Lecture 9: Cost of Capital
Mod 7
C. L. Mattoli
1
Learning outcomes
On successful completion of this module you
should be able to:
 determine a firm’s cost of equity capital
 determine a firm’s cost of debt capital
 determine a firm’s overall cost of capital
 describe some of the problems associated
with the firm’s overall cost of capital.
 Textbook Chapter 12
2
Intro




We have spent a lot of time using DFCF
evaluation.
There are, basically, two variables in that
format: forecasted cash flows and a
discounting rate.
We have also looked into what determines
rates of return, in general, like inflation, term,
and risk.
However, we have not yet given a complete
explanation of how discounting rates are
determined.
3
Intro



In this lecture, we shall discuss the
problem of determining required rates of
return in the corporate setting.
We will find a consistent means of
determining discount rates for securities
and businesses, and the relationship
between the two.
This is the cost of capital. Its
determination begins in the securities
markets.
4
Last Week



Last week, we finally examined the risk
component of returns, and we found the
SML.
The SML is a linear relationship between
reward, in terms of risk premium over riskless
return, and systematic risk, in the form of
beta, for securities.
That result told us that there has to be only
one reward-risk ratio, the reward per unit of
risk, i.e., the slope of the line, in the markets.
5
Last Week


If that were not true, and a security or
portfolio were off the line, then, there
would be buying and selling in the
marketplace until the assets were moved
onto the line.
In other words, if an asset had more
reward per unit of risk than those on the
line, people would buy it.
6
Last Week



In buying it, they would bid up the price,
which would lower the return until it was
finally only as good as the alternatives
offered on the line.
If it had less reward per unit of risk than
those investments on the line, people
would sell it, and in selling, the price
would go down and the return would
increase.
We show the situation, graphically, below.
7
One Price of Risk

Buying and selling act to put assets on the
SML
E(R)
Buy
E(R(M))
Sell
R(0)
1
β
8
Beta, Technically



We described beta, in general terms, last
time.
We also discussed correlation, in the
abstract.
The quantification of beta is embedded in the
concept of covariance, which is the
extension of the concept of variance to two
assets.
n
Cov ( k1 , k 2 )   (k1i  k1 )( k 2 i  k 2 ) Pri
i 1
9
Beta, Technically



Where the k’s are returns for two assets, in a
number of different scenarios.
The covariance of returns is a measure of
the degree of linear relationship between
the two returns, i.e. how they co-vary linearly.
However the covariance measure is depends
on the unit of measure: dividing it by the
product of the two standard deviations
removes this dependence and results in a
measure (the correlation coefficient) that
can only take values between -1 and +1.
10
Beta, Technically



In other words, the correlation coefficient, 12
is found by dividing the covariance of the two
assets by the standard deviations of both
assets, σ1 and σ2.
In that way, we normalize the covariance so
that we get a number whose absolute value
is 1 or less.
Specifically,
1, 2
Cov ( k1 , k 2 )

 1 2
11
Beta, Technically


Finally, we can say what beta really is.
Beta is just the covariance of return of the
asset with market return, divided by the
variance of the market’s return.
12
From Market to Business



According to our CAPM theory, the
markets will determine a relationship
between return and risk for securities.
That result gives the SML with slope the
reward per unit risk.
If we next consider more general
investments, like business projects, the
SML offers a benchmark against which to
rate reward-risk relationships.
13
From Market to Business



In that regard, any investment that a
company takes on must offer an expected
return that is at least as good as that offered,
in the markets, for a particular level of
(systematic) risk.
If it did not, the firm’s shareholders would be
better off, investing on their own, in the
markets.
Thus, our mandate, as corporate officers, is
to try to find investments that offer superior
returns to those offered in the markets.
14
From Market to Business


Such superior investments will have NPV
> 0 because they are worth more, based
on DFCF, using the return in the market
for that level of risk, than we have to pay
for them.
Looking at it another way, we compare the
expected return on the investment (IRR) to
the return offered in the market for the
same beta.
15
The Corporate Machine



