FINA2303 Topic 07 Cost of Capital

Topic 7: Cost of Capital
Learning Outcomes
introduction
to cost of capital
cost
of debt
cost of equity
weighted average cost of capital (WACC)
WACC and NPV
project-based cost of capital
when raising external capital is costly
Topic 7 Cost of Capital
M K Lai
Page 2
Introduction to Cost of Capital

capital:
a firms sources of financing including

debt, equity and other securities that it has
outstanding
capital
structure: relative proportions of debt,

equity and other securities that a firm has
outstanding
M K Lai
Page 3

to
attract investors capital, a firm must offer

potential them an expected return equal to what
they could expect to earn elsewhere for assuming
the same level of risk (opportunity cost)
cost of capital of a firm = expected return of
investor by assuming the same risk of the firm
similarly,
the NPV of a project is positive only if its

return exceeds what the financial markets offer
on investments with similar risk
M K Lai
Page 4

the
cost of capital is the minimum required

return for an asset given its risk level
sources
stock: cost of equity
of funds
preferred stock: cost of preferred stock
for a firm
debt: cost of debt
real assets/projects/firms: weighted average
uses of funds for a firm
cost of capital (rWACC)
common
M K Lai
Page 5

Statement of Financial Position
current assets
debt
long term assets
preferred stock
common stock
uses of funds
sources of funds
M K Lai
Page 6

in
other words, rWACC is the discount rate we use

in capital budgeting and it reflects
time
value of money
risk
M K Lai
Page 7
Weighted Average Cost of Capital

(WACC): First Look
weighted
average cost of capital: average of

firms equity and debt costs of capital, weighted
by fractions of firms value that correspond to
equity and debt respectively
the capital asset pricing model shows the positive
relationship between expected return and
systematic risk of a financial security from the
perspective of an investor
for a project with positive NPV, the rWACC must lie
above the security market line (SML) (why?)
minimize rWACC so that the firm value can be
maximized (why?)
M K Lai
Page 8

(WACC): First Look
assume
that the firm has a target and fixed debtequity ratio that it would like to maintain, i.e. the
capital structure is given
although the rWACC is a mixture of the returns
needed to compensate its creditors and
stockholders, it is not affected by the fixed capital
structure
still assume there is a separation of investment
and financing decisions
the (weighted average) cost of capital (rWACC)
only reflects the uses of funds, rather than
sources of funds, in capital budgeting
M K Lai
Page 9

(WACC): First Look
leverage:
the relative amount of debt on a firms

balance sheet
unlevered firm: a firm that does not have debt
outstanding
rWACC of an unlevered firm is the cost of equity
given no debt (why?)
levered firm: a firm that has debt outstanding
rWACC = fraction of firm financed by equity *
cost of equity + fraction of firm financed by
debt * cost of debt = cost of assets (given no
preferred stock)
M K Lai
Page 10
Cost of Debt
the
cost of debt is the return that lenders require

on a firms debt
the
prevailing interest rate the firm just pays on

new borrowing
methods
to estimate the prevailing interest rate
1.
2.
3.
M K Lai
Page 11
Cost of Debt
the
observed or calculated cost of debt rD is on a

before-tax basis, but interest expenses are tax
deductible and hence a firm should consider its
after-tax (effective) cost of debt = before-tax cost
of debt*(1-tax rate) or after-tax cost of debt =
rD*(1-TC) where TC = corporate tax rate
which tax rate to use?
marginal tax rate = additional tax paid for per
$1 additional taxable income
effective tax rate = income tax/pre-tax income
statutory tax rate = rate stated by government
M K Lai
Page 12
Example: Cost of Debt

A
firm issued a 10-year, 7% bond with annual

coupons 8 years ago. The bond is currently
selling for 96% of its face value. Given that the
marginal tax rate is 35%, what is the after-tax
cost of debt of the firm?
7
107
96 =
+
2
(1 + yield) (1 + yield)
yield = 9.28%
before - tax cost of debt = 9.28%
after - tax cost of debt = 9.28% * (1 - 35%) = 6.03%
M K Lai
Page 13
Cost of Preferred Stock

preferred
stock has a fixed dividend paid every

year indefinitely and hence its future cash flow
stream is a non-growing perpetuity
rpfd
= Divpfd/Ppfd
where rpfd
= cost of preferred stock; Divpfd = fixed

dividend of preferred stock and Ppfd = current
preferred stock price
M K Lai
Page 14
Example: Cost of Preferred Stock

