Cost of Capital

Chapter 13
COST OF
CAPITAL
Alex Tajirian
Cost of Capital 13-2
1 OBJECTIVE
# Managing the right-hand-side of the B/S
# By now, for valuation analysis, we know:

! criteria: NPV, IRR, payback
! what the relevant CFs are
! how to compute net CFs
! how to introduce forecast error in CFs (WHAT IF,. . . )
# Sources of financing:
Debt, equity, retained earnings, preferred stock, warrants, venture
capital, and bank loans, strategic alliances.
! Bank loans, venture capital, and warrants not discussed
! To simplify, we concentrate only on debt, equity, and retained

earnings.
# Cost of financing = cost of capital = ?

! Definition: The rate that must be earned to satisfy the
required rate of return of the firm's investors.
! What is the cost of each source of financing?
! What is a project's cost of capital?
# Why might cost of capital in Japan be lower than in U.S.?
© morevalue.com, 1997
Alex Tajirian
2 MOTIVATION
2.1 WHY IS COST OF CAPITAL IMPORTANT?
If financing cost is reduced Y NPV increases Y more projects end

up with NPV > 0 Y more wealth created to shareholders.
2.2 SOME PRELIMINARIES

! Minimum required return / cost of capital= that particular
discount rate “k” that makes NPV = 0.
! The return generated by a security is the cost of that security

to the company that issued it.
]
cost of capital to the firm = reward to investors.
! The cost of capital depends primarily on the use of funds, i.e.,

the risk of the CFs, not on the source.
Q risk of CFs (systematic risk)
Q company capital structure
Alex Tajirian
2.3 COST COMPONENTS

Case 1 Assume firm has no debt & has retained earnings.
Remember from the chapter on Performance Measures:

Net Income = total dividend + retained earnings
If a company cannot find profitable projects, i.e., projects with return

at least equal to ks , then the firm should distribute retained earnings
to shareholders as dividends.
Thus, if the company is retaining your money, then the minimum

acceptable reward to you (an average investor) is the required return
on equity Y required return on retained earnings = ks / required
return on equity.
But reward to investor = cost of capital to the firm.
ˆ required return on equity = cost of retained earnings.
Case 2
Now suppose firm needs to issue new equity for an expansion
project. Obviously
ke > ks ] (cost of new equity) > (cost of retained earnings) ]

(required return on new equity) > (required return on retained
earnings)
since some transactions (floatation) costs have to be paid to

investment banks for assisting firm in selling the new securities.
Alex Tajirian
Case 3
If a company has a "good" project (NPV > 0), should it be financed
using equity?
Not necessarily, firm should consider using debt.
2.4 OUTLINE
Given a company's target capital structure,
Step 1: Estimate cost of each component
Step 2: Calculate the cost of the combination of financing
sources, i.e., company WACC
Alex Tajirian
In general,
WACC ' sum of weighted rewards to firm ) s capital providers

' w d(cost of debt) % w s(cost of equity)
Debt Debt
where, wd ' '
Assets Debt % Equity
Equity
ws ' , and w d % ws ' 1
Debt % Equity
where,
WACC = Weighted Average Cost of Capital.
Debt = Market value of the company’s debt
Equity = market value of the company’s equity
wi = the weights (proportions) of each source of capital,

based on the company’s optimal/target financing
mix (capital structure).
Notes.
(a) It is not the source of financing that
determined the cost of capital.
(b) B/S weights need not be reflective of market
values.
(c) Weights are based on the optimal company’s
source of financing; the topic of next chapter.
Alex Tajirian
CALCULATING COST OF EACH COMPONENT

We first start with the cost of each source of new capital, then take
their weighted average. Note, the weights are given by the optimal
capital structure.
2.5 COST OF RETAINED EARNINGS, ks

L Cost of retained earnings = required rate of return on equity
? What are possible approaches to estimate ks
Alex Tajirian
Example: Calculating Cost of Retained Earnings

Given: kRF = 7% Dividend0 = $4.19
kM - kRF = 8.5% P0 = $50
$ = 0.847 g = 5%
ks = ?
Solution:
L Two approaches when company stock is trading on an exchange:
# 2.5.1 CAPM Approach
ks ' k RF % (k M & k RF)$s
' 7.0% % (8.5%)(.847)

