Transcript Chapter 9 THE COST OF CAPITAL

The Cost of Capital
Cost of capital components
 Accounting for flotation costs
 WACC
 Adjusting cost of capital for risk
 Estimating project risk

What types of capital do firms
use?
Debt
Preferred stock
Common equity:
Retained earnings
New common stock
Weighted Average Cost of Capital
WACC = wdkd(1 – T) + wpkp + wcks
Should we focus on before-tax
or after-tax capital costs?
Stockholders focus on A-T CFs.
Therefore, we should focus on
A-T capital costs, i.e., use A-T
costs in WACC. Only kd needs
adjustment.
Should we focus on historical (embedded)
costs or new (marginal) costs?
The cost of capital is used primarily
to make decisions that involve
raising new capital. So, focus on
today’s marginal costs (for WACC).
A 15-year, 12% semiannual bond
sells for $1,153.72. What’s kd?
0
1
2
30
i=?
...
60
-1,153.72
INPUTS
30
N
OUTPUT
60
-1153.72 60
I/YR
PV
PMT
5.0% x 2 = kd = 10%
60 + 1,000
1000
FV
Component Cost of Debt

Interest is tax deductible, so
kd AT
= kd BT(1 – T)
= 10%(1 – 0.40) = 6%.
Use nominal rate.
 Flotation costs small.

Ignore.
What’s the cost of preferred stock?
Pp = $111.10; 10%; Par = $100.
Use this formula:
Dp
$10
kp 

 0.090  9.0%.
Pp $111.10
Note:
 Preferred
dividends are not tax
deductible, so no tax adjustment.
Just kp.
 Nominal kp is used.
 Our calculation ignores flotation
costs.
Is preferred stock more or less
risky to investors than debt?
More risky; company not required to
pay preferred dividend.
 However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred
stockholders may gain control of firm.

Why is yield on preferred lower than kd?
Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
 Therefore, preferred often has a lower B-T
yield than the B-T yield on debt.
 The A-T yield to an investor, and the A-T
cost to the issuer, are higher on preferred
than on debt. Consistent with higher risk
of preferred.

Example:
kp = 9% kd = 10% T = 40%
kp, AT = kp – kp (1 – 0.7)(T)
= 9% – 9%(0.3)(0.4) =
7.92%.
kd, AT = 10% – 10%(0.4) =
6.00%.
A-T Risk Premium on Preferred = 1.92%.
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.

Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
 They could buy similar stocks and
earn ks, or company could
repurchase its own stock and earn
ks. So, ks is the cost of retained
earnings.

Three ways to determine cost of
common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.
What’s the cost of common equity based
on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM – kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
What’s the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
D1
D0(1 + g)
ks =
+g=
+g
P0
P0
= $4.19(1.05) + 0.05
$50
= 0.088 + 0.05
= 13.8%.
Suppose the company has been
earning 15% on equity (ROE =
15%) and retaining 35% (dividend
payout = 65%), and this situation
is expected to continue.
What’s the expected future g?
Retention growth rate:
g = (1 – Payout)(ROE)= 0.35(15%)
= 5.25%.
Here (1 – Payout) = Fraction retained.
Close to g = 5% given earlier. Think of
bank account paying 10% with payout =
100%, payout = 0%, and payout = 50%.
What’s g?
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.

Find ks using the own-bond-yield-plus-riskpremium method. (kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%
This RP  CAPM RP.
 Produces ballpark estimate of ks.
Useful check.

What’s a reasonable final estimate of ks?
Method
Estimate
CAPM
14.2%
DCF
13.8%
kd + RP
14.0%
Average
14.0%
Why is the cost of retained 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.
Two approaches that can be used to
account for flotation costs:
Include the flotation costs as part of the
project’s up-front cost. This reduces the
project’s estimated return.
 Adjust the cost of capital to include
flotation costs. This is most commonly
done by incorporating flotation costs in
the DCF model.

New common, F = 15%:
D0 (1  g)
ke 
g
P0 (1  F)
$4.191.05 

 5 .0 %
$501  0.15 
$4.40

 5.0%  15.4%.
$42.50
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 perproject cost is fairly small.
 We will frequently ignore flotation costs
when calculating the WACC.

What’s the firm’s WACC (ignoring
flotation costs)?
WACC = wdkd(1 – T) + wpkp + wcks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
What factors influence a
company’s composite WACC?
Market conditions.
 The firm’s capital structure and dividend
policy.
 The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.

WACC Estimates for Some Large
U. S. Corporations, Nov. 1999
Company
Intel
General Electric
Motorola
Coca-Cola
Walt Disney
AT&T
Wal-Mart
Exxon
H. J. Heinz
BellSouth
WACC
12.9%
11.9
11.3
11.2
10.0
9.8
9.8
8.8
8.5
8.2
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 project’s WACC should be adjusted to
reflect the project’s risk.

Risk and the Cost of Capital
Rate of Return
(%)
Acceptance Region
W ACC
12.0
H
8.0
0
Rejection Region
A
10.5
10.0
9.5
B
L
Risk L
Risk A
Risk H
Risk
Divisional Cost of Capital
Rate of Return
(%)
13.0
Project H
11.0
10.0
9.0
7.0
0
WACC
Division H’s WACC
Project L
Composite WACC
for Firm A
Division L’s WACC
RiskL
Risk Average
RiskH
Risk
What procedures are used to determine
the risk-adjusted cost of capital for a
particular project or division?

Subjective adjustments to the firm’s
composite WACC.

Attempt to estimate what the cost of
capital would be if the
project/division were a stand-alone
firm.

Pure Play Approach
How might corporations handle this in
real life?
Each division would have its own adjusted
WACC.
 There might be risk “baskets” within each
division.
