Cost of Capital Chapter 14 Notes to the Instructor:

Cost of Capital Chapter 14 Notes to the Instructor:
The PowerPoints are designed for an introductory finance class for undergraduates with the emphasis on the key points of each chapter Each chapter’s PowerPoint is designed for active learning by the students in your classroom Not everything in the book’s chapter is necessarily duplicated on the PowerPoint slides There are two finance calculators used (when relevant). You can delete the slides if you don’t use both TI and HP business calculators Animation is used extensively. You can speed up, slow down or eliminate the animation at your discretion. To do so just open a chapter PowerPoint and go to any slide you want to modify; click on “Animations” on the top of your PowerPoint screen tools; then click on “Custom Animations”. A set of options will appear on the right of your screen. You can “change” or “remove” any line of that particular slide using the icon on the top of the page. The speed is one of the three options on every animation under “timing”. Effort has been made to maintain the basic “7x7” rule of good PowerPoint presentations. Additional problems and/or examples are available on McGraw-Hill’s Connect. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline The Cost of Capital – Overview The Cost of Equity
The Cost of Debt The Cost of Preferred Stock The Weighted Average Cost of Capital (WACC) Divisional and Project Costs of Capital Floatation Costs relative to WACC

Why the 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 Lecture Tip: Students often find it easier to grasp the intricacies of cost of capital estimation when they understand why it is important. A good estimate is required for: -good capital budgeting decisions – neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate -financing decisions – the optimal/target capital structure minimizes the cost of capital -operating decisions – cost of capital is used by regulatory agencies in order to determine the “fair” return in some regulated industries (e.g. utilities)

Why the Cost of Capital Is Important
Our cost of capital provides us with an indication of how the market views the risk of our assets 4. Knowing our cost of capital can also help us determine our required return for capital budgeting projects Lecture Tip: Students often find it easier to grasp the intricacies of cost of capital estimation when they understand why it is important. A good estimate is required for: -good capital budgeting decisions – neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate -financing decisions – the optimal/target capital structure minimizes the cost of capital -operating decisions – cost of capital is used by regulatory agencies in order to determine the “fair” return in some regulated industries (e.g. utilities)

The Cost of Equity Business risk Financial risk
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

Dividend growth model (aka: the Gordon Model) 2. SML, or the CAPM
The Cost of Equity There are two major methods for determining the cost of equity: Dividend growth model (aka: the Gordon Model) 2. SML, or the CAPM

The Dividend Growth Model (The Gordon Model)
Start with the dividend growth model formula and rearrange to solve for RE Remind students that D1 = D0(1+g) You may also want to take this time to remind them that return is comprised of the dividend yield (D1 / P0) and the capital gains yield (g)

Dividend Growth Model Example
Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity?

Example: Estimating the Dividend Growth Rate
One method for estimating the growth rate is to use the historical average: Year Dividend Percent Change (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) / 1.30 = 4.6% (1.43 – 1.36) / 1.36 = 5.1% (1.50 – 1.43) / 1.43 = 4.9% Our historical growth rates are fairly close, so we could feel reasonably comfortable that the market will expect our dividend to grow at around 5.1%. Note that when we are computing our cost of equity, it is important to consider what the market expects our growth rate to be, not what we may know it to be internally. The market price is based on market expectations, not our private information. So, another way to estimate the market consensus estimate is to look at analysts’ forecasts and take an average. Lecture Tip: It is noted in the text that there are other ways to compute g. Rather than use the arithmetic mean, as in the example, the geometric mean (which implies a compound growth rate) can be used. OLS regression with the log of the dividends as the dependent variable and time as the independent variable is also an option. Another way to estimate g is to assume that the ROE and retention rate are constant. If this is the case, then g = ROE*retention rate. Lecture Tip: Here’s a good real-world exercise to illustrate real-world growth rates. You can assign this as homework, or do it in class if your classroom has Internet access. Go to screen.yahoo.com/stocks.html and find the “Analysts Estimates Est. 5 Yr EPS growth” box, and use up more than 30%. In August of 2008, using the S&P 500 index stocks found 91 stocks. A search of the S&P 600 (small-cap stocks) found 135 stocks (more small-cap stocks were expected to have very high growth rates than large-cap stocks). Average = ( ) / 4 = 5.1%

