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COST OF CAPITAL

What is Cost of Capital?


Definition of Capital
Cost of Capital is Cost of Financing
Company and Project Costs of Capital
Measuring the Cost of Equity and Debt
Capital Structure and COC
Discount rate to evaluate investments
Hurdle Rate
If investments dont return at least Cost of
Capital, do not make them.
Discount Rates for International Projects
Risk and DCF
Capital and Capital components
Capital Components funds provided by
investors with an expectation of a financial
return on their investment.

Common Forms of Capital Components:
Long-term debt
Preferred stock
Common equity
Component cost and Cost of Capital
The required rate-of-return for each form of
capital component is called its component costs.
Weighted Average Cost of Capital (WACC) is the rate of
return required by a capital provider in exchange for
foregoing an investment in another project, asset, or
business with similar risk.
It is also known as an opportunity cost.
Cost of Capital and Capital Budgeting
The cost of capital associated with capital
budgeting decisions is typically a weighted
average of the various components costs
Reflects the overall required return
Shall be the minimum return earned
How are the asset and liabilities
linked?
Balance Sheet
Working Capital Short-term
Obligations
LT Assets LTD
Preferred
Common
Intermediate Financial Mgmt,
Brigham and Daves
7
Cost of Capital and Capital Structure
The mix of debt and equity is known as the firms
Capital Structure.

Target Capital Structure is the percentage of the total
capital that firms target to finance the firm.
20% debt, 10% preferred, 70% common

Levels of debt and equity change over time; however,
most firms attempt to stay close to an approved target
capital structure that is designed to maximize a firms
value.
Intermediate Financial Mgmt,
Brigham and Daves
8
Why is it important to estimate
a firms cost of capital?
A concept of vital importance in decision-
making
It is useful as a financial standard for
Evaluating investment decisions
Designing a firms debt policy
Appraising the financial performance of the top
management.
Intermediate Financial Mgmt,
Brigham and Daves
9
Why is it important to estimate
a firms cost of capital?
Operating managers should look to the capital
markets for guidance (e.g., through WACC).
Managers need to estimate the CoC in order to assess
businesses or projects as they have to invest only in
those projects that generate returns in excess of the
CoC.
Most of the widely-held professionally-managed
firms do not have any promoters to provide any
guidance on the minimum return required by
investors.
Intermediate Financial Mgmt,
Brigham and Daves
10
Is the WACC set by the investors or
by the managers?
The cost of capital is set by investors, not by
managers.
We cannot observe the true cost of capital; we can only
estimate it, using the tools and concepts of modern finance.
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.
the tax shield provided by interest expense
effectively lowers a firms cost of debt.
Only cost of debt is affected.

Intermediate Financial Mgmt,
Brigham and Daves
12
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.
WACC is supposed to represent the return that
capital providers will require today to use a
companys historic cost of debt would be
inappropriate.
So, we should focus on marginal costs.
Company Cost of Capital
A firms value can be stated as the sum of
the value of its various assets
PV(B) PV(A) PV(AB) value Firm + = =
Company Cost of Capital
10% nology known tech t, improvemen Cost
COC) (Company 15% business existing of Expansion
20% products New
30% ventures e Speculativ
Rate Discount Category
Company Cost of Capital
A companys cost of capital can be compared
to the CAPM required return
Required
return
Project Beta
1.26
Company Cost
of Capital


13

5.5

0
SML
Determining Cost of Debt
Determine r
d
(cost of debt) the rate of return debt
holders require.
Some companies use fixed, floating, straight and convertible debt
(with and without sinking fund).
Estimate based on long-term debt that will be used to fund capital
projects. (Note: ST debt is typically not used to fund LT assets)
Determine current yield to maturity (or yield to call)
for outstanding issues. Adjust for any known
credit/risk adjustments between now and potential
project funding.
Kd for Debt
Techtron Ltd issues Bond with 7% Coupon, 20
year term, 5% Flotation cost, 40% tax rate
Initial CF PMT n FV
Investor gets: ($1,000) $35 40 $1,000
Company gets: $1,000 ($35)
($50) $14 Tax cr
$950 ($21) 40 ($1,000)
What is After Tax Cost of Capital?