We can think of a corporation as a simple
machine.
When the corporation starts, it is just an
empty shell, described on paper, the
corporate charter & by-laws.
Then, the corporation takes in $$dollars$$,
investments from by creditors (debt, BAB’s,
bonds, debentures, notes) and owners
(common/ordinary and preferred shares of
equity capital stock) in corporate securities.
16
The Corporate Machine



In return, for the money from these investors
in the various securities of the company, the
corporation must pay them a return on their
investment.
It is convenient, as usual, to think of those
costs of capital of the corporation for its
capital funding in percentage terms.
We call each of those percentages that
investors require as their returns on the
securities, in the market, the cost of capital of
each component of capital.
17
The Corporate Machine



We also form a weighted average of the
components, weighted according to the
percentage that each component
represents, the weighted average cost of
capital (WACC).
Now, the corporate shell is filled with
money.
The next step in the corporate machine is
to take that financial capital and invest it
in business projects.
18
The Corporate Machine


Thus, the cash on the left hand side of the
balance sheet buys investments in
equipment, inventory, and other physical,
as opposed to financial, assets to earn a
return for the company.
Those returns to the company for its
physical investments must be sufficient to
pay the expected return of the security
holders, the cost of capital to the
corporation.
19
The Corporate Machine



In that regard, the corporate cost of capital
becomes a benchmark for evaluating
corporate investment in business projects.
For the corporation COC = RRR.
If the corporation earns a return on its
investment in projects equal to the COC, it
will earn just enough to pay its investors
their required rates of return.
In other words, the COC is the BE for
corporate investments. We illustrate the
corporate machine, in the next slide.
20
The Corporate Machine
Business
Projects
Markets
Securities
Markets
Investors
in
securities
Cash
Funding
Cash
COC
paid to
securities
investors
Securities
Issued
Debt
Equity
Corporate
investment
in projects
Businesses
Inventory
PP&E
Cash &
Physical
Assets
Return on
Corporate
Investment
Debt
Equity
21
The Nature of COC



When we talk about RRR for an
investment in a business project, we mean
that the project must earn a return equal to
the RRR to have NPV non-negative.
In other words, the firm must earn a RRR
equal to COC to compensate its investors
for the use of their capital in the project.
However, consider a potential investment
with zero risk.
22
The Nature of COC
To get the proper RRR/COC we turn
to the capital markets and use the
rate for riskless investment to
discount CF’s.
 If we have another potential
investment with a determined risk
level, again, that we look at the
market’s RRR for level of risk and use
that to discount CF’s.

23
The Nature of COC
To do it any other way would be
contrary to the spirit of our
understanding of risk and its
relationship to return.
 Properly, then, COC should be a
function of the investment, not the
investors, i.e., COC depends on the
use, not the source of funds.

24
Financial Policy and COC



A company’s COC will be the RRR on
its assets.
In other words, investors, in the
markets, will come up with an RRR
based on their perceived risk of the
company’s cash flows.
On the other side, the firm will fund itself
with both debt and equity, so its COC
will be a blended value of the RRR’s of
its creditors and its shareholders.
25
Financial Policy and COC




Thus, we will have to look at its cost of
debt capital and its cost of equity capital.
Then, we can use the capital weightings to
find the overall WACC.
A firm’s capital structure, the mix of debt
and equity, is a managerial variable.
In this lecture, we assume that the firm’s
cap structure is a given: a target capital
structure with a fixed debt-equity ratio.
26
COC Equity
27
Prologue



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By beginning with COC equity, we are doing
the hard work, first.
As we have seen in our discussion of
applying DFCF methods to infinite-term
equity can only be done in idealized
circumstances.
Alternatively, the RRR of a firm’s
shareholders can not be computed directly
but must be approximated, in one way or
another.
We shall examine 2 methods: SML & CDGM.
28
COCE: CDGM Approach





If we know the market price of equity, there
should be an associated RRR.
However, to get from P to RRR we need a
DFCF equation.
The only practical DFCF equation for equity
is the CDGM, P0 = D0(1+g)/(RE – g).
Inverting substituting for D0, we have RE =
D1/P0 + g.
Since this is the apparent RRR of the firm’s
equity investors, it, effectively, becomes the
firm’s COC, equity.
29
COCE: CDGM Approach



