Financial

Financial Management
Management
Financial Management

COST OF CAPITAL
 LEARNING OBJECTIVES

• Understand the concepts underlying the firm’s

overall cost of capital and the purpose of its
calculation
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• Calculate the after-tax cost of Debt, Preferred

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Stock, and Common Equity

• Introduction to the firm’s weighted average

cost of capital (WACC)
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• Firm discount rate vs. Project discount rate in

investment evaluation – How to adjust cost for
risk
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THE COST OF CAPITAL OVERVIEW

 COST OF CAPITAL – what is it?

What? Why needed?

The opportunity cost

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Discount rate used to

investors face for
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discount project CFs

investing their funds in
one business instead of
others with similar risk Minimum required return
needed on projects (hurdle
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rate)

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 WHAT ARE THE POSSIBLE CAPITAL
COMPONENTS?
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COST OF CAPITAL
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Cost of equity
(common Cost of debts
stock) (bonds)
Cost of equity
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Cost of debts
(preferred
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(bank loans)
stock)

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 THE WACC EQUATION

WACC = the weighted average cost of possible

sources of capital (Debt, Preferred stock, Common
stock) by market value
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( ) ( ) ( )
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WACC = E V  RE + P V  R P + D V  RD  (1 − TC )
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E = market value of Common Equity RE = cost of Common Equity

D = market value of Debt RD = cost of Debt
P = market value of Preferred Equity RP = cost of Preferred Equity
V = E + D + P = market value of Firm TC = tax rate
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 A THREE-STEP PROCEDURE FOR
ESTIMATING FIRM WACC
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Step 2 Step 3
Step 1
Estimate the market Calculate after-tax
Identify permanent value and required weighted average
sources of capital return of each source of the costs of each
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of capital source of capital

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 STEP 1. IDENTIFY THE FIRM’S
PERMANENT SOURCES OF CAPITAL

Include permanent sources of capital only!

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❑ Include all classes of equity : preferred and common

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stock

❑ Include long-term debt

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❑ Exclude seasonal short-term debt and accounts payable

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❑ Exclude deferred taxes and other book liabilities that do

not generate capital
 STEP 2. DETERMINING MARKET VALUE
AND COST OF DEBT

Marketable Debt (Bond)

Use current market price to compute yield, or
Compute price using market yield
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After-tax cost of Debt = Pre-tax cost of Debt x (1-tax rate)

RD = YTM (EAR) x (1-tax rate)
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Checkpoint 1: What is the after-tax cost of Debt on a corporate

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bond that has par value = $1,000; coupon rate 8% paid annually ;
time to maturity 3 years and is currently trading at $900 if the tax
rate is 30%?
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 STEP 2. DETERMINING MARKET VALUE
AND COST OF DEBT
Non-marketable debt
Bank loan:
Use Book value to calculate weight
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Cost of Bank loan: use current market

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interest rate on the loan (given)

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 STEP 2. DETERMINING MARKET VALUE
AND COST OF COMMON EQUITY
Marketable equity

- Use current market price for value

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- Use CAPM or Gordon Growth Model (introduced in

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lecture 4) for cost of Equity

Do we have to
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adjust for tax

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when calculating
cost of Equity?

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 STEP 2. DETERMINING MARKET VALUE
AND COST OF COMMON EQUITY
THE GORDON GROWTH MODEL

(Recalled…) If we assume that the dividend grows at a constant

rate, g, the stock can be valued as
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D0 (1 + g )
P0 =
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RE − g
Where RE is the cost of common equity and g is dividend
growth → Rearranging, the cost of common equity is:
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Where to get “growth rate”?

- From analyst’s forecasts
D1 - Estimation using historical data
RE = +g
P0
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 STEP 2. DETERMINING MARKET VALUE
AND COST OF COMMON EQUITY
ESTIMATING “G”

Year Dividend Dollar Change % Change

2000 $4.00 - -
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2001 $4.40 $0.40 10.00%

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2002 $4.75 $0.35 7.95%

2003 $5.25 $0.50 10.53%
2004 $5.65 $0.40 7.62%
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→ Average growth rate = (10+7.95+10.53+7.62)/4 = 9.025%

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 STEP 2. DETERMINING MARKET VALUE
AND COST OF COMMON EQUITY
THE GORDON GROWTH MODEL

Checkpoint 2:

In 2012, the CFO of Pearson (PSO) calls for an update of the

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firm’s cost of capital. The 1st phase of estimation focuses on

the firm’s cost of common equity. How would the firm’s CFO
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determine the cost of the company’s common equity, using

the dividend growth model?