4.6%
Cost of Preferred Capital
Flotation costs for preferred are significant,
so are reflected. Use net price.
Preferred dividends are not tax-deductible
expense, so no tax adjustment. Just k
ps
.
Nominal k
ps
is used.
A practical issue arises from the use of a
sinking fund that limits the unlimited life
feature of preferred stock valuation
(calculation used above).
Is preferred stock more or less
risky to investors than debt?
Preferred stock is more risky to investors
than debt; company is 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, and (3) preferred
stockholders may gain control of firm.
Yield on preferred stock
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.
Ke for Preferred Stock
Techtron Ltd. issues Preferred Stock with 6%
Dividend, no conversion rights, sell at Par,
Flotation cost 10%, 40% tax rate
Initial CF PMT n FV
Investor gets: ($100) $6 forever N/A
Company gets: $100 ($6)
($10) $0 Tax cr
$90 ($6) forever N/A
What is After Tax Cost of Capital?

6.7%
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.
Do the equity holders bear any risk? How
much risk ? What must be the rate of
compensation ?
Why firms need to bear a charge for
equity? Why is there cost for
reinvested earnings?
Opportunity cost: The return stockholders
could earn on alternative investments of
equal risk.
They could buy similar stocks and earn k
s
,
or company could repurchase its own stock
and earn k
s
. So, k
s
, is the cost of reinvested
earnings and it is the cost of equity.
Four ways to determine the
cost of equity, k
s

:
1. CAPM: k
s
= k
RF
+ (k
M
- k
RF
)b
= k
RF
+ (RP
M
)b.
2. DCF: k
s
= D
1
/P
0
+ g.
3. Bond-Yield-Plus-Risk Premium:
K
s
= k
d
+ RP
4. Earnings capitalization: K
s
= E
1
/ P
0

Estimate the risk-free rate
Estimate the current expected market risk premium,
RP
m
.
Estimate the stocks beta coefficient, |
i
, and use it
as an index of the stocks risk.
Substitute the values in the CAPM equation to
estimate the required rate of return on the stock in
question.
Estimation of K
e
with CAPM
Ke for Common Stock
Techtron Ltd. issues Common Stock at $15/share,
pays no Dividend, Flotation cost 10%, 1.5 Beta,
4% Krf, 9% Km

Initial
CF
PMT FV
Investor gets: ($15) $0
Expects 11.5% avg
growth/year
Company gets: $15
($1.50)
$13.50
What is After Tax Cost of Capital?
Why?

12.8%
K
e
using CAPM
R
f
to be consistent with the life of the asset being
valued.
Use YTM on 30-year T-bonds as the R
f
.
Historic betas must only be used if they provide a
good estimate of a stocks expected beta. Otherwise,
an investor must use his or her own estimate of
expected beta.
Use the average daily beta, thereby assuming that future
beta is likely to be around this.
the selection of beta is truly a matter of expectations
rather than history need to make a judgment call.
Measuring Betas
The SML shows the relationship between
return and risk
CAPM uses Beta as a proxy for risk
Other methods can be employed to
determine the slope of the SML and thus
Beta
Regression analysis can be used to find
Beta
Measuring Betas
Dell Computer
Slope determined from plotting the
line of best fit.
Price data Aug 88- Jan 95
Market return (%)
D
e
l
l

r
e
t
u
r
n

(
%
)

R
2
= .11
B = 1.62
Measuring Betas
Dell Computer
Slope determined from plotting the
line of best fit.
Price data Feb 95 Jul 01
Market return (%)
D
e
l
l

r
e
t
u
r
n

(
%
)

R
2
= .27
B = 2.02
Measuring Betas
General Motors
Slope determined from plotting the
line of best fit.
Price data Aug 88- Jan 95
Market return (%)
G
M

r
e
t
u
r
n

(
%
)

R
2
= .13
B = 0.80
Measuring Betas
General Motors
Slope determined from plotting the
line of best fit.
Price data Feb 95 Jul 01
Market return (%)
G
M

r
e
t
u
r
n

(
%
)

R
2
= .25
B = 1.00
Measuring Betas
Exxon Mobil
Slope determined from plotting the
line of best fit.
Price data Aug 88- Jan 95
Market return (%)
E
x
x
o
n

M
o
b
i
l

r
e
t
u
r
n

(
%
)

R
2
= .28
B = 0.52
Measuring Betas
Exxon Mobil
Slope determined from plotting the
line of best fit.
Price data Feb 95 Jul 01
Market return (%)
E
x
x
o
n

M
o
b
i
l

r
e
t
u
r
n

(
%
)

