IBA, Main Campus

Financial Management
Sessions 5, 6 & 7
Cost of Capital
Ch 14: Ross, Westerfield & Jordan

by

M. Yousuf Saudagar
ysaudagar@iba.edu.pk
1
We know that managers should strive to make their firms more valuable &
that the value of a firm is determined by the size, timing & risk of its FCF.
Indeed, a firm’s intrinsic value is found as the present value of its FCFs,
discounted at WACC. In IBF we learnt major sources of financing (stocks,
bonds & pref. stock) & the costs of those instruments. We now put hose
pieces together & estimate WACC that is used to determine intrinsic value.

2
 Learning Objectives
• After studying this chapter, you should understand:
• How to determine & interpret a firm’s cost of equity capital.
• How to determine & interpret a firm’s cost of debt.
• How to determine & interpret a firm’s overall cost of capital.
• How to correctly include flotation costs in capital budgeting projects.
• Some of the pitfalls associated with a firm’s overall cost of capital and
what to do about them.
• How taxes affect cost of capital from different capital sources.
• Calculate and interpret the beta and cost of capital for a project.
• We will also learn when to use the firm’s cost of capital, and, perhaps
more important, when not to use it.
3
 Need for capital
• Businesses require capital to develop new products, build factories
and distribution centers, install information technology, expand
internationally, and acquire other companies.

• For each of these actions, a company must estimate the total

investment required and then decide whether the expected rate of
return exceeds the cost of the capital.

• This cost is also a key factor in choosing the firm’s mixture of debt
and equity and in decisions to lease rather than buy assets.

• As these examples illustrate, the cost of capital is a critical element in

many business decisions.

• The cost of capital is also a factor in compensation plans, with

bonuses dependent on whether the company’s return on invested
capital exceeds the cost of that capital. 4
 Concept – cost of capital
• As president of a large company, the first decision you face is whether
to go ahead with the company’s warehouse distribution system.
• Plan will cost $50 M & expected savings $12 M/year for next 6 years.
• To address it, you would determine the relevant cash flows, discount
them, and, if the NPV is +ve, take on the project; if the NPV is -ive, you
would scrap it; but what should you use as the discount rate?
• We know that the correct discount rate depends on the riskiness of
the project. The new project will have a positive NPV only if its return
exceeds what the financial markets offer on investments of similar
risk. We call this minimum required return, the cost of capital
associated with the project.
• Thus, to make the right decision as president, you must examine what
the capital markets have to offer and use this information to arrive at
an estimate of the project’s cost of capital. This cost is also a key
factor in choosing the firm’s mixture of debt and equity, called
5
components.
 The Cost of Capital: Some Preliminaries
• In IBF, we developed the security market line, or SML, and used it to
explore the relationship between the expected return on a security
and its systematic risk.

• We concentrated on how the risky returns from buying securities

looked from the viewpoint of, for example, a shareholder in the firm.

• This helped us understand more about the alternatives available to

an investor in the capital markets.

• In this chapter, we turn things around a bit and look more closely at
the other side of the problem, which is how these returns and
securities look from the viewpoint of the companies that issue them.

• The important fact to note is that the return an investor in a security

receives is the cost of that security to the company that issued it.
6
 REQUIRED RETURN VERSUS COST OF CAPITAL
• When we say that the required return on an investment is, 10%, the
investment will have a positive NPV only if its return exceeds 10%.
• Another way of interpreting it is that the firm must earn 10% to
compensate its investors.
• This is why we could also say that 10 % is the cost of capital associated
with the investment.
• To illustrate the point further, imagine that we are evaluating a risk-
free project. In this case, how to determine the required return is
obvious: We look at the capital markets and observe the current rate
offered by risk-free investments, and we use this rate to discount the
project’s cash flows.
• If a project is risky, then, the required return is obviously higher. In
other words, the cost of capital for this project, if it is risky, is greater
than the risk-free rate, and the appropriate discount rate would
exceed the risk-free rate. 7
 REQUIRED RETURN VERSUS COST OF CAPITAL
• We will be using the terms ‘required return’, ‘appropriate discount
rate’, and ‘cost of capital’ more or less interchangeably.
• The key fact to grasp is that the cost of capital associated with an
investment depends on the risk of that investment.
• This is one of the most important lessons in corporate finance, so it
bears repeating:
• The cost of capital depends on the use of the funds, not the source.
• It is a common error to forget this crucial point and fall into the trap
of thinking that the cost of capital for an investment depends
primarily on how and where the capital is raised.

8
 THE WEIGHTED AVERAGE COST OF CAPITAL
• If a firm’s only investors were common stockholders, then its cost of
capital would be the required rate of return on its equity.

• However, most firms employ different types of capital & because of

their differences in risk, each has different required rates of return.

• The required rate of return on each capital component is called its

component cost & the cost of capital used in capital budgeting
decisions is a weighted average of the various components’ costs.

• We call this weighted average just that, the weighted average cost of
capital, or WACC.

• Cost of capital provides us the hurdle rate-the minimum acceptable

return on the capital projects. Thus WACC is the minimum return a
company needs to earn to satisfy all of its investors including
common stockholders, bondholders, and preferred stockholders.9
 FINANCIAL POLICY AND COST OF CAPITAL
• The particular mixture of debt and equity a firm chooses to employ—
its capital structure—is a managerial policy.

