Financial Management:
Principles & Applications
Thirteenth Edition
Chapter 14
The Cost of Capital
Copyright Education,
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Inc. All Reserved
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Inc. Education,
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Learning Objectives (1 of 2)
1. Understand the concepts underlying the firm’s
overall cost of capital and the purpose for its
calculation.
2. Evaluate a firm’s capital structure, and determine
the relative importance (weight) of each source
of financing.
3. Calculate the after-tax cost of debt, preferred
stock, and common equity.
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Learning Objectives (2 of 2)
4. Calculate a firm’s weighted average cost of
capital.
5. Discuss the pros and cons of using multiple,
risk-adjusted discount rates and describe the
divisional cost of capital as a viable alternative
for firms with multiple divisions.
6. Adjust the NPV for the costs of issuing new
securities when analyzing new investment
opportunities.
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Principles Applied in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 3: Cash Flows Are the Source of Value.
• Principle 4: Market Prices Reflect Information.
• Principle 5: Individuals Respond to Incentives.
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14.1 THE COST OF CAPITAL: AN OVERVIEW
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The Cost of Capital: An Overview (1 of 3)
• We can view the returns that investors expect to receive
on the firm’s stocks and bonds as the cost to the firm of
attracting the capital used to fund the firm’s investment in
assets. We can think of the cost of capital for a firm as
the weighted average of the required returns of the
securities that are used to finance its business. We refer to
this as the firm’s weighted average cost of capital, or
WACC.
• WACC incorporates the required rates of return demanded
by the firm’s lenders and investors along with the particular
mix of financing sources that the firm uses.
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The Cost of Capital: An Overview (2 of 3)
The riskiness of a firm affects its WACC in two
ways:
– First, required rate of return on the debt and equity
securities that the firm issues will be higher if the firm is
riskier, and
– Second, risk influences how the firm chooses the
extent to which it is financed with debt and equity
securities.
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The Cost of Capital: An Overview (3 of 3)
The firm’s WACC is used in a number of ways:
– First, WACC is used to value the entire firm.
– Second, firms often use WACC as the starting point for
determining the discount rate for individual investment
projects they might undertake
– Finally, firms sometimes use their WACC to evaluate
their performance
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WACC equation



Proportion of
 Proportion of   

 After-Tax Cost  
   Cost of Preferred  
 
Capital Raised

   Capital Raised    

Stock ( k ps )
of Debt kd (1  T)  







of Capital (WACC ) 
 by Debt(w d )   
 by Pr eferred Stock ( k ps )  
W eighted
Average Cost

Proportion of


 Cost of Common  

 
Capital Raised


Stock ( kcs )
  by Common Stock(w )  

