Cost of Capital
Presented by:
Coteng, Walter
Malapitan, Jhe-anne
Pagulayan, Jemaima
Valdez, Jenya Dan
What is the “Cost” of Capital?
Cost of Capital - The return the firm’s
investors could expect to earn if they
invested in securities with comparable
degrees of risk.
Capital Structure - The firm’s mix of
long term financing and equity financing.
What sources of long-term capital
do firms use?
Long-Term
Capital
Long-Term
Debt
Preferred
Stock
Common
Stock
Retained
Earnings
New Common
Stock
Weighted Average Cost of Capital
(WACC) - The expected rate of return on
a portfolio of all the firm’s securities.
*Calculating the weighted average cost of
capital:
WACC = wdrd(1-T) + wprp + wcrs
• The w’s refer to the firm’s capital
structure weights.
• The r’s refer to the cost of each
component.
Should our analysis focus on beforetax or after-tax capital costs?
• Stockholders focus on A-T cashflows.
Therefore, we should focus on A-T
capital costs, i.e. use A-T costs of
capital in WACC. Only rd needs
adjustment, because interest is tax
deductible.
Should our analysis focus on historical
costs or new costs?
• The cost of capital is used primarily to
make decisions that involve raising new
capital. So, focus on today’s marginal
costs.
How are the weights determined?
• In estimating WACC, do not use the
Book Value of securities.
• In estimating WACC, use the Market
Value of the securities.
• Book Values often do not represent the
true market value of a firm’s securities.
COST OF DEBT
– Before-Tax cost of Debt (rd )
- The interest rate a firm must pay on
its new debt.
- Yield to maturity (or yield to call if
the debt is likely to be called) on their
currently outstanding debt.
Yield to Maturity
Annual interest payment +
Principal payment – Price of the bond
Number of years to maturity
0.6 (Price of the bond) + 0.4 (Principal payment)
After –Tax cost of Debt
- The relevant cost of new debt,
taking into account the tax deductibility of
interest;
- It is used to calculate WACC.
After-Tax Cost of Debt= r d
(1 – T )
Example:
• Assume that a company issues bond at
price of P940 with interest payments of
P101.50 for 20 years and a maturity
payment of P1,000. What is the Yield to
maturity?
Principal payment – Price of the bond
Annual interest payment +
Number of years to maturity
0.6 (Price of the bond) + 0.4 (Principal payment)
Y' = $101. 50 + 1,000 - 940
20
.6 ($940) + .4 ($1,000)
= $101.50 + 60
20
$564 + $400
Y’ = $101.50 + 3 = $104.50 = 10.84%
$964
$964
Example:
• L company can borrow at an
interest rate of 10% and its marginal
federal-plus-state tax rate is 35%, its
after-tax cost of debt will be…
After-tax cost of debt = rd (1-T)
= 10% (1-35%)
= 6.5%
Cost of Preferred Stock, rp
WACC = wdrd(1-T) + wprp + wcrs
• rp is the marginal cost of preferred stock.
• The rate of return investors require on
the firm’s preferred stock.
What is the cost of preferred stock?
• The cost of preferred stock can be
solved by using this formula:
rp = Dp / Pp
= $10 / $111.10
= 9%
Example
• L Company issued P100 par value
preferred stock 12 years ago. The stock
provided a 9% yield at the time of issue.
The preferred stock is now selling for
P72. What is the current yield or cost of
the preferred stock?
Solution
rp = Dp/Pp
= ($100 x 9%)/ $72
= 12.5%
Where: rp – cost of preferred stock
Dp – annual dividend
Pp – current price
Component cost of preferred stock
• Preferred dividends are not taxdeductible, so no tax adjustments
necessary. Just use rp.
• Nominal rp is used.
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 the yield on preferred stock
lower than debt?
• Corporations own most preferred stock, because
70% of preferred dividends are nontaxable to
corporations.
• Therefore, preferred stock 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 stock than on
debt. Consistent with higher risk of preferred
stock.
Cost of Equity
WACC = wdrd(1-T) + wprp + wcrs
• rs is the marginal cost of common
equity using retained earnings.