• This debt-equity ratio reflects the firm’s target capital structure.

• A firm’s overall cost of capital will reflect the required return on the
firm’s assets as a whole.

• Overall cost of capital will be a mixture of the returns needed to

compensate its creditors and those needed to compensate its
stockholders.

• In other words, a firm’s cost of capital will reflect both its cost of debt
capital and its cost of equity capital.

• We discuss these costs separately in the slides that follow.

10
 cost of debt
• Unlike a firm’s cost of equity, its cost of debt can normally be
observed either directly or indirectly: The cost of debt is simply the
interest rate the firm must pay on new borrowing, and we can
observe interest rates in the financial markets.
• If the firm already has bonds outstanding, then the yield to maturity
on those bonds is the market required rate on the firm’s debt.
• Alternatively, if we know that the firm’s bonds are rated, say, AA, then
we can simply find the interest rate on newly issued AA-rated bonds.
• Either way, there is no need to estimate a beta for the debt because
we can directly observe the rate we want to know.
• The coupon rate on the firm’s outstanding debt is irrelevant here.
That rate just tells us roughly what the firm’s cost of debt was back
when the bonds were issued, not what the cost of debt is today.
• This is why we’ve to look at yield on the debt in today’s marketplace
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 Estimating Cost of Debt
• The first step in estimating the cost of debt is to determine the rate of
return debt holders require (rd).

• Rate varies depending on mix of debt:

 Long Term vs. Short Term
 Floating vs. Fixed rate
 Straight vs. Convertible
 Debt with and without Sinking Funds etc.
• It is unlikely that the financial manager will know at the beginning of
a planning period the exact types and amounts of debt that will be
used during the period.
• The types used will depend on the specific assets to be financed and
on capital market conditions as they develop over time.
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 Calculating Cost of Debt
How to determine the component cost of debt?

1. Marginal Rate: Discuss rates with your banker. Say they expect 9%.

2. Yield to Maturity: For example you’ve outstanding bonds with 8%

annual coupon rate, 22 years remaining to maturity, & face value of
$1,000. The bonds make semiannual coupon payments and
currently are trading in market at $904.91. We can find the rate
(yield to maturity) with following inputs:

N = 44, PV = $−904.91, PMT = $40, and FV = $1000.

Solving for the rate, rd = we find rate = 4.5% x 2 = 9%.

Effective Cost of Debt = Rd(1-T) = 9% (1 – 0.3) = 6.3%

13
 THE COST OF PREFERRED STOCK
• Determining the cost of preferred stock is quite straightforward.

• Preferred stock, as we know, has a fixed dividend paid every period

forever, so a share of preferred stock is essentially a perpetuity.

• The cost of preferred stock, RP , is thus: RP = D / P0

• Where D is the fixed dividend (say $8) & P0 is the current price per
share of the preferred stock (say $100). RP = 8%

• Cost of preferred stock is simply equal to the dividend yield on the

preferred stock.

• Alternatively, because preferred stocks are rated in much the same

way as bonds, the cost of preferred stock can be estimated by
observing the required returns on other, similarly rated shares of
preferred stock. 14
 Adding Floatation Cost in Preferred Stock

Here Dps is the preferred dividend, Pps is the preferred stock price,
and F is the flotation cost as a percentage of proceeds.

Illustration: Assume the co. has preferred stock that pays $8 dividend
per share & sells for $100. It incurs flotation cost of 2.5% for issuing
new preferred stock .

Cost of preferred stock Rps = 8/100(1 – 2.5%) = 8/97.5 = 8.2%

If we had not taken flotation costs, we would have wrongly estimated

rps as 8/$100 = 8.0%, difference too big to ignore.

Why we have not taken effective cost after tax here??? 15

 Cost of Common Stock
2 ways to raise common equity (both have costs):

a) By selling newly issued shares

b) By retaining and reinvesting earnings.

• What is the firm’s overall cost of equity ?

• This is a difficult question as there is no way of directly observing the

return that the firm’s equity investors require on their investment.
Instead, we must somehow estimate it.

• There are 2 approaches to determining cost of equity:

1. The dividend growth model approach and

2. The security market line (SML) approach.

16
 THE DIVIDEND GROWTH MODEL APPROACH
• Recall that, under the assumption that the firm’s dividend will
grow at a constant rate g , the price per share of the stock, P0,
can be written as:

• Where D0 is the dividend just paid and D1 is the next period’s

projected dividend. Notice that in the symbol RE (the E stands
for equity) for the required return on the stock.
• We can rearrange this to solve for RE as follows:

• Because RE is the return that the shareholders require on the

stock, it can be interpreted as the firm’s cost of equity capital.
17
 Implementing the Approach
• To estimate RE using the dividend growth model approach, we obviously
need three pieces of information: P0 , D0 and g .

• Of these, for a publicly traded, dividend-paying company, the first two

can be observed directly, so they are easily obtained. Only the third
component, the expected growth rate for dividends, must be estimated.

• To illustrate how we estimate RE , suppose a large public utility, paid a

dividend of $4 per share last year. The stock currently sells for $60 per
share. You estimate that the dividend will grow steadily at a rate of 6%
p.a. What is the cost of equity capital?