cs  


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Figure 14.1 A Template for Calculating WACC
Source of Capitala
(1)
Market Value
Weightb (2)
×
After-Tax Cost
of Capitalc(3)
=
Product of
Columns 2 and 3d
Debt
wd
×
kd (1 − T)
=
wd × kd (1 − T)
Preferred stock
wps
×
kps
=
wps × kps
Common equity
wcs
×
kcs
=
wcs × kcs
Sum =
100%
Blank
Blank
Blank
WACC
aThe
sources of capital included in the WACC calculation include all interest-bearing debt (short- and long-term) but
exclude non-interest-bearing debt such as accounts payable and accrued expenses. In addition, preferred stock and
common equity are included. The total of all the market values of all the capital sources included in the WACC
computation is generally referred to as the firm’s enterprise value, and the mix of debt and equity defines the firm’s capital
structure.
bThe
weight used to average the cost of each source of capital should reflect the relative importance of that source of
capital to the firm’s value on the date of the analysis. This means that the proper weight for each source is based on the
market value of that source of capital as a percentage of the sum of the market values of all sources.
investor’s required rate of return is the basis for estimating the cost of capital for each source of financing to the firm.
However, because interest on the firm’s debt is tax-deductible to the firm, we must adjust the lender’s required rate of
return to an after-tax basis. The required rate of return for each source of financing, like the weight used to average it,
should reflect a current estimate based on current market conditions.
cThe
dThe
weighted average of the individual costs of the sources of capital is found by summing the products of the weight and
cost of each source.
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Three—Step Procedure for Estimating the
Firm’s WACC (1 of 2)
1. Define the firm’s capital structure by determining
the weight of each source of capital. (see column 2,
figure 14.1). The weight (importance) of each source
of capital is based on the current market value of
each source of capital.
2. Estimate the cost of each source of financing.
These costs are equal to the investor’s required
rates of return after adjusting the cost of debt for the
effects of taxes (see column 3, figure 14-1)
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Three—Step Procedure for Estimating the
Firm’s WACC (2 of 2)
3. Calculate a weighted average of the cost of
capital from all source of financing. This step
requires calculating the product of the after-tax
cost of each capital source used by the firm and
the weight associated with that source. The sum
of these products is the WACC. (see column 4,
figure 14-1)
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14.2 DETERMINING THE FIRM’S
CAPITAL STRUCTURE WEIGHTS
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Determining the Firm’s Capital Structure
Weights (1 of 2)
The weights are based on the following sources of
financing: debt (short-term and long-term), preferred
stock and common equity. Liabilities such as
accounts payable are not included in capital
structure.
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Determining the Firm’s Capital Structure
Weights (2 of 2)
• In theory, market value is preferred for all
securities. However, not all market values may be
readily available.
• In practice, we generally use book values for debt
and market values for equity securities.
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CHECKPOINT 14.1: CHECK YOURSELF
Calculating the WACC
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The Problem
After completing her estimate of Templeton’s WACC, the
CFO decided to explore the possibility of adding more lowcost debt to the capital structure. With the help of the firm’s
investment banker, the CFO learned that Templeton could
probably push its use of debt to 37.5% of the firm’s capital
structure by issuing more debt and retiring (purchasing) the
firm’s preferred shares. This could be done without
increasing the firm’s costs of borrowing or the required rate
of return demanded by the firm’s common stockholders.
What is your estimate of the WACC for Templeton under this
new capital structure proposal?
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Step 1: Picture the Problem (1 of 2)
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Step 1: Picture the Problem (2 of 2)
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Step 2: Decide on a Solution Strategy (1 of 2)
We need to determine the WACC based on the
given information:
– Weight of debt = 37.5%; Cost of debt = 6%
– Weight of common stock = 62.5%; Cost of common
stock =15%
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Step 2: Decide on a Solution Strategy (2 of 2)
We can compute the WACC based on the following
equation:



Proportion of
 Proportion of   

 After-Tax Cost  
   Cost of Preferred  
 
Capital Raised

   Capital Raised    

Stock ( k ps )
of Debt kd (1  T)  







of Capital (WACC ) 
 by Debt(w d )   
 by Pr eferred Stock ( k ps )  
W eighted
Average Cost

Proportion of


 Cost of Common  

 
Capital Raised


Stock ( kcs )
  by Common Stock(w )  

