Chapter10-CostofCapital.pdf
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Introduction to the
The Basics of the Cost of Capital
Valuing Different Costs
Approaches to Calculating the Cost of Capital
The WACC
• Defining the Cost of Capital
• Differences Between Required Return and the Cost of Capital
• Relationship Between Financial Policy and the Cost of Capital
Introduction to the Cost of Capital > The Basics of the Cost of Capital
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• If a project is of similar risk to a company's average business activities, it is
reasonable to use the company's average cost of capital as a basis for project
evaluation.
• A company's securities typically include both debt and equity; therefore, one must
calculate both the cost of debt and the cost of equity to determine a company's
cost of capital.
• Weighted average cost of capital takes into account the amount of financing that
comes through the use of debt and the use of equity.
• IRR is the rate of return that makes the net present value of all cash flows from an
investment equal zero.
Defining the Cost of Capital
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Net Present Value Equation
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• Cost of capital refers to the expected returns on all of the various securities issued
by a company, often expressed as a weighted average.
• Required refers to the rate of return necessary to achieve in order to compensate
investors for taking on the risk of the individual investment.
• The risk premium can be established by understanding business risk and financial
risk.
Differences Between Required Return and the Cost of Capital
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Obtaining Required Return
• As opposed to strictly using cost of capital, decisions must be made using
opportunity cost of capital.
• Opportunity cost of capital is the amount of money foregone by investing in one
asset compared to another.
• Facets of financial policy include valuation, portfolio theory, hedging, and capital
structure.
Relationship Between Financial Policy and the Cost of Capital
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• The Cost of Debt
• The Cost of Preferred Stock
• The Cost of Common Equity
• The Cost of Retained Earnings
• The Cost of New Common Stock
Introduction to the Cost of Capital > Valuing Different Costs
• Cost of debt equals the interest rate of the debt (composed of the risk-free rate
and a credit risk premium) times one minus the corporate tax rate.
• Cost of debt is also equal to the annual interest payment of the debt divided by its
market value.
• The yield to maturity can be used in determining the cost of debt. It is is the
discount rate at which the sum of all future cash flows from the bond are equal to
the price of the bond.
The Cost of Debt
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Union Camp Corporation Bond Certificate
• Preferred stock is an equity security with properties of both an equity and a debt
instrument.
• Because preferred stock carries a differing amount of risk than other types of
securities, we must calculate its asset specific cost of capital to work into our
overall weighted average cost of capital.
• The dividend is usually specified as a percentage of the par value or as a fixed
The Cost of Preferred Stock
preferred-stock-376-
Cost of Preferred Stock
• A company's current cost of equity can be difficult to determine because it is
unobservable and must be estimated.
• The cost of equity can be estimated by comparing the investment to other
investments with similar risk profiles.
• Other methods of estimating cost of equity include the capital asset pricing model,
the dividend growth model, and the bond plus model.
The Cost of Common Equity
common-equity-377-
CAPM Method
• Retained earnings refers to the portion of net income (or loss) that is retained by a
company rather than distributed to its owners as dividends.
• We can think of the cost of retained earnings in relation to the opportunity cost of
how we can use these funds elsewhere.
• When deciding how to finance a new project, companies have a tendency to
follow the pecking order of finance, preferring internal sources of capital to
external sources of capital.
The Cost of Retained Earnings
retained-earnings-378-
• If a mixture of internal and external sources of financing are used, a company
must determine the proportion of external financing to be used, and thus the
marginal cost of capital.
• Flotation costs include all costs of issuing the securities, such as banker's fees,
legal fees, underwriting fees, filing costs, etc.
• Cost of new common stock is calculated using the dividend growth model, by
devaluing the current stock price by the amount of flotation cost.
The Cost of New Common Stock
new-common-stock-379-
Cost of New Equity
• The Capital Asset Pricing Model
• The SML Approach
• Discounted Cash Flow Approach
• The "Bond Yield Plus Risk Premium" Approach
Introduction to the Cost of Capital > Approaches to Calculating the Cost of Capital
• CAPM determines the expected rate of return of an asset.
