Cost of Capital

By : Gaurang Badheka
FM, Sem - 2
 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
 Cost of Capital
• Why? • Business Application
• Key to understanding • Min Req’d return
cost of raising $ needed on Project
– Risk • Reflects blended
– Financing costs costs of raising capital
– Discount Rate • Relevant “i ”
• Discount rate used to
determine Project’s
NPV or to disct FCFs
by
• Hurdle rate
 Sources of Long term capital

Long-Term
Capital

Long-Term Preferred Common

Debt Stock Stock rs
rd rps

Retained New Common

Earnings Stock
rce re
 Cost of Capital
• The cost of capital represents the overall cost of
financing to the firm
• The cost of capital is normally the relevant
discount rate to use in analyzing an investment
• The overall cost of capital is a weighted average
of the various sources:
– WACC = Weighted Average Cost of Capital
– WACC = After-tax cost x weights
 Determinants of Intrinsic Value:
The Weighted Average Cost of Capital

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Firm’s debt/equity mix

Cost of debt
Market risk aversion Cost of equity Firm’s business risk
 Cost of Debt
• The cost of debt to the firm is the effective yield
to maturity (or interest rate) paid to its
bondholders
• Since interest is tax deductible to the firm, the
actual cost of debt is less than the yield to
maturity:
– After-tax cost of debt = yield x (1 - tax rate)
• The cost of debt should also be adjusted for
flotation costs (associated with issuing new
bonds)
 Tax effect of Debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
 Now, suppose the firm pays $50,000 in dividends
to the shareholders
 Tax effect of Debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
 Cost of Debt

After-tax cost Before-tax cost Tax

of Debt = of Debt
- Savings

33,000 = 50,000 - 17,000

OR
33,000 = 50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

 Cost of Debt
After-tax Before-tax Marginal
% cost of
Debt
=
% cost of
Debt
x 1 - tax
rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

 Cost of Debt
Assume that Basket Wonders (BW) has
$1,000 par value zero-coupon bonds
outstanding. BW bonds are currently trading
at $385.54 with 10 years to maturity. BW tax
bracket is 40%.
$0 + $1,000
$385.54 =
(1 + kd)10
 Cost of Debt
(1 + kd)10 = $1,000 / $385.54
= 2.5938
(1 + kd) = (2.5938) (1/10)
= 1.1
kd = .1 or 10%

ki = 10% ( 1 - .40 )
ki = 6%
 Cost of Preferred stock
• Preferred stock:
– has a fixed dividend (similar to debt)
– has no maturity date
– dividends are not tax deductible and are
expected to be perpetual or infinite

• Cost of preferred stock = dividend

price - flotation cost
 Cost of Preferred stock
• Baker corp. has preferred stock that sells
for Rs. 100 per share and pays an annual
dividend of Rs. 10.50. If the floatation
costs are Rs. 4 per share, what will be the
cost of new preference share?

Kp = 10.50 / (100 – 4) = .1094 = 10.94%

Cost of Equity: Retained earning
• Why is there a cost for retained earnings?
• Earnings can be reinvested or paid out as
dividends
• Investors could buy other securities, and
earn a return.
• Thus, there is an opportunity cost if
earnings are retained
Cost of Equity: Retained earning
• Common stock equity is available through
retained earnings (R/E) or by issuing new
common stock:
– Common equity = R/E + New common stock
 Cost of Equity: New stock
• The cost of new common stock is higher
than the cost of retained earnings because
of flotation costs
– selling and distribution costs (such as
sales commissions) for the new
securities
 Cost of Equity
• There are a number of methods used to
determine the cost of equity
• We will focus on two

• Dividend growth Model

• CAPM
3 ways to determine Cost of Eq.
• 1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β

• 2. DCF: rs = D1/P0 + g

• 3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
 Dividend Growth Model

• Estimating the cost of equity: the dividend

growth model approach
According to the constant growth (Gordon)
model,
D1
P0 =
RE - g

Rearranging D1
RE = +g
P0
 Dividend Growth Model
This model has drawbacks:

• Some firms concentrate on growth and do not pay

dividends at all, or only irregularly
• Growth rates may also be hard to estimate
• Also this model doesn’t adjust for market risk

• Therefore many financial managers prefer the

capital asset pricing model (CAPM) - or security
market line (SML) - approach for estimating the
cost of equity
 Capital Asset Pricing Model (CAPM)

kj  Rf  β ( Rm  Rf )
Cost of Co-variance Average rate of return
capital Risk-free of returns against on common stocks
return the portfolio (WIG)
(departure from the average)
B < 1, security is safer than WIG average
B > 1, security is riskier than WIG average
The Security Market Line (SML)
Required rate of return
Percent
SML = Rf +  (Km – Rf)
20.0
18.0
16.0
14.0
12.0
10.0 Market risk premium
8.0
Rf
5.5
0.5 1.0 1.5 2.0
Beta (risk)
 CAPM
The Capital Asset Pricing Model (CAPM) can be used to estimate the
required return on individual stocks. The formula:

K j  R f   j (K m  R f )

where
Kj = Required return on stock j
Rf = Risk-free rate of return (usually current rate on Treasury Bill).
j = Beta coefficient for stock j represents risk of the stock
Km = Return in market as measured by some proxy portfolio (index)

