1. CHAPTER 9
The Cost of Capital

2. Topics in Chapter
Read Sections: 9-1, 9-2, 9-3abc, 9-4, 9-6, 9-7, 9-8, 9-9, 9-10b, 9-13a.
Cost of capital components
Debt
Preferred stock
Common equity
WACC
Factors that affect WACC

3. Determinants of Intrinsic Value: The Weighted Average Cost of Capital
Net operating
profit after taxes
Required investments
in operating capital −
Free cash flow
(FCF) =
FCF1
FCF2
FCF∞
Value = ··· +
(1 + WACC)1
(1 + WACC)2
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Firm’s debt/equity mix
Cost of debt
Cost of equity
Market risk aversion
Firm’s business risk

4. Overview
The cost of capital is a critical element in many business decisions:
The hurdle rate for deciding whether to accept or reject an investment project (Chapter 10);
A key factor in choosing the firm’s capital structure, i.e. the mixture of debt and equity (chapter 15);
A factor in compensation plans for managers;
An important factor in the regulation of utility companies: rates are set to permit utility companies to earn just the cost of capital;
Used by courts to settle business valuation disputes such as in mergers and acquisitions etc.

5. 9-1 The Weighted Average Cost of Capital (WACC)
Capital Components / Financing Sources:
Long-term debt
Some firms also use permanent short-term debt.
Other firms have temporary short-term debt for seasonal fluctuations in inventory, but this is usually not part of the capital structure.
Preferred stock
Common equity: internally generated by retaining earnings or externally raised by selling stocks.

6. The WACC Formula
Equation (9-2) on P377: WACC = wdrd(1 – T) + wstdrstd(1 – T) + wpsrps + wsrs

7. Capital Components
Capital components are sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.
We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

8. Before-tax vs. After-tax Capital Costs from Firms’ Perspective
Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital.
Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs.
Only cost of debt is affected.

9. Historical (Embedded) Costs vs. New (Marginal) Costs
The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

10. 9-2 Choosing Weights for The WACC
Target capital structure (weights): the average capital structure weights (based on market values) that a company will have during the future.
Accounts payable and accruals are excluded from capital structure weights. Capital is provided by investors including interest-bearing debt, preferred stock, and common equity. Accounts payables and accruals arise from operating decisions not from financing decisions.
The WACC is used to find the present value of future cash flows, so it would be inconsistent to use weights based on the past history of the company (book values).
Current market values of total common equity often change dramatically from day to day, so companies don’t try to maintain the weights in their capital structures daily in response to changes in their stock price. Therefore, the capital structure weights based on the current market values might not be a good estimate of the capital structure that the company will have on average during the future.
The target capital structure is the one a firm intends to move towards in the future. We will explain how firms choose their capital structures in chapter 15, but for now just accept the given target weights for a firm.
Example: Figure 9-1 on Page 378: Selected Capital Structure Data for MicroDrive, Inc.

11. Determining the Weights for the WACC
The weights are the percentages of the firm that will be financed by each component.
If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

12. Estimating Weights for the Capital Structure
If you don’t know the targets, it is better to estimate the weights using current market values than current book values.
If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.
(More…)

13. Estimating Weights: Example
Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt.
(More…)

14. Estimating Weights: Example Continued
Vs = $50*3 million = $150 million.
Vps = $25 million.
Vd = $75 million.
Total capital = $150 + $25 + $75 = $250 million.

15. Estimating Weights: Example Continued
ws = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3
The target weights for this company are the same as these market value weights, but often market weights temporarily deviate from targets due to changes in stock prices.

16. 9-3abc After-Tax Cost of Debt
Method 1: Ask an investment banker what the coupon rate would be on new debt.
Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.
Method 3: Find the yield on the company’s existing debt, if it has any.

