Cost of Capital

Chapter 20
Sections:
20.2-20.3
20.5 (up to Multi-stage growth models)
20.6
The cost of capital

Sources of financing:
Debt
Equity
Main differences:
Cash flow rights
Control rights

2
Different Contractual Obligations

Debt:
IOU: an obligation to make periodic, fixed
payments to lenders
Failure to make timely payments: default
Default is followed by transfer of control
(ownership) to lenders

3
Different Contractual Obligations

Equity:
No obligation to make fixed payments
Claim on residual cash flows
Residual cash flow:
Whats left after everyone has been paid
All claims on the firms assets have been met
(including future investment needs)

4
Weighted Average Cost of Capital
(WACC)

Proportion of equity Proportion of debt

S D
WACC K E K D (1 TC )
V V

Cost of equity Cost of debt

K i K D 1 TC

5
Weighted Average Cost of Capital
(WACC with preferred stock)

S P D
WACC K E K P K i
V V V
Where : K i K D 1 TC

6
Cost of Debt

Estimate YTM using most recent bond price

Example: 5-year 10% coupon bond sells for
$1,100
Coupons paid semiannually
YTM = 7.56% (APR)
EAR = (1+0.0756/2)2 - 1 = 0.0770 = 7.7%
KD = 7.7%
Is this the true cost of debt?

7
 Debt and Taxes

Interest paid by a corporation is tax-deductible

Example: 10 year 7.7% annual coupon bonds for
$1,000,000 (at par!); corporate tax rate = 40%
Interest paid = $77,000
Tax savings = $77,000 0.4 = $30,800
Interest after taxes = $46,200
After-tax cost of debt:
$46,200/$1,000,000 = 4.62%
KD (1 TC) = 7.7% 0.6 = 4.62%
8
Cost of Equity

Required rate of return on shares of existing

stock
Types of stock:
Preferred stock (more like debt)
Common stock
Cost of preferred stock (fixed, perpetual dividend
payments):

DP DP
P0 KP
KP P0
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Cost of Common Stock

Alternative methods: dividend growth and

CAPM
Gordon dividend growth model
Inputs: stock price, dividend, and growth rate
D1 D1
P0 k g
kg P0
D1
KE g
P0
10
Example (WidgetsRus)

WidgetsRus is expected to pay a dividend

of $2.55 next year
Analysts believe that WidgetsRus
dividends will grow at an average rate of
3%
Its most recent share price is $30
D1 2.55
KE g 0.03 11.5%
P0 30

11
SML approach

CAPM (Capital Asset Pricing Model)

Inputs: risk-free rate, beta, market risk
premium

ki RF i [E[RM ] RF ]

12
SML Example (WidgetsRus)

A financial analyst estimated WidgetsRus

beta to be 0.9. Government of Canada T-
bills are yielding 7% and the expected
return on the TSE 300 index is 12%. What
is WidgetsRus cost of equity?

kE RF [ E[ RM ] RF ] 0.07 0.9 (0.12 0.07)

0.115 11.5%

13
Example (WidgetsRus)

The current YTM on WidgetsRus bonds is

8%. What is WidgetsRus before tax cost
of debt?
Coupons are paid semiannually
YTM = 8% (APR)
EAR = (1+0.08/2)2 1 = 0.0816 = 8.16%
KD = 8.16%

14
Example (WidgetsRus)

WidgetsRus has one million shares

outstanding and its most recent share
price is $30.
WidgetsRus also has $20 million in bond
financing
If the cost of equity is 11.5%, the cost of
debt is 8.16% and assuming a tax rate of
35%, what is WidgetsRus WACC?

15
Weights for WidgetsRus

Value of equity:
E = $30 1,000,000 = $30 million
Value of debt:
D = $20 million
Total value of company:
V = E + D = $50 million
Weight of equity:
E/V = 30/50 = 60%
Weight of debt:
D/V = 40%
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WidgetsRus WACC

S D
WACC K E K D (1 TC )
V V
WACC 0.6 0.115 0.4 0.0816 (1 0.35)
0.069 0.0212 0.0902 9.02%

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Using WACC - Example

WidgetsRus is considering a project that will cost

$20 million
Project is expected to generate after tax cash
flows of $5 million per year for 5 years
Should WidgetsRus undertake this project?