A
company had an issue of preferred stock that is

traded on the exchange. The issue paid $2.04
annually per share and sold for $30.75 per share.
What is the companys cost of preferred stock?
rpdf
= $2.04/$30.75 = 6.63%
M K Lai
Page 15
Cost of Equity/Common Stock

the
cost of equity/common stock is the return

that common stock investors require on their
investment in the firm
two
ways to determine the cost of equity
capital
asset pricing model
constant
dividend growth model
M K Lai
Page 16
Cost of Equity/Common Stock: CAPM

rE = rf + E * (RMkt rf )
where re
= expected return on common stock I or

cost of equity; rf = risk-free rate; E = beta of
common stock i; RMkt = expected market return
(proxied by stock market index return)
in other words, rE depends on
risk free rf
market/equity risk premium RMkt rf
systematic risk E
M K Lai
Page 17
Example: CAPM
The
risk-free rate is 2% and the expected market

return is 15%. A stock has a beta of 0.95. What
is the cost of equity?
rE
= 2% + 0.95*(15%-2%) = 14.35%
M K Lai
Page 18
Cost of Equity/Common Stock: Constant

Growth Model
rE
= Div1/PE + g
where rE = cost of equity; PE = current common
stock price; Div1 = common stock annual
dividend in year 1; g = constant growth rate of
dividends
PE can be observed directly in the stock market
given that the firm is listed
Div1 can be estimated as Div0*(1+g) where Div0 =
current annual dividend assumed to grow at g
M K Lai
Page 19

Growth Model
the
most difficult part is to estimate the growth

rate
method to estimate the growth rate
1.
2.
3.
M K Lai
Page 20

Growth Model
source: Reuters
M K Lai
Page 21
Example: Constant Growth Model

If
the current common stock price is $52, the

recently announced dividend per share is $3.25
and the expected constant dividend growth rate
is 4%, calculate the cost of equity.
rE
= $3.25*(1+4%)/52 + 4% = 10.5%
M K Lai
Page 22
Comparison Between CAPM and

Constant Dividend Growth Model
CAPM
constant dividend growth

model
equity beta
current stock price
risk-free rate
expected dividend next

year
market risk premium
future dividend growth rate
correct estimated beta
correct dividend estimate
accurate market risk

premium
growth rate matches

market expectations
valid CPMA
constant growth
inputs
assumptions
M K Lai
Page 23
WACC: Second Look

rWACC
= rE*E% + rpfd*P% + rD*(1-TC)*D%
where rWACC
= weighted average cost of capital; rE

= cost of equity; rpfd = cost of preferred stock; rD =
(before-tax) cost of debt; E% = fraction of firm
financed by common stock; P% fraction of firm
financed by preferred stock; D% fraction of firm
financed by debt; TC = marginal corporate tax rate
notice:
in many cases, P% = 0 (no preferred stock)
M K Lai
Page 24
WACC: Second Look

capital
structure weights (which to use?)

target capital structure announced by firm
estimated through market value of debt,
preferred stock and common stock
market value of assets = market value of
debt + market value of preferred stock +
market value of common stock
estimated through book value of debt,
preferred stock and common stock
assets = debt + preferred stock + common
stock (accounting equation)
M K Lai
Page 25
Example 1: WACC
Consider
the following information about Li &
Fung
source: Li & Fung AR
M K Lai
Page 26
Example 1: WACC
source: quamnet
source:
AsianBondson
line
source: http://pages.stern.nyu.edu/~adamodar/
source: BOCI
M K Lai
average = 6.359%
Page 27
Example 1: WACC
effective
tax rate = 9.4%

optimal debt ratio = 35%
beta = 2.17
risk-free rate = 1.5647%
market risk premium = 6.35%
rE = 1.564% + 2.17*6.35% = 15.15%
yield on bond = 6.359%
rWACC = 6.359%*(1-9.4%)*35% + 15.15%*(135%) = 11.86%
M K Lai
Page 28
Example 2: WACC
A
company has the following financial data:

debt with a book value of $10 million, trading
at 96% at a yield of 6%
number of preferred stock outstanding is 1
million shares, trading at a price of $5
cost of preferred stock = 15%
number of common stock outstanding is 5
million shares, trading at a price of $8
cost of equity = 18%
marginal corporate tax rate = 35%
Calculate the WACC of the company.
M K Lai
Page 29
Example 2: WACC
MV
of debt = $10 million*96% = $9.6 million

