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Chapter 14 - Cost of Capital
Chapter 14
COST OF CAPITAL
CHAPTER WEB SITES
Section Web Address
14.2 www.zacks.com
www.bloomberg.com
14.4 www.ibbotson.com
www.valuepro.net
www.sternstewart.com
CHAPTER ORGANIZATION
14.1 The Cost of Capital: Some Preliminaries
Required Return versus Cost of Capital
Financial Policy and Cost of Capital
14.2 Cost of Equity
The Dividend Growth Model Approach
The SML Approach
14.3 The Costs of Debt and Preferred Stock
The Cost of Debt
The Cost of Preferred Stock
14.4 The Weighted Average Cost of Capital
The Capital Structure Weights
Taxes and the Weighted Average Cost of Capital
Calculating the WACC for Eastman Chemical
Solving the Warehouse Problem and Similar Capital Budgeting Problems
Performance Evaluation: Another Use of the WACC
14.5 Divisional And Project Costs of Capital
The SML and the WACC
Divisional Cost of Capital
The Pure Play Approach
The Subjective Approach
14.6 Company Valuation With the WACC
14.7 Flotation Costs and the Weighted Average Cost of Capital
The Basic Approach
Flotation Costs and NPV
Internal Equity and Flotation Costs
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Chapter 14 - Cost of Capital
14.8 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
1. The Cost of Capital: Some Preliminaries
A. Required Return Versus Cost of Capital
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)
Lecture Tip: EVA (“Economic Value Added”) is discussed more
later in the chapter. It is a metric of firm and managerial
performance that has become widely accepted in modern business.
It may be useful to mention it here as a motivation for
understanding WACC. The students’ bonuses may very well depend
on whether or not they can outperform this number. You can take
the students to the Stern Stewart web site (www.sternstewart.com)
to show them how it is described by the “inventors.”
Cost of capital, required return, and appropriate discount rate are
different phrases that all refer to the opportunity cost of using
capital in one way as opposed to alternative financial market
investments of the same systematic risk.
-required return is from an investor’s point of view
-cost of capital is the same return from the firm’s point of view
-appropriate discount rate is the same return as used in a PV
calculation
B. Financial Policy and Cost of Capital
Capital structure – the firm’s combination of debt and equity. The
capital structure decision is discussed later; here, a firm’s cost of
capital reflects the average riskiness of all of the securities it has
issued, which may be less risky (bonds) or more risky (common
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Chapter 14 - Cost of Capital
stock).
2. The Cost of Equity
A. The Dividend Growth Model Approach
According to the dividend growth model,
P0 = D1 / (RE – g)
Rearranging and solving for the cost of equity gives:
RE = (D1 / P0) + g
which is equal to the dividend yield plus the growth rate (capital
gains yield).
Implementing the Approach
Price and latest dividend are directly observed; g must be
estimated.
Estimating g – typically use historical growth rates or analysts’
forecasts.
Example:
Year Dividen
d
$ Change % Change
2001 1.10 - -
2002 1.20 0.10 9.09%
2003 1.35 0.15 12.50%
2004 1.40 0.05 3.70%
2005 1.55 0.15 10.71%
Average growth rate = (9.09 + 12.50 + 3.70 + 10.71) / 4 = 9.00%
Advantages and Disadvantages of the Approach
-Approach only works for dividend paying firms
-RE is very sensitive to the estimate of g
-Historical growth rates may not reliably predict future growth
rates
-Risk is only indirectly accounted for by the use of the price
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Chapter 14 - Cost of Capital
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: Some students may question how you value the stock
for a firm that doesn’t pay dividends. In the case of growth-
oriented, non-dividend-paying firms, analysts often look at the
trend in earnings or use similar firms to project the future date of
the first expected dividend and its future growth rate. However,
such processes are subject to greater estimation error, and when
companies fail to meet (or even exceed) estimates, the stock price
can experience a high degree of variability. It should also be
pointed out that no firm pays zero dividends forever – at some
point, every going concern will pay dividends. Microsoft is a good
example. Many people believed that Microsoft would never pay
dividends, but even it ran out of investments for all of the cash that
it generated and began paying dividends in 2003.
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
February 2012, Yahoo! found 639 stocks that met this criteria.
B. The SML Approach
CAPM, RE = Rf + E(E(RM) – Rf)
Implementing the Approach
Betas are widely available, and T-bill rates or the rate on long-
term Treasury securities are often used for Rf. The expected
market risk premium is the more difficult number to come up
with – make sure that the market risk premium used is
consistent with the risk-free rate chosen. One of the problems
is that we really do need an expectation, but we only have past
information and market risk premiums vary through time.
Early in 2000, Federal Reserve Chairman Alan Greenspan
indicated that part of his concern with the state of the U.S.
stock markets at that time was the reduction in the market risk
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Chapter 14 - Cost of Capital
premium. He felt that investors were either becoming less risk
averse, or they did not truly understand the risk they were
taking by investing in the stock. Nonetheless, the historical
average is often used as an estimate for the expected market
risk premium.