We say effectively, because, properly it is the
COC of current shareholders, determined from
the secondary markets.
If, on the other hand, the firm issued new equity,
there would be costs of issuance to pay brokers,
investment bankers, lawyers, etc.
Those costs would come out of the price
investors pay for shares, and would lower the
net proceeds received by the firm, raising the
actual effective COC return that the firm must
cover.
30
CDGM COCE Example




Assume the market price of XYZ’s shares
is $50/share.
Assume the firm paid a dividend of
$2/share, yesterday, and we expect
dividends to grow by 3%/year, forever.
Then, D1 = D0(1+g) = $2(1.03) = $2.06.
And RE = COCE = D1/P0 + g = $2.06/$50 +
3% = 7.12%
31
Estimating G in the CDGM



We know price. We want RRR, and the only
thing that we need to estimate is g, in the
CDGM.
The simple ways to do that are to either come
up with your own estimate for growth or to
use security analysts’ numbers.
For example, we can look at past dividends
over the past 6 years and find the average
growth rate over the period, as we have done
in the next slide.
32
Estimating G in the CDGM

Estimate from past data.
Dividend
% Δ Calc
%Δ#
2002
$1.00
--
--
2003
$1.10
(1.10 - 1.00)/1.00
10.00%
2004
$1.25
(1.25 - 1.10)/1,10
13.64%
2005
$1.40
(1.40 - 1.25)/1.25
12.00%
2006
$1.50
(1.50 - 1.40)/1.40
7.14%
2007
$1.70
(1.70 - 1.50)/1.50
13.33%
(10+13.64+12+7.14+13.33)/5
11.22%
Year
Average=
33
Estimating G in the CDGM



Thus, our estimate from these few past
years is 11.22%.
Using a longer past will actually be less
valuable than a short past since the
company might have had a different
growth rate in the distant past, and the
near past gives a more appropriate
estimate.
On the other hand, the past is seldom a
true precursor of the future.
34
Estimating G in the CDGM




Securities analysts also might project future
dividends or dividend growth rates.
You can find those estimates from, e.g.,
Zack’s or other services, some for pay, some
are free.
Again, even those estimates may vary
between analysts, so we might take some
kind of average of their results.
In addition, there are more sophisticated
methods of estimating dividend growth, but,
in the end, they all root the future in the past.
35
CDGM Pros and Cons




Although a simple equation, like the CDGM,
might not give realistic answers, it is simple,
and it is easy to understand.
Problems, as you might expect, are
numerous.
First, if the company pays no dividend, none
of our dividend models can be used.
Even companies that do pay dividends
seldom increase their dividends at some
constant annual rate.
36
CDGM Pros and Cons


Moreover, since the equation is linear in g
[i.e., RE = D1/P0 + g], the COCE will
increase or decrease by the amount that
estimated growth rate is increased or
decreased.
Finally, the approach explicitly neglects
risk, in that there is, e.g., no adjustment for
uncertainty of the growth rate.
37
CDGM Pros and Cons


In fact, though, since we are using a
market price, and we assume that
investors in markets adjust prices for risk )
the higher the risk, the lower the price),
there is some implicit inclusion of a risk
factor in this approach.
The next method that we shall look at, the
SML approach, which explicitly accounts
for risk.
38
The SML Approach




According to the theory, the COCE is found
from E(RE) = RE = RF + [E(RM) – RF].
To implement the approach, we need a
riskless rate of return, which we can find from
the government securities market.
We can find E(RM) as the expected market
return, and we use it to find the ERP.
The final ingredient is beta, which is
calculated by many data services, or we can
calculate it on our own.
39
SML COCE Example



In earlier chapters of the book, we found
that the ERP on the ASX all Ords was
around 6%, and the authors use 5% as the
riskless government bond rate.
Also, in the book, beta for Pacific Brands
Ltd. Was estimated at 1.43.
Thus, the COCE for Pacific Brands is
E(RE) = RE = RF + [E(RM) – RF] = 5% +
1.43x6% = 13.58%.
40
SLM Pros & Cons