• The rate of return investors require
on the firm’s common equity using
new equity is re.
Cost of Retained Earnings, rs
• Earnings can be reinvested or paid out as
dividends.
• Investors could buy other securities, earn a
return.
• If earnings are retained, there is an
opportunity cost (the return that
stockholders could earn on alternative
investments of equal risk).
The Capital Asset Pricing Model
(CAPM) Approach
rs = rRF + (RPM) bi
= rRF + (rM - rRF) bi
where:
rs - required return on common stock
rRF - risk-free rate of return
bi - beta coefficient
rM - return in the market as measured by an
approximate index
Example: CAPM Approach
• If L company’s beta is 1.5, the risk-free
rate is 10%, and the average return on
the market is 13%, what will be its cost
of common equity?
rs= rRF + (rM - rRF) bi
= 10% + (13% - 10%) 1.5
rs = 14.5%
Bond-Yield-plus-Risk-Premium Approach
*risk premium estimate : 3%-5%.
rs= Bond yield + Risk premium
Example:
If L’s bonds yield 13%, its cost of equity
might be estimated as follows:
rs = 13% + 4%
= 17%
Discounted-Yield-plus-Growth-Rate or
Discounted Cash Flow (DCF) Approach
rs =
where:
𝐷1
𝑃0
+g
D1= dividend expected to be paid at the end of
the year
P0 = current stock price
g = Constant growth rate in dividends
Example: DCF Approach
• L’s stock sells for P23.20, its next
expected dividend is P1.50, and analysis
expect its growth rate to be 9.3%. Thus,
rs =
𝐷1
+g
𝑃0
P1.50
=
+ 9.3%
P23.20
= 6.47% + 9.3%
= 15.77%
Averaging the Alternative Estimates
If management is highly confident of
one method, it would probably use that
method’s estimate. Otherwise, it might use
an average of the three methods.
Solving for the Average:
CAPM: rs = 14.5%
Bond-Yield-plus-Risk-Premium: rs= 17%
DCF: rs = 5.77%
(14.5% + 17% + 15.77%)
Average =
3
= 15.76%
Why is the cost of retained earnings cheaper
than the cost of issuing new common stock?
• When a company issues new common stock
they also have to pay flotation costs to the
underwriter.
• Issuing new common stock may send a negative
signal to the capital markets, which may depress
the stock price.
If issuing new common stock incurs a
flotation cost of 15% of the proceeds, what is
ke?
D 0 (1  g)
ke 
g
P0 (1 - F)
$4.19(1.05)

 5.0%
$50(1 - 0.15)
$4.3995

 5.0%
$42.50
 15.4%
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 per-project cost is fairly small.
• We will frequently ignore flotation costs when
calculating the WACC.
What factors influence a company’s
composite WACC?
• Market conditions.
- Interest rates
- Stock prices
- Tax rates
• The firm’s capital structure and dividend
policy.
• The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.
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
What are the three types of project
risk?
• Stand-alone risk
• Corporate risk
• Market risk
How is each type of risk used?
• Market risk is theoretically best in
most situations.
• However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
• Therefore, corporate risk is also
relevant.
Problem areas in cost of capital
•
•
•
•
Depreciation-generated funds
Privately owned firms
Measurement problems
Adjusting costs of capital for
different risk
• Capital structure weights
How are risk-adjusted costs of
capital determined for specific
projects or divisions?
• 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. This requires
estimating the project’s beta.
Finding a divisional cost of capital:
Using similar stand-alone firms to estimate a
project’s cost of capital
• Comparison firms have the following
characteristics:
– Target capital structure consists of 40%
debt and 60% equity.
– rd = 12%
– rRF = 7%
– RPM = 6%
– βDIV = 1.7
– Tax rate = 40%
Calculating a divisional cost of
capital
• Division’s required return on equity
– rs
= rRF + (rM – rRF)β
= 7% + (6%)1.7 = 17.2%
• Division’s weighted average cost of capital
– WACC = wd rd ( 1 – T ) + wc rs
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
• Typical projects in this division are
acceptable if their returns exceed 13.2%.