FINANCIAL CH III

MANAGEMENT II THE COST OF CAPITAL

 Learning Goals
LG1 Understand the basic concept and sources of capital
associated with the cost of capital.

LG2 Determine the cost of long-term debt, and explain why

the after-tax cost of debt is the relevant cost of debt.

LG3 Determine the cost of preferred stock.

LG4 Calculate the cost of common stock equity, and convert

it into the cost of retained earnings and the cost of new
issues of common stock.

LG5 Calculate the weighted average cost of capital (WACC)

and discuss alternative weighting schemes.
Capital Budgeting Decisions

Capital budgeting is the process of evaluating and selecting long-

term investments that are consistent with the firm’s goal of
maximizing owner wealth.

Investment Decision
These decisions are often called capital budgeting or Capital
Expenditure (CAPEX) decisions.
Overview
Sources -- the
of Long Cost
Term of Capital:
Capital???
 the
The Cost
Cost of Capital
of Capital

The cost of capital represents the firm’s cost of

financing, and
It is the minimum rate of return that a project must
earn to increase firm value.

✓Financial managers are ethically bound to only invest

in projects that they expect to exceed the cost of
capital.
✓The cost of capital reflects the total of the firm’s
financing activities.
Overview of The Cost of Capital
Overview of the Cost of Capital

Most firms attempt to maintain an optimal mix of debt

and equity financing.

• Capture all of the relevant financing costs,

• Need to look at the overall cost of capital rather than just

the cost of any single source of financing.

• What will be the proportion ??

A firm is currently faced with two investment opportunities.
Assume the following:

Investment A Investment B
• Cost = $100,000 • Cost = $100,000
• Life = 20 years
• Life = 20 years
• Expected Return =
• Expected Return = 7% 12%
Least costly financing Least costly financing
source available source available
• Debt (bonds) = 6% • Equity = 14%

– The analyst
Firm can earn 7% on the recommends that the
investment of funds firm rejects the
costing only 6%, the opportunity,
analyst recommends because the 14%
financing cost is
that the firm undertake greater than the 12%
this investment. expected return.
Combined Cost of Capital
Combined cost of capıtal??
What if instead the firm used a combined cost of
financing?
• Assuming that a 50–50 mix of debt and equity is targeted,
the weighted average cost here would be:
(0.50  6% debt) + (0.50  14% equity)
WACC= 10%

With this average cost of financing,

• the first opportunity would have been rejected (7%
expected return < 10% weighted average cost), and
• the second would have been accepted
(12% expected return > 10% weighted average cost).
Weighted Average Cost of Capital, WACC

 A weighted average of the component costs

of debt, preferred stock, and common
equity

 Proportion   After - tax   Proportion   Cost of   Proportion   Cost of 

           
=  of    cost of  +  of preferred    preferred  +  of common    common 
 debt   debt   stock   stock   equity   equity 
     

= W  k + W  k + W  k
d dT ps ps s s
A Three-Step Procedure for Estimating Firm WACC

Define the firm’s capital structure by determining the weight

of each source of capital.

Estimate the opportunity cost of each source of financing.

Calculate a Weighted Average of the costs (WACC) of each

source of financing.
Estimating the individual sources of long term debt
Cost of Long Term Debt; cd
✓Pretax Cost of Debt (Before Tax Cost of Debt); cbd
✓After-Tax Cost of Debt; cad

Cost of Preferred Stock; cps

Cost of Common Stock; ccs

✓Cost of Retained Earnings; crs
✓Cost of New Issues in Common Stock; cns
• The constant-growth valuation (Gordon) model
• Capital Asset Pricing Model (CAPM)
BEFORE TAX COST OF DEBT
PRETAX COST OF DEBT

The pretax cost of debt is the financing cost associated with new
funds through long-term borrowing.

• Typically, the funds are raised through the sale of

corporate bonds.
• The before-tax cost of debt, Cbd, is simply the rate of
return the firm must pay on new borrowing.
AFTER TAX COST OF DEBT

The interest payments paid to bondholders are tax

deductable for the firm, so the interest expense on debt
reduces the firm’s taxable income and, therefore, the firm’s
tax liability.