Advantages and Disadvantages of the Approach
-This approach explicitly adjusts for risk in a fashion that is
consistent with capital market history
-It is applicable to virtually all publicly traded stocks
-The main disadvantage is that the past is not a perfect
predictor of the future, and both beta and the market risk
premium vary through time
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.
3. The Costs of Debt and Preferred Stock
A. The Cost of Debt
Cost of debt (RD) – the interest rate on new debt can easily be
estimated using the yield to maturity on outstanding debt or by
knowing the bond rating and looking up rates on new issues with
the same rating.
Lecture Tip: Consider what happens to corporate bond rates and
mortgage rates as the Federal Reserve board changes the federal
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.
Lecture Tip: It is beneficial to reemphasize the distinction between
the coupon rate, the current yield, and the yield to maturity. The
cost of debt is equal to the yield to maturity because it is the
market rate of interest that would be required on new debt issues.
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Chapter 14 - Cost of Capital
The coupon rate, on the other hand, is the firm’s promised interest
payments on existing debt and the current yield is the income
portion of total return. If you don’t emphasize this point, some
students want to just use the coupon rate on current debt.
Real-World Tip: “Corporate Treasurers Rush to Sell Bonds” – so
read the headline of a Wall Street Journal article describing the
reactions of corporate treasurers facing the welcome combination
of a strong economy and low interest rates in 1996. Firms that had
issued bonds to take advantage of low market rates were described
as “opportunistic issuers.” More than $30 billion of debt was
issued between September and November 1996. Good anecdotal
evidence comes from Alice Peterson, treasurer of Sears, Roebuck,
and Co. According to the article, Sears Roebuck Acceptance Corp.
issued $300 million of debt. Ms. Peterson indicated that they
looked at 10-year Treasury yields, which were historically low.
B. The Cost of Preferred Stock
Preferred stock is generally considered to be a perpetuity, so you
rearrange the perpetuity equation to get the cost of preferred, RP
RP = D / P0
4. The Weighted Average Cost of Capital
A. The Capital Structure Weights
E = market value of the firm’s equity = # of outstanding shares
times price per share
D = market value of the firm’s debt = # of bonds times price per
bond or take bond quote as percent of par value and multiply
by total par value
V = combined market value of the firm’s equity and debt = E + D
(Assuming that there is no preferred stock and current
liabilities are negligible. If this is not the case, then you need to
include these components as well. This is really just the market
value version of the balance sheet identity. The market value of
the firm’s assets = market value of liabilities + market value of
equity.)
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
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Chapter 14 - Cost of Capital
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.
B. Taxes and the Weighted Average Cost of Capital
After-tax cash flows require an after-tax discount rate. Let TC
denote the firm’s marginal tax rate. Then, the weighted average
cost of capital is:
WACC = (E/V)RE + (D/V)RD(1-TC)
WACC – overall return the firm must earn on its assets to maintain
the value of its stock. It is a market rate that is based on the
market’s perception of the risk of the firm’s assets.
Lecture Tip: If the firm utilizes substantial amounts of current
liabilities and has issued preferred stock, 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 and P
represents the market value of preferred stock.
V = E + D + P + CL.
C. Calculating the WACC for Eastman Chemical
Several web sites are utilized to find the information required to
compute the WACC.
1. Go to a site such as finance.yahoo.com; type in EMN and
choose key statistics. Get the market value of equity (price*shares
outstanding) and beta.
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Chapter 14 - Cost of Capital
2. Go to the bonds section to get the risk-free rate and decide on an
estimate of the market risk premium, such as 7.0%. Estimate RE
using the CAPM.
3. Use the dividend growth model and estimates of EPS growth to
estimate RE.
4. Decide which model provides the most realistic estimate or
average them.
5. Go to www.finra.org/marketdata to find the weighted average of
the yield to maturity for bond issues. Book value and market value
of debt is often similar, so you may want to use the book value for
simplicity, which can be found on financial statements reported to
the SEC.
6. Use market value weights to compute the WACC.
D. Solving the Warehouse Problem and Similar Capital Budgeting
Problems
Lecture Tip: The warehouse problem employs the WACC as the
discount rate in an NPV calculation. This is only appropriate if the
warehouse has approximately the same risk characteristics as the
overall firm. A second assumption that is often discussed in
financial literature is that the project should be financed in the
same proportion of debt versus equity as used in the WACC.
However, as discussed earlier, the appropriate discount rate for a
project depends on the risk of the project, not on how it is paid for.
The WACC is the best estimate we have of the market’s perception
about the risk of the firm and the required return given that risk.
Consequently, the key assumption is that the project is the same
risk as the firm’s current assets.
E. Performance Evaluation: Another Use of the WACC
EVA (Economic Value Added) basically suggests that a firm must
earn more than its cost of capital in order to create value for
investors.
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