1. Cost of Capital Rate of return required by firm’s investors
Cost of capital is required rate of return for projects with same level of risk as overall firm
Required rate of return must be adjusted to reflect anticipated risk of project
Cost of Capital

2. Cost of Capital Cost of Capital = Average cost of debt and equity
The Big Picture….
Cost of Capital
Cost of Capital = Average cost of debt and equity
For now, assume ratio of debt to equity constant
As debt increases, required will start to increase at some point
Cost of Capital

3. Cost of debt After-tax YTM on debt Includes flotation costs
Cost of Capital

4. Cost of Debt Rate of return required by firm’s investors
YTM (required return) on IBM’s bonds is 10%
(Ms. Investor demands a 10% rate of return)
However, IBM’s after-tax cost of debt is 7% Assuming IBM has a 30% tax rate
$100 Interest (10%)
Tax Savings
= 70 After-Tax Interest Cost (7%)
Cost of Capital

5. Cost of Debt Rate of return required by firm’s investors
Coupon rate on debt is not relevant
12% coupon bond, trading at $1,117 has a 9% YTM
Would issue additional debt at 9% (before tax)
This would be 6.3% after-tax (assume 30% tax rate)
Cost of Capital

6. Calculating Required Rate of Return (Yield to Maturity)
Bond has 6.5% coupon rate, 7 years to maturity and has net price of $870. What is yield to maturity?
Required rate of return (YTM) = 9.09%
After-tax rate required rate of return = 9.09% - (38% x 9.09%) = 5.64%
Cost of Capital

7. Cost of Preferred Stock
Cost of preferred stock = annual dividend / net price of preferred stock
Net price is after flotation costs
Cost of Capital

8. Cost of Equity
Must be estimated. No stated rate like YTM on bonds or loans.
Calculate cost for both:
Retained earnings
Issuing new equity
Cost of Capital

9. Cost of Equity Dividend Growth Model NP = D1 / (RR – G)
RR = (D1/NP) + G
Calculate cost of retained earnings
Price (P) , Dividend (D) are known.
Can estimate growth rate (G).
Then solve for required return (RR)
Use Net Price after flotation costs for P
Cost of Capital

10. Cost of Equity Dividend Growth Model NP = D1 / (RR – G)
RR = (D1/NP) + G
P = $32, D = $2.20, G = 4%, NP = $32.00, D1 = $2.29
RR = ($2.29/$32.00)+4%
RR = 11.15%
Cost of Capital

11. Cost of Equity Dividend Growth Model Advantage: Issues: Simple
Must estimate growth rate
Some companies don’t pay dividends
Take into account risk?
Cost of Capital

12. Cost of Equity Capital Asset Pricing Model (CAPM)
RR = RF + (RM – RF) X Beta
Risk-free rate of return (RF) is known
Beta is generally known
Required Return for Market (RM) must be estimated
Cost of Capital

13. Cost of Equity Capital Asset Pricing Model (CAPM)
RR = RF + (RM – RF) X Beta
Advantages
Adjusts for risk
Can be used for companies with no dividends
Cost of Capital

14. Cost of Equity Capital Asset Pricing Model (CAPM)
RR = RF + (RM – RF) X Beta
Issues:
Calculating Market Risk Premium (RM – RF)
One study: 9.2% for large cap stocks
Another study: 9.5% for large cap stocks
Another study: 4-6% for large cap stocks
Cost of Capital

15. Cost of Equity Bond-yield plus equity risk RR = YTM + (RM – RF)
Advantage
Uses YTM for company’s bonds as starting point
Can be used to compare with other two methods
Cost of Capital

16. WACC Market Value Company = Equity Value + Debt Value
Equity Value = Market cap
Number of shares x Price of stock
Debt Value
Number of bonds x Value of Bonds
Cost of Capital

17. WACC
WACC =
(Debt Value x Cost of Debt) +
(Equity Value x Cost of Equity)
Due to risk premium for equity, generally equity will have a larger cost than debt
But required return on debt will increase if very little equity
Cost of Capital

18. WACC: cost of capital Debt: usually cheapest after-tax cost
Deduct interest
Barclays 2006 study:
Investment grade: 4.0%; high-yield: 5.6%
Preferred stock
Less risk than common stock
Internal equity (retained earnings)
No flotation costs
External equity (issue new stock)
Usually most expensive
Barclays 2006 study: 9%
Cost of Capital

19. WACC Value of firm maximized when WACC is minimized
Should reduce Required Return
This would increase NPV of projects
WACC is not Required Return for all projects
Adjust Required Return based on risk of project
If use WACC for all projects, will accept risky projects and decline safe projects
Since safe projects will generally have low IRR
Cost of Capital