• Using the dividend growth model, we can calculate that the expected
dividend for the coming year, D1, is:
D1 = D0 X (1 + g) = 4 X 1.06 = 4.24
RE = (D1 / P0) + g = (4.24 / 60) + 0.06 = 13.07%
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 Estimating dividend growth (g)
• To use the dividend growth model, we must come up with an
estimate for g. There are essentially two ways of doing this:
• Analysts’ forecasts: These are available from a variety of sources.
Different sources will have different estimates, so obtain multiple
estimates and then average them.
• Historical growth rates: We might observe dividends for the
previous, say, five years, calculate the year-to-year growth rates &
average/compound them.

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 Advantages and Disadvantages of the Approach
Advantage
1. The primary advantage of the dividend growth model approach is its
simplicity. It is both easy to understand and easy to use.
Disadvantages.
1. The dividend growth model is applicable only to companies that pay
dividends. This means that the approach is useless in many cases.
2. Even for dividend paying companies, the key assumption is that the
dividend grows at constant rate in future. This will never be the case.

3. This approach does not consider risk. Unlike the SML approach,
there is no direct adjustment for the riskiness of the investment.

4. The estimated cost of equity is very sensitive to the estimated

growth rate. An upward revision of g by just 1 %age point increases
the estimated cost of equity by at least a full %age point. 20
 THE SML APPROACH
• In SML, our primary conclusion was that the required or
expected return on a risky investment depends on 3 things:

1. The risk-free rate, Rf.

2. The market risk premium, RM - Rf .

3. Its beta coefficient, which is the systematic risk of the

asset relative to average.

• Using the SML, we can write the expected return on the

company’s equity as:

RE = Rf + [RM - Rf] X bE

where bE is the estimated beta. 21

 Implementing the Approach
• To use the SML approach, we need a risk-free rate, Rf , an estimate of
the market risk premium, RM - Rf , and an estimate of the relevant bE .
• Risk-free rate is the SBP Treasury bills which are currently paying
about 10%.
• Market risk premium (based on large stocks) at PSE is about 5.13%
• Beta coefficients for publicly traded companies are widely available.
• To illustrate, we just saw that Byco had an estimated beta of 1.33
• We could thus estimate Byco’s cost of equity as:
• RByco = Rf + bByco X (RM - Rf)
= 10% + 1.33 X 5.13% = 10% + 6.8% = 16.8%
• Thus, using the SML approach, we calculate that Byco’s cost of equity
is about 16.8%.
22
Pakistan Risk Free rate

23
 Index30 - Weightage & Beta
KSE Code Company Name Weightage Beta
AGL Agritech Limited 0.22 1.79
Aisha Steel Mills
ASL 0.72 1.44
Limited
Azgard Nine
ANL 0.63 1.39
Limited
BOP Bank of Punjab Ltd 1.65 0.98
BYCO BYCO Petroleum 4.48 1.33
D.G. Khan Cement
DGKC 3.66 1.38
Company Limited
Descon Oxychem
DOL 0.25 1.25
Limited
Dewan Cement
DCL 0.46 1.52
Limited
Engro Fertilizers
EFERT 9.07 0.54
Limited
Engro Polymer and
EPCL 2.37 1.07
Chemicals
Fauji Cement 24
FCCL 3.04 1.31
Company Limited
 Index30 - Weightage & Beta
• ASL Aisha Steel Mills Limited 0.95 1.34
• ATRL Attock Refinery Limited 0.76 1.19
• ANL Azgard Nine Limited 0.47 1.43
• BOP Bank of Punjab Ltd0.82 1.28
• BYCO Byco Petroleum Pakistan Limited 4.96 1.07
• CWSM Chakwal Spinning Mills Limited 0.01 1.25
• DGKC D.G. Khan Cement Company Limited 4.52 1.01
• DCL Dewan Cement Limited 0.67 1.34
• DFML Dewan Farooque Motors Limited 0.27 1.16
• DSL Dost Steels Limited 0.29 1.43
• ENGRO Engro Corporation Limited 10.95 0.88 25
 Advantages and Disadvantages of the Approach
Advantages:

It explicitly adjusts for risk.

It is applicable to companies not with steady dividend growth.

Thus, it may be useful in a wider variety of circumstances.

Drawbacks:

SML approach requires b & Rm to be estimated. If our estimates are

poor, the resulting cost of equity will be inaccurate. For example, our
estimate of the market risk premium, 5.13% is based on about 26
quarters of returns. Using different time periods or different stocks
could result in different estimates.

Finally, as with the dividend growth model, here also we essentially rely
on the past to predict the future. Economic conditions can change
quickly; so as always, the past may not be a good guide to the future.
26
 Example
Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk
premium is 7%, and the risk-free rate is 6%. Alpha’s last dividend was
$2 per share, and the dividend is expected to grow at 8% indefinitely.
The stock currently sells for $30. What is Alpha’s cost of equity capital?
SML Approach:
REAlpha = R f + (RM - Rf) = 6% + 1.2 X 7% = 14.4%
Dividend Growth Model:
The projected dividend D1 = D0 (1 + g ) = $2 X 1.08 = $2.16
So the expected return using this approach is:
RE = (D1 / P0) + g = $2.16 / 30 + 0.08 = 15.2%
Our two estimates are reasonably close, so we should average them to
find that Alpha’s cost of equity is approximately 14.8 %.

