Cost of Capital
Cost of Capital
• Cost of capital of a company is a
combination of
– Cost of Equity
– Cost of Debt
• Cost of Debt
• Cost of bank loan
• Cost of bonds
• Other forms of debt
Cost of Capital
• Every business is financed through a mix of Debt (borrowed
funds) and Equity (owned funds) financing.
• How much of each component should be used depends on the
riskiness of the business
• Equity is much more expensive than debt
• Debt on the other hand while being cheaper, results in a liability
or obligation that must be serviced. Interest on Debt though is
tax deductible, unlike equity.
• Here, we discuss the cost-related aspects of each form of
capital and how the capital structure determines what the Cost
of Capital is for your business.
• why determining an accurate Cost of Capital is important.
Cost of Debt
• Cost of loan
– Interest cost on loan
– Other costs of loan
• Cost of bond
• Cost of other forms of debt: Cost of
Preferred stock
Cost of Debt
Coupon Rate
Maturity
Book Value of
Price (% of Par
Debt (in Millions)
Value)
YTM
3.25%
2008
72
96.00
5.02
7.00%
2012
187
108.00
5.36
6.30%
2018
143
100.10
6.20
7.25%
2024
497
104.00
6.45
7.60%
2024
200
112.00
6.41
7.65%
2017
297
114.00
6.41
Cost of Equity
• Cost of Equity (Ke) is the minimum rate of return
which a company must earn to convince
investors to invest in the company's common
stock at its current market price. It is also called
cost of common stock or required return on
equity.
• There are two commonly used methods to
calculate cost of equity: CAPM and DDM
Cost of Equity - DDM
• Start with the DGM:
D 0 (1  g)
D1
P0 

R -g
R -g
Rearrange and solve for R:
D 0 (1  g)
D1
R
g 
g
P0
P0
•
Where D1 is the dividend per share expected over the next year, P0 is the
current stock price and g is the dividend growth rate. Dividends in next
period equals dividends per share in current period multiplied by (1 + growth
rate). Growth rate is equal to the sustainable growth rate which is the
product of retention ratio and return on equity
Cost of equity - CAPM
• In the capital asset pricing model, cost of equity
can be calculated as follows:
• Cost of Equity = Risk Free Rate + Equity Risk
Premium
• Equity risk premium is the product of the stock's
beta coefficient and the market risk premium.
The Cost of Equity
• From the firm’s perspective, the
expected return is the Cost of Equity
Capital: R i  R  β ( R M  R )
F
i
F
• To estimate a firm’s cost of equity capital, we
need to know three things:
1. The risk-free rate, RF
2. The market risk premium, R M
 RF
Cov ( Ri , R M ) σ i , M
 2
3. The company beta, β i 
Var ( R M )
σM
Cost of Equity: Example
• Suppose the stock of Stansfield Enterprises, a
publisher of PowerPoint presentations, has a
beta of 1.5. The firm is 100% equity financed.
• Assume a risk-free rate of 5% and a market
risk premium of 10%.
• What is the appropriate discount rate for an
expansion of this firm?
R  RF  βi ( R M  RF )
R  5 %  1 . 5  10 %
R  20 %
Cost of Equity
• The Dybvig Corp. common stock has a
beta of 1.17. If the risk free rate is 3.8
percent and the expected return on the
market is 11 percent, what is its cost of
equity?
Cost of Equity
Cost of Equity
Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows
+
Beta
- Measures market risk X
Type of
Business
Operating
Leverage
Risk Premium
- Premium for average
risk investment
Financial
Leverage
Base Equity
Premium
Country Risk
Premium
Industry Beta and Cost of Equity
• It is frequently argued that one can better
estimate a firm’s beta by involving the whole
industry.
• If you believe that the operations of the firm are
similar to the operations of the rest of the industry,
you should use the industry beta.
• If you believe that the operations of the firm are
fundamentally different from the operations of the
rest of the industry, you should use the firm’s
beta.
• Do not forget about adjustments for financial
leverage.
Determinants of Beta
• Nature of the business
• Operating leverage refers to the sensitivity to
the firm’s fixed costs of production.
• Financial leverage is the sensitivity to a firm’s
fixed costs of financing.
• The relationship between the betas of the
firm’s debt, equity, and assets is given by:
bAsset =
Debt
Debt + Equity
× bDebt +
Equity
Debt + Equity
× bEquity
• Financial leverage always increases the equity beta
relative to the asset beta.
Nature of Business and Beta
• High beta sectors
–
–
–
–
–
–
Automobiles Sector
Materials Sector
Information Technology Sector
Consumer Discretionary Sector
Industrial Sector
Banking Sector
• Low beta sectors
–
–
–
–
–
Consumer Staples
Beverages
HealthCare
Telecom
Utilities
Equity Beta and Asset Beta
The asset beta (unlevered beta) is the beta of a company on
the assumption that the company uses only equity financing.
In contrast, the equity beta (levered beta, project beta) takes
into account different levels of the company's debt/capital
structure.
Beta Adjustment
Unlevered Beta
• Unlevered Beta = βL/ (1 + ((1 – t) x (D/E)))
• Levered Beta = βU x (1 + ((1 – t) x (D/E)))
• Example: Beta = 1.2, D/E = 2/3, t = 30%,
and new D/E = 3/2
Capital Structure and Beta: Example
Consider Grand Sport, Inc., which is currently allequity financed and has a beta of 0.90.
The firm has decided to lever up to a capital
structure of 1 part debt to 1 part equity.
Since the firm will remain in the same industry, its
asset beta should remain 0.90.
However, assuming a zero beta for its debt, its
equity beta would become twice as large:
bAsset = 0.90 =
1
× bEquity
1+1
bEquity = 2 × 0.90 = 1.80
Capital Budgeting & Project Risk
Suppose the Conglomerate Company has a cost of capital,
based on the CAPM, of 17%. The risk-free rate is 4%, the
market risk premium is 10%, and the firm’s beta is 1.3.
17% = 4% + 1.3 × 10%
This is a breakdown of the company’s investment projects:
1/3 Automotive Retailer b = 2.0
1/3 Computer Hard Drive Manufacturer b = 1.3
1/3 Electric Utility b = 0.6
average b of assets = 1.3
When evaluating a new electrical generation investment,
which cost of capital should be used?
Cost of Debt
• Advance Inc. is trying to determine its cost
of debt. The firm has a debt issue
outstanding with 13 years to maturity that
is quoted at 95 percent of face value. The
issue makes semiannual payments and
has coupon rate of 7 percent. What is the
company’s pre-tax cost of debt? If the tax
rate is 35 percent, what is the after tax
cost of debt?
Cost of Capital with Debt
• Consider a firm having a debt of Rs.40 million
and equity of Rs.60 million. The firm pays a 15%
rate of interest on its new debt and has a beta of
1.41. The risk premium in market is 9.5% and the
current T-bill rate is 10%. What is the WACC?
• What happens to WACC if corporate tax rate is
30%?
The Cost of Capital
• The Weighted Average Cost of Capital is given
by:
rWACC =
Equity
Debt
× rEquity +
× rDebt ×(1 – TC)
Equity + Debt
Equity + Debt
S
B
rWACC =
× rS +
× rB ×(1 – TC)
S+B
S+B
• Because interest expense is tax-deductible, we
multiply the last term by (1 – TC).
Managing Cost of Capital
• Increase liquidity
– Brokerage fees
– Bid-ask spread
• Reduce adverse selection
– Stock split
– Reduce information assymetry