Financial Management

FIN300

Cost of Capital

Objectives

• Upon completion of this lesson, you will be able to:– Determine a firm’s cost of equity capital– Determine a firm’s cost of debt– Determine a firm’s overall cost of capital– Identify some of the pitfalls associated with a

firm’s overall cost of capital and what to do about them

Why Cost of CapitalIs Important

• The required return to an investor in our company is the same as the cost to our company

• We know that the expected return on assets depends on the risk of those assets

• Our cost of capital provides us with an indication of how the market views the risk of our assets

• Knowing our cost of capital is essential in determining our required return for capital budgeting projects

Cost of Equity

• The cost of equity is the return required by equity investors given the perceived risk of the expected cash flows from the firm

• There are two primary methods for determining the cost of equity– Dividend growth model– CAPM or SML

Dividend GrowthModel Approach

• Start with the dividend growth model formula and rearrange to solve for RE

gP

DR

gR

DP

E

E

0

1

10

Dividend Growth Model Example

• Suppose that the market expects our company to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends averaging 5.1% per year and the market expects that to continue. The current price per share is $25. What is the cost of equity? It calculates as 11.1%.

111.051.25

50.1ER

Advantages/Disadvantages of Dividend Growth Model

• Advantage – easy to understand and use• Disadvantages

– Only applicable to companies currently paying dividends

– Not applicable if dividends aren’t growing at a reasonably constant rate

– Extremely sensitive to the estimated growth rate – a change in g of 1% changes the cost of equity by 1%

– Does not explicitly adjust for risk

The CAPM Approach

• Use the following information to compute our cost of equity– Risk-free rate, Rf

– Market risk premium, E(RM) – Rf

– Systematic risk of asset,

])([ fMEfE RRERR

CAPM Example

• Suppose our company has an equity beta of .58 and the current risk-free rate is 6.1%. If the market risk premium is 8.6%, what is our cost of equity capital?– RE = 6.1 + .58(8.6) = .111

• It calculates to 11.1%

Advantages andDisadvantages of CAPM

• Advantages– Explicitly adjusts for systematic risk– Applicable to all companies, as long as we can

compute beta

• Disadvantages– Have to estimate the expected market risk

premium, which does vary over time– Have to estimate beta, which also varies over time– We are relying somewhat on the past to predict the

future, which is not always reliable

Cost of Preferred Stock

• Reminders– Preferred generally pays a constant

dividend every period– Dividends are expected to be paid every

period perpetually

• Preferred stock is a perpetuity, so we take the formula, rearrange, and solve for RP

• RP = D / P0

Cost of Preferred Stock: Example

• Our company has preferred stock that has an annual dividend of $2.40. If the current price is $25, what is the cost of our preferred stock?

• RP = 2.40 / 25 = 9.6%

Cost of Debt

• The cost of debt is the required return on our company’s debt

• We usually focus on the cost of long-term debt or bonds, which are part of our capital structure

• The required return is best estimated by computing the yield-to-maturity on the existing debt

• We may also use estimates of current rates based on the bond rating we expect when we issue new debt

• The cost of debt is not the coupon rate

Cost of Debt Example

• Suppose we have a bond issue outstanding that has 23 years left to maturity. The coupon rate is 9% and the bonds are selling for $918 per $1000 bond. What is the (pretax) cost of debt? It is the required yield to maturity of the bonds.– 23 [N]– -918 [PV]– .09 * 1,000 = 90 [PMT]– 1,000 [FV]– [CPT] [I/Y] = 9.92%

Tax Effect

• From the previous example, the pretax cost of our debt is 9.92%

• If our company is profitable, the interest paid on debt is tax deductible

• If our tax rate is 34%, then 34% of the interest paid will represent tax shelter, and 66% will represent net interest cost

• Our after-tax cost of debt is– (1-.34)9.92 = .66 * 9.92 = 6.55%

Check Your Understanding

Weighted AverageCost of Capital

• We can use the individual costs of capital that we have computed to get our weighted average cost of capital (WACC) for the firm

• The average is the required return on our assets, based on the market’s perception of the risk of those assets

• The weights are determined by how much of each type of financing that we use

Capital Structure Weights

• Notation– E = market value of equity (market cap) = number

of outstanding shares times price per share– D = market value of debt = number of outstanding

bonds times price per bond– V = market value of the firm = D + E

• Weights– wE = E/V = percent financed with equity

– wD = D/V = percent financed with debt

Example: WACC

• Equity Information– 50 million shares– $80 per share– Market cap

• 80 * 50,000,000 =

$4,000,000,000

– Cost = 11.1%

• Debt Information– 1,050,420 bonds

outstanding– $952 per bond– $1 billion in

outstanding debt (market value)

– YTM = 9.92%– Tax rate = 34%– After-tax cost = 6.55%

Example: WACC, continued

• What are the capital structure weights?– E = 4 billion– D = 1 billion– V = 4b + 1b = 5 billion– wE = E/V = 4 / 5 = .80 = 80%– wD = D/V = 1 / 5 = .20 = 20%

• What is the WACC?– WACC = .8(11.1) + .2(6.55) = – 8.88 + 1.31 = 10.19%

Divisional and ProjectCosts of Capital

• Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operations

• If we are looking at a project that is not of the same risk as the firm, then we need to determine the appropriate discount rate for that project

• Divisions also often require separatediscount rates

• However, caution is required for using a discount rate less than our WACC

Pure Play Approach

• Find one or more companies that specialize in the product or service that we are considering

• Find or compute the beta for each company

• Take an average• Use that average in the CAPM to find the

appropriate return for a project of that risk• Often difficult to find pure play companies

Summary

• Cost of equity capital• Cost of debt• Overall cost of capital• Pitfalls associated with overall cost of

capital