?
f A 0.70 0.15 0.30 0.07

12.6%
The weighted average flotation cost is 12.6 per cent.

ExampleProject Cost including
Flotation Costs (continued)
Saddle Co. needs to raise $30 million for the project
after covering flotation costs.
Project cost (ignoring flotationcosts)

T rue cost of project
1 f A
$30m

1 0.126
$34.32 million

ExampleFlotation Costs & NPV
Apollo Co. Ltd needs $1.5 million to finance a new
project expected to generate annual after-tax cash
flows of $195 800 forever. The company has a
target capital structure of 60 per cent equity and 40
per cent debt. The financing options available are:
An issue of new ordinary shares. Flotation costs of equity
are 12 per cent of capital raised. The return on new
equity is 15 per cent.
An issue of long-term debentures. Flotation costs of debt
are 5 per cent of the capital raised. The return on new
debt is 10 per cent.
Assume a corporate tax rate of 30 per cent.

ExampleNPV (No Flotation Costs)
WACC 0.6 15% 0.4 0.1 1 0.30
0.118 or 11.8%
$195800
NPV $1 500 000
0.118
$159 322

ExampleNPV (With Flotation
Costs)
f A 0.6 0.12 0.4 0.05
0.092 or 9.2%
$1 500 000
T rue cost $1 651982
1 0.092
$195 800
NPV $1 651982
0.118
$7340
Flotation costs decrease a projects NPV and

could alter an investment decision.
Note: If the flotation costs are tax-deductible, we can calculate an after-
tax weighted average flotation cost, fAT = fA(1-TC)

Summary and Conclusions
The cost of equity is the return that equity investors
require on their investment in the firm.
There are two approaches to determine the cost of
equity: the dividend growth model approach and the
SML approach.
The cost of debt is the return that lenders require on
the firms debt.
WACC is both the required rate of return and the
discount rate appropriate for cash flows that are
similar in risk to the overall firm.
Flotation costs can affect a projects NPV and alter
the investment decision.

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Chapter Seventeen

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-1

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-2

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-3

The cost of capital depends primarily on the use of

The assumption is made that a firms capital

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-4

There are two major methods for determining the

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-5

According to the constant growth model:

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-6

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-7

Year Dividend Dollar Change % Change

Average growth rate 10.00 7.95 10.53 7.62/4

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-8

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-9

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-10

Assume the beta is 1.40.

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-11

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-12

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-13

The historic cost of debt is irrelevantwhy?

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-14

The yield to maturity is 14.4 per cent, so this is used

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-15

Preference shares are a perpetuity, so the cost is:

Notice that the cost is simply the dividend yield.

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-16

The dividend yield today is $8.00/$100 = 8 per cent,

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-17

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-18

After - tax cost of debt RD 1 TC

Dividends on preference shares and ordinary

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-19

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-20

Bond Coupon Book Market Yield to

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-21

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-22

The weighted average cost of debt is 7.15 per cent.

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-23

V $4.539 billion $1.474 billion $6.013billion

D $1.474b 0.245 or 24.5%

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-24

WACC is the return that the firm must earn on its

WACC is the appropriate discount rate to use for

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-25

Other approaches to estimating a discount rate:

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-26

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-27

Project Required Return IRR Decision

Project A should be accepted because its risk is

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-28

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-29

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-30

f A 0.70 0.15 0.30 0.07

The weighted average flotation cost is 12.6 per cent.

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-31

Project cost (ignoring flotationcosts)

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-32

Assume a corporate tax rate of 30 per cent.

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-33

WACC 0.6 15% 0.4 0.1 1 0.30

Copyright 2007 McGraw-Hill Australia Pty Ltd 17-34