FIN 3403 – Unit 12: Cost of Capital

Cost of Capital

The minimum return a company must earn to satisfy investors who provide financing.

Required Return

The minimum return investors expect based on an investment's risk.

Discount Rate

Rate used to find the present value of future cash flows; depends on risk.

Investor Required Return vs. Company Cost of Capital

Same rate viewed differently: investors earn it; the company pays it.

Capital Budgeting Required Return

Minimum return a project must earn to compensate investors for its risk.

Cost of Equity (RE)

Return stockholders require based on the company's risk.

Business Risk

Risk caused by normal business operations.

Financial Risk

Extra risk caused by using debt.

Dividend Growth Model (DGM)

Finds cost of equity using dividends, stock price, and growth.

DGM Formula

RE = D1/P0 + g. Dividend yield plus growth rate.

D0 vs. D1

D0 = last dividend; D1 = next expected dividend.

Estimating Dividend Growth

Use historical dividend growth or analysts' estimates.

DGM Advantage

Simple to understand and use.

DGM Disadvantages

Needs fairly constant dividend growth; sensitive to growth estimates; does not explicitly measure risk.

Capital Asset Pricing Model (CAPM)

Calculates cost of equity using risk-free rate, beta, and market risk premium.

Security Market Line (SML)

Shows how required return relates to systematic risk (beta).

CAPM Formula

RE = Rf + β(RM − Rf).

Risk-Free Rate (Rf)

Return on an investment assumed to have no default risk.

Market Risk Premium

Expected market return minus risk-free rate.

Beta

Measures a stock's systematic risk relative to the market.

Systematic Risk

Market-wide risk diversification cannot eliminate.

CAPM Advantages

Adjusts for systematic risk and works when beta can be estimated.

CAPM Disadvantages

Beta and market risk premium are estimates that change over time.

Cost of Debt (RD)

Current return lenders require, usually estimated using YTM.

Yield to Maturity (YTM)

Bond return if held until maturity and all promised payments are made.

Coupon Rate vs. Cost of Debt

Coupon rate is stated interest; current cost of debt is based on YTM.

Semiannual Bond Calculator Setup

N = years × 2; PMT = annual coupon ÷ 2; FV = par; PV = negative price; annual YTM = I/Y × 2.

Estimating Cost of New Debt

Use current YTM or current rates based on the expected bond rating.

Preferred Stock

Stock that generally pays a constant dividend.

Preferred Stock as a Perpetuity

Its constant dividends are expected to continue forever.

Cost of Preferred Stock (RP)

Required return on preferred stock. RP = annual dividend ÷ current price.

Weighted Average Cost of Capital (WACC)

Average required return across financing sources, weighted by market value.

Capital Structure

Mix of debt, common equity, and possibly preferred stock used to finance a company.

Market Value of Equity (E)

Outstanding shares × current stock price.

Market Value of Debt (D)

Outstanding bonds × current bond price.

Total Firm Value (V)

D + E, plus preferred stock if present.

Equity Weight (wE)

E/V; percentage financed by equity.

Debt Weight (wD)

D/V; percentage financed by debt.

Capital Structure Weight Rule

All financing weights must equal 100%.

Market Values in WACC

Use current market values for financing weights.

Tax Advantage of Debt

Interest is tax-deductible; dividends are not.

After-Tax Cost of Debt

RD(1 − TC); cost of borrowing after tax savings.

Corporate Tax Rate (TC)

Tax rate used in calculating after-tax borrowing cost.

WACC Formula

WACC = wE×RE + wP×RP + wD×RD×(1−TC).

Divisional Cost of Capital

Required return for a division based on its risk.

Project Cost of Capital

Required return based on a specific project's risk.

When to Use Company WACC

When a project has the same risk as existing company operations.

Using One WACC for Every Project

Can accept overly risky projects and reject worthwhile safer ones.

Pure Play Approach

Uses beta from similar businesses to estimate project risk and return.

Pure Play Approach Limitation

Comparable companies may be difficult to find.

Subjective Approach

Adjusts discount rates based on project risk.

Subjective Risk Adjustment

Higher risk = higher discount rate; lower risk = lower rate.

Flotation Costs

Expenses of issuing new stocks or bonds.

DGM Calculation

D1=$1.50, P0=$25, g=5.1%. RE = 1.50/25 + .051 = 11.10%.

CAPM Calculation

Rf=5.9%, β=.58, premium=8.6%. RE = 5.9% + .58(8.6%) = 10.89%.

Comparing CAPM and DGM

Professor's example: CAPM = 19.50%; DGM = 19.55%. Both estimate cost of equity.

Bond YTM Calculation

25 years, 9% coupon, semiannual, price $908.72: N=50, PMT=45, FV=1000, PV=−908.72. Annual YTM = 10%.

Preferred Stock Calculation

Dividend $3, price $25. RP = 3/25 = 12%.

Capital Structure Weights

E=$500m, D=$475m, V=$975m. wE = 51.28%, wD = 48.72%.

Weighted Average Flotation Cost

Average issuance cost using target financing weights.