Text: Financial Management:

Principles & Applications (13th

Financial Edition) by Titman, Keown and

Martin

Management(
FN504) Session_09&10: Cost of capital
 The concepts underlying the firm’s overall cost of capital and
Understand the purpose for its calculation

Learning Evaluate Firm’s capital structure and determine the relative importance
(weight) of each source of financing.

outcomes
Calculate Firm’s weighted average cost of capital (WACC).
 1. Money Has a Time Value.
2. There is a Risk-Return
Tradeoff.
Principles of
3. Cash Flows Are the Source of
Finance Value.
Used? 4. Market Prices Reflect
Information.
5. Individuals Respond to
Incentives.
An Overview of the Cost of Capital
• Notably, the returns that investors expect to receive on the firm’s
stocks and bonds are basically the cost to the firm of attracting the
capital used to fund the firm’s investment in assets.
• This cost of capital for a firm is the weighted average of the required
returns of the securities that are used to finance its business.
• We refer to this as the firm’s weighted average cost of capital, or
WACC.
• WACC incorporates the required rates of return demanded by the
firm’s lenders and investors along with the specific mix of financing
sources that the firm uses.
An Overview of the Cost of Capital
The riskiness of a firm affects its WACC in two ways:

• First, required rate of return on the debt and equity securities that
the firm issues will be higher if the firm is riskier, and

• Second, risk influences how the firm chooses the extent to which it
is financed with debt and equity securities.
An Overview of the Cost of Capital
The firm’s WACC is used in several ways:

• First, WACC is used to value the entire firm.

• Second, firms often use WACC as the starting point for determining
the discount rate for individual investment projects they might
undertake.

• Finally, firms sometimes use their WACC to evaluate their

performance.
WACC calculation using equation
Tabulated Calculation of WACC
Tabulated Calculation of WACC: Explanation
• a The sources of capital included in the WACC calculation include all
interest-bearing debt (short- and long-term) but exclude non-interest-
bearing debt such as accounts payable and accrued expenses. In
addition, preferred stock and common equity are included. The total of
all the market values of all the capital sources included in the WACC
computation is generally referred to as the firm’s enterprise value, and
the mix of debt and equity defines the firm’s capital structure.
• b The weight used to average the cost of each source of capital should
reflect the relative importance of that source of capital to the firm’s
value on the date of the analysis. This means that the proper weight for
each source is based on the market value of that source of capital as a
percentage of the sum of the market values of all sources.
Tabulated Calculation of WACC: Explanation
• c The investor’s required rate of return is the basis for estimating the
cost of capital for each source of financing to the firm. However,
because interest on the firm’s debt is tax-deductible to the firm, we
must adjust the lender’s required rate of return to an after-tax basis. The
required rate of return for each source of financing, like the weight used
to average it, should reflect a current estimate based on current market
conditions.

• d The weighted average of the individual costs of the sources of capital

is found by summing the products of the weight and cost of each source.
Three Steps to Estimate Firm’s WACC
I. Define the firm’s capital structure by determining the weight of
each source of capital (Column 2, previous table). The weight
(importance) of each source of capital is based on the current
market value of each source of capital.
II. Estimate the cost of each source of financing. These costs are
equal to the investor’s required rates of return after adjusting the
cost of debt for the effects of taxes (Column 3).
III. Calculate a weighted average of the cost of capital from all source
of financing. This step requires calculating the product of the after-
tax cost of each capital source used by the firm and the weight
associated with that source. The sum of these products is the
WACC. (Column 4).
Determining the Firm’s Capital Structure
Weights
The weights are based on the following three sources of financing:
• Debt (d) i.e., short-term as well as long-term
• Preferred stock (ps)
• Common stock or equity (cs or e).