17. The Cost of Short-Term Debt rstd
Short-term debt should be included in the capital structure only if it is a permanent source of financing in the sense that the company plans to continually repay and refinance the short-term debt.
Example: MicroDrive, Inc.’s bankers charge the firm 10% on notes payable. Therefore, MicroDrive’s before-tax cost of short-term debt is 10%.
Interest is tax deductible to the firm, so the effective cost to the firm is the after-tax (AT) cost of debt:
rstd AT = rstd BT(1 – T)
= 10%*(1 – 0.40) = 6%

18. The Cost of Long-Term Debt rd Example: MicroDrive’s 15-year, 9% coupon rate, semiannual bond sells for $1,000. What’s rd? 45
45 + 1,000 1 2 30
rd = ?
-1,000
... ,
4.5(%) x 2 = rd = 9% N
I/YR PV FV
PMT
INPUTS
OUTPUT

19. The Cost of Long-Term Debt (Continued)
Interest is tax deductible to the firm, so the effective cost to the firm is the after-tax (AT) cost of debt:
rd AT = rd BT(1 – T)
rd AT = 9%(1 – 0.40) = 5.4%
Use annual rate.
Flotation costs for debt usually small, so may ignore.

20. 9-4 Cost of Preferred Stock rps Example: MicroDrive’s has preferred stock that pays an $8 annual dividend/share and sells for $100/share. If it issues new shares of preferred stock, it would incur a flotation/underwriting cost of 2.5%. What is MicroDrive’s cost of preferred stock?
Use this formula:
rps =
Dps
Pps (1 – F) = $8
$100*(1 – 0.025)
$97.5
0.082 = 8.2%

21. Note:
Flotation costs for preferred are significant, so are reflected. Use net price/share the firm receives as the denominator in the formula.
Preferred dividends are not tax deductible, so no tax adjustment. Just rps.
Annual rps is used.

22. Is preferred stock more or less risky to investors than debt?
More risky; company not required to pay preferred dividend.
However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.

23. Why is yield on preferred lower than rd?
Corporations own most preferred stock, because 70% (or more) of preferred (or common) dividends received are nontaxable to corporate investors.
Therefore, from investors’ perspective preferred often has a lower B-T yield than the B-T yield on debt even they are riskier than debt.
However, the A-T yield to investors and the effective after-tax cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.

24. Example: Returns to Investors rps = 8%, rd = 9%, T = 40%
rps, AT = rps – rps(1 – 0.7)(T)
= 8% – 8%(0.3)(0.4) = %
rd, AT = 9% – 9%(0.4) = 5.4%
A-T Risk Premium on Preferred vs. Debt = 1.64%

25. Estimate the Cost of Common Stock: Overview on 9-6, 9-7, 9-9 and 9-10b
What are the two ways that companies can raise common equity?
Directly, by issuing new shares of common stock.
Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

26. Why is there a cost for reinvested earnings?
Earnings can be reinvested or paid out as dividends.
Investors could use dividends to buy other securities, earning a return.
Thus, there is an opportunity cost if earnings are reinvested.

27. Cost for Reinvested Earnings (Continued)
Opportunity cost: The return stockholders could earn on alternative investments of equal risk.
They could buy similar stocks and earn rs, or company could reinvest earnings and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of common equity.

28. Three ways to determine the cost of equity, rs:
CAPM Approach (9-6):
rs = rRF + (rM – rRF)b = rRF + (RPM)b
Dividend Growth Approach (9-7):
rs = D1/P0 + g
Own-Bond-Yield-Plus-Judgmental-Risk Premium Approach (9-10b):
rs = rd + Judgmental RP

29. rs = rRF + (RPM )b = 5% + (6.0%)1.43 = 13.6%.
9-6 Using the CAPM to Estimate the Cost of Common Stock rs Example: MicroDrive Data rRF = 5%, RPM = 6%, b = 1.43
rs = rRF + (RPM )b
= 5% + (6.0%)1.43 = 13.6%.

30. Issues in Using CAPM
Most analysts use the rate on a long-term (i.e. 10 year) government bond as an estimate of rRF.
(More…)

31. Issues in Using CAPM (Continued)
Most analysts use a rate of 3% to 7% for the market risk premium (RPM)
Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval).