The after-tax cost of debt, ri, can be found by multiplying the

before-tax cost, rd, by 1 minus the tax rate, T, as stated in the
following equation:

cad = cd  (1 – T)
Ex – The cost of bank credits
For X corp; Earnings before Interest and Taxes (EBIT) is
$50.000, the company borrowed $100,000 at 10% interest
rate. Tax rate is 30%.
Find the pretax and after tax cost of bank credit.
.

cad = cbd(1-t)
Cad = 0.10 (1-0.30)
Cad = 0.07
Ex:
Brown Corporation has a 40% tax rate.

Before-tax debt cost = 9.452 %

Calculate the after-tax cost of debt;

after-tax cost of debt

= [9.452%  (1 – 0.40)].
= 5.67 %
Cost of Preferred Stock

Preferred stock gives preferred stockholders the right to

receive their stated dividends before the firm can distribute
any earnings to common stockholders.

• Preferred stock dividends may be stated as a dollar

amount.
• Sometimes preferred stock dividends are stated as an
annual percentage rate, which represents the percentage
of the stock’s par, or face, value that equals the annual
dividend.
The Cost of Preferred Stock

The cost of preferred stock is the rate of return investors

require of the firm when they purchase its preferred stock.

The cost is not adjusted for taxes since dividends are paid to
preferred stockholders out of after-tax income.

• is the ratio of the preferred stock dividend to the firm’s net

proceeds from the sale of preferred stock.
• Since there is no tax savings related to preferred stock, no tax-
adjustment is made.

Np = P0-Flotation Costs
The Cost of Preferred Stock
Duchess Corporation is contemplating the issuance of a 10%
preferred stock that they expect to sell for $87 per share.

The cost of issuing and selling the stock is expected to be $5

per share.

The dividend is $8.70 (10%  $87).

The net proceeds (Np) equal $82 ($87 – $5), the share price
less the flotation costs.

The cost of Duchess’ preferred stock is:

rp = DP/Np
= $8.70/$82
= 10.6%
EX
ex
Brown Company

If a share of preferred stock sells for $45, and the

issuing/selling the stock is $5 per share,

and it pays a dividend of $3 per share, what is the expected

return on that share of stock?

Net proceeds are the funds actually received by the firm from the sale of a
security.Flotation costs are the total costs of issuing and selling a
security.
13-19
Cost of Common Stock

The cost of common stock is the return required on the stock

by investors in the marketplace.

There are two forms of common stock financing:

1. retained earnings
2. new issues of common stock

The cost of common stock equity, rs, is the rate at which

investors discount the expected dividends of the firm to
determine its share value.
The Cost of Common Stock – Gordon Model

The constant-growth valuation (Gordon) model

P0 = value of common stock

D1 = per-share dividend expected at the end of year 1
rs = required return on common stock
g = constant rate of growth in dividends
EX

Brown Company’s common stock shares are trading for $45 per
share.
The firm is expected to pay a $2 per share dividend at the end of
the year.

What is its expected return on equity assuming a 9% constant

growth rate?

The constant-growth formula can only be used for firms that

have a stable and predictable growth pattern for dividends.

13-22
The Cost of Common Stock – CAPM formula

When the firms with very high current rates of growth, or firms
with unpredictable rates of growth; use CAPM formula!

The Capital Asset Pricing Model (CAPM) describes the

relationship between the required return, rs, and the risk of
the firm as measured by the beta coefficient, β.

rs = rf + [ β (rm – rf)]
where
rf = risk-free rate of return
rm = market return; return on the market portfolio of assets
β = measure of risk ……
The Cost of Common Stock – cont’d

The CAPM technique differs from the constant-growth

valuation model in that it directly considers the firm’s risk, as
reflected by beta, in determining the required return or cost of
common stock equity.

The constant-growth model does not look at risk; it uses the

market price, P0, as a reflection of the expected risk–return
preference of investors in the marketplace.

The constant-growth valuation and CAPM techniques for

finding rs are theoretically equivalent, though in practice
estimates from the two methods do not always agree.
BETA COEFFICIENT

• The beta coefficient, β is a relative measure of risk.

• An index of the degree of movement of an asset’s return in

response to a change in the market return.

• The beta coefficient for the entire market equals 1.0.

• All other betas are viewed in relation to this value.

Selected Beta Coefficients and Their
Interpretations
Beta Coefficients for Selected Stocks
Beta coeffıcients – BIST firms
EX

A firm’s beta is 1.5,

Treasury bills currently yield 4%, and
the long-run market risk premium is 8%
(market return is 12% )

What is the firm’s cost of common stock/equity?

