CHAPTER 14
COST OF CAPITAL
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
KEY CONCEPTS AND SKILLS
• Know how to determine a firm’s cost of
equity capital
• Know how to determine a firm’s cost of
debt
• Know how to determine a firm’s overall
cost of capital
14-2
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
CHAPTER OUTLINE
• The Cost of Capital: Some Preliminaries
• The Cost of Equity
• The Costs of Debt and Preferred Stock
• The Weighted Average Cost of Capital
14-3
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WHY COST OF CAPITAL IS
IMPORTANT
• We know that the return earned on assets
depends on the risk of those assets
• The return to an investor is the same as
the cost to the company
• Our cost of capital provides us with an
indication of how the market views the risk
of our assets
• Knowing our cost of capital can also help
us determine our required return for capital
budgeting projects
14-4
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REQUIRED RETURN
• The required return is the same as the
appropriate discount rate and is based on
the risk of the cash flows
• We need to know the required return for
an investment before we can compute the
NPV and make a decision about whether
or not to take the investment
• We need to earn at least the required
return to compensate our investors for the
financing they have provided
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COST OF EQUITY
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm
Business risk
Financial risk
• There are two major methods for
determining the cost of equity
Dividend growth model
SML, or CAPM
14-6
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THE DIVIDEND GROWTH MODEL
APPROACH
• Start with the dividend growth model
formula and rearrange to solve for RE
D1
P0
RE g
D1
RE g
P0
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EXAMPLE: DIVIDEND
GROWTH MODEL
• Suppose that your company is
expected to pay a dividend of $1.50
per share next year.
• There has been a steady growth in
dividends of 5.1% per year and the
market expects that to continue.
• The current price is $25. What is the
cost of equity?
14-8
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EXAMPLE: DIVIDEND
GROWTH MODEL
• Suppose that your company is
expected to pay a dividend of $1.50
per share next year.
• There has been a steady growth in
dividends of 5.1% per year and the
market expects that to continue.
• The current price is $25. What is the
cost of equity?
1 . 50
RE . 051 . 111 11 . 1 %
25
14-9
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EXAMPLE: ESTIMATING THE
DIVIDEND GROWTH RATE
• One method for estimating the growth rate
is to use the historical average
Year Dividend Percent Change
2008 1.23 -
2009 1.30 (1.30 – 1.23) / 1.23 = 5.7%
2010 1.36 (1.36 – 1.30) / 1.30 = 4.6%
2011 1.43 (1.43 – 1.36) / 1.36 = 5.1%
2012 1.50 (1.50 – 1.43) / 1.43 = 4.9%
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
14-10
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ADVANTAGES AND 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 --- an increase in g of 1% increases the
cost of equity by 1%
Does not explicitly consider risk
14-11
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THE SML 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,
RE R f E (E (RM ) R f )
14-12
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EXAMPLE - SML
• Suppose your company has an equity
beta of .58, and the current risk-free
rate is 6.1%. If the expected market
risk premium is 8.6%, what is your
cost of equity capital?
14-13
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EXAMPLE - SML
• Suppose your company has an equity
beta of .58, and the current risk-free rate
is 6.1%. If the expected market risk
premium is 8.6%, what is your cost of
equity capital?
RE = 6.1% + .58(8.6%) = 11.1%
• Since we came up with similar numbers
using both the dividend growth model
and the SML approach, we should feel
good about our estimate
14-14
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ADVANTAGES AND
DISADVANTAGES OF SML
• Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can
estimate 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 using the past to predict the future, which
is not always reliable
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EXAMPLE – COST OF EQUITY
• Suppose our company has a beta of 1.5. The
market risk premium is expected to be 9%, and
the current risk-free rate is 6%.
• We have used analysts’ estimates to determine
that the market believes our dividends will grow
at 6% per year and our last dividend was $2.
• Our stock is currently selling for $15.65. What is
our cost of equity?
Using SML: RE = 6% + 1.5(9%) = 19.5%
Using DGM: RE = [2(1.06) / 15.65] + .06 =
19.55%
14-16
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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
• 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
14-17
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EXAMPLE: COST OF DEBT
• Suppose we have a bond issue currently
outstanding that has 25 years left to
maturity.