Notably, liabilities such as accounts payable are not included in capital

structure.
Determining the Firm’s Capital Structure Weights
• In theory, market value is preferred for all securities. However, not all market values
may be readily available.
• In practice, we generally use book values for debt and market values for equity
securities.
Practice Exercise (1)
In the spring of 2016, Templeton was considering the acquisition of a chain of extended care facilities
and wanted to estimate its own WACC as a guide to the cost of capital for the acquisition. The capital
structure of Templeton was as follows:
Source of capital Market Value
Debt $100 million
Preferred stock 50 million
Common stock 250 million
Total capital $ 400 million

Templeton contacted the firm’s investment banker to get an estimate the firm’s current cost of
financing and was told that if the firm were to borrow the same amount of money today, it would have
to pay lenders 8% (the marginal tax rate is 25%). The preferred stockholders currently demand a 10%
rate of return whereas common stockholders demand around 15%.
As a CFO of Templeton, determine the firm’s WACC.
Practice Exercise (1)
Solution:
Step I: Determine the capital structure and using that calculate the weights.
Source of capital Market Value Calculation of Weights Final Weights (w)
Debt $100 million $100/400 0.25
Preferred stock 50 million 50/400 0.125
Common stock 250 million 250/400 0.625
Total capital $ 400 million 400/400 1.000
Practice Exercise (1)
Solution:
Step II: Estimate the cost of each source of financing.
Source of capital Market Value Final Weights (w) Cost of each source
Debt $100 million 0.25 0.08 (1-0.25)
Preferred stock 50 million 0.125 0.10
Common stock 250 million 0.625 0.15
Total capital $ 400 million 1.000
Practice Exercise (1)
Solution:
Step III: Calculate a weighted average of the cost of capital.
Source of Market Value Final Weights (w) Cost of each source (k) WACC (w*k)
capital
Debt $100 million 0.25 0.08 (1-0.25) 0.015
Preferred 50 million 0.125 0.10 0.0125
stock
Common 250 million 0.625 0.15 0.09375
stock
Total capital $ 400 million 1.000 WACC = Sum of col. 5 0.12125

WACC = 12. 125 %.

It is closest to common stock cost because of the maximum weightage of the same in the capital mix.
Practice Exercise (1) Contd.
After completing her estimate of Templeton’s WACC, the CFO decided to
explore the possibility of adding more low-cost debt to the capital
structure.
With the help of the firm’s investment banker, the CFO learned that
Templeton could probably push its use of debt to 37.5% of the firm’s
capital structure by issuing more debt and retiring (purchasing) the firm’s
preferred shares. This could be done without increasing the firm’s costs of
borrowing or the required rate of return demanded by the firm’s common
stockholders. What is your estimate of the WACC for Templeton under this
new capital structure proposal?
Practice Exercise (1) Contd.
Solution:
Step I, II & III (together in one table).
Source of capital Final Weights (w) Cost of each source (k) WACC (w*k)
Debt 0.375 0.08 (1-0.25) 0.0225
Preferred Stock 0 0.10 0
Common stock 0.625 0.15 0.09375
Total capital 1.000 WACC = Sum of col. 5 0.11625

WACC = 11. 625 %.

Notably, altering the weights will change the WACC.
Practice exercise (2)
Apex Builders Ltd. Is a Hong Kong based reputed property developer with a
portfolio of projects around the territory. The government has recently approved
parts of Lantau Island, which is near Hong Kong , for housing estate development.
Apex has decided to develop a housing estate at the projected cost of HK$250
million on the island. They do not have any debt financing at present, but they
plan to borrow HK$150 million and invest remaining HK$100 in equity for this
project. What weights should Apex use for debt and equity in computing the
WACC for this project?

Solution:
Practice exercise (2)
Solution:
Apex’s investment of HKD 250 million will be financed by HKD 100 million in equity
and HKD 150 million in debt.
Thus, Apex is using (HKD 100,000,000/HKD 250,000,000) 40% in equity financing
and
(HKD 150,000,000/ HKD 250,000,000) 60% in debt financing.