Advantages and Disadvantages of the Dividend Growth Model
Easy to understand and use Point out that there is no allowance for the uncertainty about the growth rate

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

The SML Approach Use the following information to compute our cost of equity: Risk-free rate, Rf Market risk premium, E(RM) – Rf Systematic risk of asset,  You will often hear this referred to as the Capital Asset Pricing Model Approach as well. www: Click on the web surfer to go to finance.yahoo.com. Both betas and 3-month T-bills are available on this site. To get betas, enter a ticker symbol to get the stock quote, then choose key statistics. To get the T-bill rates, click on “Rates” under Bonds on the home page.

Example - SML Suppose your company has: an equity beta of .58
the current risk-free rate is 6.1% the expected market risk premium is 8.6% The similarity is completely dependent on estimates of the risk-free rate and market risk premium. What is the cost of equity using the SML valuation technique? RE = (8.6) = 11.1%

How Did We Do? Since we came up with similar numbers using both the dividend growth model (11.1%) and the SML approach (11.1%), we should feel good about our estimate!

Advantages and Disadvantages of SML
Explicitly adjusts for systematic risk Applicable to all companies, as long as we can estimate beta A good example to illustrate how beta estimates can lag changes in the risk of equity, consider Keithley Industries (KEI) which was used as one of the portfolio stocks in the last chapter. In Sept. 2000, (based on calculations on Yahoo) KEI had a beta of .59. Yet, its capital gains return from Sept 27, 1999 – Sept 27, 2000 was about 835%!!!!! Beta has since caught up to some extent and was as of November However, in the most recent period as of August 2008, the beta had declined again to .53. Lecture Tip: Students are often surprised when they find that the two approaches typically result in different estimates. Suggest that it would be more surprising if the results were identical. Why? The underlying assumptions of the two approaches are very different. The constant growth model is a variant of a growing perpetuity model and requires that dividends are expected to grow at a constant rate forever and that the discount rate is greater than the growth rate. The SML approach requires assumptions of normality of returns and/or quadratic utility functions. It also requires the absence of taxes, transaction costs, and other market imperfections.

Advantages and Disadvantages of SML
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 A good example to illustrate how beta estimates can lag changes in the risk of equity, consider Keithley Industries (KEI) which was used as one of the portfolio stocks in the last chapter. In Sept. 2000, (based on calculations on Yahoo) KEI had a beta of .59. Yet, its capital gains return from Sept 27, 1999 – Sept 27, 2000 was about 835%!!!!! Beta has since caught up to some extent and was as of November However, in the most recent period as of August 2008, the beta had declined again to .53. Lecture Tip: Students are often surprised when they find that the two approaches typically result in different estimates. Suggest that it would be more surprising if the results were identical. Why? The underlying assumptions of the two approaches are very different. The constant growth model is a variant of a growing perpetuity model and requires that dividends are expected to grow at a constant rate forever and that the discount rate is greater than the growth rate. The SML approach requires assumptions of normality of returns and/or quadratic utility functions. It also requires the absence of taxes, transaction costs, and other market imperfections.

Example – Cost of Equity
Our company has a beta of 1.5. The market risk premium is expected to be 9%, and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity using the SML? RE = 6% + 1.5(9%) = 19.5%

Example – Cost of Equity
Our company has a beta of 1.5. The market risk premium is expected to be 9%, and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. Since the two models are reasonably close, we can assume that our cost of equity is probably around 19.5%. Again, though, this similarity is a function of the inputs selected and is not indicative of the true similarity that could be expected. What is our cost of equity using the DGM? RE= [2(1.06) / 15.65] = 19.55%

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 (as opposed to short-term debt like notes payable) Point out that the cost of debt is rarely the coupon interest rate as the coupon rate was the cost of debt for the company when the bond was issued. We are interested in the rate we would have to pay on newly issued debt, which could be very different from past rates.