cs  


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Step 3: Solve
The WACC is equal to 11.625% as calculated below.
Blank
Weights
Cost
Product
Debt
0.375
0.06
0.0225
Common Stock
0.625
0.15
0.09375
Preferred Stock
0
0.1
0
Blank
1
WACC
0.11625
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Step 4: Analyze
We observe that as Templeton chose to increase
the level of debt to 37.5% and retire the preferred
stock, the WACC decreased marginally from
12.125% to 11.625%. Thus altering the weights will
change the WACC.
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14.3 ESTIMATING THE COST OF
INDIVIDUAL SOURCES OF CAPITAL
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The Cost of Debt (1 of 4)
The cost of debt is the rate of return the firm’s
lenders demand when they loan money to the firm.
We estimate the market’s required rate of return on
a firm’s debt using its yield to maturity and not the
coupon rate.
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The Cost of Debt (2 of 4)
After-tax cost of debt = Yield (1-tax rate)
Example What will be the yield to maturity on a debt
that has par value of $1,000, a coupon interest rate
of 5%, time to maturity of 10 years and is currently
trading at $900? What will be the cost of debt if the
tax rate is 30%?
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The Cost of Debt (3 of 4)
Enter:
– N = 10; PV = −900; PMT = 50; FV =1000
– I/Y = 6.38%
– After-tax cost of Debt = Yield (1-tax rate)
= 6.38 (1−.3)
= 4.47%
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The Cost of Debt (4 of 4)
It is not easy to find the market price of a specific
bond. It is a standard practice to estimate the cost
of debt using yield to maturity on a portfolio of
bonds with similar credit rating and maturity as the
firm’s outstanding debt.
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Figure 14-2 A Guide to Corporate Bond Ratings (1 of 2)
Moody’s
S&P
Fitch
Definitions
Aaa
AAA
AAA
Prime, Maximum Safety
Aa1
AA+
AA+
High Grade, High Quality
Aa2
AA
AA
Blank
Aa3
AA−
AA−
Blank
A1
A+
A+
Upper Medium Grade
A2
A
A
Blank
A3
A−
A−
Blank
Baa1
BBB+
BBB+
Lower Medium Grade
Baa2
BBB
BBB
Blank
Baa3
BBB−
BBB−
Blank
Ba1
BB+
BB+
Non-investment Grade
Ba2
BB
BB
Speculative
Ba3
BB−
BB−
Blank
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Figure 14-2 A Guide to Corporate Bond Ratings (2 of 2)
Moody’s
S&P
Fitch
Definitions
B1
B+
B+
Highly Speculative
B2
B
B
Blank
B3
B−
B−
Blank
Caa1
CCC+
CCC
Substantial Risk
Caa2
CCC
−
In Poor Standing
Caa3
CCC−
−
Blank
Ca
−
−
Extremely Speculative
C
−
−
May Be in Default
−
−
DDD
Default
−
−
DD
Blank
−
D
D
Blank
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Figure 14-3 Corporate Bond Yields: Default Ratings and
Term to Maturity (1 of 2)
Rating
1 year
2 years
3 years
5 years
7 years
10 years
30 years
Aaa/AAA
0.22
0.31
0.42
0.76
1.26
2.00
3.41
Aa1/AA+
0.26
0.43
0.58
0.96
1.46
2.17
3.62
Aa2/AA
0.29
0.55
0.74
1.16
1.66
2.35
3.83
Aa3/AA−
0.31
0.58
0.77
1.20
1.70
2.39
3.88
A1/A+
0.32
0.60
0.80
1.23
1.73
2.43
3.93
A2/A
0.55
0.80
0.98
1.40
1.89
2.57
4.03
A3/A−
0.62
0.95
1.18
1.66
2.19
2.92
4.51
Baa1/BBB+
0.83
1.19
1.42
1.91
2.45
3.18
4.80
Baa2/BBB
1.00
1.39
1.65
2.17
2.73
3.48
5.17
Baa3/BBB−
1.49
1.87
2.11
2.62
3.16
3.91
5.56
Ba1/BB+
2.27
2.64
2.90
3.41
3.98
4.75
6.37
Ba2/BB
3.04
3.41
3.68
4.21
4.79
5.58
7.19
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Figure 14-3 Corporate Bond Yields: Default Ratings and
Term to Maturity (2 of 2)
Rating
1 year
2 years
3 years
5 years
7 years
10 years
30 years
Ba3/BB−
3.82
4.18
4.47
5.00
5.61
6.42
8.00
B1/B+
4.60
4.95
5.25
5.79
6.42
7.26
8.82
B2/B
5.38
5.72
6.04
6.59
7.24
8.10
9.63
B3/B−
6.15
6.49
6.82
7.38
8.06
8.93
10.45
Caa/CCC+
6.93
7.26
7.61
8.17
8.87
9.77
11.26
U.S. Treasury Yield
0.18
0.25
0.32
0.60
1.00
1.59
2.76
Legend:
These data are actually reported as spread to Treasury yields, so for a 30-year Baa1/BBB+-rated corporate bond, the yield
would be reported as 204 basis points over the 30-year Treasury yield of 2.76%. A basis point is 1/100th of a percent, so 204
basis points correspond to 2.04%.
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The Cost of Preferred Equity (1 of 2)
The cost of preferred equity is the rate of return
investors require of the firm when they purchase its
preferred stock.
k ps 
Div ps
Pps
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The Cost of Preferred Equity (2 of 2)
Example The preferred shares of Relay Company
that are trading at $25 per share. What will be the
cost of preferred equity if these stocks have a par
value of $35 and pay annual dividend of 4%?
Using equation 14-2a
kps = $1.40 ÷ $25 = .056 or 5.6%
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The Cost of Common Equity
The cost of common equity is the rate of return
investors expect to receive from investing in firm’s
stock, which, in turn, reflects the risk of investing in
the equity of the firm. This return comes in the form
of cash distributions (dividends and cash proceeds
from the sale of the stock). There are two commonly
used approaches for calculating the cost of equity:
1. The dividend growth model (from chapter 10)
2. CAPM (from chapter 8)
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The Dividend Growth Model: Discounted
Cash Flow Approach (1 of 2)
1. First, estimate the expected stream of dividends
that the common stock is expected to provide t
the stockholder.
2. Second, using these estimated dividends as the
estimated cash flows from the stock, and the
firm’s current stock price, calculate the internal
rate of return on the stock investment.
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The Dividend Growth Model – Discounted
Cash Flow Approach (2 of 2)
Market Price
of Common Stock (Pcs )