• The model takes into account the asset's sensitivity to systematic risk (beta), the
expected return of the market, and the expected return of a risk-free asset.
• CAPM states that investors are only rewarded for bearing systematic risk.
• CAPM states that if the expected return is not greater than or equal to our
required return the investment should not be made.
The Capital Asset Pricing Model
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CAPM Equation
• The SML graphs the relationship between risk β (beta) and expected return.
• All correctly priced assets lie on the SML.
• If a security is priced above the SML, it is undervalued. If it is priced below the
SML, it is overvalued.
The SML Approach
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SML Equation
• In the DCF approach, all future expected cash flows associated with the asset are
discounted in order to find their present values.
• To determine the value of the asset, the present values of all expected cash flows
are summed.
• When future cash flows are infinite or extend past a certain period, a terminal
value can be found and discounted back to the present.
• Comparing a value found using the DCF approach with the actual price of an
asset determines if an asset is undervalued, overvalued, or correctly priced.
Discounted Cash Flow Approach
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Present Value Equation
• The BYPRP approach applies to a company's publicly traded equity.
• The yield to maturity is the discount rate at which the sum of all future cash flows
from a bond are equal to its price.
• The equity risk premium is the return that stocks are expected to receive in
excess of the risk-free interest rate.
• The BYPRP approach does not produce as accurate an estimate as the capital
asset pricing model or discounted cash flow analysis.
The "Bond Yield Plus Risk Premium" Approach
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Bond Yield Plus Risk Premium Equation
• Weighted Average Cost of Capital
• The Weightings
• Factors Controlled by the Firm
• Factors External to the Firm
• Making Risk Adjustments
• Problems with WACC
Introduction to the Cost of Capital > The WACC
• The WACC is the minimum rate of return a company must earn on a new venture
in order to make the investment worthwhile.
• The various securities that companies use as sources of finance are expected to
generate different returns.
• To calculate WACC, multiply the cost of debt by the ratio of debt to total market
value of the company. Then add this to the cost of equity multiplied by the ratio of
equity to total market value.
Weighted Average Cost of Capital
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WACC Equation
• The WACC must take into account the weight of each component of a company's
capital structure.
• The calculation of the WACC usually uses the market values of the various
components rather than their book values.
• Market value is the price at which an asset would trade in a competitive auction
• Book value refers to the value of an asset according to the account balance
present on the balance sheet of a company.
• If the value of a company's debt exceeds the value of its equity, the cost of its
debt will have more "weight" in calculating its total cost of capital than the cost of
equity. If the value of the company's equity exceeds its debt, the cost of its equity
will have more weight.
The Weightings
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Domestic Balance Sheet
• Capital structure refers to the way a company finances its assets through some
combination of equity, debt, or hybrid securities.
• When a higher proportion of debt is chosen, the cost of debt must factor in credit
• Changes in a company's dividend policy provide information to investors, who
should react accordingly to either increase or decrease the value of an asset.
Factors Controlled by the Firm
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Expected Investor Return
• Since debt expense is tax-deductible, the cost of debt is computed as an after tax
cost to make it comparable with the cost of equity.
• The Federal Reserve moderates long-term interest rates, which causes
fluctuations in the risk-free rate that affect the cost of capital.
• Economic conditions refer to the demand and supply of capital in the marketplace
that can impact how capital is raised, and therefore what the cost of capital will
• Market conditions refer to the demand for higher rates of return by investors,
which will increase the cost of capital.
Factors External to the Firm
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U.S. Corporate Taxes
• It is possible to adjust risk by figuring the differing risk into the company's beta.
• The beta coefficient is the risk of a new project in relation to the risk of the market
as a whole.
• Therefore, if a new project of differing risk is undertaken, the beta for that project
will be weighted into the company's overall cost of capital.
