Cost of capital

9-1

Institute of Human Resource Advancement

University of Colombo

• Lecturer: Dr. A. A. Azeez

• Program: MBM

• Subject : MBM 14-Financial Management

• Topic : Cost of capital

• Date :18. 04.2015

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Cost of Capital

Firms raise funds from both equity investors and

lenders to fund investments.

Cost of Equity is the rate of return investors

require on an equity investment in a firm.

Cost of Capital is the required rate of return on

the various types of financing. It is a weighted

average of the individual required rates of return.

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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

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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/ discounted cash flow

approach

– SML, or CAPM

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9-6

The CAPM Approach

• From the firm’s perspective, the

expected return is the Cost of Equity

Capital: )( FMiF RRβRke

• To estimate a firm’s cost of equity capital, we need to know three things:

1. The risk-free rate, RF

FM RR 2. The market risk premium,

2

,

)(

),(

M

Mi

M

Mii

σ

σ

RVar

RRCovβ 3. The company beta,

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Example• Suppose the stock of Stansfield Enterprises, a

publisher of PowerPoint presentations, has a

beta of 2.5. The firm is 100% equity financed.

• Assume a risk-free rate of 5% and a market

risk premium of 10%.

• What is the appropriate discount rate for an

expansion of this firm?

)( FMiF RRβRKe

%105.2%5 ke

%30ke

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Example

Suppose Stansfield Enterprises is evaluating the

following independent projects. Each costs $100 and

lasts one year.

Project Project b Project’s

Estimated Cash

Flows Next

Year

IRR NPV at

30%

A 2.5 $150 50% $15.38

B 2.5 $130 30% $0

C 2.5 $110 10% -$15.38

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Using the SML

An all-equity firm should accept projects whose IRRs

exceed the cost of equity capital and reject projects

whose IRRs fall short of the cost of capital.

Pro

ject

IRR

Firm’s risk (beta)

SML

5%

Good

project

Bad project

30%

2.5

A

B

C

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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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9-11

The Discounted Cash flow

Approach

• Three inputs are required to use the DCF

Approach: the current stock price, the

current dividend, and the expected growth

in dividends.

• ke = D1 + g

P0

• Of these inputs , the growth rate is the

most difficult to estimate. To estimate this

Retention growth model is used.

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The Discounted Cash flow

Approach

• Retention Growth Model:

g = ROE * Retention ratio

• Retention Ratio= (1- payout ratio)

• ROE is the return on equity defined as net

income available for stockholders divided

by equity.

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The Discounted Cash flow

Approach

• A firm has been earning 14% on equity (ROE = 14%) and retaining 35% of its earnings (dividend payout = 65%). This situation is expected to continue. If D0 = Rs. 4.19, and P0 = Rs.50, what’s the cost of equity based upon the DCF approach?

g = ( 1 – Payout ) (ROE) D1 = D0 (1+g)

= (0.35) (14%) D1 = Rs. 4.19 (1 + .049)

= 4.9% D1 = Rs. 4.395

ke = D1 / P0 + g

= Rs.4.395 / Rs.50 + 0.049

= 13.7%

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Advantages and Disadvantages of

Discounted cash flow approach

• 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

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Why is there a cost for

retained earnings?• Earnings can be reinvested or paid out as

dividends.

• Investors could buy other securities, earn a return.

• If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk).– Investors could buy similar stocks and earn ke.

– Firm could repurchase its own stock and earn ke.

– Therefore, ke is the cost of retained earnings.

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Why is the cost of retained earnings

cheaper than the cost of issuing new

common stock?

• 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

the stock price.

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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 will frequently ignore flotation costs

when calculating the WACC.

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If issuing new common stock incurs a

flotation cost of 15% of the proceeds, and

D0 = Rs. 4.19, P0 = Rs.50, and g = 5%, what

is ke?