• The coupon rate is 9%, and coupons are paid
semiannually.
• The bond is currently selling for $908.72 per
$1,000 bond.
• What is the cost of debt?
N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT
I/Y = 5%; YTM = 5(2) = 10%
14-18
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COST OF PREFERRED STOCK
• Reminders
Preferred stock generally pays a constant dividend
each period
Dividends are expected to be paid every period
forever
• Preferred stock is a perpetuity, so we take
the perpetuity formula, rearrange and solve
for RP
• RP = D / P0
14-19
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EXAMPLE: COST OF PREFERRED
STOCK
• Your company has preferred stock that has an
annual dividend of $3.
• If the current price is $25, what is the cost of
preferred stock?
• RP = 3 / 25 = 12%
14-20
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THE WEIGHTED AVERAGE COST OF
CAPITAL
• We can use the individual costs of capital
that we have computed to get our
“average” cost of capital for the firm
• This “average” is the required return on
the firm’s 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 is used
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CAPITAL STRUCTURE WEIGHTS
• Notation
E = market value of equity = # of
outstanding shares times price per share
D = market value of debt = # of
outstanding bonds times bond price
V = market value of the firm = D + E
• Weights
wE = E/V = percent financed with equity
wD = D/V = percent financed with debt
14-22
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EXAMPLE: CAPITAL STRUCTURE
WEIGHTS
• Suppose you have a market value of equity
equal to $500 million and a market value of
debt equal to $475 million.
What are the capital structure weights?
14-23
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EXAMPLE: CAPITAL STRUCTURE
WEIGHTS
• Suppose you have a market value of equity
equal to $500 million and a market value of
debt equal to $475 million.
What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%
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TAXES AND THE WACC
• We are concerned with after-tax cash flows, so we
also need to consider the effect of taxes on the
various costs of capital
• Interest expense reduces our tax liability
This reduction in taxes reduces our cost of debt
After-tax cost of debt = RD(1-TC)
• Dividends are not tax deductible, so there is no tax
impact on the cost of equity
• WACC = wERE + wDRD(1-TC)
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EXTENDED EXAMPLE: WACC - I
• Equity • Debt Information
Information $1 billion in
50 million shares outstanding debt
(face value)
$80 per share
Current quote = 110
Beta = 1.15 Coupon rate = 9%,
Market risk semiannual coupons
premium = 9% 15 years to maturity
Risk-free rate = • Tax rate = 40%
5%
14-26
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EXTENDED EXAMPLE: WACC - II
• What is the cost of equity?
• What is the cost of debt?
• What is the after-tax cost of debt?
14-27
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EXTENDED EXAMPLE: WACC - II
• What is the cost of equity?
RE = 5 + 1.15(9) = 15.35%
• What is the cost of debt?
N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT
I/Y = 3.9268
RD = 3.927(2) = 7.854%
• What is the after-tax cost of debt?
RD(1-TC) = 7.854(1-.4) = 4.712%
14-28
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EXTENDED EXAMPLE: WACC - III
• What are the capital structure weights?
• What is the WACC?
14-29
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EXTENDED EXAMPLE: WACC - III
• What are the capital structure weights?
E = 50 million (80) = 4 billion
D = 1 billion (1.10) = 1.1 billion
V = 4 + 1.1 = 5.1 billion
wE = E/V = 4 / 5.1 = .7843
wD = D/V = 1.1 / 5.1 = .2157
• What is the WACC?
WACC = .7843(15.35%) + .2157(4.712%) =
13.06%
14-30
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SML PROBLEM
• The City Street Corporation's common
stock has a beta of 1.2. The risk-free
rate is 3.5 percent and the expected
return on the market is 13 percent.
What is the firm's cost of equity?
14-31
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TABLE 14.1 COST OF EQUITY
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TABLE 14.1 COST OF DEBT
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TABLE 14.1 WACC
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CHAPTER 14
END OF CHAPTER
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