Making Risk Adjustments
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Beta Equation
• While the relative debt and equity values can be easily determined, calculating the
costs of debt and equity can be problematic.
• The problem inherent in different methods used to calculate cost of equity is that
at least one component is an estimate.
• The terms of risk-free bonds used in determining cost of debt may not always
adequately match the terms of the company's debt.
Problems with WACC
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dless
U.S. Treasuries Yield
• benchmark A standard by which something is evaluated or measured.
• beta Average sensitivity of a security's price to overall securities market prices.
• business risk The risk associated with the operational and administrative procedures of the particular industry or company.
• capital Money and wealth; the means to acquire goods and services, especially in a non-barter system.
• capital intensity ratio the amount of fixed or real capital present in relation to other factors of production, especially labor
• coupon payment A periodic interest payment that the bondholder receives during the time between when the bond is issued
and when it matures.
• covariance A measure of how much two random variables change together.
• default To fail to meet an obligation.
• discount rate The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used to
decrease the amounts of future cash flow to yield their present value.
• dividend payout ratio The fraction of net income a firm pays to its stockholders in dividends.
Introduction to the Cost of Capital
• dividend yield A company's total annual dividend payment per share, divided by its price per share.
• financial risk An umbrella term for multiple types of risk associated with financing, including financial transactions that include
company loans in risk of default.
• hybrid instrument A broad group of securities that pay a predictable (fixed or floating) rate of return or dividend until a certain
date, at which point the holder has a number of options including converting the securities into the underlying share.
• inflation An increase in the general level of prices or in the cost of living.
• internal rate of return IRR. The rate of return on an investment which causes the net present value of all future cash flows to be
• leverage The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and
earn an expected higher return (usually at high risk).
• lobbying The act of attempting to influence decisions made by officials in the government, most often legislators or members of
regulatory agencies.
• Marginal Cost of Capital The cost of the marginal dollar of capital that a firm could raise externally.
• maturity Date when payment is due.
• Opportunity cost The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity);
the most valuable forgone alternative.
• principal payment The payment made upon maturity of a bond
• projection period The time duration for estimating the future cash flows of a proposed investment.
• proxy A measurement of one physical quantity that is used as an indicator of the value of another.
• proxy fight a conflict where two powers use third parties as a supplement to, or a substitute for fighting each other directly
• required return the minimum gain expected by investors
• retained earnings The portion of net income that is retained by the corporation rather than distributed to its owners as
dividends.
• risk The potential (conventionally negative) impact of an event, determined by combining the likelihood of the event occurring
with the impact, should it occur.
• slope The ratio of the vertical and horizontal distances between two points on a line; zero if the line is horizontal, undefined if it
is vertical.
• Synergy Benefits resulting from combining two different groups, people, objects, or processes.
• systematic risk The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as
its beta.
• time value of money The value of money, figuring in a given amount of interest, earned over a given amount of time.
• Unsystematic risk Risk peculiar to an asset, which can be eliminated through diversification.
States that the required return on an equity equals the yield of the company's long-term debt plus the equity's risk premium.
Code Cogs. "Online LaTeX Equation Editor – create, integrate and download." CC BY http://codecogs.com/latex/eqneditor.php View on Boundless.com
Yield To Maturity Graph
A hypothetical graph showing yield to maturities (or internal rates of return) for corresponding present values.
Wikipedia. "IRR1 – Grieger." CC BY-SA http://en.wikipedia.org/wiki/File:IRR1_-_Grieger.jpg View on Boundless.com
If the person analyzing a company chooses or if the market value of a company's debt and equity is not available, the book value can be used. The book
value of debt and equity can be found on the company's balance sheet.
Wikimedia. "DWBA DBS." CC BY-SA 3.0 http://commons.wikimedia.org/wiki/File:DWBA_DBS.jpg View on Boundless.com
The cost of preferred stock is equal to the preferred dividend divided by the preferred stock price, plus the growth rate.