MV of preferred stock = $5*1 million = $5 million
MV of common stock = $8*5 million = $40
million
market value of assets = $9.6 million + $5
million + $40 million = $54.6 million
D% = $9.6 million/$54.6 million = 0.1758
P% = $5 million/$54.6 million = 0.0916
E% = $40 million/$54.6 million = 0.7326
rWACC = 18%*0.7326 + 15%*0.0916 + 6%*(135%)*0.01758 = 15.25%
M K Lai
Page 30
WACC in Practice
use
net debt rather than total debt and use

enterprise value (EV = equity plus net debt) as
basis for calculating weights
net debt = debt cash and risk-free securities
E% = MV of equity/EV and D% = net debt/EV
risk-free
rate = yield on government bond but

which maturity?
correspond to investment horizon of firms
investors survey shows that usually 10 year
government bond
M K Lai
Page 31
WACC in Practice
market
risk premium: some financial managers

that market risk premium has been declining and
it is the future market risk premium matters and
they should adjust it downward because of the
downward trend (?)
M K Lai
Page 32
WACC in Practice
M K Lai
Page 33
Using WACC to Value a Project

use rWACC
as discount rate in capital budgeting

levered value: project value includes the benefit
of interest tax deduction given the firms leverage
policy (assuming the capital structure is fixed)
WACC method: discount future incremental free
cash flows (FCF) using the firms rWACC to produce
the levered value (V0L) of a project with a life of n
years
n
FCFt
V =
t
t = 0 (1 + rWACC )
L
0
M K Lai
Page 34
Using WACC to Value a Project

key
assumptions
project risk is the same as firms assets (why?)
fixed capital structure with constant debtequity ratio
limited leverage effects, e.g. no financial
distress
M K Lai
Page 35
Example: Using WACC to Value a Project

A
company is carrying out a capital budgeting

exercise on an expansion project by increasing
the size of its production facility. The initial
investment is $50 million and it is expected to
generate an even cash flow of $12 million in
each of the coming six years. The WACC of the
firm is 16.65%. What is the NPV of the project?
M K Lai
Page 36
Example: Using WACC to Value a Project

As this is an expansion project, we believe that the
project risk is similar to the existing assets of the
firm and the appropriate discount rate is its WACC.
6
$12m
levered value =
= $43.47m
t
t =1 (1 + 16.65%)
NPV = $43.47m - $50mm = 6.53m
As NPV < 0, reject the project.
M K Lai
Page 37
Project Risk Different from Firms Risk

rWACC
does not necessarily reflect the risk of the

project, e.g. launching a new product, entering a
new market, etc.
in practice, we should look for a firm which has
similar characteristics as our project and use the
similar firms data to calculate its rWACC which
reflects the risk of the project (pure play
approach)
furthermore, if the similar firm has a different
capital structure from the subject firm, need to
make adjustment for the different debt-equity
ratios (out of scope)
M K Lai
Page 38
Project Risk Different from Firms Risk

discount rate on project
SML
WACC
beta of existing
assets of firm
beta of project
M K Lai
Page 39
Exercise
Which
is the appropriate discount rate for the

following projects? (re, after-tax rd, own firms
WACC, similar firms WACC)
a company acquires the control over a target
company
a company carries out a research and
development project for a new product
a company expands its business to a new
market
a company invests in the shares of another
company
M K Lai
Page 40
Exercise
a
company expands its production facilities

a company carries out a cost reducing program
a company uses a new technology to produce
a product
a company buys the bonds issued by another
company
M K Lai
Page 41
Example: WACC for a New Acquisition

Company
A wants to acquire the control over

company B which carries out unrelated business
to company A. To determine the NPV of this
acquisition project, company As rWACC is not
appropriate because it cannot reflect the risk of
company B. Given that the two companies have
similar capital structure, company Bs rWACC
should be used because it reflects the risk of the
project.
M K Lai
Page 42
Divisional Cost of Capital

consider
a company with several divisions of

different risk nature, i.e. a conglomerate
the companys rWACC reflects its overall risk and
cannot accommodate the different risk levels of
these business lines
a divisional cost of capital should be determined
for each business line with the objective to reflect
its risk level
pure play approach: use of rWACC that is unique to
a particular project based on companies in
similar lines of business as the project
M K Lai
Page 43
Example: Divisional Cost of Capital