Common Stock Dividend for Year 1( D1)
 Common Equity Required   Growth Rate in 



Rate
of
Return
(
k
)
cs

  Dividends ( g ) 
kcs
D1

g
Pcs
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CHECKPOINT 14.2: CHECK YOURSELF
Estimating the Cost of Common Equity for
Pearson plc using the
Constant Dividend Growth Rate Model
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The Problem
Prepare two additional estimates of Pearson’s cost
of common equity using the dividend growth model
where you use growth rates in dividends that are
25% lower than the estimated −1.70% (i.e., for g
equal to −2.13% and −1.28%)
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Step 1: Picture the Problem (1 of 2)
We are given the following:
– Price of common stock (Pcs ) = $10.79
– Growth rate of dividends (g) = −2.13% and −1.28%
– Dividend (D0) = $1.08 per share
– Cost of equity is given by dividend yield + growth rate.
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Step 1: Picture the Problem (2 of 2)
Dividend Yield
=D1 ÷ P0
Growth Rate (g)
Cost of Equity
(kcs )
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Step 2: Decide on a Solution Strategy
We can determine the cost of equity using equation
14-3a
kcs
D1

g
Pcs
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Step 3: Solve
At growth rate of 4.69%
kcs = {$1.08(.9787)/$10.39} + −.0213 = .0771 or 7.71%
At growth rate of 7.81%
kcs = {$1.08(.9872)/$10.39} −.0128 = .0856 or 8.56 %
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Step 4: Analyze
• Pearson’s cost of equity is estimated at 7.33% and
10.53% based on the different assumptions for
growth rate.
• Thus growth rate is an important variable in
determining the cost of equity. However,
estimating the growth rate is not easy.
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Estimating the Rate of Growth, g
The growth rate can be obtained from:
– websites that post analysts forecasts, and
– using historical data to compute the arithmetic average
or geometric average.
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Arithmetic and Geometric Average
Year
Dividend
$ Change
% Change
2012
$0.800
Blank
Blank
2013
0.825
$0.025
3.1%
2014
0.840
0.015
1.8%
2015
0.875
0.035
4.2%
2016
0.900
0.025
2.9%
Blank
Arithmetic Average
Blank
3.0%
Blank
Geometric Average
Blank
2.99%
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Pros and Cons of the Dividend Growth
Rate Model Approach
• Pros – Simplicity
• Cons – severely dependent upon the quality of
growth rate estimates; constant dividend growth
rate for ever is an oversimplification
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The Capital Asset Pricing Model (1 of 2)
CAPM (from chapter 8) was designed to determine
the expected or required rate of return for risky
investments.
Risk Premium for Common Equity
(  Equity Beta  Market Risk Premium)
Cost of common Risk - Free
Equity Beta  Expected Return on
Risk - Free 





Equity (kcs )
Rate (rf ) Coefficient ( cs )  the Market Portfolio ( rm ) Rate ( rf ) 
Market Risk Premium
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The Capital Asset Pricing Model (2 of 2)
Equation 14-4 illustrates that the expected return on
common stock is determined by three key
ingredients:
– The risk-free rate of interest,
– The beta or systematic risk of the common stock
returns, and
– The market risk premium.
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Advantages and Disadvantages of the
CAPM approach
Advantages – simplicity, wider applications
Disadvantages – Choice of risk-free is not clearly
defined, estimates of beta and market risk premium
will vary depending on the data used.
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CHECKPOINT 14.3: CHECK YOURSELF
Estimating the Cost of Common Equity
Using the CAPM
Prepare two additional estimates of Pearson’s cost of common equity using the CAPM
where you use the most extreme values of each of the three factors that drive the
CAPM.
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Step 1: Picture the Problem (1 of 4)
CAPM describes the relationship between the
expected rates of return on risky assets in terms of
their systematic risk. Its value depends on:
– The risk-free rate of interest,
– The beta or systematic risk of the common stock
returns, and
– The market risk premium.
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Step 1: Picture the Problem (2 of 4)
However, there can be wide variation in the
estimates for each one of these variables. Here we
are given the following estimates:
– The risk-free rate of interest (.01% or 2.80%)
– The beta or systematic risk of the common stock
returns (.8 or 1.2)
– The market risk premium (4% or 8%)
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Step 1: Picture the Problem (3 of 4)
The cost of equity can be estimated using the
CAPM equation:
Risk Premium for Common Equity
( Equity Beta  Market Risk Premium)
Cost of Common Risk - Free
Equity Beta  Expected Return on
Risk - Free 