' 14.2%
Alex Tajirian
# 2.5.2 DCF Approach:
Given: Dividend0 = $4.19, g = 5%, p0 = $50

ks = ?
Solution:
From equation (4) chapter 7, we have:
Dividend1
ks ' % g 7
P0
Dividend0 × (1 % g)
' % g
P0
4.19 × (1.05)
' % .05
$50
' 0.088 % 0.05 ' 13.8%
ˆ You can use the average of these two approaches = 14%.
Alex Tajirian
2.6 COST OF NEWLY ISSUED COMMON STOCK, ke

# Floatation costs (F) are not part of capital budgeting CFS. Thus, if
existing shareholders finance projects using new equity, they require
a higher return to cover this cost Y ke > ks .
# If P0 = $50 and F = 15% of issue price, then additional cost per share
= (50)(15%) = $7.5.
Alex Tajirian
Example: Calculating Component Cost of New Equity

Given:
F = 15% of issue price, Dividend0 = 4.19 , g = 5% , P0 = $50
ke = ?
Solution:
Using equation (4), Chapter 7, and including F, we have:
# Accounting vs. Financial/Economic Valuation
Dividend1
ke ' % g
net value of new equity per share
Dividend1
' % g
issue price & floatation cost
Dividend1
' % g
P0 & (P0)(F)
Dividend0 × (1% g)
' % g
P0(1& F)
$4.19 × (1.05)
' % .05 ' 15.4%
$50(1& .15)
Alex Tajirian
2.7 COST OF PREFERRED STOCK, kps

Given:
Dividendps = $10 annually, perpetually paid
price (Pps) = $113.1 per share (market price)
F = floatation cost = $2.00 per share
Solution:
Using equation (3), from Chapter 7, and including F, we have:
Dividend ps
kps '
P ps& F
$10 $10
' ' ' 0.09 ' 9.0%
$113.1& 2.00 $111.1
Note. No tax adjustment is needed since preferred dividends are

paid from after-tax income.
Alex Tajirian
2.8 COST OF DEBT = kd (1-T)

kd is the interest paid to new bond holders.
But since interest is tax deductible Y
effective cost of debt = after-tax cost of debt
= before tax cost - tax benefit
= kd - T × kd
= kd(1 - T)
Example: Calculating Component Cost of Debt

Given: Semiannual bond; coupon rate = 12%; years to maturity = 15;
price of a similar bond = $1,153.72; T = 40%
kd(1-T) = ?
Alex Tajirian
Solution: Based on formula for PV of bonds

Step 1: Calculate semi-annual coupon
Step 2: Use Trial & Error methods
Trial & Error Method:
coupon interest × par value 12% × $1,000

coupon ' ' ' 60
2 2
PV ' SUM of discounted CFs

Y $1,153.75 ' 60(PVIFAk d ,30 ) % $1,000(PVIFk d ,30)
2 2
Try k d ' 6%
2
Y 60(PVIFA6,30) % 1,000(PVIF6,30)
' 60(13.7648) % 1,000(.1741) ' 825.88 % 174.1 ' 999.98
< price ' $1,153.72
You have to try a number < 6%, say k d ' 4%
2
Y 60(17.2920)% 1,000(.3083) ' 1,346.35 > price
If you try kd/2 = 5%, you will get it right.

ˆ kd = 5% x 2 = 10% Y kd(1-T) = 10%(0.6) = 6%
Alex Tajirian
Example: Calculating Company WACC

Given:
! optimal proportions are: 30% Debt, 10% Preferred, 60% common
equity
! Retained Earnings = $300,000
! T = 40%
! Value of k from above examples is used.
! $ financing needed = $200,000
Solution:
If retained earnings are to be used to finance projects, as in this
example,
WACC ' w dk d(1& T) % w psk ps % w sk s % w ek e
' 0.3(10%)(0.6) % 0.1(9%) % 0.6(14%) % 0

' 1.8% % 0.9% % 8.4%
' 11.1%
? What is the amount raised of each component?
Alex Tajirian
? What is the maximum amount of financing that can be sustained

without issuing new equity?
Alex Tajirian
Where do the weights come from?

# Possibilities include:
! proportional current book value of each component
! proportional current market value of each component
! target capital structure
# Should short-term debt be included in wd?
Alex Tajirian
3 WHAT IS A PROJECT'S COST OF CAPITAL
? Suppose debt = 0 and project is financed through 100% equity.