Wikispaces. "SU3FINANCE – Chapter 12 – Determining the Cost of Capital." CC BY-SA http://su3finance.wikispaces.com/Chapter+12+-
+Determining+the+Cost+of+Capital View on Boundless.com
Systematic vs. Unsystematic Risk
As the number of stocks in a portfolio increase, the amount of unsystematic risk approaches zero. However, it is impossible to remove systematic risk,
as it concerns the economy in general.
Wikibooks. "Principles of Finance/Section 1/Chapter 5/Risk/Risk." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_5/Risk/Risk
Present Value of the Terminal Value
Use this equation to find the present value of a future terminal value. Where TV = terminal value, k = discount rate, and n = the number of periods back
to the present.
OER Commons. CC BY http://www.oercommons.org/courses/entrepreneurial-finance-spring-2011/view View on Boundless.com
Example Equation
$10 divided by $100, plus 3%.
Equation used to determine net present value, and therefore internal rate of return. DPV = discounted net present value, N = total number of periods in
which a cash flow occurs, t = the specific period of the cash flow, FV = the value of the future cash flow, and i = internal rate of return.
Wikipedia. "Discounted cash flow." GNU FDL http://en.wikipedia.org/wiki/Discounted_cash_flow View on Boundless.com
The SML is the graphical representation of CAPM, and thus is found using the same equation.
Wikibooks. "Principles of Finance/Section 1/Chapter 7/Capital Asset Pricing Model." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_Model View on Boundless.com
Terminal Value Equation
FCFN+1 = future cash flow one year after the projection period. k = discount rate. g = assumed constant growth rate.
Wikipedia. "Terminal value (finance)." GNU FDL http://en.wikipedia.org/wiki/Terminal_value_(finance) View on Boundless.com
Cost of Debt Equation
Cost of debt is equal to the annual interest payment of the debt divided by its market value.
The Motley Fool. CC BY-SA http://wiki.fool.com/Cost_of_debt View on Boundless.com
Required return = 6% + 4%
The expected rate of return = the rate of return for a risk-free asset + beta* (the rate of return of the market – the risk-free rate). The return of the market
minus the risk-free rate is also known as the risk premium.
Equation For Cost of Debt
Cost of debt equals the interest rate of the debt (composed of the risk-free rate and a credit risk premium) times one, minus the corporate tax rate.
Wikipedia. "Cost of capital." GNU FDL http://en.wikipedia.org/wiki/Cost_of_capital View on Boundless.com
In this formula, V is equal to the value of the firm, or Debt (D) plus Equity (E). r(D) is the company's rate on debt, r(E) the rate on equity. T is the
company's marginal tax rate.
Wikibooks. "Principles of Finance/Section 1/Chapter 6/Corp/WACC." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_6/Corp/WACC View on Boundless.com
To calculate expected investor return, divide the dividend payment per share by the market price of the asset and add the expected growth rate.
Companies often use hedging techniques to offset price fluctuations for commodities. The fluctuation of oil prices can be seen in the above graph.
Wikimedia. "Oil.2001-2005jpg.smaller." CC BY-SA http://commons.wikimedia.org/wiki/File:Oil.2001-2005jpg.smaller.jpg View on Boundless.com
CAPM-SML
The Security Market Line for the Dow Jones Industrial Average over a 3 year period, with the x-axis representing beta and the y-axis representing
expected return.
Cost of new equity equals dividends payed in year one divided by the current stock price, devalued by the amount of flotation cost, plus the growth rate.
Wikipedia. "Marginal cost of capital schedule." GNU FDL http://en.wikipedia.org/wiki/Marginal_cost_of_capital_schedule View on Boundless.com
The capital asset pricing model is a good representation of how to obtain required return. It adds the risk-free rate to the risk premium of the market
adjusted to an investment's beta.