The advantage over the CGDM approach
is that risk is explicitly included in the
computation.
Certainly, in the actual markets, investors
will adjust their required returns for risk.
Then, as long as we can compute a beta
for the company and an ERP for the
market, we can find an value for COCE.
41
SLM Pros & Cons



Another advantage is that the approach does
not explicitly need dividends for its
calculation, so it will also be applicable to
companies that do not pay dividends or even
consistent dividends.
Of course, all of the variables, beta, ERP,
and RF, can change over time.
The other problem is that beta calculations
can also change over time, and usually
several years of data are used to compute
them.
42
In the End



We can, of course, compare the results for
COCE found by both approaches (and any
others) to see how well the two agree.
As an additional check, we check companies
in the same industry to see if we get similar
results for either or both methods.
Also, just to make sure you are in the right
neighborhood, you should check to make
sure that the COCE is higher than COC debt
and preferred stock, which are less risky
securities of the company.
43
COC Debt & Pfd
44
COC Pfd



Even though a preferred stock might have
an infinite potential life (if it is
redeemable, it will have a specific finite
life), the dividend is a fixed, non-changing
dollar amount.
In that regard, it is similar to the situation
that we have for debt: there are specific
known payments at know future dates.
In a preceding section, we valued pfd’s as
perpetual annuities.
45
COC Pfd



Thus, reversing the process and solving for
RRR = COC, given a price, we have COCPfd
= RP = D/P0.
That equation is just the current dividend
yield on the pfd.
In fact, since preferred’s have the same kind
of definite payment pattern that is
characteristic of debt, we can also get a
sense of COC pfd for one preferred stock by
comparing to yields of other similar pfd’s in
the markets.
46
COC Pfd Example



Assume that a preferred stock pays an
annual dividend of $10, and it is currently
selling in the market for $98.
Then, the COCPfd = RP = D/P0 = $10/$98 =
10.2%.
That should be compared to the COCE and
COCD: the value should lie somewhere in
between those values because of the relative
risks of debt an equity.
47
COC Debt




Like preferred shares, debt has definite
payments at specific times.
Unlike perpetual preferred, debt normally
has a finite life.
The COC debt is just the RRR of creditors
of the firm.
We might look at the firm’s marginal, i.e.,
new, borrowing costs, in the markets for
debt.
48
COC Debt



We might use an SML approach to adjust for
risk.
We could also see what the market’s RRR,
the market YTM, is on already outstanding
debt securities of the firm.
There is also a COC debt approximation
formula, given by:
Face Value
( FV  P)
I
n
RD 
( FV  P)
2
Coupon Interest
Selling Price
Time to maturity
49
WACC
50
Capital Weightings



Now that we have computed all of the
component costs of various forms of
capital, we must put them together to form
a composite blended COC value.
There are a number of ways that we could
approach the weighting.
For example, a firm with privately-placed
equity and debt will have only accounting
values for capital and weights.
51
Capital Weightings



A market-based approach is to take the price
times the number of shares or bonds on
issue and together all of the market
capitalization values for debt, equity and
preferred to get the total market value of the
firm’s capital.
In equations, Total Market Capitalization of
capital = V = PE#shares + PP#pfd shares +
PD#bonds = E+P+D.
Then, the capital weightings for equity, pfd,
and debt, respectively, will be: WE = E/V, WP
= P/V, and WD = D/V.
52
Capital Weightings
They are simply the percentage that
each form of capital represents of the
total.
 These weights are like portfolio
weights and are sometimes called the
capital structure weights.
 Certainly, market values and weights
will be better than accounting values.

