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Corporate Finance
Lecture 7
Cost of Capital
Selcuk Caner
Bilkent University
7/17/2015
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Chapter 10 Outline
Cost of capital components
 Accounting for flotation costs
 WACC
 Adjusting cost of capital for risk
 Estimating project risk

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What types of capital do firms
use?
Debt
Preferred stock
Common equity:
Retained earnings
New common stock
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Should we focus on before-tax or
after-tax capital costs?
Stockholders focus on A-T CFs.
Therefore, we should focus on
A-T capital costs, i.e., use A-T
costs in WACC. Only kd needs
adjustment.
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Should we focus on historical
(embedded) costs or new
(marginal) costs?
The cost of capital is used primarily
to make decisions that involve
raising new capital. So, focus on
today’s marginal costs (for WACC).
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A 15-year, 12% semiannual bond
sells for $1,153.72. What’s kd?
0
1
2
i=?
...
60
-1,153.72
Given
Result
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30
60
-1153.72 60
60 + 1,000
1000
5.0% x 2 = kd = 10%
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Component Cost of Debt

Interest is tax deductible, so
kd AT
= kd BT(1 – T)
= 10%(1 – 0.40) = 6%.
Use nominal rate.
 Flotation costs small.

Ignore.
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What’s the cost of preferred
stock?
Pp = $111.10; 10%Q; Par = $100.
Use this formula:
Dp
$10
kp 

 0.090  9.0%.
Pp $111.10
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Picture of Preferred Stock
0
-111.1
kp = ?
1
2
...
2.50
2.50

2.50
DQ
$2.50
$111.10 =
=
.
kPer
kPer
$2.50
kPer =
= 2.25%;
$111.10
kp(Nom) = 2.25%(4) = 9%.
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Note:
Preferred dividends are not tax
deductible, so no tax adjustment.
Just kp.
 Nominal kp is used.
 Our calculation ignores flotation
costs.

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Is preferred stock more or less
risky to investors than debt?
More risky; company not required to
pay preferred dividend.
 However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to
raise additional funds, (3) preferred
stockholders may gain control of
firm.

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Why is yield on preferred lower
than kd?
Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
 Therefore, preferred often has a lower
B-T yield than the B-T yield on debt.
 The A-T yield to an investor, and the A-T
cost to the issuer, are higher on
preferred than on debt. Consistent with
higher risk of preferred.

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Example:
kp = 9% kd = 10% T = 40%
kp, AT = kp – kp (1 – 0.7)(T)
= 9% – 9%(0.3)(0.4) =
7.92%.
kd, AT = 10% – 10%(0.4) =
6.00%.
A-T Risk Premium on Preferred = 1.92%.
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Why is there a cost for retained
earnings?
Earnings can be reinvested or paid
out as dividends.
 Investors could buy other securities,
earn a return.
 Thus, there is an opportunity cost if
earnings are retained.

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Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
 They could buy similar stocks
and earn ks, or company could
repurchase its own stock and
earn ks. So, ks is the cost of
retained earnings.

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Three ways to determine cost of
common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.
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What’s the cost of common
equity based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM – kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
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What’s the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
D1
D0(1 + g)
ks =
+g=
+g
P0
P0
$4.19(1.05)
=
+ 0.05
$50
= 0.088 + 0.05
= 13.8%.
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Suppose the company has
been earning 15% on equity
(ROE = 15%) and retaining 35%
(dividend payout = 65%), and
this situation is expected to
continue.
What’s the expected future g?
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Retention growth rate:
g = (1 – Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 – Payout) = Fraction retained.
Close to g = 5% given earlier. Think of
bank account paying 10% with payout =
100%, payout = 0%, and payout = 50%.
What’s g?
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Could DCF methodology be
applied if g is not constant?
YES, nonconstant g stocks are
expected to have constant g at
some point, generally in 5 to 10
years.
 But calculations get complicated.

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Find ks using the own-bondyield-plus-risk-premium method.
(kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%
This RP  CAPM RP.
 Produces ballpark estimate of ks.
Useful check.

