COST OF CAPITAL

2016

Compiled by Mr Mfinanga
 Cost of Capital
Cost of Capital - The return the firms
investors could expect to earn if they
invested in securities with comparable
degrees of risk

Capital Structure - The firms mix of long

term financing and equity financing

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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
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 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)
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 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) - (119,000)
EAT 400,000 231,000
Now, suppose the firm pays $50,000 in dividends
to the shareholders
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 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (-) (119,000)
EAT 400,000 231,000
- dividends (50,000) 0
Retained earnings 350,000 231,000
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 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:

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 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)

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 EXAMPLE: Cost of Debt
Prescott Corporation issues a $1,000
par, 20 year bond paying the market rate
of 10%. Coupons are annual. The bond
will sell for par since it pays the market
rate, but flotation costs amount to $50
per bond.

What is the pre-tax and after-tax cost of

debt for Prescott Corporation?
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EXAMPLE: Cost of Debt
Pre-tax cost of debt:
950 = 100(PVIFA 20, Kd) + 1000(PVIF 20, Kd)
using a financial calculator:
Kd = 10.61% So a 10% bond
costs the firm
After-tax cost of debt: only 7%
(with flotation costs)
Kd = Kd (1 - T) because interest
Kd = .1061 (1 - .34) is tax deductible
Kd = .07 = 7%
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Cost of New 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

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 Cost of Preferred stock:
Example
Baker Corporation has preferred stock that sells for $100 per share and pays an annual
dividend of $10.50. If the flotation costs are $4 per share, what is the cost of new
preferred stock?

$10.50
KP .1094 10.94%
$100 - 4

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Cost of Equity:
Retained Earnings
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

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Cost of Equity:
Retained Earnings
Common stock equity is available through
retained earnings (R/E) or by issuing new
common stock:
Common equity = R/E + New common stock

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Cost of Equity:
New Common 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

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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

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 The Dividend Growth Model
Approach

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

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Example: Estimating the
Dividend Growth Rate

Percentage
Year Dividend Dollar Change Change

1990 $4.00 - -
1991 4.40 $0.40 10.00%
1992 4.75 0.35 7.95
1993 5.25 0.50 10.53
1994 5.65 0.40 7.62

Average Growth Rate

(10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%

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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 doesnt 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
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 Capital Asset Pricing Model (CAPM)

kj Rf ( 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

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 The Security Market Line (SML)
Required rate
of return
Percent
20.0 SML = Rf + (Km Rf)

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)
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Finding the Required Return on
Common Stock using the Capital
Asset Pricing Model
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%

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.
Finding the Required Return on
Common Stock using the Capital
Asset Pricing Model

Then, using the CAPM we would get a required return of

K j 5.5 1.0 (12 - 5.5) 12%

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.
CAPM/SML approach
Advantage: Evaluates risk, applicable
to firms that dont 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

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Estimation of Beta: Measuring
Market Risk

Market Portfolio - Portfolio of all assets in

the economy
In practice a broad stock market index,
such as the WIG, is used to represent the
market
Beta - sensitivity of a stocks return to the
return on the market portfolio

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 Estimation of Beta
Theoretically, the calculation of beta is
straightforward: Cov ( Ri , RM ) iM
Problems = = 2
1. Betas may vary over time.
Var ( RM ) M
2. The sample size may be inadequate.
3. 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.

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 Stability of Beta
Most analysts argue that betas are generally
stable for firms remaining in the same industry
Thats not to say that a firms beta cant
change
Changes in product line
Changes in technology
Deregulation
Changes in financial leverage

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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

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Survey evidence: What do you use for
the risk-free rate?
Corporations Financial Advisors
90-day T-bill (4%) 90-day T-bill (10%)

3-7 year Treasuries (7%) 5-10 year Treasuries (10%)

10-year Treasuries (33%) 10-30 year Treasuries (30%)

20-year Treasuries (4%) 30-year Treasuries (40%)

10-30 year Treasuries (33%) N/A (10%)

10-years or 90-day; depends

(4%)
Source: Bruner et. al. (1998)
N/A (15%)

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Weighted Average Cost of Capital
(WACC)

WACC weights the cost of equity and the cost

of debt by the percentage of each used in a
firms 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

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 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 ABCs =.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18%
Tax rate is 40%
Current yield on market debt is 11%

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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%

Compiled by Mr Mfinanga
 Final notes on WACC
WACC should be based on market rates and
valuation, not on book values of debt or equity
Book values may not reflect the current
marketplace
WACC will reflect what a firm needs to earn on
a new investment. But the new investment
should also reflect a risk level similar to the
firms Beta used to calculate the firms RE.
In the case of ABC Co., the relatively low WACC of
8.81% reflects ABCs =.74. A riskier investment
should reflect a higher interest rate.

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 Final notes on WACC
The WACC is not constant
It changes in accordance with the risk of
the company and with the floatation
costs of new capital

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Marginal cost of capital and
investment projects
Percent
16.0 - A
14.0 -
B 10.77% 11.23%
12.0 - C Kmc Marginal
10.41% cost of
10.0 - E capital
D
8.0 - F
G
6.0 - H

4.0 -

2.0 -

0.0 -
10 15 19 39 50 70 85 95
Amount of capital ($ millions)
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The End .

Compiled by Mr Mfinanga