53
Capital Weightings


However, others argue that these
weights will fluctuate with the markets,
and that since firms are often shooting
for certain target capital weight that
those target weights should be the one
to use.
Either way, the next step is to combine
these capital weights with the COC’s of
the various components.
54
Taxes & WACC



In a classical tax system, investors will be
concerned with what they really get: after-tax
returns.
The COC equations for ordinary and
preferred equity (at least the CDGM and the
Perpetuity), containing, explicitly, dividends,
which come out of after-tax income, give
after-tax COC’s.
On the other hand, interest on debt is a tax
deductible expense, so COC debt, using
interest payments, is a pre-tax return.
55
Taxes & WACC



To get from pre-tax to after-tax interest expense,
we use the tax shield method. After-tax interest
payment = pre-tax interest – Tx(pre-tax interest)
= Pre-tax interest x (1 – T) where T is the
corporate tax rate.
For example, if the interest rate on debt is 10%
on $1 million of bond issue, then PT interest
expense is $100,000, and AT interest is (1 –
T)$100,000 - $70,000.
Then, the effective pre-tax interest rate is
$70,000/$1,000,000 = 7%, which is just 10%x(1
– T).
56
Taxes & WACC



Since the general rule for pre/after tax
interest rate is as above, we can write after
tax COC debt = RD(1 – T).
In order to have consistency in our
construction of WACC, we need all of the
component costs to be expressed on an
equal footing: either before-tax or after tax.
In the classical type of tax system in which
dividends and interest are both taxable
income to investors, we use after-tax COC’s
of the corporation.
57
Taxes & WACC



Then, we can construct the WACC as the
sum of the COC of each component times
its capital structure weight.
WACC = WExRE + WPxRP + (1 – T)WDxRD.
The WACC is the overall rate of return that
a firm must earn on its assets in order to
pay all of its investors/creditors their
RRR’s.
58
Taxes & WACC


If it earns less than that rate, debt and
preferred payments must be made before
any income can be paid to ordinary
shareholders, so the ordinary shareholders
would lose out, and share value would
decrease.
In that regard, we can say that the WACC is
the minimum rate of return that a firm must
earn on its assets, if it is to maintain share
value.
59
Taxes & WACC



In turn, if a firm is considering investing in a
new project, assuming that the project has
the same risk as existing operations of the
firm, it must also earn at least the WACC to
continue to maintain share value.
Thus, the WACC is a hurdle rate for new
projects: it must be used as the firm’s RRR
for new projects.
Firms are even using WACC to evaluate
financial performance.
60
WACC AT Example



Following an example in the text, assume
XYZ company has 1.4 million shares issued
and outstanding, currently selling in the
market for $20/share.
Assume that the firm has total debt securities
outstanding with FV = $5 million, selling at
93% of FV, and yielding 11% in the market.
The riskless rate of return is 8%, the ERP =
7%, and beta for the company is estimated
as 0.74.
61
WACC AT Example




Then, first, we compute RE = RF + xERP
= 8% + 0.74x7% = 13.18%.
Equity capital = 1.4 million shares x
$20/share = $28 million.
Debt capital = 0.93x$5 million = $4.65
million.
Total capital = $28 million + 4.65 million =
32.65 million.
62
WACC AT Example



The weights are WE = $28 million/32.65
million = 85.76%; WD = $4.65 million/32.65
million = 14.24% [notice that they must
add up to 1.0 = 100%].
Then, WACC = WExRE + WDxRD =
13.18%x85.76% + 11%(1 – 30%)x14.24%
= 12.40 %.
This is the firm’s overall cost of capital.
63
Extended Example – WACC I
(Authors’ PP’s)

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%
64
Extended Example – WACC II

What is the cost of equity?


What is the cost of debt?



RE = 5 + 1.15(9) = 15.35%
N = 30; PV = -1100; PMT = 45; FV = 1000; CPT
I/Y = 3.9268
RD = 3.927(2) = 7.854%
What is the after-tax cost of debt?

RD(1-TC) = 7.854(1-.4) = 4.712%
65
Extended Example – WACC III

What are the 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 = .7843
wD = D/V = 1.1 / 5.1 = .2157
What is the WACC?