PSO stock is trading at $10.09. The last dividend paid is $0.47

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per share, and we expect a growth rate of 6.25%

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 STEP 2. DETERMINING MARKET VALUE
AND COST OF COMMON EQUITY
THE CAPM APPROACH

CAPM says that Required return on a risky investment depends

on three factors:
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❑ The risk-free rate, Rf

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❑ The market risk premium, (RM – Rf)

❑ The systematic risk of the asset relative to the average, 

 
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RE = R f +  E  RM − R f
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 STEP 2. DETERMINING MARKET VALUE
AND COST OF COMMON EQUITY
THE CAPM APPROACH

Checkpoint 3: A review of current market conditions at the

end of March 2009 reveals that the 10-year US Treasury
Bond’s yield was 2.81%, the estimated market risk premium
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was 6.5%, and the Beta for Drilling's common stock was 1.2
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Determine Drilling's cost of common equity using CAPM, as

of March 2009
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 STEP 2. DETERMINING MARKET VALUE AND
COST OF PREFERRED EQUITY

Preferred stock pay a constant dividend every period.

Dividend is a perpetuity, so the cost is:
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D RP is simply
Rp = the dividend
P0
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yield!

D= Fixed Dividend; P0 = current price per preferred share

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Checkpoint 4: Relay company’s preferred stock is trading at

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$25 per share. What is the cost of preferred equity if the stock
has a par value of $35 and pay annual dividend of 4%?

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 STEP 3. CALCULATE FIRM’S WACC
WACC = the weighted average cost of capital (Debt,
Preferred stock, Common stock) by market value
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( ) ( ) ( )
WACC = E V  RE + P V  R P + D V  RD  (1 − TC )
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V = Total value of firm’s assets

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= market value of Debt (D) + market value of

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Preferred equity (P) + market value of Common

Equity (E)
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 SUMMING UP: WACC CALCULATION
REQUIRES CONSISTENCY

Must include the opportunity costs from all sources of

capital
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Must weigh each security’s required return by its

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market-based weight, not historical book value

Must be computed after-taxed

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Must be denominated in the same currency as cash

flows

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RATE FOR PROJECT EVALUATION

DETERMINING APPROPRIATE DISCOUNT
 WHEN CAN’T WE USE FIRM WACC TO
DISCOUNT PROJECT’S CASH FLOWS?
More than 50% of firms tend to use a single, company-wide
discount rate to evaluate all of their investment proposals
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This is wrong if new projects more or less risky than its

existing business
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Each project should in principle be discounted using its

own opportunity cost of capital
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 WHEN CAN’T WE USE FIRM WACC TO
DISCOUNT PROJECT’S CASH FLOWS?

❑ Duke Power (a utility company) has low risk and thus low
company cost of capital
❑ Singapore Airlines has high risk and as a result,
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high company cost of capital

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❑ If both firms used its WACC to evaluate the SAME

project (expands to fast food industry), possible that
❑ Duke Power would accept the project
❑ Singapore Airlines would reject the project
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EXPANDS EXPANDS
 WACC EXAMPLE 1: DURIAN LTD.

Equity Debt
❑P0=$2.40/share ❑$10 million face value, 8
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❑15 million shares years to maturity

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❑Beta=1.2 ❑8% coupon rate

❑RM = 12% ❑6% market yield
❑RF =4% ❑Semi-annual coupons
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Other
❑Corporate tax rate: 30%

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 WACC EXAMPLE 2: PHILIPS EQUIPMENT

❑ Philips Equipment has 80,000 bonds outstanding that

are selling at par of $1,000 each. Bonds with similar
characteristics are yielding at 6.75%.
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❑ Phillips has 750,000 shares of 7% $100 preferred

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stock currently sells for $53 a share

❑ Philips has 2.5m shares of common stock
outstanding. The common stock has a beta of 1.34
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and sells for $42 a share.

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❑ The US Treasury bill is yielding 2.8% and the return on

the market is 11.2%. The corporate tax rate is 38%.
What is the firm’s WACC?
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