Cost of Debt The required return is best estimated by computing the yield-to-maturity on the existing long-term debt (the YTM). The computation of the YTM was presented in the chapter on Bond Valuation Lecture Tip: Consider what happens to corporate bond rates and mortgage rates as the Federal Reserve board changes the fed funds rate. If the Federal Reserve raises the fed funds rate by a quarter point, virtually all bond rates, from government to municipal to corporate, will increase after this action.

Example: Cost of Debt: computing the YTM
Suppose we have a corporate bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9%, and coupons are paid semiannually. The bond is currently selling for $ per $1,000 bond. What is the cost of debt?

HP 12-C 25 years/2 = 50 periods = N $-908.72 = PV
$90/2 = $45 = Payment (PMT) YTM = i = ? $1,000 = FV 5.00 (x2 = 10%) Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet application. 14-26

TI BA II Plus $ -908.72 = PV $1,000 = FV YTM = I/Y = ?
25 yrs/2 = 50 payments = N 5%(5 x 2 = 10% $ = PV $90/2 = $45 (PMT) $1,000 = FV Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet application. YTM = I/Y = ? 1st 2nd 14-27

Cost of Preferred Stock
Preferred stock is a perpetuity, so we take the perpetuity formula: and then rearrange the terms to solve for RP P0 = D_ Rps Rps = D_ P0

Example: Cost of Preferred Stock
Your company has preferred stock that has an annual dividend of $3.00 The current price is $25 What is the cost of preferred stock? RP = 3 / 25 = 12%

Capital Structure Weights
To compute the WACC, we first need the weights of each source of funds: namely debt, preferred stock and equity

Let’s simplify with an example of just debt and equity. We often use the market value of both debt and equity

Capital Structure Valuation
Debt’s Market Value = (# of outstanding bonds ) x (the market price of one bond) Equity’s Market Value = (# shares of outstanding common stock) x (the market price of one share of common stock) Note that for bonds we would find the market value of each bond issue and then add them together. Also note that preferred stock would just become another component of the equation if the firm has issued it.

Capital Structure Valuation
A firm’s market value is simply the added value of both the debt and the equity: V = D + E Note that for bonds we would find the market value of each bond issue and then add them together. Also note that preferred stock would just become another component of the equation if the firm has issued it.

WD = D/V This is the % financed with debt WE = E/V This is the % financed with equity Finally, we generally ignore current liabilities in our computations. However, if a company finances a substantial portion of its assets with current liabilities, it should be included in the process. Lecture Tip: It may be helpful to mention and differentiate between the three types of weightings in the capital structure equation: book, market and target. It is also helpful to mention that the total market value of equity incorporates the market value of all three common equity accounts on the balance sheet (common stock, additional paid-in capital and retained earnings). Lecture Tip: The cost of short-term debt is usually very different from that of long-term debt. Some types of current liabilities are interest-free, such as accruals. However, accounts payable has a cost associated with it if the company forgoes discounts. The cost of notes payable and other current liabilities depends on market rates of interest for short-term loans. Since these loans are often negotiated with banks, you can get estimates of the short-term cost of capital from the company’s bank. The market value and book value of current liabilities are usually very similar, so you can use the book value as an estimate of market value.

Student Alert! WD + WE = 100% or WD + WPS + WE = 100%
The capital structure weights must always add up to 100% WD + WE = 100% or WD + WPS + WE = 100%

Example: Capital Structure Weights
Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million. What are the capital structure weights? V = $500 million + $475 million = $975 million wD = D/V = 475 / 975 = = 48.72% wE = E/V = 500 / 975 = = 51.28%

Taxes and the WACC Wait a minute!
Debt and Equity are not equal in the eyes of the firm. Debt gets a tax advantage and Equity does not. We are concerned with after-tax cash flows, so we also need to consider the effect of taxes on the various costs of capital Dividends are not tax deductible, so there is no tax impact on the cost of equity

Taxes and the WACC Interest expense reduces our tax liability
This reduction in taxes reduces our cost of debt Thus, our real cost of debt is actually the AFTER-TAX cost of debt or … After-tax cost of debt = RD(1-TC)

Taxes and the WACC WACC = WDRD(1-TC) + WE RE
Our new equation for the WACC is: WACC = WDRD(1-TC) + WE RE This is one of the most powerful relationships in finance. Point out that if we have other financing that is a significant part of our capital structure, we would just add additional terms to the equation and consider any tax consequences. Lecture Tip: If the firm utilizes substantial amounts of current liabilities, equation 14.7 from the text should be modified as follows: WACC = (E/V)RE + (D/V)RD(1-TC) + (P/V)RP + (CL/V)RCL(1-TC) where CL/V represents the market value of current liabilities in the firm’s capital structure and V = E + D + P + CL.