15.4%

5.0% Rs.42.50

4.3995 Rs.

5.0% 0.15)-Rs.50(1

05)Rs.4.19(1.

g F)-(1P

g)(1D k

0

0e

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The Firm versus the Project

• Any project’s cost of capital depends

on the use to which the capital is

being put—not the source.

• Therefore, it depends on the risk of

the project and not the risk of the

company.

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Capital Budgeting & Project

Risk

A firm that uses one discount rate for all projects may over

time increase the risk of the firm while decreasing its value.

Pro

ject

IR

R

Firm’s risk (beta)

SML

rf

bFIRM

Incorrectly rejected

positive NPV projects

Incorrectly accepted

negative NPV projects

Hurdle

rate)( FMFIRMF RRβR

The SML can tell us why:

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Suppose the Conglomerate Company has a cost of capital,

based on the CAPM, of 17%. The risk-free rate is 4%, the

market risk premium is 10%, and the firm’s beta is 1.3.

17% = 4% + 1.3 × 10%

This is a breakdown of the company’s investment projects:

1/3 Automotive Retailer b = 2.0

1/3 Computer Hard Drive Manufacturer b = 1.3

1/3 Electric Utility b = 0.6

average b of assets = 1.3

When evaluating a new electrical generation investment,

which cost of capital should be used?

Capital Budgeting & Project Risk

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Capital Budgeting & Project

RiskP

roje

ct I

RR

Project’s risk (b)

17%

1.3 2.00.6

Ke = 4% + 0.6×(14% – 4% ) = 10%

10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of the project.

10%

24%Investments in hard

drives or auto retailing

should have higher

discount rates.

SML

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What is debt?

Debt generally has the following

characteristics:

• Commitment to make fixed payments in

the future

• The fixed payments are tax deductible

• Failure to make the payments can lead to

either default or loss of control of the firm

to the party to whom payments are due.

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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

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The Cost of Capital with Debt

• The Weighted Average Cost of Capital is given

by:

• Because interest expense is tax-deductible, we multiply the last term by (1 – TC).

rWACC = Equity + Debt

Equity× KEquity +

Equity + Debt

Debt× KDebt ×(1 – TC)

rWACC = S + B

S× ke +

S + B

B× Kd ×(1 – TC)

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Example: International Paper• First, we estimate the cost of equity

and the cost of debt.

– We estimate an equity beta to estimate

the cost of equity.

– We can often estimate the cost of debt

by observing the YTM of the firm’s debt.

• Second, we determine the WACC by

weighting these two costs

appropriately.

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Example: International Paper

• The industry average beta is 0.82, the

risk free rate is 3%, and the market

risk premium is 8.4%.

• Thus, the cost of equity capital is:

Ke = RF + bi × ( RM – RF)

= 3% + 0.82×8.4%

= 9.89%

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Example: International Paper

• The yield on the company’s debt is 8%,

and the firm has a 37% marginal tax rate.

• The debt to value ratio is 32%

8.34% is International’s cost of capital. It should be used to

discount any project where one believes that the project’s risk

is equal to the risk of the firm as a whole and the project has

the same leverage as the firm as a whole.

= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)

= 8.34%

rWACC = S + B

S× Ke +

S + B

B× Kd ×(1 – TC)

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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

• kP = D / P0

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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?

• KP = 3 / 25 = 12%

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Is preferred stock more or less

risky to investors than debt?

• More risky; company not required to pay

preferred dividend.

• However, firms try to pay preferred

dividend. Otherwise, (1) cannot pay

common dividend, (2) difficult to raise

additional funds, (3) preferred

stockholders may gain control of firm.

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Calculating the weighted

average cost of capital

WACC = wdkd(1-T) + wpkp + weke

• The w’s refer to the firm’s capital

structure weights.

• The k’s refer to the cost of each

component.

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How are the weights

determined?

WACC = wdkd(1-T) + wpkp + weke

• Use accounting numbers or market value (book vs. market weights)?

• Use actual numbers or target capital structure?

• The target capital structure is one which the firm intends to maintain in the long run given its operating conditions and attitude towards risk.