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 Example
• On May 30, 2008, Alabama Power Co. had two issues of ordinary
preferred stock in equal proportion, with a $25 par value that traded
on the NYSE. One issue paid dividend of $1.30 annually per share and
sold for $21.05 per share. The other paid $1.46 per share annually
and sold for $24.35 per share. What is Alabama Power’s cost of
preferred stock?

• Using the first issue, we calculate that the cost of preferred stock is:

• RP = D / P0 = $1.30 / 21.05 = 6.2%

• Using the second issue, we calculate that the cost is:

• RP = D / P0 = $1.46 / 24.35 = 6%

• So, Alabama’s cost of preferred stock appears to be about 6.1%.

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 The Weighted Average Cost of Capital
• Now that we have the costs associated with the main
sources of capital the firm employs, we need to worry
about the specific mix.

• We will take this mix, which is the firm’s capital structure.

• Financial analysts frequently focus on a firm’s total

capitalization, which is the sum of its long-term debt and
equity. This is particularly true in determining cost of
capital; (short-term liabilities are generally ignored)

• We will not explicitly distinguish between total value and

total capitalization in the following discussion; the general
approach is applicable with either.
29
Book Values, Market Values, and Target Capital Structure

• Common stock price is $32 per share with 325 million shares o/s.
• A/P & Accrls. are not sources of investor-supplied capital, so excluded.
• No distinction made b/w common equity raised by issuing stock & 30R/E.
 THE CAPITAL STRUCTURE WEIGHTS
• We calculate market value of firm’s equity (E) by taking the number
of shares outstanding and multiplying it by the price per share.

• For long-term debt (D), we calculate this by multiplying the number

of bonds outstanding with the market price (because we need the
current market value of the firm) of the bond.

• The combined market value of the debt and equity V = E + D

• If we divide both sides by V , we can calculate the percentages of the

total capital represented by the debt and equity: 100% = E/V + D/V

• These percentages can be interpreted just like portfolio weights, and

they are often called the capital structure weights.

• WACC = (E/V ) X RE + (D/V ) X RD

• For short-term debt, the book (accounting) values and market values
31
should be somewhat similar, so we might use the book values as
 THE CAPITAL STRUCTURE WEIGHTS
• For example, if the total market value of a company’s stock were
calculated as $200 M & the total market value of the company’s debt
were calculated as $50 M, then the combined value would be $250 M

• Of this total, E/V = $200 M/250; M =80%, so 80% of the firm’s

financing would be equity & the remaining 20% would be debt.

• Pl note that the correct way to proceed is to use the market values of
the debt and equity.

• Under certain circumstances, such as when calculating figures for a

privately owned company, it may not be possible to get reliable
estimates of these quantities. In this case, we might go ahead and
use the accounting values for debt and equity or yield on similar
publicly traded debt.

32
 TAXES AND THE WEIGHTED AVERAGE COST OF CAPITAL
• There is one final issue we need to discuss. Recall that we are always
concerned with after-tax cash flows.

• If we are determining the discount rate appropriate to those cash

flows, then the discount rate also needs to be expressed on an after-
tax basis.

• As we discussed previously, the interest paid by a corporation is

deductible for tax purposes. Payments to stockholders, such as
dividends, are not.

• What this means, effectively, is that the government pays some of

the interest.

• Thus, in determining an after-tax discount rate, we need to

distinguish between the pretax and the after-tax cost of debt.
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 TAXES AND THE WEIGHTED AVERAGE COST OF CAPITAL
• To illustrate, suppose a firm borrows $1 million at 9% interest. The
corporate tax rate is 34%. What is the after-tax interest rate on this
loan?

• If we use the symbol TC to stand for the corporate tax rate, then the
after-tax rate can be written as RD (1 - TC ) = 9% (1 - 0.34) = 5.94%.

• Notice that, in general, the after-tax interest rate is simply equal to

the pretax rate multiplied by 1 minus the tax rate.

• Bringing together the various topics we have discussed in this

chapter, we now have the capital structure weights along with the
cost of equity and the after-tax cost of debt.

• To calculate the firm’s overall cost of capital, we multiply the capital

structure weights by the associated costs and add them up.

• WACC = (E/V ) X RE + (D/V ) X RD (1 - TC ) 34

 Interpretation of WEIGHTED AVERAGE COST OF CAPITAL
• This WACC has a straightforward interpretation.

• It is the overall return the firm must earn on its existing assets to
maintain the value of its stock.

• It is also the required return on any investments by the firm that

have essentially the same risks as existing operations.

• So, if we were evaluating the cash flows from a proposed expansion

of our existing operations, this is the discount rate we would use.

• If a firm uses preferred stock in its capital structure, then our

expression for the WACC needs a simple extension.

• WACC (E/V ) x RE + (P/V ) x RP + (D/V ) x RD (1 - T C )

• Where RP is the cost of preferred stock.