Equity (kcs )
Rate (rf ) Coefficient ( βcs )  theMarket Portfolio ( rm ) Rate ( rf ) 
Market Risk Premium
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Step 1: Picture the Problem (4 of 4)
The cost of equity is given by Risk-free rate + (Risk
premium × Beta):
Risk-Free Rate
Risk Premium
× Beta
Cost of Equity
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Step 2: Decide on a Solution Strategy
Since we have been given the estimates for market
factors (risk-free rate and risk premium) and firmspecific factor (beta), we can determine the cost of
equity using CAPM.
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Step 3: Solve
Risk Premium for Common Equity
(  Equity Beta  Market Risk Premium)
Cost of Common Risk - Free
Equity Beta  Expected Return on
Risk - Free 





Equity (kcs )
Rate (rf ) Coefficient ( βcs )  the Market Portfolio ( rm ) Rate ( rf ) 
Market Risk Premium
• kcs = 0.014 + 0.8(4) = 3.214%
• kcs = 3.01 + 1.2(8) = 12.61%
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Step 4: Analyze
• Pearson’s cost of equity is shown to be sensitive
to the estimates used for risk-free rate of interest,
beta and market risk premium.
• Based on the estimates used, the cost of common
equity ranges from 3.21% to 12.61%.
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14.4 SUMMING UP: CALCULATING THE
FIRM’S WACC
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Summing Up: Calculating the Firm’s
WACC
When estimating the firm’s WACC, following issues
should be kept in mind:
– Use Market-Based Weights: weights should be based
on market values of firm’s securities rather than their
book values
– Use Market-Based Costs of Capital: the cost of capital
for each source of funds should reflect the current
market prices and expected future returns rather than
historical rates from the past.
– Use Forward-Looking weights and Opportunity Costs.
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Weighted Average Cost of Capital in
Practice
• The cost of capital varies across firms because of
differences in their lines of business, which
determine business risk, and differences in
individual firms’ capital structures or financial
leverage, which is the source of financial risk.
• Figure 14.4 shows the estimates of WACCs for a
sample of large U.S. firms. The WACCs range
from 3.31 percent to 7.20 percent. In general, the
firms with the highest costs of capital are those
with the lowest use of debt financing.
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Figure 14.4 WACCs for a Sample of Large U.S. Firms (1 of 2)
(Panel A) Cost of Capital Estimates
Debta
After-Tax
Cost of Debtb
% Equity
Cost of
Equityc
WACC
Blank
%
American Airlines (AAL)
28.20%
2.94%
71.80%
7.50%
6.22%
American Electric Power (AEP)
40.61%
2.60%
59.39%
3.80%
3.31%
Emerson Electric (EMR)
11.64%
2.26%
88.36%
7.85%
7.20%
Exxon-Mobil (XOM)
8.53%
1.79%
91.47%
7.10%
6.65%
Ford (F)
65.21%
2.94%
34.79%
7.90%
4.67%
General Electric (GE)
19.11%
2.15%
80.89%
8.05%
6.92%
Starbucks (SBUX)
0.81%
2.86%
99.19%
6.15%
6.12%
Target (TGT)
19.23%
2.26%
80.77%
5.20%
4.63%
Wal-Mart (WMT)
16.77%
2.09%
83.23%
3.90%
3.60%
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Figure 14.4 WACCs for a Sample of Large U.S. Firms (2 of 2)
(Panel B) Supporting Information Used to estimate the WACC
Bond
Ratingd
Spread to
10-Year
Treasury
Risk-Free
Rate (10Year Treasury)
BeforeTax Cost
of Debt
Beta
Cost of
Equity
(CAPM)
American Airlines (AAL)
Baa3
2.53%
2.0%
4.53%
1.10
7.50%
American Electric Power
(AEP)
Baa1
2.00%
2.0%
4.00%
0.36
3.80%
Emerson Electric (EMR)
A2
1.47%
2.0%
3.47%
1.17
7.85%
Exxon-Mobil (XOM)
Aaa
0.76%
2.0%
2.76%
1.02
7.10%
Baa3
2.53%
2.0%
4.53%
1.18
7.90%
A1
1.30%
2.0%
3.30%
1.21
8.05%
Baa2
2.40%
2.0%
4.40%
0.83
6.15%
Target (TGT)
A2
1.47%
2.0%
3.47%
0.64
5.20%
Wal-Mart (WMT)
Aa2
1.21%
2.0%
3.21%
0.38
3.90%
Blank
Ford (F)
General Electric (GE)
Starbucks (SBUX)
Source: Computations performed by the authors using publicly available sources in 2016.
a% Debt = Net Debt/Enterprise Value.
bThe assumed tax rate is 35%, so After-Tax Cost of Debt = Before-Tax Cost of Debt (1 − .35).
c% Equity = Equity Value/Enterprise Value = 1 − % Debt.
dMoody's rating for a recent debt issue by the firm.
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14.5 ESTIMATING PROJECT COSTS OF CAPITAL
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Estimating Project Cost of Capital
• Should one overall WACC be used to evaluate all
new investments? In theory, No, since all projects
may not the same risk characteristics as the
overall firm.
• However, a recent survey found that more than 50
percent of firms tend to use a single, companywide discount rate to evaluate all of their
investment proposals.
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The Rationale for Using Multiple Discount
Rates
Figure 14.5 illustrates the danger of using a single
discount rate to evaluate investment projects with
different levels of risk. There will be a tendency to to