Wikipedia. "Capital asset pricing model." GNU FDL http://en.wikipedia.org/wiki/Capital_asset_pricing_model View on Boundless.com
Effective U.S. corporate tax rates from 1947-2011.
Wikimedia. "US Effective Corporate Tax Rate 1947-2011 v2." CC BY-SA http://commons.wikimedia.org/wiki/File%253AUS_Effective_Corporate_Tax_Rate_1947-
2011_v2.jpg View on Boundless.com
$25,000 Corporation Sinking Fund Bond Certificate.
Wikimedia. "Union Camp Corporation – A Specimen "Sinking Fund" Bond Certificate c.1971." CC BY-SA
http://commons.wikimedia.org/wiki/File:Union_Camp_Corporation_-_A_Specimen_%2522Sinking_Fund%2522_Bond_Certificate_c.1971.jpg View on
Boundless.com
To find the discounted present value of an asset, it is necessary to sum the discounted present value of each future cash flow (FV) at any time period (t)
in years from the present time, using the appropriate interest rate (i).
$10 in dividends. Current price of $100. Flotation cost of 3%. Growth rate of 5%.
Yields on 1-mont, 10-year, and 30-year U.S. government debt.
Wikimedia. "US Treasury bills and bonds yield." CC BY-SA http://commons.wikimedia.org/wiki/File%253AUS_Treasury_bills_and_bonds_yield.png View on
IRR Investment Comparison
A graph showing the decision between two exclusive investments based on IRR.
Wikipedia. "Internal rate of return." GNU FDL http://en.wikipedia.org/wiki/Internal_rate_of_return View on Boundless.com
The retention rate equals retained earnings divided by net income.
Wikipedia. "Retention ratio." GNU FDL http://en.wikipedia.org/wiki/Retention_ratio View on Boundless.com
The beta of an investment is equal to the covariance between the rate of return of the investment, r(a), and that of the portfolio, r(p).
Wikipedia. "Beta (finance)." GNU FDL http://en.wikipedia.org/wiki/Beta_(finance) View on Boundless.com
Expected return for a security equals the risk-free return for the market plus the beta for the security times its risk premium.
The average cost of capital is:
A) a benchmark for accepting or rejecting projects.
B) fixed through time
C) the same for all companies
Saylor OER. "Business Administration « Saylor.org – Free Online Courses Built by Professors." CC BY 3.0
http://www.saylor.org/majors/Business/
Which of the following explains the differences between a
company's required return and its cost of capital?
A) Required return measures business risk; cost of capital measures
financial risk.
B) Required return measures financial risk; cost of capital measures
business risk.
C) Required return is from the company's perspective; cost of capital
from the investor's.
D) Required return is from the investor's perspective; cost of capital from
the company's.
Boundless – LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/
A company's cost of capital is used as a tool in relation to which
aspect of financial policy?
A) Diversifying a company's porfolio
B) Valuing projects by discounting cash flows, and then selecting projects
with the highest return.
C) Hedging a company's investments.
D) Evaluating a company's capital structure.
A company has a risk free rate of 3% and a risk premium of 6%.
Its tax rate is 35%. What is the company's cost of debt?
A) 5.85%
B) 3.15%
C) 3.9%
D) 2.1%
A company has issued preferred stock that are valued at $75 a
share. The preferred dividend is $5. The company's growth rate is
5%. What is the cost of the company's preferred stock?
A) 11.67%
C) 1.67%
D) 5%
A company issues common equity and has a beta of 1.5. The risk
free return is 3% and the market return is 7%. What is the
company's cost of common equity?
A) 6%
B) 7%
C) 9%
D) 13.5%
A company has retained earnings of $1.5 million and net income
of $8 million. What is the retention rate?
A) 0.1875
B) .08125
C) 0.8125.
D) .01875.
A company is thinking of issuing more common stock. Its stock's
current market price is $50 a share with a dividend of $3 a share.
The company has a 5% growth rate and a flotation cost of 10%.
What is the company cost of new common stock?