35
 Calculating the WACC
• The ABC Co. has 1.4 M shares of stock outstanding. The stock
currently sells for $20 per share. The firm’s debt is traded & was
recently quoted at 93% of face value. Total face value is $5 M & it is
currently priced to yield 11%. The risk-free rate is 8% & the market
risk premium is 7%. ABC has a beta of 0.74. If the corporate tax rate is
34%, what is its WACC?
• Cost of equity (RE) = 8% + 7% x 0.74 = 13.18%.
• Total value of the equity = 1.4 mln X $20 = $28 mln.
• Current market value of debt = 0.93 X $5 mln = $4.65 mln.
• Total market value (equity & debt) = $28 + 4.65 = $32.65 mln.
• The weight of equity (E/V) = $28 /$32.65 = 85.76%.
• Weight of debt (D/V) = 1 - 0.8576 = 14.24%.
• WACC = (E/V) X RE + (D/V) X RD X (1 - TC )
• = 0.8576 X 13.18% + 0.1424 X 11% X (1 - 0.34) = 12.34%
36
Summary of Capital Cost Calculations

37
 Determinants of WACC

• State of the financial markets

• Interest rates

• Investors’ aversion to risk & market risk premium

• Tax rates

• Debt structure

38
 Divisional and Project Costs of Capital
• As we have seen, using the WACC as the discount rate for future cash
flows is appropriate only when the proposed investment is similar to
the firm’s existing activities.

• For example if we are in the pizza business, and we are thinking of

opening a new location, then the WACC is the discount rate to use.
The same is true of a retailer thinking of a new store, a manufacturer
thinking of expanding production, or a consumer products company
thinking of expanding its markets.

• Nonetheless, despite the usefulness of the WACC as a benchmark,

there will clearly be situations in which the cash flows under
consideration have risks distinctly different from the overall firm.

• When we are evaluating investments with risks that are

substantially different from those of the overall firm, use of the
WACC will potentially lead to poor decisions. 39
 DIVISIONAL COST OF CAPITAL
• Same type of problem with WACC can arise in a corporation with
more than one lines of business. Imagine a corporation that has 2
divisions: regulated telephone company & electronics mfg operation.
• The phone operation has low risk; the electronics mfg has high risk.
• In this case, the firm’s overall cost of capital is really a mixture of two
different costs of capital, one for each division.
• If the two divisions were competing for resources, and the firm used
a single WACC as a cutoff, which division would tend to be awarded
greater funds for investment?
• The answer is that the riskier division would tend to have greater
returns (ignoring the greater risk), so it would tend to be the
“winner.” The less glamorous operation might have great profit
potential that would end up being ignored.
• So we need to develop separate divisional costs of capital.
40
 THE PURE PLAY APPROACH
• In such cases once again using the firm’s WACC inappropriately can lead
to problems. How can we come up with appropriate discount rates in
such circumstances?

• Because we cannot observe the returns on these investments, there

generally is no direct way of coming up with a beta. Instead, what we
must do is examine other investments outside the firm that are in the
same risk class & use the market required return on these investments
as the discount rate.

• For example, going back to our telephone division, suppose we want to

come up with a discount rate to use for that division. What we could do
is identify several other phone companies that have publicly traded
securities. We might find that a typical phone company that has a beta
of .80, AA-rated debt, and a capital structure that is about 50% debt &
50% equity.

• Using this info, we could develop a WACC for a typical phone company
41
and use this as our discount rate.
 THE PURE PLAY APPROACH
• What we try to do here is to find companies that focus as exclusively
as possible on the type of project in which we are interested. Our
approach, therefore, is called the pure play approach to estimating
the required return on an investment.
• Suppose McDonald’s decides to enter the personal computer and
network server business with a line of machines called McPuters.

• Risks involved are quite different from those in the fast food business.

• McDonald’s would need to look at companies already in the personal

computer business to compute a cost of capital for the new division.

• An obvious pure play candidate would be Dell, which is

predominantly in this line of business.

• HP, on the other hand, would not be as good a choice because its
primary focus is elsewhere, and it has many different product lines.
42
 THE SUBJECTIVE APPROACH
• We may not be able to find any suitable companies. In this case, how
to objectively determine a discount rate. Because of the difficulties in
objectively establishing discount rates for individual projects, firms
often adopt an approach that involves making subjective adjustments
to the overall WACC. Suppose a firm has overall WACC of 14%. It
places all proposed projects into 4 categories as follows:

43
 THE SML AND THE WACC
• In Figure below, we have plotted an SML corresponding to a risk-free
rate of 7% and a market risk premium of 8%. To keep things simple,
we consider an all-equity company with a beta of 1.

• As we have indicated, the WACC and the cost of equity are exactly
equal to 15% for this company because there is no debt.

• Suppose your firm uses its WACC to evaluate all investments. This
means that any investment with a return of greater than 15% will be
accepted and any investment with a return of less than 15% will be
rejected.

• We know from our study of risk and return, however, that a desirable
investment is one that plots above the SML.

• Using the WACC for all types of projects can result in the firm’s
incorrectly accepting relatively risky projects and incorrectly rejecting
relatively safe ones. 44
 THE SML AND THE WACC
• Consider point A. This project has a beta of .60 compared to the firm’s
beta of 1.0. It has an expected return of 14%. Is this a desirable
investment?
• If we use the WACC as a cutoff, then this project will be rejected
because its return is less than 15%.
• However, the answer is yes because its required return is only:
• Required return = Rf +bA ( RM - R f ) = 7% + 0.60 x 8% = 11.8%
• This example illustrates that a firm that uses its WACC as a cutoff will
tend to reject profitable projects with risks less than those of the overall
firm.
• Now consider point B. This project has a beta of b=1.2. It offers a 16%
return, which exceeds the firm’s WACC. This is not a good investment,
because, given its level of systematic risk, its return should be 16.6%. So
the second error that will arise if we use the WACC as a cutoff is that we
will tend to make unprofitable investments 45
SML and the WACC

46
 THE SUBJECTIVE APPROACH
• The effect of this crude partitioning is to assume that all projects either
fall into one of 3 risk classes or else mandatory. In the last case, the cost
of capital is irrelevant because the project must be taken.

