1

Cost of Capital

2

Weighted average cost of capital (WACC).

• The discount rate used in the capital budgeting

1. Identify the components to be used in a project’s cost of capital

2. The method used to determine the cost of each component.

3. How are the component costs combined into a weighted average cost of capital?

3

Cost of equity

• The return that equity investors require on their investment in the firm

• Two approaches to determine the cost of equity

1. dividend growth model approach

Since is the return that the shareholders required on the stock, it can be interpreted as the firm’s cost of equity.

gR

D

gR

gDP

EE

100

1

gP

DRE

0

1

4

Example

• Great Wall Co. paid dividend of $4 last year, has dividend growth rate of 6%, current price of $60.

• In using the dividend growth model approach, we need to estimate g:

• )use historical growth rate;

• b) use analysts’ forecasts of future growth rates.

24.406.014101 gDD

1307.006.060/24.40

1 gP

DRE

5

• Advantages of the dividend growth model approach: Simple

• Disadvantages of the dividend growth model approach:

• Only applicable to firms that pay dividends and have a constant dividend growth rate.

• The estimated cost of equity is very sensitive to the estimated growth rate.

• Does not explicitly consider risk.

6

2). The Security Market Line (SML) approach

We drop E, the expectation, to express an estimate.

fMEfE RRERRE

fMEfE RRRR

7

Example

• IBM: %4.5R %,14R ,9.0 fM

1314.0)054.14.0(9.0054.0 IBMR

8

• Advantages of the SML approach• .Adjust risk

• .Applicable to companies other than just those with steady dividend growth.

• Disadvantages of the SML approach• .Need to estimate two parameters: the market risk

premium and the beta coefficient

• .Rely on the past to predict the future.

9

The cost of debt

• The cost of debt is the return that the firm’s creditors demand on new borrowing. Unlike the cost of equity, a firm’s cost of debt can normally be observed either directly or indirectly.

• Example: 30-year bond, coupon rate = 7%, B0=800, face value=1000.

• Yield to maturity = 8.93562 = RD

10

The cost of preferred stock

• Preferred stock has a fixed dividend paid every period forever.

• Example: Tai Power has one issue of preferred stock paying dividend of $7.72 annually, and being sold for $102 per share.

0P

DRp

0757.0102

72.7

0

P

DRp

11

The weighted average cost of capital• The capital structure weights

• E: the market value of the firm’s equity = the number of shares outstanding × price per share

• D: the market value of the firm’s debt

• A firm’s market value = the market value of the firm’s equity + the market value of the firm’s debt

• V = E + D

V

D

V

E%100

12

The weighted average cost of capital

where TC stands for the corporate tax rate. The interest paid by a firm is deductible for tax purposes.

CDE TRV

DR

V

EWACC 1

13

Example

• Ging Din Co. has 1.4 million shares of stock outstanding. The stock quoted at 93% of face value. It has a total face value of 5 million, and it is currently priced to yield of 11%. The risk-free rate is 8%, and the market risk premium is 7%. The beta of the firm is 0.74. The corporation tax rate is 34%. What is the WACC for Ging Din Co.?

=0.08+0.74×(0.07)=0.1318

=11%

=34%

E=1.4 million×20 = 28 million

D=0.93×5 million = 4.65 million

V=28+4.65 = 32.65

WACC=28/32.65×0.1318+4.65/32.65×0.11×(1-0.34%)=0.1234=12.34%

14

Example

• If Ging Din’s fund is used to finance a new project. The project had a cost of 50 million and the expected after tax cash flow of 12 million per year for 6 years.

• The NPV will be:

• The project has a negative NPV using the firm’s WACC. The project should be rejected.

62 1

12..

1

12

1

1250

WACCWACCWACCNPV

03.49

%34.121

12..

%34.121

12

%34.121

1250 62

NPV

15

Flotation cost

• The percentage cost of issuing new common stock.

• When we issue new stocks, a flotation cost occurs to make the cost of equity higher.

gFP

DRE

10

1