Fundamentals of Corporate Finance

Chapter 13

Cost of Capital
Overview of Lecture

Some Preliminaries

The Cost of Equity

The Costs of Debt and Preference Shares

The Weighted Average Cost of Capital

Divisional and Project Costs of Capital

Flotation Costs and WACC

Required Return versus Cost of Capital

The cost of capital

depends primarily on
the use of the funds,
not the source.
The Cost of Equity Capital

The return that equity

investors require on
their investment in the
firm.
The Dividend Growth Model Approach

Under the assumption that the firm’s dividend will grow at a

constant rate g, the share price, P0, can be written below
where D0 is the dividend just paid and D1 is the next period’s
projected dividend. Notice that we have used the symbol RE
(the E stands for equity) for the required return on the equity.

D0  (1  g ) D1
P0  
RE  g RE  g
The Dividend Growth Model Approach

We can rearrange this to solve for

RE as follows:
RE = D1/P0 + g
Because RE is the return that the
shareholders require on the
equity, it can be interpreted as the
firm’s cost of equity capital.
Implementing the Approach

Great Country Public Service, a

large public utility, paid a dividend of
€4 per share last year. The equity
currently sells for €60 per share.
You estimate that the dividend will
grow steadily at a rate of 6 per cent
per year into the indefinite future.
What is the cost of equity capital for
Great Country?
Implementing the Approach

Using the dividend growth model, we can calculate

that the expected dividend for the coming year, D1, is:

D1 = D0  (1 + g) = €4  1.06 = €4.24

Given this, the cost of equity, RE, is:

RE = D1/P0 + g = €4.24/60 + .06 = 13.07%

The cost of equity is thus 13.07 per cent.

 The Security Market Line Approach
From the firm’s perspective, the expected return is the cost of
equity capital. Under the CAPM, the expected return on a
security can be written as:

RE = RF + E × (RM  RF)

where RF is the risk-free rate and RM  RF is the difference

between the expected return on the market portfolio and the
riskless rate. This difference is often called the expected excess
market return or market risk premium.
The Cost of Equity Capital

To Estimate Cost of Equity Capital

you need to know
The
The Risk- The
Market
Free Company
Risk
Rate Beta
Premium
Implementing the Approach

To use the SML approach, we need a risk-free rate, Rf, an

estimate of the market risk premium, RM  Rf, and an
estimate of the relevant beta, E. One estimate of the market
risk premium (based on large UK equities is about 6.1 per
cent. Assume that treasury bills are paying about .5 per cent,
so we will use this as our risk-free rate for the UK.
According to Yahoo! Finance, Associated British Foods plc
(ABF) had an estimated beta of 0.37 in 2010. We could thus
estimate ABF’s cost of equity as:
RE = Rf + ABF  (RM  Rf) = .5% + .37  6.1% = 7.26%

Thus, using the SML approach, we calculate that ABF’s cost

of equity is about 7.26 per cent.
Example 13.1
The Cost of Equity

Equity in Alpha Air Freight has a

beta of 1.2. The market risk
premium is 7 per cent, and the risk-
free rate is 6 per cent. Alpha’s last
dividend was €2 per share, and the
dividend is expected to grow at 8
per cent indefinitely. The equity
currently sells for €30. What is
Alpha’s cost of equity capital?
Example 13.1
The Cost of Equity
We can start off by using the SML. Doing this, we find that the
expected return on the equity of Alpha Air Freight is:

RE = Rf + E  (RM  Rf) = 6% + 1.2  7% = 14.4%

This suggests that 14.4 per cent is Alpha’s cost of equity. We next
use the dividend growth model. The projected dividend is D0  (1 + g)
= €2  1.08 = €2.16 so the expected return using this approach is:

RE = D1/P0 + g = €2.16/30 + .08 = 15.2%

Our two estimates are reasonably close, so we might just average

them to find that Alpha’s cost of equity is approximately 14.8 per
cent.
Calculating Cost of Equity Capital in Practice
The Cost of Debt