Assumption: this project is an integral part of the

firms business and it is just as risky as the firm
as a whole
Appropriate discount rate = WACC = 9.02%

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Solution

$5 1
NPV $20 1
WACC (1 WACC ) 5
$5 1
$20 1 5
0.0902 (1.0902)
$0.56
Since the NPV is negative, WidgetsRus should
NOT undertake this project
Also, IRR = 7.93% < WACC
19
Another Example: Columbia Power

Capital structure:
Debt: 4,000 10-year, 8% semi-annual coupon bonds
priced at par (face value = $1,000)
Common stock: 50,000 shares outstanding, price = $62
and = 1.1
Preferred stock: 9,000 shares of 4% preferred stock
outstanding, price = $60 (face value = $100)
Market risk premium: 5%
Risk-free rate: 6%
Tax rate: 35%
Consider a 4-year project. New equipment costs $100,000
and will be salvaged for $15,000. The CCA rate is 25%.
Inventory will increase immediately by $10,000

(S E)(1 TC) = $12,000. Should project be accepted?

20
Columbia Project - Roadmap
Determine cost of capital
to obtain discount rate

Estimate annual cash flows,

discount cash flows

Determine PV
of tax shields

NPV (+ or - ?)
21
 Cost of Capital

First, we have to calculate relative weights of different

sources of capital
Debt : D 4,000 1,000 $4,000,000
Preferred Stock : P 9,000 $60 $540,000
Common Stock : S 50,000 $62 $3,100,000
Firm value : V D P S $7, 640, 000
Proportions Market Value Weights
Debt (V) 4,000,000 D/V = 52.36%
Preferred stock (P) 540,000 P/V = 7.07%
Common stock (S) 3,100,000 S/V = 40.57%
Firm Value (V) 7,640,000 100.00%
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After-Tax Cost of Debt

The interest cost of debt is a tax-deductible

cost. We must take this into account when
calculating cost of debt

After-Tax Cost of Debt (Ki)= KD x (1 TC)

Eg.: With a 10% before-tax cost and a 40%

marginal tax rate the relevant after-tax cost of
debt is:

10% x (1 40%) = 6%
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 Cost of Debt: Columbia Power
Bond price = Par value YTM = Coupon rate = 8%

YTM cost of debt! YTM = semi-annually

compounded APR must calculate EAR!
2
0.08
K D EAR 1 1 8.16%
2

After - tax cost of debt :

K D (1- TC ) 0.0816 0.65 5.30%

24
Cost of Preferred Stock

Preferred stock is assumed to be a perpetuity

(zero growth)
Dividend = Face value Dividend rate
= $100 4% = $4
Market price=$60

DP $4
KP 6.67%
PP $60

Looks familiar?
Perpetuity formula: P0 =
D/k 25
Cost of Common Stock

Apply CAMP (Capital Asset Pricing Model):

K E RF (Market risk premium)

RF E R M RF
0.06 1.1 0.05
0.115

Cost of common stock: KE = 11.5%

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 WACC of Columbia Power

D E P
WACC K D (1 Tc) K E R P
V V V
0.5236 5.30% 0.4058 11.5% 0.0707 6.67%
7.91%

If this is a typical project for the firm, then

the WACC is the appropriate discount rate for
the capital budgeting problem.

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NPV (Using WACC as discount rate)
CCA Rate 25%
Tax Rate 35%
WACC 7.91%
Year 0 1 2 3 4
Investment ($100,000) $15,000
(S-E)(1-Tc) $12,000 $12,000 $12,000 $12,000
CF from NWC ($10,000)
NWC Recapture $10,000
CFs ($110,000) $12,000 $12,000 $12,000 $37,000
Discounted CFs ($110,000) $11,120 $10,305 $9,550 $27,287
PV(excl.CCATS) ($51,738)
PVCCATS* $22,672
NPV ($29,066)

*see next slide

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PV of CCA Tax Shield

C 0 dT 1 0.5k SVn dT 1
PV (CCATax Shield) 1 k d k n
d k (1 k )
(Net New asset) (CCA Rate) (Tax Rate) 1 0.5 k

(CCA Rate) k 1k
(Net Salvage) (CCA Rate) (Tax Rate) 1
-
(CCA Rate) k (1 k)n
100,000 0.25 0.35 1 0.5 0.0791

0.25 0.0791 1 0.0791
15,000 0.25 0.35 1
4
22,672
0.25 0.0791 (1 0.0791)

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