B) 65%
C) 16.3%
D) 11.67%
A company has a risk free rate of 3%. The market rate of return is
8% and the company has a beta of 2. What is the company's
expected rate of return?
C) 13%
D) 10%
In the capital asset pricing model (CAPM), you derive a stock’s:
A) Beta
B) Expected return (or cost of capital)
C) Equity Premium
D) Beta, expected return (or cost of capital), and equity premium
Saylor OER. "Business Administration « Saylor.org – Free Online Courses Built by Professors." CC BY 3.0 http://www.saylor.org/majors/Business/
In order to compute the statistical values in the capital asset
pricing model (CAPM), you need information over time about:
A) The rate of return of a risk-free asset, the overall stock market return,
and a company's rate of return.
B) a rate of return from a risk-free asset (like the 90-day U.S. Treasury bill
rate).
C) an overall stock market rate of return.
D) a company’s rate of return.
Which of the following interpretations of data related to a Security
Market Line (SML) is correct?
A) If an asset is priced at a point above the SML it is overvalued.
B) If an asset is priced at a point below the SML, it is undervalued.
C) All of these answers.
D) If an asset's value lies on the SML, it is correctly priced.
A company makes an initial $10,000 investment in a project. This
project is projected to earn $8000 in year one, $10,000 in year 2,
$12,000 in year 3, and $20,000 in year 4. If the interest rate is 5%,
what is the project's present value?
A) $33,509
B) $43,509
C) $40,000
D) $37,619
Which of the following is NOT an element in the bond yield plus
risk premium approach?
A) The company's CAPM.
B) The future cash flows from the benchmark bond.
C) The current yield of a 10-year U.S. Treasury Bond.
D) The benchmark bond's internal rate of return.
Which of the following is NOT a way weighted average cost of
capital (WACC) is used to analyze a company's financial
activities?
A) WACC is the rate a company is expected to pay, on average, to its
security holders.
B) WACC influences how a company's capital structure is balanced.
C) WACC is the minimum rate of return a company must earn on a new
venture.
D) All of these answers.
Suppose that a company has total financing where 10% comes
from bonds, 10% from a loan, and 80% from shareholders’ equity.
The bonds pay on average a 10% interest rate, the loan has a
10% interest rate, and shareholders require a 10% return. The
interest payment on the loan is tax deductible and the tax rate is
20%. What is the simple average cost of capital equal to?
B) 0.0333
C) 0.0733
D) 0.1
10% interest rate, and shareholders require a 10% return. What is
the weighted average cost of capital (WACC) equal to?
B) 0.3
C) 0.1
D) 0.3333
The weighted average cost of capital "weighting" is based on
_____.
A) the market value of the company's debt and equity.
B) the book value of the company's debt and equity.
C) the company's tax rate.
D) the company's returns on equity and debt.
Which of the following correctly explains how a specific factor can
influence a company's weighted average cost of capital?
A) Increasing the amount of debt generally improves performance and
increases return on equity.
B) If a company increases it dividends, it leads to an increase in its
WACC.
C) Increased fixed costs will decrease a company's WACC.
Which of the following are factors that influence the weighted
average cost of capital (WACC) calculation and is external to the
firm?
A) The corporate tax rate.
B) Changes in interest rates.
C) The conditions in the stock market.
A company is considering investing in a project that requires the
company to take on risks outside of the company's current scope.
As a result, which of the following things will happen?
A) The company does not have to recalculate its WACC to evaluate the
B) The project would decrease the company's cost of equity.
C) All of these things.
D) The company's stock value would drop unless the project increase the
company's expected returns.
Which of the following is a problem associated with using the
weighted average cost of capital?
A) All of these answers.
B) The calculation is not exact as at least one component is an estimate.
C) WACC will vary for the same business based on which method you
D) It may be difficult to find a risk-free rate that corresponds to the
investment being analyzed.
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discussion week 1*Organization Behavior & Communication
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