Cost of Capital

10 - 1
Copyright 2001 by Harcourt, Inc. All rights reserved.

CHAPTER 10
The Cost of Capital
Cost of capital components
Accounting for flotation costs
WACC
Adjusting cost of capital for risk
Estimating project risk
10 - 2
Coleman Technologies
Marginal tax rate is 40 percent.
Current price of its 12 percent coupon,
semiannual bonds with 15 years to
maturity is $1,153.72.
Current price of 10 percent, $100 par
preferred stock is $111.10.
Common stock is selling at $50 per share.
Its last dividend was $4.19 and constant 5
percent growth rate.
10 - 3
Colemans beta is 1.2.
The yield on T-bonds is 7 percent.
The market risk premium is
estimated to be 6 percent.
For the bond-yield-plus-risk-premium
approach, the firm uses a 4 percent
risk premium.
10 - 4
The firms target capital structure is:
30 percent long-term debt;
10 percent preferred stock; and
60 percent common equity.
10 - 5
What are the sources of capital for
firms?
Debt
Preferred stock
Common equity:
Retained earnings
New common stock
10 - 6
The cost of capital is used primarily
to make decisions that involve
raising new capital. So, focus on
todays marginal costs (for WACC).
Should we focus on historical
(embedded) costs or new (marginal)
costs?
10 - 7
A 15-year, 12% semiannual bond sells
for $1,153.72. Whats k
d
?
60 60 + 1,000 60
0 1 2 30
i = ?
30 -1153.72 60 1000

5.0% x 2 = k
d
= 10%
N I/YR PV FV PMT
-1,153.72
...
INPUTS
OUTPUT
10 - 8
Component Cost of Debt
Interest is tax deductible, so
k
d AT
= k
d BT
(1 T)
= 10%(1 0.40) = 6%.
Use nominal rate.
Flotation costs small.
Ignore.
10 - 9
Whats the cost of preferred stock?
P
p
= $111.10; 10%Q; Par = $100.
Use this formula:
%. 0 . 9 090 . 0
10 . 111 $
10 $
P
D
k
p
p
p

10 - 10
Picture of Preferred Stock
2.50 2.50
0 1 2
k
p
= ?
-111.1

...
2.50
$111.10 = = .
k
Per
= = 2.25%;
k
p(Nom)
= 2.25%(4) = 9%.
D
Q

k
Per

$2.50
k
Per

$2.50
$111.10
10 - 11
Note:
Preferred dividends are not tax
deductible, so no tax adjustment.
Just k
p
.
Nominal k
p
is used.
Our calculation ignores flotation
costs.
10 - 12
Why is there a cost for retained
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 retained.
10 - 13
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
retained earnings.
10 - 14
Three ways to determine cost of
common equity, k
s
:
1. CAPM: k
s
= k
RF
+ (k
M
k
RF
)b.
2. DCF: k
s
= D
1
/P
0
+ g.
3. Own-Bond-Yield-Plus-Risk
Premium: k
s
= k
d
+ RP.
10 - 15
Whats the cost of common equity
based on the CAPM?
k
RF
= 7%, RP
M
= 6%, b = 1.2.
k
s
= k
RF
+ (k
M
k
RF
)b.
= 7.0% + (6.0%)1.2 = 14.2%.
10 - 16
Whats the DCF cost of common
equity, k
s
? Given: D
0
= $4.19;
P
0
= $50; g = 5%.
D
1

P
0

D
0
(1 + g)
P
0

$4.19(1.05)
$50
k
s
=

+ g = + g
= + 0.05
= 0.088 + 0.05
= 13.8%.
10 - 17
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?
10 - 18
Retention growth rate:

g = (1 Payout)(ROE) = 0.35(15%)
= 5.25%.

Here (1 Payout) = Fraction retained.

Close to g = 5% given earlier.
10 - 19
Could DCF methodology be applied if
g is not constant?
YES, nonconstant g stocks are
expected to have constant g at
some point, generally in 5 to 10
years.
But calculations get complicated.
10 - 20
Find k
s
using the own-bond-yield-plus-
risk-premium method.
(k
d
= 10%, RP = 4%.)
This RP CAPM RP.
Produces ballpark estimate of k
s
.
Useful check.
k
s
= k
d
+ RP

= 10.0% + 4.0% = 14.0%
10 - 21
Whats a reasonable final estimate of k
s?
Method Estimate
CAPM 14.2%
DCF 13.8%
k
d
+ RP 14.0%
Average 14.0%
10 - 22
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 retained earnings
cheaper than the cost of issuing new
common stock?
10 - 23
Two approaches that can be used to
account for flotation costs:
Include the flotation costs as part of
the projects up-front cost. This
reduces the projects estimated return.
Adjust the cost of capital to include
flotation costs. This is most
commonly done by incorporating
flotation costs in the DCF model.
10 - 24
New common, F = 15%:
g
) F 1 ( P
) g 1 ( D
k
0
0
e

%. 4 . 15 % 0 . 5
50 . 42 $
40 . 4 $
% 0 . 5
15 . 0 1 50 $
05 . 1 19 . 4 $

10 - 25
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.
10 - 26
Whats the firms WACC (ignoring
flotation costs)?
WACC = w
d
k
d
(1 T) + w
p
k
p
+ w
c
k
s

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

10 - 27
What factors influence a companys
composite WACC?
Market conditions.
The firms capital structure and
dividend policy.
The firms investment policy. Firms
with riskier projects generally have a
higher WACC.
10 - 28
WACC Estimates for Some Large
U. S. Corporations, Nov. 1999
Company WACC
Intel 12.9%
General Electric 11.9
Motorola 11.3
Coca-Cola 11.2
Walt Disney 10.0
AT&T 9.8
Wal-Mart 9.8
Exxon 8.8
H. J. Heinz 8.5
BellSouth 8.2
10 - 29
Should the company use the
composite WACC as the hurdle rate for
each of its projects?
NO! The composite WACC reflects the
risk of an average project undertaken
by the firm. Therefore, the WACC only
represents the hurdle rate for a
typical project with average risk.
Different projects have different risks.
The projects WACC should be
adjusted to reflect the projects risk.
10 - 30
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
10 - 31
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
10 - 32
What are the three types of project
risk?
Stand-alone risk
Corporate risk
Market risk
10 - 33
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.
10 - 34
Subjective adjustments to the
firms composite WACC.
Attempt to 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?
10 - 35
Methods for Estimating a Projects Beta
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.
10 - 36
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.
10 - 37
Find the divisions market risk and cost
of capital based on the CAPM, given
these inputs:
Target debt ratio = 40%.
k
d
= 12%.
k
RF
= 7%.
Tax rate = 40%.
beta
Division
= 1.7.
Market risk premium = 6%.
10 - 38
Beta = 1.7, so division has more market
risk than average.
Divisions required return on equity:
k
s
= k
RF
+ (k
M
k
RF
)b
Div.

= 7% + (6%)1.7 = 17.2%.
WACC
Div.
= w
d
k
d
(1 T) + w
c
k
s

= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.
10 - 39
How does the divisions market risk
compare with the firms overall market
risk?
Division WACC = 13.2% versus
company WACC = 11.1%.
Indicates that the divisions market risk
is greater than firms average project.
Typical projects within this division
would be accepted if their returns are
above 13.2%.

Cost of Capital

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Copyright 2001 by Harcourt, Inc. All rights reserved.

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