A
conglomerate has a division in producing

household products. The rWACC of the
conglomerate is 20%. The rWACC of a household
product manufacturer is 16%. What is the
(weighted average) cost of capital of the division?
The
divisional cost of capital is 16%.
If
the division wants to launch a new household

product, is 16% still the appropriate discount rate
for the project?
M K Lai
Page 44
When Raising External Capital is Costly

flotation
costs: costs associated with new issue of

debt or equity
1.
2.
zero
flotation costs for internal equity (retained

earnings)
M K Lai
Page 45
When Raising External Capital is Costly

how
to include them in rWACC
method
1: adjust rWACC through the weighted

average cost of flotation
method
2: when carrying out the capital

budgeting exercise, consider the flotation cost
as an initial investment
M K Lai
Page 46
Example: When Raising External Capital

is Costly
A
company decides to issue new equity to finance

a project. The flotation costs are $456,221. The
present value of the future cash flows generated
by the project is $3,300,000. The estimated
initial investment (before flotation costs) for the
project is $3,000,000. Calculate the NPV of the
project after adjusting for flotation costs.
NPV = $3,300,000 - $3,000,000 - $456,221
= $156,221
as the NPV < 0, reject the project
M K Lai
Page 47
Challenging Questions
1. What is the relationship between the required
return on an investment and the cost of capital
associated with that investment?
2. What are the likely consequences if a company
uses its rWACC to evaluate all proposed
investments from different divisions?
3. Discuss whether the CFO of a company should
use the WACC of the company to evaluate the
following projects:
M K Lai
Page 48
A. An expansion project that the company
will expand its production facilities to enlarge
its output level of the existing products in
Hong Kong. Hopefully, it can take advantage
of the economy of scale to reduce the
production costs.
B. An expansion project that the company
will build up new distribution channels in
Mainland China. Hopefully, it can take
advantage of the huge population in the
Mainland to enhance its sales revenue.
M K Lai
Page 49
4. A company has announced a target capital
structure of 40% debt and 60% equity. According
to the values in the financial market, the capital
structure is 35% debt and 65% equity. According
to the values in the statement of financial position,
the capital structure is 45% debt and 55% equity.
The company intends to use 100% equity to
finance a project. Given that the project has the
same risk as the existing assets of the company,
what weights of debt and equity should be used in
calculating the rWACC? Explain.
M K Lai
Page 50
5. An investment bank is appointed to be the
financial advisor to an acquiring company. The
acquiring company wants to take control over a
target company by buying more than 50% of its
shares from the shareholders. If the investment
bank has to determine the value of the target
company as a whole, which of the following is
the appropriate discount rate for this
acquisition project? Explain.
M K Lai
Page 51
A. the cost of equity of the acquiring
company
B. the weighted average cost of capital of the
acquiring company
C. the cost of equity of the target company
D. the weighted average cost of capital of the
target company
M K Lai
Page 52

FINA2303 Topic 07 Cost of Capital

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Topic 7: Cost of Capital

Topic 7 Cost of Capital

Introduction to Cost of Capital

a firms sources of financing including

structure: relative proportions of debt,

Topic 7 Cost of Capital

Introduction to Cost of Capital

attract investors capital, a firm must offer

the NPV of a project is positive only if its

Topic 7 Cost of Capital

Introduction to Cost of Capital

cost of capital is the minimum required

Topic 7 Cost of Capital

Introduction to Cost of Capital

long term assets

Topic 7 Cost of Capital

Introduction to Cost of Capital

other words, rWACC is the discount rate we use

Topic 7 Cost of Capital

Weighted Average Cost of Capital

average cost of capital: average of

Weighted Average Cost of Capital

Weighted Average Cost of Capital

the relative amount of debt on a firms

cost of debt is the return that lenders require

prevailing interest rate the firm just pays on

to estimate the prevailing interest rate

observed or calculated cost of debt rD is on a

Example: Cost of Debt

firm issued a 10-year, 7% bond with annual

Topic 7 Cost of Capital

Cost of Preferred Stock

stock has a fixed dividend paid every

= cost of preferred stock; Divpfd = fixed

Topic 7 Cost of Capital

Example: Cost of Preferred Stock

company had an issue of preferred stock that is

Topic 7 Cost of Capital

Cost of Equity/Common Stock

cost of equity/common stock is the return

ways to determine the cost of equity

asset pricing model

Topic 7 Cost of Capital

dividend growth model

Cost of Equity/Common Stock: CAPM

= expected return on common stock I or

risk-free rate is 2% and the expected market

Topic 7 Cost of Capital

Cost of Equity/Common Stock: Constant

Topic 7 Cost of Capital

Cost of Equity/Common Stock: Constant

most difficult part is to estimate the growth

Topic 7 Cost of Capital

Cost of Equity/Common Stock: Constant

Topic 7 Cost of Capital

Example: Constant Growth Model

the current common stock price is $52, the

Topic 7 Cost of Capital

Comparison Between CAPM and

constant dividend growth

current stock price

expected dividend next

market risk premium

future dividend growth rate

= rEE% + rpfdP% + rD(1-TC)D%