Cost of Capital

• This chapter is about the cost of capital
• Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Key Concepts and Skills

• Learn to determine a firm's cost of equity capital
• Learn to determine a firm's cost of debt
• Learn to determine a firm's overall cost of that capital
• Understand pitfalls of overall cost of capital and how to manage them

Chapter Outline

• The Cost of Capital: Some Preliminaries
• The Cost of Equity
• The Costs of Debt and Preferred Stock
• The Weighted Average Cost of Capital
• Divisional and Project Costs of Capital
• Flotation Costs and the Weighted Average Cost of Capital

Why Cost of Capital Is Important

• The return earned on assets is related to the risk of those assets
• Return to investor = the company's cost
• The cost of capital gives an indication of how the market views the risk of assets
• Cost of capital assists in determining the required return for capital budgeting projects

Required Return

• The required return = appropriate discount rate, based on the risk of the cash flows
• The required return for an investment must be known before computing NPV
• Businesses need to earn at least the required return to compensate investors

Cost of Equity

• The cost of equity is the return needed by equity investors based on risk of cash flows from the firm
• Risk includes business risk and financial risk
• There are two methods for determining the cost of equity; the dividend growth model, and SML (CAPM)

The Dividend Growth Model Approach

• Start with the dividend growth model formula and rearrange the formula to solve for R(E)
• P(0) = D(1) / (R(E) - g)
• R(E) = D(1) / P(0) + g

Dividend Growth Model Example

• Company is expected to pay a dividend of $1.50 per share next year
• Dividends are expected to grow at a steady rate of 5.1% per year
• The current price is $25
• R(E) = 1.50/25 + 0.051 = 0.111 = 11.1%

Estimating the Dividend Growth Rate

• One method to estimate the growth rate is to use the historical average
• Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

Advantages and Disadvantages of Dividend Growth Model

• Advantage: easy to understand and use
• Disadvantage: Only applicable to companies currently paying dividends
• Disadvantage: Not applicable if dividends aren’t growing at a reasonably constant rate
• Disadvantage: Sensitive to estimated growth rate where an increase in g of 1% increases the cost of equity by 1%
• Disadvantage: risk is not explicitly considered

The SML (Security Market Line) Approach

• Use the following information to compute the cost of equity:
• Risk-free Rate: R(f)
• Market risk premium: E(R(M)) – R(f)
• Systematic risk of asset: β
• Formula: R(E) = R(f) + β(E(R(M)) – R(f))

SML Example

• A company has an equity beta of 0.58 and the current risk-free rate is 6.1%
• Assuming the expected market risk premium is 8.6%
• R(E) = 6.1 + 0.58(8.6) = 11.1%

Advantages and Disadvantages of SML

• Advantage: Explicitly adjusts for systematic risk
• Advantage: Applicable to all companies, as long as beta can be estimated
• Disadvantage: Has to estimate the expected market risk premium, which does vary over time
• Disadvantage: It is necessary to estimate beta, which also varies over time
• Disadvantage: The past is being used to predict the future, which is not always reliable

Cost of Equity Example

• A company has a beta of 1.5, market risk premium is expected to be 9%, and the current risk-free rate is 6%
• Analysts believe dividends will grow at 6% per year and last dividend was $2
• Stock is currently selling for $15.65
• Using SML: R(E) = 6% + 1.5(9%) = 19.5%
• Using DGM: R(E) = [2(1.06) / 15.65] + 0.06 = 19.55%

Cost of Debt

• The cost of debt is the required return on a company’s debt
• Focus is usually on the cost of long-term debt or bonds
• Required return is best estimated by computing the yield-to-maturity on the existing debt
• One can also estimate current rates based on the bond rating expected when new debt is issued
• The cost of debt is NOT the coupon rate

Cost of Debt example

• A company has a bond issue currently outstanding with 25 years left to maturity
• The coupon rate is 9%, and coupons are paid semiannually
• The bond is selling for $908.72 per $1,000 bond.
• N = 50; PMT = 45; FV = 1000; PV = -908.72;
• CPT I/Y = 5%; YTM = 5(2) = 10%

Cost of Preferred Stock

• Preferred stock generally pays a constant dividend each period
• Dividends are expected to be paid every period forever
• Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for R(P)
• Where R(P) = D / P(0)

Cost of Preferred Stock Example

• A company has preferred stock that has an annual dividend of $3
• If the current price is $25
• R(P) = 3 / 25 = 12%

The Weighted Average Cost of Capital

• The individual costs of capital that have been computed are used to get an average cost of capital for the firm
• This average is the required return on the firm’s assets
• Weights are determined by how much of each type of financing is used

Capital Structure Weights

• E = market value of equity = # of outstanding shares times price per share
• D = market value of debt = # of outstanding bonds times bond price
• V = market value of the firm = D + E
• wE = E/V = percent financed with equity
• wD = D/V = percent financed with debt

Example Capital Structure Weights

• Market value of equity = $500 million, market value of debt = $475 million.
• V = 500 million + 475 million = 975 million
• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%

Taxes and the WACC

• After-tax cash flows must be considered and the effect of taxes on the various costs of capital should be considered
• Interest expense reduces tax liability
• This reduction in taxes reduces the cost of debt
• After-tax cost of debt = R(D)(1-T(C))
• Dividends are not tax deductible, so there is no tax impact on the cost of equity
• WACC = wERE + wDRD(1-TC)

Extended Example: WACC - I

• Equity Information: 50 million shares, $80 per share, beta = 1.15, market risk premium = 9%, risk-free rate = 5%
• Debt Information: $1 billion in outstanding debt (face value), current quote = 110, coupon rate = 9%, semiannual coupons, 15 years to maturity
• Tax rate = 40%