Suppose that Baker has the following values:

Rf = 5.5%
j = 1.0
Km = 12%

.
 CAPM/ SML Approach
• Advantage: Evaluates risk, applicable to
firms that don’t pay dividends

• Disadvantage: Need to estimate

– Beta
– the risk premium (usually based on past data,
not future projections)
– use an appropriate risk free rate of interest
 Estimation of Beta
• Market Portfolio - Portfolio of all assets in
the economy
• In practice a broad stock market index,
such as the BSE30, NIFTY50, NASDAQ,
Etc., is used to represent the market
• Beta - sensitivity of a stock’s return to the
return on the market portfolio
 Estimation of Beta
• Theoretically, the calculation of beta is
straightforward: Cov( Ri , RM ) σ iM
• Problems β  2
Var ( RM ) σM
Betas may vary over time.
The sample size may be inadequate.
Betas are influenced by changing financial leverage and business
risk.
• Solutions
Problems 1 and 2 (above) can be moderated by more sophisticated
statistical techniques.
Problem 3 can be lessened by adjusting for changes in business
and financial risk.
Look at average beta estimates of comparable firms in the industry.
 Stability of Beta
• Most analysts argue that betas are
generally stable for firms remaining in the
same industry
• That’s not to say that a firm’s beta can’t
change
– Changes in product line
– Changes in technology
– Deregulation
– Changes in financial leverage
 What is the appropriate risk-free rate?

• Use the yield on a long-term bond if you are

analyzing cash flows from a long-term
investment
• For short-term investments, it is entirely
appropriate to use the yield on short-term
government securities
• Use the nominal risk-free rate if you discount
nominal cash flows and real risk-free rate if
you discount real cash flows
What is the appropriate risk-free rate?

Corporations Financial Advisors

90-day T-bill 90-day T-bill

3-7 year Treasuries 5-10 year Treasuries

10-year Treasuries 10-30 year Treasuries

20-year Treasuries 30-year Treasuries

10-30 year Treasuries N/A

10-years or 90-day; depends

N/A
 Weighted Average Cost of Capital
• WACC weights the cost of equity and the cost of
debt by the percentage of each used in a firm’s
capital structure
• WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
– (E/V)= Equity % of total value
– (D/V)=Debt % of total value
– (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The
after-tax rate must be considered because interest on
corporate debt is deductible
 WACC Illustration
• ABC Corp has 1.4 million shares common valued at $20
per share =$28 million. Debt has face value of $5 million
and trades at 93% of face ($4.65 million) in the market.
Total market value of both equity + debt thus =$32.65
million. Equity % = .8576 and Debt % = .1424
• Risk free rate is 4%, risk premium=7% and ABC’s β=.74
• Return on equity per SML : RE = 4% + (7% x
.74)=9.18%
• Tax rate is 40%
• Current yield on market debt is 11%
 WACC Illustration
• WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
 Factors affecting WACC
• Market conditions
– Interest rates
– The market risk premium
– Tax rates
• Firm’s capital structure
• Firm’s dividend policy
• Firm’s investment policy
– Firms with riskier projects generally have a
higher WACC
 3 ways to determine Cost of Equity

• 1. CAPM: rs = rRF + (rM – rRF)b

= rRF + (RPM)b.
• 2. DCF: rs = D1/P0 + g.
• 3. Own-Bond-Yield-Plus-Judgmental-Risk
Premium: rs = rd + Bond RP.
 Equity Cost Components
• Risk free = 5.6%
• Mrkt Risk Prem = 6%
• Beta = 1.2
• Div today = $3.12
• Price today = $50
• Growth = 5.8%
• Cost of Debt = 10%
• Risk prem = 3.2%
• 3,000,000 shs outstanding
CAPM Cost of Equity: rRF = 5.6%,
RPM = 6%, b = 1.2

rs = rRF + (RPM )b

= 5.6% + (6.0%)1.2 = 12.8%.

 DCF Cost of Equity, rs:
D0 = $3.12; P0 = $50; g = 5.8%

D1 D0(1 + g)
rs = +g= +g
P0 P0

= $3.12(1.058) + 0.058
$50
= 6.6% + 5.8%
= 12.4%
 Estimating the Growth Rate
• Use historical growth rate if believe future
be like past.
• Obtain analysts’ estimates: Value Line,
Zacks, Yahoo!Finance.
• Use earnings retention model.
Earnings Retention Model

• Suppose company has been earning

15% on equity (ROE = 15%) and
been paying out 62% of its earnings.
• If expected to continue as is, what’s
the expected future g?
 Earnings Retention Model
(Continued)
• Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.

Close to g = 5.8% given earlier.

Could DCF methodology be
applied if g is not constant?
• YES, nonconstant g stocks are
expected to have constant g at some
point, generally in 5 to 10 years.
The Own-Bond-Yield-Plus-Judgmental-Risk-
Premium Method: rd = 10%, RP = 3.2%

• rs = rd + Judgmental risk premium

• rs = 10.0% + 3.2% = 13.2%

• This over-own-bond-judgmental-risk
premium  CAPM equity risk premium,
RPM.
• Produces ballpark estimate of rs.
Useful check.
 Final estimate of rs?

Method Estimate
CAPM 12.8%
DCF 12.4%
Bond Yld + risk prem 13.2%

Average 12.8%