Putting All the Pieces Together – WACC Example
Equity Information: 50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5% Debt Information: $1 billion in outstanding debt (face value) Current quote = 110 Coupon rate = 9%, semiannual coupons 15 years to maturity Remind students that bond prices are quoted as a percent of par value The firm’s tax rate is 40%

WACC Example = 7.854% 1. What is the cost of debt?
N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = RD = 3.927(2) = 7.854% Point out that students do not have to compute the YTM based on the entire face amount. They can still use a single bond or they could also base everything on 100 (PV = -110; FV = 100; PMT = 4.5). 2. What is the cost of equity (using the CAPM)? RE = (9) = 15.35%

WACC Example RD (1 – TC) = 7.854 (1 - .40) = 4.712%
What is the AFTER-TAX cost of debt? RD (1 – TC) = ( ) = 4.712%

WACC Example 4. What are the capital structure weights?
Debt = 1 billion ($1.10) = $1.1 billion Equity = 50 million ($80) = $4 billion Value of the Firm = = $5.1 billion

WACC Example (Plug and Chug)
Compute the Weighted Average Cost of Capital (the WACC) WACC = WDRD(1-TC) + WE RE WACC = (4.712%) (15.35%) = 13.06%

Eastman Chemical I Click on the web surfer to go to Yahoo Finance to get information on Eastman Chemical (EMN) Under Profile and Key Statistics, you can find the following information: # of shares outstanding Book value per share Price per share Beta

Eastman Chemical IV Find the weighted average cost of the debt
Use market values if you were able to get the information Use the book values if market information was not available They are often very close Compute the WACC Use market value weights if available

Find estimates of WACC at www.valuepro.net
Work the Web Find estimates of WACC at How do the assumptions impact the estimate of WACC?

Divisional and Project Costs of Capital
Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm’s current operations If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project

Divisional and Project Costs of Capital
Divisions also often require separate discount rates It is important to point out that a single corporate WACC is not very useful for companies that have several disparate divisions. www: Click on the web surfer icon to go to an index of business owned by General Electric. Ask the students if they think that projects proposed by the “Capital Group” should have the same discount rate as projects proposed by “NBC Universal.” You can go through the list and illustrate why the divisional cost of capital is important for a company like GE. If GE’s WACC was used for every division, then the riskier divisions would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects.

Project Risk – An Example
What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15% Project Required Return IRR A 20% 17% B 15% 18% C 10% 12% Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to the IRR and accept projects A and B. Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C. So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier. What will happen to the firm’s cost of capital as the firm becomes riskier? It will increase (adjusting for changes in market returns in general) as well. Lecture Tip: It may help students to distinguish between the average cost of capital to the firm and the required return on a given investment if the idea is turned around from the firm’s point of view to the investor’s point of view. Consider an investor who is holding a portfolio of T-bills, corporate bonds and common stocks. Suppose there is an equal amount invested in each. The T-bills have paid 5% on average, the corporate bonds 10%, and the common stocks 15%. Thus, the average portfolio return is 10%. Now suppose that the investor has some additional money to invest and they can choose between T-bills that are currently paying 7% and common stock that is expected to pay 13%. What choice will the investor make if he uses the 10% average portfolio return as his cut-off rate? (Invest in common stock 13%>10%, but not in T-bills 7%<10%.) What if he uses the average return for each security as the cut-off rate? (Invest in T-bills 7% > 5%, but not common stock 13%<15%.) Lecture Tip: You may wish to point out here that the divisional concept is no more than a firm-level application of the portfolio concept introduced in the section on risk and return. And, not surprisingly, the overall firm beta is therefore the weighted average of the betas of the firm’s divisions.