Extended Example: WACC - II

• Cost of equity: R(E) = 5 + 1.15(9) = 15.35%
• Cost of debt: N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268, R(D) = 3.927(2) = 7.854%
• After-tax cost of debt: R(D)(1-TC) = 7.854(1-0.4) = 4.712%

Extended Example: WACC - III

• Capital structure weights: E = 50 million (80) = 4 billion, D = 1 billion (1.10) = 1.1 billion, V = 4 + 1.1 = 5.1 billion, wE = E/V = 4 / 5.1 = 0.7843, wD = D/V = 1.1 / 5.1 = 0.2157
• WACC = 0.7843(15.35%) + 0.2157(4.712%) = 13.06%

Eastman Chemical I

• Click on the web surfer to go to Yahoo Finance to get information on Eastman Chemical (EMN)
• Under Profile and Key Statistics, the following information can be found: number of shares outstanding, book value per share, price per share, and beta
• Under analyst estimates, analyst estimates of earnings growth (use as a proxy for dividend growth) can be found
• The Bonds section at Yahoo Finance can provide the T-bill rate
• Use this information, with the CAPM and DGM to estimate the cost of equity

Eastman Chemical II

• Go to FINRA for market information on Eastman Chemical’s bond issues
• Enter Eastman Chemical to find the bond information
• Note that you may not be able to find information on all bond issues due to the illiquidity of the bond market
• Go to the SEC site to get book valve information from the firm’s most recent 10Q

Eastman Chemical III

• Financial the weighted average cost of the debt if you were able to get sufficient information
• Use book values if market information was not available and they are often very close
• Compute the WACC and use market value weights if available

Work the Web

• Find estimates of WACC at www.valuepro.net
• Consider the assumptions and how those assumptions impact the estimate of WACC

Table 14.1 Cost of Equity

• Dividend growth model approach: RE = D1/P0 + g, where D1 is the expected dividend, g is the dividend growth rate, and P0 is the current stock price
• SML approach: RE = Rf + βE * (RM- Rf), where Rf, is the risk-free rate, RM is the expected return on the overall market, and βE is the systematic risk of the equity.

Table 14.1 Cost of Debt

• For a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt
• The coupon rate is irrelevant and yield to maturity is covered in chapter 7
• If the firm has no publicly traded debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds. Bond ratings are discussed in chapter 7

Table 14.1 WACC

• The firm’s WACC is the overall required return on the firm as a whole and it is the appropriate discount rate for cash flows similar in risk to those of the overall firm.
• The WACC is calculated as: WACC = (E/V) X RE + (D/V) x RD x (1-TC), where TC is the corporate tax rate, E is the market value of the firm's equity, D is the market value of the firm's debt, and V = E + D where E/V is the percentage of the firm's financing and D/V is the percentage that is debt.

Divisional and Project Costs of Capital

• Using the WACC as the discount rate is only appropriate for projects that have the same risk as the firm’s current operations
• If considering accepting a project that has a different risk profile from the firm, an appropriate discount rate must be determined for that project
• A firm's divisions also often require separate discount rates

WACC for All Projects Example

• Assume the WACC = 15%.
• If the required returns are project A-20%, project B-15%, project C- 10% and the IRR are project A-17%, project B-18% and project C-12%

The Pure Play Approach

• Identify one or more companies that specialize in the product or service being considered
• Compute the beta for each company and take an average
• Use that beta along with the CAPM to find the appropriate return for a project of that risk
• Note: It is often difficult to find pure play companies

Subjective Approach

• Risk of projects under consideration are assessed relative to the firm overall
• The discount rate of projects with more risk than the firm should be higher than the WACC
• The discount rate of projects with less risk than the firm should be lower than the WACC
• This approach can reduce error relative to not considering differential risk at all

Subjective Approach Example

• Very Low Risk projects require a discount rate of WACC – 8%
• Low Risk projects require a WACC – 3%
• Same Risk as Firm uses the WACC (no adjustment)
• High Risk projects require a discount rate of WACC + 5%
• Very High Risk projects require a discount rate of WACC + 10%

Flotation Costs

• The required return relies on risk, not how the money is raised
• The cost of issuing new securities should not be ignored either
• Compute the weighted average flotation cost
• Use the target weights because the firm will issue securities in these percentages over the long term

NPV and Flotation Costs Example

• Considering a project that will cost $1 million that will generate after-tax cash flows of $250,000 per year for 7 years
• WACC is 15%, and the firm’s target D/E ratio is .6
• Flotation cost for equity is 5%, and the flotation cost for debt is 3%
• fA = (0.375)(3%) + (0.625)(5%) = 4.25%
• PV of future cash flows = $1,040,105
• NPV = 1,040,105 - 1,000,000/(1-0.0425) = -$4,281
• The project would have a positive NPV of $40,105 without considering flotation costs
• Once the cost of issuing new securities is considered, the NPV turns negative

Quick Quiz

• The two approaches for computing the cost of equity
• How to compute the cost of debt and the after-tax cost of debt
• How to compute the capital structure weights required for the WACC
• Definition of the WACC
• What happens if the WACC is used for the discount rate for all projects
• Two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate
• How to factor flotation costs into analysis

Ethics Issues

• It may be possible for a project manager to adjust the cost of capital, to increase the likelihood of having their project accepted
• Note that this may not be ethical or financially sound

Comprehensive problem

• A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price
• The company has 100,000 shares of preferred stock which pay a $3 annual dividend, and sell for $30 per share
• The company has 500,000 shares of common stock which sell for $25 per share and have a beta of 1.5
• The risk free rate is 4%, and the market return is 12%
• Assume a 40% tax rate and determine the company’s WACC