32. 9-7 Using the Dividend Growth Approach to Estimate the Cost of Common Stock Example: Data for a constant growth firm P0 = $32; D1 = $1.82; g = 5.4%
rs = D1 P0
+ g =
$1.82
$32
5.7% + 5.4%
= 11.1%

33. Estimating the Dividend Growth Rate
Use the historical growth rate if you believe the future will be like the past.
Obtain analysts’ estimates: Value Line, Zacks, Yahoo! Finance etc.
Use the (earnings) retention growth model, illustrated on next slide.

34. Retention Growth Model
Suppose the company has been earning 14.5% on (book value) equity (ROE = 14.5%) and has been paying out 63% of its earnings.
If this situation is expected to continue, what’s the expected future dividend growth rate g?

35. Retention Growth Model (Continued)
Estimating dividend growth rate from the retention growth model: g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE)
g = (1 – 0.63)(14.5%) = 5.4%.

36. 9-9 Adjusting the Cost of Equity for Flotation Costs
When a company issues new common stock they also have to pay flotation costs to the underwriter.
Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

37. Cost of New Common Equity: P0 = $32, D1 = $1.82, g = 5.4%, and F = 12.5%
re = D1
P0(1 – F)
+ g =
$1.82
$32(1 – 0.125)
+ 5.4%
$28
+ 5.4% = 11.9%

38. Comments about flotation costs:
Flotation costs depend on the risk of the firm and the type of capital being raised.
The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.
We may ignore flotation costs when calculating the WACC if they are not significant.

39. rs = rd + Judgmental risk premium rs = 10% + 4% = 14%
9-10b The Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method (for Privately Owned Firms) Example: rd = 10%, Judgmental RP = 4%
rs = rd + Judgmental risk premium
rs = 10% + 4% = 14%
This judgmental-risk premium  CAPM equity risk premium, RPM.
Produces ballpark estimate of rs.

40. What’s a reasonable final estimate of rs
What’s a reasonable final estimate of rs? Use different approaches with all available information, and calculate the average as the final estimate of rs.
Method
CAPM
DCF
rd + judgment
Average rs

41. 9-8 Calculating WACC with Target Capital Structure Weights
Example: If MicroDrive has a target capital structure calling for 28% long-term debt, 2% short-term debt, 3% preferred stock, and 67% common equity. Its marginal tax rate is 40%. (Its before-tax cost of long-term debt is 9%, its before-tax cost of short-term debt is 10%, its cost of preferred stock is 8.2%, and its cost of common equity using CAPM is 13.6%. These numbers are from previous examples.) What is MicroDrive’s WACC?
WACC = wdrd(1 – T) + wstdrstd(1 – T) + wpsrps + wsrs
WACC = 0.28(9%)(1−0.4)+0.02(10%)(1-0.4)+0.03(8.2%)
+ 0.67(13.6%)
WACC ≈ 11%

42. Discussions on the WACC Formula:
9-8a Marginal Rates versus Historical Rates
Because investors’ required rates of return are based on current market conditions not past market conditions, the cost of capital are always marginal cost (of raising new capital) not historical cost.
9-8b Target Weights versus Annual Financing Choices
The weights should be based on management’s target (optimal) capital structure, not annual financing choices.
9-8c Weights for Component Costs: Book Values versus Market Values versus Targets
The weights should be based on the market-value weights expected on average in the future (in the target capital structure), not necessarily the current weights based on current market values, not book-value weights as book values are a record of historical investments.

43. 9-13a How Managerial Decisions Affect a Company’s WACC?
Uncontrollable factors:
Market conditions, especially interest rates.
Market risk premium.
Tax rates.
Controllable factors:
Capital structure policy (Chapter 15).
Dividend policy (Chapter 14).
Investment policy: Firms with riskier projects generally have a higher cost of capital (Chapters 10 & 11).

44. Homework Problems Questions on Page 406: 9-1, 9-2.
Mini Case on Page 411: a, b, c, d, e(1&2), f, g, h, i, n, o(1).