Should firm use ks?
If you use ks, then you are implicitly assuming that the risk of
projects = risk of company
L Remember: discount rate reflects risk of CFs.
If company has no debt, then

kproject = kRF + (km - kRF)$project
Alex Tajirian
USING COMPANY k
Vs. Project k
k
Project risk < firm’s Project risk > firm’s
firm’s
k
risk-
Reject good projects Accept Bad Projects
free
Beta
Alex Tajirian
3.1 Project Required Return (k project) and NPV.

if and
project $ Company (kproject - WACC) NPVproject NPVWACC implication of using
Y
risk risk NPVWACC
yes + - + accepting bad projects
yes + + + no problem
No - + - rejecting good projects
- - no problem
No -
NPVproject = NPV using k project as the discount rate
NPVWACC = NPV using company WACC as the discount rate
L use k = kproject to appropriately incorporate project CF-risk
Alex Tajirian
3.2 PROJECT COST OF CAPITAL IN PRACTICE.

! To incorporate risk of CFS, companies have adopted a "crude" way
of calculating kproject. The "hurdle rate" is one such method. It reflects
both project risk and cost of capital.
hurdle rate = company WACC ± risk premium
! Assume company WACC = 15%,
hurdle rates
project category discount rate (k) risk premium
speculative venture 30% 15%
new product 25% 10%
expansion of existing
15% 0
business
cost of improvement,
10% -5%
known technology
Alex Tajirian
PROJECT COST OF CAPITAL
Does Firm
Have Debt?
No Yes
Is Project Same Is Project Same

Risk As Firm? Risk As Firm?
Yes No Yes No
Use Firm Use k Reflecting Use Firm Use

K Project Beta WACC “Hurdle Rate”
Alex Tajirian
4 COST OF CAPITAL (k) IN JAPAN & U.S.?

Unlike U.S. firms, Japanese firms have traditionally relied more on bank
loans as a source of financing. This has enhanced firm monitoring by
creditors (banks). Recently, debt and equity financing has increased.
German firms have also traditionally relied more heavily on bank loans.
? Why might the cost be lower in Japan?

# Keiretsu (Companies aligned with financial giants)
! Agency problem lower, thus, k is lower
! Floatation cost is low
# Government loans and subsidies, especially for R&D.
Alex Tajirian
5 SUMMARY
Dividend Dividendps
T From P0 ' Y k ps '
k P ps
Dividend ps
Including Floatation costs Y kps '
P ps& F
Dividend1 Dividend1
T From P0 ' Yk ' % g
k& g P0
Dividend1
including Floatation costs Y k e ' % g
P0(1& F)
T
Long-term financing used for long-term projects. Short-term financing is used only if there
is a temporary mismatch between timing of inflows and outflows.
T WACC ' wdkd(1& T) % weke % wpskps % wsks
Note. Only debt is tax deductible.
The weights are determined by the target capital structure. The target proportions are not
book values.
Alex Tajirian
6 QUESTIONS
I. Agree/Disagree-Explain
1 If a manager, with no finance background, uses the firm's WACC as the cost of project
finance, then he/she would be accepting bad projects.
2 A project's cost of capital > company WACC.
3 kd is the cost of debt financing to a firm.
4 Consider the simple case of only two sources of financing, debt and equity. If the target
(Debt/Asset) = 0, then a company's WACC = ks.
5 Floatation costs are irrelevant to capital budgeting.
II. What Happens to kd(1-T) and WACC if:

a. firm incurs more debt
b. interest rates increase
c. inflation increases
d. company undertakes risky projects
e. tax rates are increased
Alex Tajirian
III. NUMERICAL.
1 WAK Inc. has a cost of equity of 15%, before-tax cost of debt of 10%, and a marginal tax
rate of 40%. Its equity and debt are trading at book value.
(a) Using its balance sheet data below, calculate WAK's WACC.
Assets Liabilities and Equity