Its debt and equity weights are, therefore, 60% and 40%, respectively.
Practice exercise (3)
In August 2015, the capital structure of the Emerson electronic Corporation (EMR)
was as follows:
Source of capital Book value Market value
Shor-term debt $ 2,553 $ 2,553
Long-term debt 4,289 4,289
Common stock 8,081 35,690
Total capital $ 14,923 $ 42,532

What weights should Emerson use when computing the firm’s WACC?
Practice exercise (3)
Solution:
we use the firm’s market values, not its book values, to determine its capital
structure weights.

Source of capital Market value Weights (based on MV)

Shor-term debt $ 2,553 0.06
Long-term debt 4,289 0.10
Common stock 35,690 0.84
Total capital $ 42,532 1.00
Practice exercise (4)
J&J Ltd. has a target capital structure of 50% equity, 15% preferred stock and 35%
debt. If the cost of common equity is 15%, preferred stock is 9% and before-tax
cost of debt is 5%. What is its WACC?. Consider the tax rate as 22%.
Practice exercise (4)
Solution:
Source of capital Weights (w) Cost of source or capital (k) WACC (w*k)
Common stock 0.50 0.15 0.075
Preferred stock 0.15 0.09 0.0135
Debt 0.35 0.05(1-0.22) 0.01365
Total capital 1.00 WACC 0.10215

WACC is 10.22%.
The firm should not accept projects of average risk whose returns are less than
10.22%.
Practice exercise (5)
In the spring of last year, the management of Silver Steel Company learned that
the firm would need to revaluate their WACC% following a significant issue of
debt. The firm has a capital mix of 40% debt and 60% equity. Calculate WACC if
the borrowing rate of firm is 6% and the return expected by the stockholders is
15%. Consider tax rate as 40%.
Practice exercise (5)
Solution:
Source of capital Weights (w) Cost of source or capital (k) WACC (w*k)
Common stock 0.60 0.15 0.09
Debt 0.40 0.06(1-0.40) 0.0144
Total capital 1.00 WACC 0.1044

WACC is 10.44%.
Silver Steel should not invest in any project of average risk whose return is
less than 10.44%
Estimating the Cost of Individual Sources of
Capital
The Cost of Debt:
• The cost of debt is the rate of return the firm’s lenders demand when they loan
money to the firm.
• We estimate the market’s required rate of return on a firm’s debt using its yield
to maturity and not the coupon rate.

After-tax cost of debt = Yield (1-tax rate)

• Yield to maturity (YTM) is the total rate of return that will have been earned by a
bond when it makes all interest payments and repays the original principal. YTM
is essentially a bond's internal rate of return (IRR) if held to maturity.
Estimating the Cost of Individual Sources of
Capital
The Cost of Debt:
Example, What will be the yield to maturity on a debt that has par value of $1,000,
a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at
$900? What will be the cost of debt if the tax rate is 30%?

Market price = Interest amount *PVIFA (YTM,n) + Redemption Value* PVIF (YTM,n)
900 = 50*PVIFA (YTM,10) + 1000* PVIF (YTM,10)

Use excel or trial and error approach or approx. formula.

Estimating the Cost of Individual Sources of
Capital
The Cost of Debt:
Example, What will be the yield to maturity on a debt that has par value of $1,000,
a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at
$900? What will be the cost of debt if the tax rate is 30%?
Solution: Using trial and error approach
Market price = Interest amount *PVIFA (YTM,n) + Redemption Value* PVIF (YTM,n)
900 = 50*PVIFA (YTM,10) + 1000* PVIF (YTM,10)
Try 5 % rate and calculate MP
50*PVIFA (5%,10) + 1000* PVIF (5%,10) = 999.58
At 7% try again
50*PVIFA (7%,10) + 1000* PVIF (7%,10) = 859.48
Estimating the Cost of Individual Sources of
Capital
The Cost of Debt:
Interpolate the two rates as the MP of bond i.e., $900 should lie between the two
rates MP.
Lower rate + [(MP of lower – MP today)/(MP of lower –higher rate)]* diff in rates
=5 + [(999.58- 900)/(999.58-859.48)]*2
=6.42%