take on too many risky investment projects, and
pass up good investment projects that are relatively
safe.
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Figure 14.5 Using the Firm’s WACC Can Bias Investment
Decisions toward Risky Projects
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Why Don’t Firms Typically Use Project
Cost of Capital?
1. It may be difficult to trace the source of financing
for individual project since most firms raise
money in bulk for all the projects.
2. It adds to the time and cost in getting approval
for new projects.
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Estimating Divisional WACCs (1 of 2)
• If a firm undertakes investment with very different
risk characteristics, it will try to estimate divisional
WACCs.
• Generally, the divisions are defined either by
geographical regions (e.g., Latin American region)
or by industry (e.g., exploration and production,
pipelines, and refining for a large, integrated oil
company)
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Estimating Divisional WACCs (2 of 2)
• The advantages of using a divisional WACC
include the following:
– It provides different discount rates that reflect
differences in the systematic risk of the projects
evaluated by different divisions
– It entails only one cost of capital estimate per division
(as opposed to unique discount rates for each project)
– The use of common discount rate throughout the
division limits managerial latitude and the attendant
influence costs
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Using Pure Play Firms to Estimate
Divisional WACCs
• Here a firm with multiple divisions may identify a
comparable firm with only one division (called a
“pure play” comparison firms or “comps”).
• The estimate of pure play firm’s cost of capital can
then be used as a proxy for that particular
division’s cost of capital.
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Figure 14.6 Choosing the Right WACC: Discount Rates and
Project Risk
Method
Description
Advantages
WACC
Estimated WACC
for the firm as an
entity; used as the
discount rate on all
projects.
• Is a familiar concept to
• Does not adjust discount
most business executives.
rate for differences in
project risk.
• Minimizes estimation
Divisional
WACC
Disadvantages
When to Use
• When projects are similar in
risk to the firm as a whole.
• When using multiple discount
costs, as there is only one • Does not provide for
rates creates significant
cost-of capital calculation
flexibility in adjusting for
problems with influence
for the firm.
differences in project debt in
costs.
the
capital
structure.
• Reduces the problem of
influence cost issues.
Estimated WACC for • Uses division-level risk to
individual business
adjust discount rates for
units or divisions
individual projects.
within the firm; used • Reduces influence costs
as the only discount
to the competition among
rate within each
division managers to
division.
lower their division’s cost
of capital.
• Does not capture
• When individual projects
intradivision risk differences
within each division have
in projects.
similar risks and debt
capacities.
• Does not account for
differences in project debt
capacities within divisions.
• Allows potential influence
costs associated with the
choice of discount rates
across divisions.
• When discount rate
discretion creates significant
influence costs within
divisions but not between
divisions.
• Is difficult to find singledivision firms to be proxies
for divisions.
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Divisional WACC—Estimation Issues and
Limitations (1 of 2)
Although divisional WACC is generally a significant
improvement over the single, company-wide WACC, the
way that it is often implemented using industry-based
comparison firms has a number of potential
shortcomings:
• The sample of firms in a given industry may include
firms that are not good matches for the firm doing the
analysis or for one of its divisions.
• The division being analyzed may not have a capital
structure that is similar to that of the sample firms in
the industry data.
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Divisional WACC—Estimation Issues and
Limitations (2 of 2)
• The firms in the chosen industry that are used as
proxies for divisional risk may not be good
reflections of project risk.
• Good comparison firms for particular division may
be difficult to find.
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14.6 FLOATATION COSTS AND PROJECT NPV
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Floatation Costs
Floatation costs are fees paid to an investment
banker and costs incurred when securities are sold
at a discount to the current market price.
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WACC, Floatation Costs and Project NPV
(1 of 3)
Because of floatation costs, the firm will have to
raise more than the amount it needs.
Financing
Flotation-Cost-Adjusted
Initial Outlay