R
2
= .16
B = 0.42
Beta Stability
% IN SAME % WITHIN ONE
RISK CLASS 5 CLASS 5
CLASS YEARS LATER YEARS LATER

10 (High betas) 35 69

9 18 54

8 16 45

7 13 41

6 14 39

5 14 42

4 13 40

3 16 45

2 21 61

1 (Low betas) 40 62

Source: Sharpe and Cooper (1972)
Issues with DCF methodology
Dividends are so managed that the growth of a
company is often not well represented by dividends.
DDM is best used for mature, stable-growth
companies with a constant and predictable growth
rate in dividends.
It may be better to use EPS growth rates as a proxy
for dividends.
Revenue and earnings growth rates in the past five years
can hardly be characterized as stable many a times.
K
e
using the earnings capitalization
model
K
e
= E
1
/ P
0

Like the DDM, the earnings capitalization model will
not work for growth companies.
Expectations of high growth embedded in the price of
growth stocks will inflate the denominator leads
to an underestimated cost of equity.
Weighted Average Cost of Capital
Mix of Bonds, Common, Preferred =
Capital Structure
Calculate Weighted Average Cost
WACC
Change Mix = Change Cost of Capital

Debt and equity weights
Market values should be used in
calculating weights.
We are concerned with estimating how much it
will cost a company to raise the capital today.
That cost is approximated by the market value
of the companys capital, not its book or
accounting values.
Marginal cost view of the investor.
Weights in the WACC equation
Weights of each component can be based on:
accounting values on the balance sheet (BV)
Current market values of the capital structure.
Managements targeted capital structure for the future.
Firm can control capital structure but cannot
control level of interest rates, market risk premium,
tax rates.
WACC is the marginal dollar of capital (raising
new money).
Target weights and Target CS
Target weights may also be used in calculating
WACC since companies will often lever up or
down toward a desired debtequity weighting
(usually toward the average debt-equity
weighting in their industry or peer group).
For debt, book values usually approximate
market values.
For equity, book values do not reliably reflect
market values.
Weighted Average Cost of Capital
Example: if Company has 50% tax rate

% Capital Structure Source Rate Weighted Average
20% Short term Notes @ 12% 1.2%
40% Long term Bonds @ 10% 2.0%
10% Preferred Stock @ 18% 1.8%
30% Common Stock @ 20% 6.0%
0% Retained Earnings @ 20% 0.0%
100% 11.0%
What would change WACC?
Company Cost of Capital
simple approach
Company Cost of Capital (COC) is based
on the average beta of the assets

The average Beta of the assets is based on
the % of funds in each asset



Company Cost of Capital
simple approach
Company Cost of Capital (COC) is based on the average
beta of the assets

The average Beta of the assets is based on the % of funds
in each asset

Example
1/3 New Ventures | =2.0
1/3 Expand existing business | =1.3
1/3 Plant efficiency | =0.6

Average | of assets = 1/3*2.0 + 1/3*1.3 + 1/3*0.6 = 1.3

Capital Structure - the mix of debt & equity within a company

Expand CAPM to include CS

R = r
f
+ | ( r
m
- r
f
)
becomes
R
equity
= r
f
+ | ( r
m
- r
f
)
Capital Structure
Capital Structure & COC
COC

=

r
portfolio
= r
assets


r
assets
= WACC = r
debt
(D) + r
equity
(E)
(V) (V)

|
assets
= |
debt
(D) + |
equity
(E)
(V) (V)

r
equity
= r
f
+ B
equity
( r
m
- r
f
)
IMPORTANT
E, D, and V are
all market values
Risk and the Cost of Capital
Rate of Return
(%)
WACC
Rejection Region
Acceptance Region
Risk
L
B
A
H
12.0
8.0
10.0
10.5
9.5
0 Risk
L
Risk
A
Risk
H
Divisional Cost of Capital
Rate of Return
(%)
WACC
Project H
Division Hs WACC
Risk
Project L
Composite WACC
for Firm A
13.0
7.0
10.0
11.0
9.0
Division Ls WACC
0 Risk
L
Risk
Average
Risk
H
What are the three types of project
risk?
Stand-alone risk
Corporate risk
Market risk
How is each type of risk used?
Market risk is theoretically best in most
situations.
However, creditors, customers, suppliers,
and employees are more affected by
corporate risk.
Therefore, corporate risk is also relevant.
Subjective adjustments to the firms
composite WACC.
Estimate what the cost of capital would
be if the project/division were a stand-
alone firm. This requires estimating the
projects beta.
What procedures are used to
determine the risk-adjusted cost of
capital for a particular project or
division?
0
20
0 0.2 0.8 1.2
Capital Structure & COC
Expected
return (%)
B
debt
B
assets