After tax cost of debt = YTM (1-tax rate)

= 6.42 (1-0.30)
= 4.49%
Estimating the Cost of Individual Sources of
Capital
The Cost of Debt:
Example, What will be the yield to maturity on a debt that has par value of $1,000,
a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at
$900? What will be the cost of debt if the tax rate is 30%?
Solution: Using approx. method
YTM = [Annual Interest + {(FV- Market Price)/Maturity}] / [(FV+ Market Price)/2]
YTM = [50 + {(1000-900)/10}]/[(1000+900)/2]
YTM= [60/950]
YTM = 0.063 or 6.3%

After tax cost of debt = 6.3 (1-0.30) = 4.41%

Estimating the Cost of Individual Sources of
Capital
The Cost of Debt:
• It is not easy to find the market price of a specific bond as majority of them do
not trade in public markets.
• It is a standard practice to estimate the cost of debt using yield to maturity on a
portfolio of bonds with similar credit rating and maturity as the firm’s
outstanding debt.
Estimating the Cost of Individual Sources of
Capital
A Guide to Corporate Bond Ratings
Moody’s S&P Fitch Definitions Moody’s S&P Fitch Definitions

Aaa AAA AAA Prime, Maximum Safety B2 B B Blank

Aa1 AA+ AA+ High Grade, High Quality
B3 B− B− Blank
Aa2 AA AA Blank
Caa1 CCC CCC Substantial Risk
Aa3 AA− AA− Blank +
A1 A+ A+ Upper Medium Grade Caa2 CCC − In Poor Standing
A2 A A Blank
A3 A− A− Blank Caa3 CCC − Blank
−
Baa1 BBB+ BBB+ Lower Medium Grade
Ca − − Extremely
Baa2 BBB BBB Blank Speculative
Baa3 BBB− BBB− Blank C − − May Be in Default
Ba1 BB+ BB+ Non-investment Grade
− − DDD Default
Ba2 BB BB Speculative
− − DD Blank
Ba3 BB− BB− Blank
B1 B+ B+ Highly Speculative − D D Blank
Estimating the Cost of Individual Sources of
Capital
Corporate Bond Yields: Default Ratings and Term to Maturity
Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years
Aaa/AAA 0.22 0.31 0.42 0.76 1.26 2.00 3.41
Aa1/AA+ 0.26 0.43 0.58 0.96 1.46 2.17 3.62
Aa2/AA 0.29 0.55 0.74 1.16 1.66 2.35 3.83
Aa3/AA− 0.31 0.58 0.77 1.20 1.70 2.39 3.88
A1/A+ 0.32 0.60 0.80 1.23 1.73 2.43 3.93
A2/A 0.55 0.80 0.98 1.40 1.89 2.57 4.03
A3/A− 0.62 0.95 1.18 1.66 2.19 2.92 4.51
Baa1/BBB+ 0.83 1.19 1.42 1.91 2.45 3.18 4.80
Baa2/BBB 1.00 1.39 1.65 2.17 2.73 3.48 5.17
Baa3/BBB− 1.49 1.87 2.11 2.62 3.16 3.91 5.56
Ba1/BB+ 2.27 2.64 2.90 3.41 3.98 4.75 6.37
Ba2/BB 3.04 3.41 3.68 4.21 4.79 5.58 7.19
Estimating the Cost of Individual Sources of
Capital
Corporate Bond Yields: Default Ratings and Term to Maturity
Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years

Ba3/BB− 3.82 4.18 4.47 5.00 5.61 6.42 8.00

B1/B+ 4.60 4.95 5.25 5.79 6.42 7.26 8.82

B2/B 5.38 5.72 6.04 6.59 7.24 8.10 9.63

B3/B− 6.15 6.49 6.82 7.38 8.06 8.93 10.45

Caa/CCC+ 6.93 7.26 7.61 8.17 8.87 9.77 11.26

U.S. Treasury Yield 0.18 0.25 0.32 0.60 1.00 1.59 2.76

This table tells the term structure of the bond or debt.