WACC = .7843(15.35%) + .2157(4.712%) =
13.06%
66
WACC with Dividend Imputation



In the imputation system, if fully franked
dividends are paid to shareholders, they get a
tax credit for all of the tax paid on the pre-tax
income that made the dividend.
We assume also that all shareholders are
domestic entities, so that they can fully utilize
the tax credits of franking.
The, shareholders, effectively get the pretax
income [=D + TD/(1 – T) = D/(1 – T)], the
grossed up dividend, on a fully franked
dividend.
67
WACC with Dividend Imputation



On a partially franked dividend with franking
credit TC’ , we gross it up as D/(1 – TC’)
Therefore, dividend income is worth more to
investors, and the COC will be (inversely)
less than in the classical tax system.
We adjust the interest and COC debt to after
tax, at the company level, by multiplying the
RRR, in the debt market, the YTM, by
subtracting out the tax shield by multiplying
RD by (1 – T).
68
WACC with Dividend Imputation



In turn, we adjust to after-company tax for the
RRR on equity by taking out the tax credit,
similarly, by multiplying the RRR equity in the
market, by multiplying RE by (1 – TC’).
The equation for WACC, in the imputation
system, is then, WACC = (1 – TC’)WExRE +
(1 – T)WDxRD.
We would also have to adjust the RRR pfd for
franking credits to preferred shareholders, in
a similar manner.
69
WACC Imputation Example




Using the previous book example, assume
XYZ is an Australian co.
Assume that it pays fully franked dividends.
Assume that all shareholders are resident
Australians who can use tax credits.
Assume that all of the other information is the
same as in the example, including market
results for debt and equity.
70
WACC Imputation Example




Then, RE = 13.18%.
Equity capital = 1.4 million shares x
$20/share = $28 million.
Debt capital = 0.93x$5 million = $4.65
million.
Total capital = $28 million + 4.65 million =
32.65 million.
71
WACC Imputation Example



The weights are WE = $28 million/32.65
million = 85.76%; WD = $4.65 million/32.65
million = 14.24% [notice that they must
add up to 1.0 = 100%].
Then, WACC = (1 – T)WExRE + WDxRD =
(1 – 30%)13.18%x85.76% + 11%(1 –
30%)x14.24% = 9.01 %.
This is the firm’s cost of capital with
imputation.
72
WACC with Imputation



The important points are the resident
shareholders and the ability of the
company to pay out all of its tax credits to
shareholders.
In real life, many companies in Australia
have non-resident shareholders.
In addition, to pay out all tax credits could
mean paying out all earnings as dividends,
which would mean no retention.
73
WACC with Imputation



If the company pays not fully franked
dividends, then, we adjust, as in the theory
part, in a previous slide.
Then, We use the franking rate TC’, which
can be as small as zero and as large as T =
30%.
The focus of the result is that in using WACC
for projects, both the project cash flows and
the WACC are after-company-tax but before
personal investor tax.
74
Table 12.1
75
WACC with Dividend Imputation
 Note:
Peter at USQ has
informed me that his lecture
and exam will not cover
COC with imputation.
76
EVA, SVA & COC




Another way people are using COC, these
days, is to find EVA, economic value added,
also called SVA, shareholder value added.
It is computed for many companies by Stern
Stewart & Co.
Find COC, then, multiply by total capital used
by the company to get a dollar figure.
Then, EVA is that figure minus operating
cash flow.
77
WACC Case Studies
78
The warehouse problem



Suppose that the company is analyzing a
project to renovate its warehouse
distribution system at a cost of $50 million.
The renovation will result in cost savings
of $12 million/year for 6 years.
From first principles, we should find a
comparable investment in the market, i.e.,
similar risk = same risk class.
79
The warehouse problem


Since the WACC embodies the risk and
target cap structure of the firm as a whole, it
is appropriate to use it as the discounting rate
for projects that replicate the firm’s existing
operations, i.e., are in the same risk class as
the firm.
Assuming that the warehouse project is an
integral operation of the firm, it seems natural
to classify it as same risk class as normal
operations.
80
The warehouse problem




Then, suppose the target cap structure is
1/3 debt-equity ratio = D/E.
Then, D = 1/3 E, Total capital = TC = E+D
= E + 1/3 E, and D/TC = ¼, E/TC = ¾
Assume COC debt = 10% and COC equity
= 20%.
Then, WACC = 0.75 x 20% + 0.25 x 10%
(1 – 30%) = 16.75%.
81
The warehouse problem
The ATCF is assumed to be a 6 year
annuity of $12 million, and we have
NPV = $50 million - $12 million[1 –
(1+WACC)-6]/WACC = – 6.65 million.
 It is negative, so do not accept.
 It means that the financial markets
offer superior projects for the same
risk.