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What’s a reasonable final estimate
of ks?
Method
CAPM
14.2%
DCF
13.8%
kd + RP
14.0%
Average
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Estimate
14.0%
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Why is the cost of retained
earnings cheaper than the cost of
issuing new common stock?
1. When a company issues new
common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.
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Two approaches that can be used
to account for flotation costs:
Include the flotation costs as part of
the project’s up-front cost. This
reduces the project’s estimated return.
 Adjust the cost of capital to include
flotation costs. This is most
commonly done by incorporating
flotation costs in the DCF model.

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New common, F = 15%:
D0 (1  g)
ke 
g
P0 (1  F)
$4.191.05 

 5 .0 %
$501  0.15 
$4.40

 5.0%  15.4%.
$42.50
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Comments about flotation costs:
Flotation costs depend on the risk of
the firm and the type of capital being
raised.
 The flotation costs are highest for
common equity. However, since
most firms issue equity infrequently,
the per-project cost is fairly small.
 We will frequently ignore flotation
costs when calculating the WACC.

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What’s the firm’s WACC
(ignoring flotation costs)?
WACC = wdkd(1 – T) + wpkp + wcks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
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What factors influence a
company’s composite WACC?
Market conditions.
 The firm’s capital structure and
dividend policy.
 The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.

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WACC Estimates for Some Large
U. S. Corporations, Nov. 1999
Company
Intel
General Electric
Motorola
Coca-Cola
Walt Disney
AT&T
Wal-Mart
Exxon
H. J. Heinz
BellSouth
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WACC
12.9%
11.9
11.3
11.2
10.0
9.8
9.8
8.8
8.5
8.2
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Should the company use the
composite WACC as the hurdle
rate for each of its projects?
NO! The composite WACC reflects the
risk of an average project undertaken
by the firm. Therefore, the WACC only
represents the “hurdle rate” for a
typical project with average risk.
 Different projects have different risks.
The project’s WACC should be adjusted
to reflect the project’s risk.

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Risk and the Cost of Capital
Rate of Return
(%)
Acceptance Region
W ACC
12.0
H
8.0
0
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Rejection Region
A
10.5
10.0
9.5
B
L
Risk L
Risk A
Risk H
Risk
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Divisional Cost of Capital
Rate of Return
(%)
13.0
Project H
11.0
10.0
9.0
7.0
0
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WACC
Division H’s WACC
Project L
Composite WACC
for Firm A
Division L’s WACC
RiskL
Risk Average
RiskH
Risk
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What are the three types of project
risk?
Stand-alone risk
 Corporate risk
 Market risk

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How is each type of risk used?
Market risk is theoretically best in
most situations.
 However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
 Therefore, corporate risk is also
relevant.

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What procedures are used to determine
the risk-adjusted cost of capital for a
particular project or division?
Subjective adjustments to the
firm’s composite WACC.
 Attempt to estimate what the cost
of capital would be if the
project/division were a stand-alone
firm. This requires estimating the
project’s beta.

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Methods for Estimating a
Project’s Beta
1. Pure play. Find several publicly
traded companies exclusively in
project’s business.
Use average of their betas as
proxy for project’s beta.
Hard to find such companies.
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2. Accounting beta. Run regression
between project’s ROA and S&P
index ROA.
Accounting betas are correlated
(0.5 – 0.6) with market betas.
But normally can’t get data on new
projects’ ROAs before the capital
budgeting decision has been made.
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Find the division’s market risk
and cost of capital based on the
CAPM, given these inputs:
Target debt ratio = 40%.
 kd = 12%.
 kRF = 7%.
 Tax rate = 40%.
 betaDivision = 1.7.
 Market risk premium = 6%.

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Beta = 1.7, so division has more market
risk than average.
 Division’s required return on equity:

ks = kRF + (kM – kRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv.
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= wdkd(1 – T) + wcks
= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.
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How does the division’s market
risk compare with the firm’s
overall market risk?
Division WACC = 13.2% versus
company WACC = 11.1%.
 Indicates that the division’s market risk
is greater than firm’s average project.
 “Typical” projects within this division
would be accepted if their returns are
above 13.2%.

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