1) Lower the rating, higher is the risk and higher is the yield or return.
2) Higher is the maturity period, higher the uncertainty and higher is the return.
Estimating the Cost of Individual Sources of
Capital
The Cost of Preferred stock:
• The cost of preferred equity is the rate of return investors require from the firm
when they purchase its preferred stock.

Example The preferred shares of Relay Company that are trading at $25 per share.
What will be the cost of preferred equity if these stocks have a par value of $35 and
pay annual dividend of 4%?
Estimating the Cost of Individual Sources of
Capital
The Cost of Preferred stock:
Example The preferred shares of Relay Company that are trading at $25 per share.
What will be the cost of preferred equity if these stocks have a par value of $35 and
pay annual dividend of 4%?
Solution:
Divps = 4% of FV of share ($35)
Pps = $25 per share

Kps = 1.4/25
Kps = 5.6%
Estimating the Cost of Individual Sources of
Capital
The Cost of Preferred stock:
Practice exercise:
The preferred shares of Pacific gas corporation are trading at $25.14 per share.
What will be the cost of preferred equity if these stocks have a par value of $25 and
pay annual dividend of 6%?

Solution:
Estimating the Cost of Individual Sources of
Capital
The Cost of Common stock:
• The cost of common equity is the rate of return investors expect to receive from
investing in firm’s stock, which, in turn, reflects the risk of investing in the equity
of the firm.
• This return comes in the form of cash distributions (dividends and cash proceeds
from the sale of the stock).
• There are two commonly used approaches for calculating the cost of equity or
common stock:
• The dividend growth model
• CAPM
Estimating the Cost of Individual Sources of
Capital
The Cost of Common stock using Dividend growth model
• First, estimate the expected stream of dividends that the common stock is
expected to provide t the stockholder.
• Second, using these estimated dividends as the estimated cash flows from the
stock, and the firm’s current stock price, calculate the internal rate of return on
the stock investment.
Estimating the Cost of Individual Sources of
Capital
The Cost of Common stock:
Example:
Pearson PLC company’s CFO wants to estimate its cost of common stock. In the last
year i.e., 2015, PLC paid $1.08 as dividend. The growth rate in dividend is observed
to be -1.70% for PLC. The stock is currently being traded at $10.79.
Solution:
D1 = D0 (1+ g%) = 1.08(1-1.70%)
Pcs = $10.79
G = -1.70%
Kcs = [{1.08(1-1.70%)}/10.79] + (-0.017)
Kcs = 8.14%
Estimating the Cost of Individual Sources of
Capital
The Cost of Common stock:
Example:
Pearson PLC company’s CFO wants to estimate its cost of common stock. In the last
year i.e., 2015, PLC paid $1.08 as dividend. The growth rate in dividend is observed
to be (−2.13% and −1.28%) for PLC. The stock is currently being traded at $10.79.
Estimating the Cost of Individual Sources of
Capital
Estimation of growth for cost of equity using Dividend growth model:
• Thus, growth rate is an important variable in determining the cost of equity.
However, estimating the growth rate is not easy.
• The growth rate can be obtained from the websites that post analysts forecasts
and using historical data to compute the arithmetic average or geometric
average. Year Dividend $ Change % Change

2012 $0.800 Blank Blank

2013 0.825 $0.025 3.1%

2014 0.840 0.015 1.8%

2015 0.875 0.035 4.2%

2016 0.900 0.025 2.9%

Blank Arithmetic Average Blank 3.0%

Blank Geometric Average Blank 2.99%

Estimating the Cost of Individual Sources of
Capital
Dividend growth model for estimating the cost of common stock:
• Pros – Simplicity
• Cons – severely dependent upon the quality of growth rate estimates; constant
dividend growth rate for ever is an oversimplification