82
Domino’s Pizza Australia/NZ




We go through a calculation for DMP (ASX
symbol). There are web sources in the
book for looking up info on-line.
Market Price for analysis is $3.69, beta =
1.18, government bonds are 6.2%, and the
ERP = 6%.
Thus, RE = 0.062 + 1.18x0.06 = 13.28%.
Domino’s was a new listing with not much
history.
83
Domino’s Pizza Australia/NZ



The dividend = $0.007/share, and the 2
year earnings growth rate projection was
29.9%
(Note: normally we would like to see a 5 or
10 year projection of dividend growth, but
none was available for this stock).
Then, the CDGM gives RE =
$0.007(1+29.9%)/$3.69 +29.9% =
30.15%, which is quite different from the
result using the CAPM, and we have not
used imputation.
84
Domino’s Pizza Australia/NZ



So, we average the 2 results to get RE
(averaged) = 21.7%.
The long-term debt consists of one bond
issue and one LT finance lease. Both are
private issues, so there is no market price
available.
In the book, the authors use the fact that the
debt is CB’s are floating rate, so book value
should be market value. The same is
assumed for the lease.
85
Domino’s Pizza Australia/NZ



We assume that the second table on page
379 is the correct one (there is a conflict
between the values of yield for the financing
lease), and the weighted average COC debt
is 6.63%.
There are $221.6 million market value of
equity, and $14.495 million in debt; total cap
= $236.1 million.
Thus WACC = (221.6/236.1)21.7% +
(14.5/236.1)6.63(70%) = 20.7%
86
Other COC Concepts
87
Divisional & Project COC’s



For projects similar to the firm’s existing
operations, the WACC is a proper
benchmark.
However, other projects might require a
different discounting rate.
If we use WACC to evaluate projects with
risks different from the average firm risk, it
will lead to improper decisions.
88
Divisional & Project COC’s
Note, even a new line of business will
be riskier than the firm’s average risk.
 From SML theory, we know that NPV
> 0 projects lie above the line.
 However, using WACC might lead to
accepting projects below the line and
rejecting projects above the line.
 We illustrate this, in the next slide.

89
Divisional & Project COC’s
SML
WACC
Accept
improperly
Reject
improperly
90
Divisional & Project COC’s




A company, like a conglomerate, may have
divisions with vastly different risks, like
military hardware and canned soup.
Then, the company might, quite naturally,
think of finding appropriate COC’s for each
division.
Riskier divisions will have a higher COC
hurdle and less risky divisions, a lower rate.
In sum, the weighted divisional COC must
equal the firm’s average perceived risk.
91
Pure Play Approach



One way that it might be possible to come up
with risk and return for a project or a division
is the pure play approach.
In this approach, we look to the market for
companies that are in the same business or
in the same risk class.
For example, if our project or division is a cell
phone maker, we can look at the market RRR
for cell phone makers.
92
Subjective Approach



Often companies will take the WACC as an
average value for average projects, and will
subjectively determine appropriate rate for
less and more risky projects.
One reason that a company might settle for
this method is the cost of trying to figure out
perfect rates, inavailability of pure plays to
look to, or for simplicity.
This will, however, lead to a better system
than pure WACC, as illustrated, below.
93
Split RRR’s for Projects
SML
Reject
WACC
Accept
High Risk
Average
Risk
Low risk
94
Learning activity
Attempt all of the critical thinking
and concepts review questions on
pages 385 to 386.
 Attempt questions and problems 1, 3,
4, 5, 8, 9, 15, 19 and 30

95
END
96