13 Cost of Capital-R2

Cost of Capital
1
Cost of Capital
• Two Types of Capital
Debt
Equity
• Two Types of Cost of Capital
Cost of Debt
Cost of Equity
• Cost of Capital
Weighted Average Cost of Capital (WACC)
2
WACC (Discount rate)
• The Weighted Average Cost of Capital (WACC) is essentially the
return that a company requires to operate a business. It is often
used in valuation as a discount rate.
• What happen if the firm’s profit is less than WACC?
• WACC = wE x KE + wD x KD x (1 – t)
wE = Equity / (Debt + Equity)=E/TA

wD = Debt / (Debt + Equity)=D/TA
KE = Cost of Equity
KD = Cost of Debt (effective rate a company pays on current
debt)
t = Tax Rate
3
Ke – Estimation of Cost of Equity
1) Gordon’s Dividend Growth Model
Ke= RE = (D1/P0)+g, 혹은 Ke=E/P (if D=E, then g=0)

D1=Dividend at time 1,
P0=stock price at time 0,
g=growth rate
E=Net profit
Or Ve=D1/(Ke-g) replace Ve with P0 and solve for Ke.

Ke= (D1/P0)+g
2) CAPM
Ke = RE = Rf + β x [E(RM) – Rf]
4
CAPM
• If Rf = 8.7%, βi =1.23, E[Rm] =14.5%
• Then Ke = E(Ri)
= Rf + βi(E[Rm] - Rf)
=8.7% + 1.23(5.8%)
= 15.8%
5
Gordon Model
• If P = 100, D1=10, g=5%,
• Ke= RE = (D1/P0)+g=10/100+5%=15%
6
Estimating the Cost of Debt
• The cost of debt is the rate at which you can borrow at currently, It will reflect not
only your default risk but also the level of interest rates in the market.
• The three most widely used approaches to estimate the cost of debt are:
– 1) Looking up the yield to maturity (Bond yield) on a straight bond outstand-
ing from the firm. The limitation of this approach is that very few firms have
long term straight bonds that are liquid and widely traded
– 2) Looking up the interest expense in income statement and debt amount I in
balance sheet. Then cost of debt Rd= Interest/Debt
– 3) Looking up the credit rating for the firm and estimating a default spread
(=risk premium) based upon the rating. While this approach is more robust
– If possible, use 1)
7
c.f.> Rd =Rf+ Risk Premium
Example)
Bond Grade Yield Risk Premium (=Default spread)
AAA 6.00 43 bp
AA 6.04 47 bp
A 6.20 63 bp
BBB 6.44 87 bp (basis point: 100 bp is 1%
BB 7.47 190 bp
B 9.47 390 bp
If bond grade = BBB, and Rf=5.57,

Rd=5.57+RP=5.57+0.87=6.44
If bond grade = AAA, and Rf=5.57,
Rd=5.57+RP=5.57+0.43=6.00
8
Alternative measure for Cost of Debt
• Interest expense 700 – from income

statement
• Amount of debt 10,000 – from balance
sheet
• Cost of debt = interest/outstanding debt
=700/10,000=7%
9
After tax cost of debt
• Since the debt cost (interest) is tax de-
ductible, actual cost of debt is reduced
by tax amount.
10
Actual cost of debt = Kd* (1-t)
Firm A has no debt. Firm B has $ 1,000 of debt with 20% of cost of
debt.
Income statement: Firm A Income statement :Firm B
Sales 1,000 Sales 1,000

Cost of Goods and Service 700 Cost of Goods and Service 700
EBIT 300 EBIT 300
Tax (35%) 105 Interest 200
Net income 195 EBT 100
Tax (35%) 35
Net Income 65
•
Actual cost is not 200. It is 200-70=130.
200 (1-0.35)=130.
11
After tax cost of debt
 For firm B, presence of interest expense , 200, reduces tax
to 35. Compared with the tax amount of Firm A, saved
amount of tax is 70 (=200*0.35).
 Therefore, from the firm B’s point of view, part of interest
expense is recovered from the tax saving, and the actual in-
terest payment is 130 (=200-200*0.35=200(1-T)).
 If debt amount is 1000, then cost of debt is reduced to 13%

(=130/1000) from 20%(=200/1000).
 Generalization of this process will lead to Actual cost of

debt = Kd* (1-t)
12
Calculation Example of WACC
Balance Sheet for XYZ co. (unit 10 mil. KRW)
CA 4,000 Current Liabilities 3,500
Long-term liabilities 1,000

FA 6,000
TL 4,500
TA 10,000 Common stock 5,500
Total Equity 5,500
Total Liabilities and Equity 10,000
Other Information, Tax rate=30.8%, Rf = 8.7%, βi

=1.23, E[Rm] =14.5%, Interest =533.25, outstanding
number of shares =10,000,000 shares
Kd=533.25/4500=11.85%
13
WACC
• WACC=Ke× WE ＋ Kd ×(1-t) × WD
= 15.8% x 55% + 11.85% x (1-0.308) x 45%
≒ 12.3%
• wE = Equity / (Debt + Equity)
wD = Debt / (Debt + Equity)
Ke = Cost of Equity
Kd = Cost of Debt (effective rate a company pays on current
debt)
t = Tax Rate
14

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Cost of Capital

• Two Types of Cost of Capital

Weighted Average Cost of Capital (WACC)

wE = Equity / (Debt + Equity)=E/TA

1) Gordon’s Dividend Growth Model

Ke= RE = (D1/P0)+g, 혹은 Ke=E/P (if D=E, then g=0)

Or Ve=D1/(Ke-g) replace Ve with P0 and solve for Ke.

If bond grade = BBB, and Rf=5.57,

• Interest expense 700 – from income

Sales 1,000 Sales 1,000

Tax (35%) 105 Interest 200

Net income 195 EBT 100

 If debt amount is 1000, then cost of debt is reduced to 13%

 Generalization of this process will lead to Actual cost of

CA 4,000 Current Liabilities 3,500

Long-term liabilities 1,000

TA 10,000 Common stock 5,500

Total Equity 5,500

Total Liabilities and Equity 10,000

Other Information, Tax rate=30.8%, Rf = 8.7%, βi

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