Project Risk Differentiation
We have two tools in finance to help us here: The Pure Play Approach The Subjective Approach Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to the IRR and accept projects A and B. Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C. So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier. What will happen to the firm’s cost of capital as the firm becomes riskier? It will increase (adjusting for changes in market returns in general) as well. Lecture Tip: It may help students to distinguish between the average cost of capital to the firm and the required return on a given investment if the idea is turned around from the firm’s point of view to the investor’s point of view. Consider an investor who is holding a portfolio of T-bills, corporate bonds and common stocks. Suppose there is an equal amount invested in each. The T-bills have paid 5% on average, the corporate bonds 10%, and the common stocks 15%. Thus, the average portfolio return is 10%. Now suppose that the investor has some additional money to invest and they can choose between T-bills that are currently paying 7% and common stock that is expected to pay 13%. What choice will the investor make if he uses the 10% average portfolio return as his cut-off rate? (Invest in common stock 13%>10%, but not in T-bills 7%<10%.) What if he uses the average return for each security as the cut-off rate? (Invest in T-bills 7% > 5%, but not common stock 13%<15%.) Lecture Tip: You may wish to point out here that the divisional concept is no more than a firm-level application of the portfolio concept introduced in the section on risk and return. And, not surprisingly, the overall firm beta is therefore the weighted average of the betas of the firm’s divisions.

We have two tools in finance to help us here: The Pure Play Approach The Subjective Approach

The Pure Play Approach Find one or more companies that specialize in the product or service that we are considering Compute (or research) the beta for each company Take an average of the betas Note that technically you need to unlever the beta for each company before computing the average. Once the average of the unlevered beta has been found, you then relever to match the capital structure of the firm. This is done because the equity beta contains both business risk and financial risk – what we really need is the business risk and then we apply our own financial risk.

The Pure Play Approach Use that beta along with the CAPM to find the appropriate return for a project of that identical risk 5. Use this computed cost of capital for capital budgeting computations While interesting in theory, in reality, it is often difficult to find pure play companies.

We have two tools in finance to help us here: The Pure Play Approach The Subjective Approach

Subjective Approach Consider the project’s risk relative to the firm overall: If the project has more risk than the firm, use a discount rate greater than the WACC If the project has less risk than the firm, use a discount rate less than the WACC If the project’s risk > firm’s risk, increase the WACC number Lecture Tip: Ask the class to consider a situation in which a company maintains a large portfolio of marketable securities. Now ask them to consider the impact this large security balance would have on a company’s current and quick ratios and how this might impact the company’s ability to meet short-term obligations. The students should easily remember that a larger liquidity ratio implies less risk (and less potential profit). Although the revenue realized from the marketable securities would be less than the interest expense on the company’s comparable debt issues, these holdings would result in lowering the firm’s beta and WACC. This example allows students to recognize that the expected return and beta of an investment in marketable securities would be below the company’s WACC, and justification for such investments must be considered relative to a benchmark other than the company’s overall WACC. International Note: The difficulty in arriving at an appropriate estimate of the cost of capital for project analysis is magnified for firms engaged in multinational investing. In Financial Management for the Multinational Firm, Abdullah suggests that adjustments to foreign project hurdle rates should reflect the effects of the following: -foreign exchange risk -political risk -capital market segmentation -international diversification effects Making these adjustments requires a great deal of judgment and expertise, as well as an understanding of the underlying financial theory. Most multinational firms find it expeditious to adjust the hurdle rates subjectively, rather than attempting to quantify precisely the effects of these factors for each foreign project. If the project’s risk < firm’s risk, Decrease the WACC number

Subjective Approach You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all.

Subjective Approach: An Example
Risk Level Discount Rate Very Low Risk WACC – 8% Low Risk WACC – 3% Same Risk as Firm WACC High Risk WACC + 5% Very High Risk WACC + 10% Lecture Tip: What an individual firm considers a risky investment and what the financial market considers a risky investment may not be the same. Recall that the market is concerned with systematic risk, or non-diversifiable risk. If a firm is considering an investment’s total risk in assigning it to a risk category, the risk categories may not line up with the SML.