• With the subjective approach, the firm’s WACC may change through
time as economic conditions change. As this happens, the discount rates
for the different types of projects will also change.

• Within each risk class, some projects will presumably have more risk
than others, and the danger of making incorrect decisions still exists.

• Comparing with earlier figure, we see that similar problems exist; but
the magnitude of the potential error is less with the subjective
approach. For example, the project labeled A would be accepted if the
WACC were used, but it is rejected once it is classified as a high risk
investment.

• What this illustrates is that some risk adjustment, even if it is subjective,

47
is probably better than no risk adjustment.
The Security Market Line & the Subjective Approach

48
 Flotation Costs and the WACC
• If a company accepts a new project, it may be required to issue, or
float, new bonds and stocks. This means that the firm will incur some
costs, which we call flotation costs .
1. If $100 mln are required we need to sell enough equity to raise $100
million after covering the flotation costs. In other words:
Amount raised = $100/(1 - 0.10) = $100/0.9 = $111.11 M
2. Suppose Weinstein Corporation has a target capital structure of 80 %
equity & 20 % debt. The flotation costs for equity are 20 % of the
amount raised; the flotation costs for debt are 6%. If Weinstein needs
$65 million for a new manufacturing facility, what is the true cost
once flotation costs are considered?
• Weighted average flotation cost = 80% X 0.20 + 20% X 0.06 = 17.2%
• The project cost is $65 mln when we ignore flotation costs. If we
include them, then true cost = $65 mln / (1 - fA ) = $65 / 0.828 = $78.5
mln, again illustrating that flotation costs can be considerable.
49
 FLOTATION COSTS AND NPV
• To illustrate how flotation costs can be included in an NPV analysis
suppose the ABC has target debt equity ratio of 100%. It is planning
building a new $500,000 printing plant, expected to generate after-
tax cash flows of $73,150/year forever. The tax rate is 34%.
• What is the NPV of the new printing plant if there are two financing
options:
1. A $500,000 new issue of common stock: The floatation costs would
be 10% of the amount raised. The required return on the company’s
new equity is 20%.
2. A $500,000 issue of 30-year bonds: The issuance costs would be 2%
of the proceeds. The company can raise new debt at 10%.

• To begin, because printing is the company’s main line of business, we

will use the company’s weighted average cost of capital to value the
new printing plant:
WACC = .50 X 20% + .50 X 10% X (1 - .34) = 13.3% 50
 FLOTATION COSTS AND NPV
• Because the cash flows are $73,150 per year forever, the PV of the
cash flows at 13.3% per year is = $73,150/.133 = $550,000.

• If we ignore flotation costs, the NPV is: $550,000 - 500,000 = $50,000

• With no flotation costs, the project generates an NPV that is greater

than zero, so it should be accepted.

• Here what we are missing is financing arrangements and issue costs?

From the information given, we know that the flotation costs are 2%
for debt and 10% for equity.

• Because ABC uses equal amounts of debt and equity, the weighted
average flotation cost, fA = .50 X 10% + .50 X 2% = 6%

The true cost, once we include flotation costs = $500,000/(1 - f A )

= $500,000 / .94 = $531,915. Because the NPV of the cash flows is
$50,000, the plant has an NPV of $550,000 - 531,915 = $18,085 51
 FLOTATION COSTS and INTERNAL EQUITY
• Our discussion of flotation costs to this point implicitly assumes that
firms always have to raise the capital needed for new investments.

• In reality, most firms rarely sell equity at all. Instead, their internally
generated cash flow is sufficient to cover the equity portion of their
capital spending. Only the debt portion must be raised externally.

• The use of internal equity doesn’t change our approach. However, we

now assign a value of zero to the flotation cost of equity because
there is no such cost. In our ABC example, the weighted average
flotation cost would therefore be:

• fA = (EV) X fE + (DV) X fD = 0.50 X 0% + 0.50 X 2% = 1%

• Notice that whether equity is generated internally or externally

makes a big difference because external equity has a relatively high
flotation cost. 52
 Marginal Cost of Capital
• The cost of capital may increase as the capital budget increases—this
is called an increasing/marginal cost of capital.
• As we discussed earlier, flotation costs associated with issuing new
equity can be quite high. This means that the cost of capital will
increase once a company has invested all of its internally generated
cash and must sell new common stock.
• In addition, once a firm has used up its normal credit lines & seeks
additional debt capital, it may encounter increase in its cost of debt.
• This means that a project might have a positive NPV if it is part of a
$10 million capital budget but the same project might have a
negative NPV if it is part of a $20 million capital budget because the
cost of capital might increase.
• Fortunately, these problems rarely occur for most firms, especially
those that are stable and well established. When a rising cost of
capital is encountered, we would proceed as indicated below. 53
Internal opportunity & Marginal cost

54
 Summary of facts about WACC
• Using WACC in capital evaluation does not imply that each
investment is financed using the mix of all financing sources.