13-29
Constant Growth Rate vs CAPM

The CAPM technique differs from the constant-growth

valuation model in that it directly considers the firm’s risk,
as reflected by Beta, in determining the required return or
cost of common stock equity.

The constant-growth model does not look at risk; it uses

the market price, P0, as a reflection of the expected risk–
return preference of investors in the marketplace.

The constant-growth valuation and CAPM techniques for

finding rs are theoretically equivalent, though in practice
estimates from the two methods do not always agree.
The Cost of Retained Earnings

The cost of retained earnings, rr, is the same as the cost of an

equivalent fully subscribed issue of additional common stock,
which is equal to the cost of common stock equity, rs.
rr = r s
• The cost of retained earnings for Brown Corporation was
actually calculated in the preceding examples:

• It is equal to the cost of common stock equity.

• Thus rr equals 13.44%.
The Weighted Average Cost of Capital

The weighted average cost of capital (WACC),reflects the

expected average future cost of capital over the long run; found
by weighting the cost of each specific type of capital by its
proportion in the firm’s capital structure.

WACC = (wi  ri) + (wp  rp) + (ws  rr or n)

where
The Weighted Average Cost of Capital cont’d
Weighted Average Cost of Capital (cont.)

Three important points should be noted in the equation for ra:

1. For computational convenience, it is best to convert the
weights into decimal form and leave the individual
costs in percentage terms.
2. The weights must be non-negative and sum to 1.0. Simply
stated, WACC must account for all financing costs within
the firm’s capital structure.
3. The firm’s common stock equity weight, ws, is multiplied
by either the cost of retained earnings, rr, or the cost of new
common stock, rn. Which cost is used depends on whether
the firm’s common stock equity will be financed using
retained earnings, rr, or new common stock, rn.
TheWeighted
WeightedAverage
AverageCost
Cost of
of Capital
Capital (cont.)
cont’d

In earlier examples, we found the costs of the various types of

capital for Brown Corporation to be as follows:

• Cost of debt, rd= 5.67%

• Cost of preferred stock, rp = 7.5%
• Cost of retained earnings, rrs = 13.44%
• Cost of new common stock, rrn = 14.06 %

The company uses the following weights in calculating its

weighted average cost of capital:
Source of Capital Weight
Long-term debt 40%
Preferred stock 10%
Common stock equity 50%
Total 100%
 Calculation of WACC for Brown Corporation

Calculation of the Weighted Average Cost of Capital

for Brown Corporation

Source of Weight Cost Weighted

Capital Cost
Long term 0.40 5.67 2.268
debt
Preferred 0.10 7.50 0.75
stock
Common 0.50 13.44 6.72
stock equity
1.0 9.738

WACC = 9.8 %
Typically, the cost of long-term debt for a given firm is less than the cost of
preferred or common stock, partly because of the tax deductibility of
interest.
WHY WACC IS
NECESSARY?
I. Discounted Cash Flow
Techniques
 I. Net Present Value (NPV)
 II. Profitability Index (PI)
 III. Discounted Payback
Period (DPB)
 IV. Internal Rate of Return
(IRR)

II. Firm Valuation; valuing

Entire Business!
 WACC
I. FINDING NPV
Suppose that Brown Corporation wishes to establish a capital
budgeting project. Intial cost of the project is 20.000$.

The discount rate was 9.8% (WACC)

Find NPV of the project.

Years Cash flows
1 5.000
2 10.000
3 12.000

𝐶1 𝐶2 𝐶𝑛
𝑁𝑃𝑉 = + 2 +. . . + 𝑛 −𝐼
1 + 𝑖 (1 + 𝑖) (1 + 𝑖)
Brown Corp;

Years CashFlows Discount factor (%10) Present value

WACC

1 5.000 0,9091 4.545,5

2 10.000 0,8264 8.264

3 12.000 0,7513 9.015,5

21.825

-20.000

C0 = 1.825
WACC
WACC and IRR

we calculated the firm’s WACC to be 9.8%; around 10%

• Which one of the project can be undertaken??

• Investing in a project offering an expected return

11% return?

• Investing in a project offering an expected return

9 % return?

13-39
II. Valuing Entire Businesses

A free cash flow valuation model determines the value of

an entire company as the present value of its expected free
cash flows discounted at the firm’s weighted average cost
of capital, which is its expected average future cost of
funds over the long run.

where

VC = value of the entire company

FCFt = free cash flow expected at the end of year t end of year
t
ra = the firm’s Weighted Average Cost of Capital
(WACC)