Cash $500
Accounts receivable 300
Inventories 800 Long-term debt $500
Plant and equipment 400 Equity 1,500
Total assets 2,000.00 Total liabilities and equity 2,000.00
(b) How would you calculate WACC if equity and debt were not trading at book values?
Also assume that the firm is currently at its target capital structure.
Alex Tajirian
ANSWERS TO QUESTIONS
I. Agree/Disagree-Explain
1 Disagree. It depends on the project's risk. See p. 20.
2 Disagree. Only if the project is more risky than the company.
3 Disagree. Interest is deductible. Thus cost of debt is kd(1-T).
4 Agree. Assuming that the only two components of assets are debt and equity, at (Debt/Asset)
= 0, the WACC would have wd = 0 and ws = 1. Thus, WACC = ks.
5 Disagree. Although floatation costs are not part of the relevant CFs, they are part of the cost
of capital (k). Thus, they do impact capital budgeting decisions.
II. What Happens to kd(1-T) and WACC if:

a. firm incurs more debt
b. interest rates increase
c. inflation increases
d. company undertakes risky projects
e. tax rates are increased
Alex Tajirian
III. Problems.
1.
Step 1: Calculate weights: proportions of each source of capital
Step 2: substitute in WACC equation
Capital Sources Amount

Long-term debt 500
Equity 1,500
2,000
Debt 500
wd ' ' ' .25
Asset 500% 1,500
ws ' 1& wd ' .75
Y WACC ' wdkd(1& T) % wsks
' .25(.10)(.6) % .75(.15) ' 12.75%
(b) What happens if stock is not trading at book value, i.e., book value is different from
market value?
Calculate market values of debt and Equity.

Debt = Market value of Debt
= sum of [(market price of each bond)(# of bonds outstanding)]
Equity = Market value of Equity
= (price of stock)(# of shares outstanding)
Thus, the proportions have to be based on market-value proportions, not book value
proportions.
Alex Tajirian

Cost of Capital

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Chapter 13

# Managing the right-hand-side of the B/S

# By now, for valuation analysis, we know:

! Bank loans, venture capital, and warrants not discussed

! To simplify, we concentrate only on debt, equity, and retained

# Cost of financing = cost of capital = ?

! What is the cost of each source of financing?

! What is a project's cost of capital?

# Why might cost of capital in Japan be lower than in U.S.?

2.1 WHY IS COST OF CAPITAL IMPORTANT?

If financing cost is reduced Y NPV increases Y more projects end

2.2 SOME PRELIMINARIES

! The return generated by a security is the cost of that security

! The cost of capital depends primarily on the use of funds, i.e.,

2.3 COST COMPONENTS

Remember from the chapter on Performance Measures:

If a company cannot find profitable projects, i.e., projects with return

Thus, if the company is retaining your money, then the minimum

But reward to investor = cost of capital to the firm.

ˆ required return on equity = cost of retained earnings.

ke > ks ] (cost of new equity) > (cost of retained earnings) ]

since some transactions (floatation) costs have to be paid to

Not necessarily, firm should consider using debt.

WACC ' sum of weighted rewards to firm ) s capital providers

Debt = Market value of the company’s debt

Equity = market value of the company’s equity

wi = the weights (proportions) of each source of capital,

CALCULATING COST OF EACH COMPONENT

2.5 COST OF RETAINED EARNINGS, ks

? What are possible approaches to estimate ks

Example: Calculating Cost of Retained Earnings

# 2.5.1 CAPM Approach

ks ' k RF % (k M & k RF)$s

' 7.0% % (8.5%)(.847)

# 2.5.2 DCF Approach:

Given: Dividend0 = $4.19, g = 5%, p0 = $50

From equation (4) chapter 7, we have:

ˆ You can use the average of these two approaches = 14%.

2.6 COST OF NEWLY ISSUED COMMON STOCK, ke

Example: Calculating Component Cost of New Equity

2.7 COST OF PREFERRED STOCK, kps

Note. No tax adjustment is needed since preferred dividends are

2.8 COST OF DEBT = kd (1-T)

Example: Calculating Component Cost of Debt

Solution: Based on formula for PV of bonds

coupon interest × par value 12% × $1,000

PV ' SUM of discounted CFs

If you try kd/2 = 5%, you will get it right.

Example: Calculating Company WACC

WACC ' w dk d(1& T) % w psk ps % w sk s % w ek e

' 0.3(10%)(0.6) % 0.1(9%) % 0.6(14%) % 0

? What is the amount raised of each component?

? What is the maximum amount of financing that can be sustained

Where do the weights come from?

! proportional current market value of each component

! target capital structure

# Should short-term debt be included in wd?

3 WHAT IS A PROJECT'S COST OF CAPITAL

? Suppose debt = 0 and project is financed through 100% equity.

L Remember: discount rate reflects risk of CFs.

If company has no debt, then

3.1 Project Required Return (k project) and NPV.