Flotation Costs Flotation costs are the fees paid to issue stocks or bonds While the required return for a project depends on the risk, it should not depend upon how the money is raised However, the cost of issuing new securities should not just be ignored either

Flotation Costs However, the cost of issuing new securities should not just be ignored either. The Basic Approach: Compute the weighted average flotation cost 2. Use the target weights because the firm will issue securities in these percentages over the long term

Flotation Costs: An NPV Example
Your company is considering a project that will cost $1 million. The project will generate after-tax cash flows of $250,000 per year for 7 years. The WACC is 15%, and the firm’s target D/E ratio is .6 The flotation cost for equity is 5%, and the flotation cost for debt is 3%.

What is the NPV for the project before adjusting for flotation costs? WACC = 15% PV of future cash flows = $1,040,105 NPV = 1,040, ,000,000 = $ 40,105

What is the NPV for the project after adjusting for flotation costs? fA = (.375)(3%) + (.625)(5%) = 4.25% PV of future cash flows = 1,040,105 NPV = 1,040, ,000,000/( ) = $ -4,281

The project would have a positive NPV of $40,105 without considering flotation costs Once we consider the cost of issuing new securities, the NPV becomes a negative $4,281!

Comprehensive Problem
A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price. The company’s 100,000 shares of preferred stock pay a $3 annual dividend, and sell for $30 per share. The company’s 500,000 shares of common stock sell for $25 per share and have a beta of 1.5. The risk free rate is 4%, and the market return is 12%. Assuming a 40% tax rate, what is the company’s WACC? MV of debt = 10,000 x $1,100 = $11,000,000 Cost of debt = YTM: 8 N; -1,100 PV; 60 PMT; 1,000 FV; CPT I/Y = 4.48% MV of preferred = 100,000 x $30 = $3,000,000 Cost of preferred = 3/30 = 10% MV of common = 500,000 x $25 = $12,500,000 Cost of common = x ( ) = 16% Total MV of all securities = $11M + $3M + $12.5M = 26.5M Weight of debt = 11M/26.5M = .4151 Weight of preferred = 3M/26.5M = .1132 Weight of common = 12.5M/26.5M = .4717 WACC = x x (1 - .4) x x .16 = = 9.8%

Ethics Issues Is this ethical or financially sound?
How could a project manager adjust the cost of capital (i.e., appropriate discount rate) to increase the likelihood of having his/her project accepted? Is this ethical or financially sound? These Ethics Issues can be addressed throughout the chapter or as a dedicated discussion as given here. A manager could assume that the project is less risky than the typical firm project and therefore apply a lower discount rate, which would increase the NPV. This illustrates the importance of sensitivity analysis for corporate headquarters in evaluating proposed projects.

Terminology Security Market Line (SML)
Capital Asset Pricing Model (CAPM) Yield or Yield to Maturity (YTM) Cost of Capital Weighted Average Cost of Capital (WACC) Pure Play risk Subjective Risk

Terminology (ctd) Capital Structure Cost of Equity Cost of Debt
Cost of Capital Capital Budgeting (NPV, IRR) Floatation Costs

Formulas Cost of Equity (Dividend Growth Model) Cost of Equity (CAPM)

Formulas (continued) WACC = WDRD(1-TC) + WE RE Rps = D_ P0
Cost of Preferred Stock After-tax cost of debt = RD(1-TC) WACC = WDRD(1-TC) + WE RE

Key Concepts and Skills
Be able to compute a firm’s cost of equity using the CAPM and the Dividend Growth model Be able to compute a firm’s after-tax cost of debt

Key Concepts and Skills
Know how to compute the WACC of a firm Identify the consequences to the WACC of considering floatation costs

What are the most important topics of this chapter?
There are two ways to compute the cost of equity: DGM and CAPM. 2. The relevant cost of debt to a firm is the after-tax cost. 3. Capital structure determines the weights of debt, preferred stock and equity used by the firm.

What are the most important topics of this chapter?
The WACC determines the discount rate to be used for capital budgeting purposes for NPV, IRR and MIRR. 5. All projects may not have the identical risk classification and we may need to adjust the WACC accordingly.

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