B
equity

R
rdebt
=8
R
assets
=12.2
R
equity
=15
Expected Returns and Betas prior to refinancing
Union Pacific Corp.
R
equity
= Return on Stock
= 15%

R
debt
= YTM on bonds
= 7.5 %

Union Pacific Corp.
.17 .50 Portfolio Industry
.21 .40 Pacific Union
.26 .52 Southern Norfolk
.24 .46 tion Transporta CSX
.20 .64 Northern Burlington
Error Standard. Beta
Union Pacific Corp.
Example
100 value Firm Assets Total
70 ue Equity val
30 Debt value 100 Assets
% 75 . 12 % 15
70 30
70
% 5 . 7
70 30
30
=
+
+
+
=
+
+
+
=
assets
equity debt assets
R
r
equity debt
equity
r
equity debt
debt
R
International Risk
0.77 .30 2.58 Venezuela
1.39 .48 2.91 Thailand
0.81 .42 1.93 Poland
0.55 .18 3.11 Egypt
Beta
t coefficien
n Correlatio
Ratio o
Source: The Brattle Group, Inc.
o Ratio - Ratio of standard deviations, country index vs. S&P composite
index
Asset Betas
) PV(revenue
PV(asset)
) PV(revenue
cost) e PV(variabl

) PV(revenue
cost) PV(fixed
asset cost variable
cost fixed revenue
| |
| |
+ +
+ =
Asset Betas
(

=
=
PV(asset)
cost) PV(fixed
1
PV(asset)
cost) e PV(variabl - ) PV(revenue
revenue
revenue asset
|
| |
1. 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.
Methods for Estimating Beta for a
Division or a Project
2. 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.
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.
Why is the cost of internal equity from
reinvested earnings cheaper than the
cost of issuing new common stock?
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, use
the current interest rate on new debt,
not the coupon rate on existing debt.
2. When estimating the risk premium for
the CAPM approach, dont subtract
the current long-term T-bond rate from
the historical average return on
common stocks.
(More ...)
3. 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. 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.
WACC Self Test:
If Company has 50% tax rate

% Capital Structure Source Rate Weighted Average
20% Short term Notes @ 10%
30% Long term Bonds @ 5%
10% Preferred Stock @ 10%
40% Common Stock @ 25%
0% Retained Earnings @ 25%
100%
WACC Self Test:
If Company has 50% tax rate

% Capital Structure Source Rate Weighted Average
20% Short term Notes @ 10% 1.0%
30% Long term Bonds @ 5% 0.8%
10% Preferred Stock @ 10% 1.0%
40% Common Stock @ 25% 10.0%
0% Retained Earnings @ 25% 0.0%
100% 12.8%
Use Market Values for WACC:
If Company has

Example: Book Value Market Value % of
Capital
Bonds issued at
Par, trading at 80
$5mm 5% transaction cost =
$4,750,000
$4,000,000 9.0%
Preferred issued
at $100, trading at
60
$1mm 10% transaction cost
= $900,000
$600,000 1.3%
Common issued
at $15, trading at
$40
$15 IPO price x 1mm shares
10% transaction cost =
$13.5mm
$40,000,000 89.7%
Retained Earnings $500,000 0 0%
$44,600,000 100%
Pre-Tax and After-Tax
Relationships
Cash
Flows
Cost of
Capital
Pre-Tax High Pre-Tax High
After Tax Low After Tax Low
What happens if you use Pretax Cash Flow
stream with an After Tax Cost of Capital?
Market Value Relationships
When Stock Market goes DOWN, Cost of Capital goes?
When Stock Market goes UP, Cost of Capital goes?
When Interest Rates go DOWN, Cost of Capital goes?
When Interest Rates go UP, Cost of Capital goes?
When Company Increases DEBT, Cost of Capital goes?
When Company gets riskier, Cost of Capital goes?
UP

DOWN
DOWN
UP
DOWN
UP
What is WACC Used for?
Capital Investments
Mergers & Acquisitions
Which WACC to use?
Expansion of current business with no change in risk?
Enter new business area with different risk profile?
What happens if project does not return at least
the Cost of Capital?
Shareholder Value goes DOWN

Cost of Capital Review
How calculate Kd?
How calculate Ke for Preferred Stock?
How calculate Ke for Common Stock?
How calculate WACC?
When do you use Pretax vs After Tax
WACC?
What does Hurdle Rate refer to?