• WACC is a forward-looking concept.

• WACC is calculated on an after-tax basis.

• WACC does not remain constant for all levels of required financing.

• WACC includes the cost of financing the long-term funds only.

• A new project will have a positive NPV only if its return exceeds what
the financial markets offer on investments of similar risk.

• This minimum required return is called the cost of capital associated

with the project.
Cost of Capital 55
 Calculating Cost of Equity
• The Down and Out Co. just issued a dividend of $2.16 per
share on its common stock. The company is expected to
maintain a constant 5 percent growth rate in its dividends
indefinitely. If the stock sells for $30 a share, what is the
company's cost of equity?
• Solution
• With the information given, we can find the cost of equity
using the dividend growth model. Using this model, the
cost of equity is:
• RE = (D1/P0) + g
• RE = [$2.16(1.05)/$30] + 0.05 = 0.13 or 13%
Cost of Capital 56
 Calculating Cost of Equity
• The Up and Coming Corporation's common stock has a
beta of 1.2. If the risk-free rate is 5.5 percent and the
expected return on the market is 13 percent, what is the
company's cost of equity capital? (Do not round your
intermediate calculations.)

• Solution

• Here we have information to calculate the cost of equity

using the CAPM. The cost of equity is:

• RE = Rrf + (RM – Rrf)xb

• RE = 0.055 + (0.13 – 0.055)x1.2 = 0.145 or 14.5%

Cost of Capital 57
 Calculating the Cost of Equity
• Suppose stock in ABC Corporation has a beta of 0.80. The market risk
premium is 6 %, and the risk-free rate is 6 %. ABC’s last dividend was
$1.20 per share & the dividend is expected to grow at 8 %
indefinitely. The stock currently sells for $45 per share. What is it’s
cost of equity?
Solution
SML approach: Based on the information given, the expected return
on ABC’s common stock is:
RE = Rf + b X ( RM Rf ) = 6% + 0.80 X 6% = 10.80%

Dividend growth model: The projected dividend is:

D1 = D0 X (1 + g ) = $1.20 X 1.08 = $1.296.
The expected return using this approach is:
RE = D1 / P0 + g = $1.2 96 / 45 + .08 = 10.88%
Cost of equity = 10.84%
Cost of Capital 58
 Calculating the WACC
• In addition to the information given in the previous problem, suppose
ABC has a target debt equity ratio of 50%. Its cost of debt is 9%
before taxes. If the tax rate is 35 percent, what is the WACC?
• Solution
• Because the target debt–equity ratio is .50, ABC uses $.50 in debt for
every $1 in equity. In other words, ABC’s target capital structure is
.5/1.5 debt and 1/1.5 equity, or 1/3 & 2/3 respectively.

The WACC is thus:

WACC = (E/V) X R E + (D/V) X R D X (1 - T C )
= 2/3 X 10.84% + 1/3 X 9% X (1 - .35)
= 9.177%

Cost of Capital 59
 Flotation Costs
• Suppose in the previous problem ABC is seeking $30 million for a new
project. The necessary funds will have to be raised externally. ABC’s
flotation costs for selling debt and equity are 2% and 16%,
respectively. If flotation costs are considered, what is the true cost of
the new project?
Solution
Because ABC uses both debt and equity to finance its operations, we
first need the weighted average flotation cost. As in the previous
problem, the percentage of equity & debt financing is 2/3 & 1/3
respectively so the weighted average cost is:

fA = (E/V) X fE + (D/V) X fD = 2 / 3 X 16% + 1 / 3 X 2% = 11.33%

If ABC needs $30 million after flotation costs, then the true cost of
the project is:
$30 million / (1 - f A ) = $30 million / 0.8867 = $33.83 million.
Cost of Capital 60
 Calculating Cost of Equity
• Stock in Country Road Industries has a beta of 0.58. The market
risk premium is 8 %, and T-bills are currently yielding 5.5 %. The
company's most recent dividend was $1.6 per share, and dividends
are expected to grow at a 4.5% annual rate indefinitely. If the stock
sells for $36 per share, what is your best estimate of the
company's cost of equity?
• Solution
• We have the information available to calculate the cost of equity
using the CAPM and the Dividend Growth Model.
SML/CAPM: RE = 0.06+0.58(0.08) = 0.1014 or 10.14%
Dividend growth model: RE=((1.6(1+0.045))/36)+0.045 = 9.14%
• We cannot definitively say one of the estimates is incorrect. So we
can use the average: RE = ((0.1014)+(0.0914))/2 = 9.64%
Cost of Capital 61
 Estimating the Growth Rate
• Suppose In a Found Ltd. just issued a dividend of $1.43 per share on
its common stock. The company paid dividends of $1.05, $1.12,
$1.19, and $1.30 per share in the last four years. If the stock currently
sells for $45, what is your best estimate of the company's cost of
equity capital using the arithmetic average growth rate and
geometric average growth rate in dividends.
• g1 = ($1.12 – 1.05)/$1.05 = 6.67%; g2 = ($1.19 – 1.12)/$1.12 =
6.25%; g3 = ($1.30 – 1.19)/$1.19 = 9.24%; g 4 = ($1.43 –
1.30)/$1.30 = 10.00%
• Avg arith growth rate in div=(.0677+.0625+.0924+.1000)/4 = 8.04%
• Cost of equity RE = [$1.43(1.0804)/$45.00] + .0804 = .1147 or 11.47%
• Calculating the geometric growth rate in dividends, we find:
4
$1.43 = $1.05(1 + g) or g = 0.0803 or 8.03% The cost of equity using
the geometric dividend growth rate is: R E = [$1.43(1.0803)/$45.00] +
.0803 = .1146 or 11.46% . Cost of Capital 62
 Calculating Cost of Preferred Stock
• Holdup Bank has an issue of preferred stock with a
$6 stated dividend that just sold for $96 per share.
What is the bank’s cost of preferred stock?