Needed
Flotation Cost


1



as
a
Percent
of
Funds
Raised


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WACC, Floatation Costs and Project NPV
(2 of 3)
Example If a firm needs $100 million to finance its
new project and the floatation cost is expected to be
5.5%, how much should the firm raise by selling
securities?
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WACC, Floatation Costs and Project NPV
(3 of 3)
Financing
Flotation-Cost-Adjusted
Initial Outlay

Needed
Flotation Cost


1



as
a
Percent
of
Funds
Raised


= $100 million ÷ (1−.055) = $105.82 million
• Thus the firm will raise $105.82 million, which
includes floatation cost of $5.82 million.
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CHECKPOINT 14.4: CHECK YOURSELF
Incorporating Floatation Costs
Into the Calculation of NPV
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The Problem
Before Tricon could finalize the financing for the
new project, stock market conditions changed such
that new stock became more expensive to issue. In
fact, floatation costs rose to 15% of new equity
issued and 3% of new debt issued. Is the project
still viable (assuming the present value of future
cash flows remain unchanged)?
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Step 1: Picture the Problem (1 of 2)
The NPV will be equal to the present value of the
future cash flows less the initial outlay and floatation
costs.
NPV = PV(inflows)
– Initial outlay
– Floatation costs
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Step 1: Picture the Problem (2 of 2)
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Step 2: Decide on a Solution Strategy (1 of 2)
We need to first estimate the average floatation
costs that Tricon will incur when raising the funds.
This can be done using equation 14-5.
Weighted Average
Flotation Cost
Flotation Cost
Flotation Cost

 

  wd 

w

  cs

of
Debt
as
a
Percent
of
Equity
as
a
Percent

 

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Step 2: Decide on a Solution Strategy (2 of 2)
Next, the “grossed-up” investment outlay can be
estimated using equation 14-6 and subtracted from
the present value of the expected future cash flows
to determine whether the project has a positive
NPV.
Financing
Flotation-Cost-Adjusted
Initial Outlay

Needed
Flotation Cost


1



as
a
Percent
of
Funds
Raised


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Step 3: Solve (1 of 3)
We can use equation 14-5 to estimate the weighted
average floatation cost as follows:
Weighted Average
Flotation Cost
Flotation Cost
Flotation Cost

 

  wd 

w

  cs

of Debt as a Percent  
of Equity as a Percent 

= .40 × .03 + .60 × .15
= .102 or 10.2%
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Step 3: Solve (2 of 3)
The “grossed up” initial outlay for $100 million
project can be estimated using equation 14-6:
Financing
Flotation Cost Adjusted
Initial Outlay

Needed
 Flotation Cost 
1

as
a
Percent


= $100 million ÷ (1 − 0.102) = $111.36 million
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Step 3: Solve (3 of 3)
• Thus, floatation costs is equal to $11.36 million.
• NPV = $115 million − $111.36 million
= $3.64 million
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Step 4: Analyze
• The project is feasible even after consideration of
higher floatation costs as the NPV is positive at
$3.64 million.
• However, the problem illustrates that floatation
costs can be significant and cannot be ignored
while evaluating projects.
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Key Terms
• Cost of capital
• Cost of common equity
• Cost of debt
• Cost of preferred equity
• Divisional WACC
• Floatation costs
• Risk Premium
• Weighted Average Cost of Capital (WACC)
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