• Rp = $6/$96 = .06 = 6%

Cost of Capital 63
 Calculating WACC
• Mullineaux Inc has a target capital structure of 60% common stock,
5% preferred stock & 35% debt. Its cost of equity is 14%, the cost of
preferred stock is 6% & cost of debt is 8%. Relevant tax rate is 35%.

a) What is Mullineaux’s WACC?

b) The company president has approached you about Mullineaux’s
capital structure. He wants to know why the company doesn’t use
more preferred stock financing because it costs less than debt.
What would you tell the president?
• Solution

a) WACC = 0.60(0.14) + (0.05)(0.06) + (0.35)(.08)(1 - 0.35) = 10 %

b) Actual cost of Debt (which is after tax) = .08 X .65 = 5.2% as
against cost of preferred stock of 6%

64
 Taxes and WACC
• Sixx AM Manufacturing has a target debt equity ratio of .65. Its cost
of equity is 15 percent, and its cost of debt is 9 percent. If the tax rate
is 35 percent, what is the company’s WACC?

• WACC = (1/1.65)(0.15) + (0.65/1.65)(0.09)(1 - 0.35)

= .09 + .02 = 11 %

65
 Divisional cost of capital
Wd = 30%; Wps = 10%; Wcs = 60%
Debt Borrowing Rate = 15%
Preferred Yield = 13%
Tax Rate = 40%
Beta for health foods = 0.90
Beta for specialty metals = 1.30
Rrf = 12% Rm 17%
Find out WACC = ?

Cost of Debt = 15X(1 - .4) = 15 X .6 = 9%

Cost of Preferred Stock = 13%
Cost of Equity for Health Food = 12 + (17 – 12) X .9 = 16.5%
Cost of Equity for Specialty Metals = 12 + (17 – 12) X 1.3 = 18.5%

WACC for Health Foods = .3 X 9 + .1 X 13 + .6 X 16.5 = 13.9%

WACC for Specialty Metals = .3CostXof9Capital

+ .1 X 13 + .6 X 18.5 = 15.1% 66
 cost of capital
• Zapata Enterprises is financed by two sources of funds: bonds and
common stock. The capital structure consists of B dollar of bonds and
S dollar of stock, where the amounts represent the market values.
Assume that B is $3 million and S is $7 million. The bonds have a 14 %
yield to maturity, and the stock is expected to pay $500,000 in
dividends this year. The growth rate of dividends has been 11% and is
expected to continue at the same rate. Find the cost of capital the
corporation tax rate on income is 40%.
• Solution

Bond = 3 mln Stock = 7 mln

Wb = .3 Ws = .7
Cost of Bond = 14(.6)=8.4% Cost of Stock=D/P0+g=500,000+.11=18.14%
7000,000
WACC = .3 X 8.4 + .7 X 18.14 = 15.218%

Cost of Capital 67
 Cost of new equity vs retained earnings
• Compute the cost of Retained Earnings and the cost of New Equity
under each case.
a) D1= $4.20, P0 =$55, g=5%, F= $3.80
b) Earnings at the end of period 1= $8, Payout ratio= 25%, P0= $32,
g= 5%, F= $1
c) Dividend at the start of the period 1= $3, P0= $60, g=9%, F= $3.50

Retained Earning New Equity

a) D1/P0+g = 4.20/55+.05=12.63% D1/(P0 – F)+g = 4.2/(55–3.8)+.05=13.2%

b) D1/P0+g = 2/32+.05=1.25% D1/(P0 – F)+g = 2/(32–1)+.05=11.45%

c) D1/P0+g = 3x1.09/60+.09=14.45% D1/(P0 – F)+g = 3.27/(60–3.5)+.09=14.78%

68
• Business has been good for Keystone Controls Systems, as indicated
by the four-year growth in EPS. The Earnings have been grown from
$1.00 to $1.63
a) Determine the compound annual rate of growth in earnings.
b) Project the earnings for the next year.
c) If the dividend payout is 40% and price of the stock is $50, compute
K. Assume the growth in dividends will remain constant in future.
d) If the floatation cost is $3.75, compute the cost of new common stok.

n
a) PV X (1 + g) or 1 X (1 + g)4= 1.63 therefore g = 12.99% (Fin Calcltr)
b) 1.63 X 1.1299 = 1.84
c) Earnings 1.84, Payout = .736 therefore K .736/50 + .1299 = 14.45%
d) K = .736 / (50 – 3.75) + .1299 = 14.58%
Cost of Capital 69