The return that

lenders require on the
firm’s debt.
Example 13.2
The Cost of Debt

Suppose General Tools

issued a 30-year, 7 per cent
bond 8 years ago. The bond
is currently selling for 96 per
cent of its face value of
£50,000, or £48,000. What is
General Tool’s cost of debt?
Example 13.2
The Cost of Debt

We need to calculate the

yield to maturity on this
bond. The yield to maturity
is about 7.37 per cent,
assuming annual coupons.
General Tool’s cost of debt,
RD, is thus 7.37 per cent.
The Cost of Preference Shares

Preference shares have a fixed

dividend paid every period forever, so
a single preference share is
essentially a perpetuity. The cost of
preference shares, RP, is thus:
RP = D/P0
where D is the fixed dividend and P0
is the current preference share price.
Example 13.3
Cost of Preference Shares

On May 30, 2010, Edinburgh Power

had two issues of ordinary
preference shares with a £25 par
value. One issue paid £1.30 annually
per share and sold for £21.05 per
share. The other paid £1.46 per
share annually and sold for £24.35
per share. What is Edinburgh
Power’s cost of preference shares?
Example 13.3
Cost of Preference Shares
Using the first issue, we calculate that the cost of
preference shares is:

RP = D/P0 = £1.30/21.05 = 6.2%

Using the second issue, we calculate that the cost is:

RP = D/P0 = £1.46/24.35 = 6%

So, Edinburgh Power’s cost of preference shares

appears to be about 6.1 per cent.
The Weighted Average Cost of Capital (WACC)

The weighted average

of the cost of equity
and the after-tax cost
of debt.
Example 12.6
WACC

To Compute WACC, You need

Proportions
After-tax
Cost of of Each in
Cost of
Equity Capital
Debt
Structure
The Capital Structure Weights

Equity Debt
• We calculate this • we calculate this
by taking the by multiplying the
number of shares market price of a
outstanding and single bond by the
multiplying it by number of bonds
the share price. outstanding.
• Use the symbol, • Use the symbol,
E. D.
The Capital Structure Weights

we will use the symbol V (for value) to stand for the

combined market value of the debt and equity:
V=E+D

If we divide both sides by V, we can calculate the

percentages of the total capital represented by the debt
and equity:
100% = E/V + D/V

These percentages can be interpreted just like portfolio

weights, and they are often called the capital structure
weights.
 Taxes and WACC
Suppose a firm uses both debt and equity to finance its
investments. If the firm pays RB for its debt financing and RS for
its equity, what is the overall or average cost of its capital?

 S   B 
  × RS    × RB × (1  tc )
S B S B

This is called
the Weighted
Average Cost of
Capital (WACC)
Example 13.4
Calculating the WACC

Travis SpA. has 1.4 million shares of equity

outstanding. The equity currently sells for
€20 per share. The firm’s debt is publicly
traded and was recently quoted at 93 per
cent of face value. It has a total face value
of €5 million, and it is currently priced to
yield 11 per cent. The risk-free rate is 8 per
cent, and the market risk premium is 7 per
cent. You’ve estimated that Travis has a
beta of .74. If the corporate tax rate is 34
per cent, what is the WACC of Travis SpA?
Example 13.4
Calculating the WACC

We can first determine the cost of equity and

the cost of debt. Using the SML, we find that
the cost of equity is 8% + .74  7% = 13.18%.
The total value of the equity is 1.4 million  €20
= €28 million. The pre-tax cost of debt is the
current yield to maturity on the outstanding
debt, 11 per cent. The debt sells for 93 per cent
of its face value, so its current market value
is .93  €5 million = €4.65 million. The total
market value of the equity and debt together is
€28 million + 4.65 million = €32.65 million.
Example 13.4
Calculating the WACC

The percentage of equity used by Travis to finance its

operations is €28 million/€32.65 million = 85.76%.
Because the weights have to add up to 1, the percentage
of debt is 1  .8576 = 14.24%. The WACC is thus:

WACC = (E/V)  RE + (D/V)  RD  (1  TC)

= .8576  13.18% + .1424  11%  (1  .34)
= 12.34%

Travis thus has an overall weighted average cost of

capital of 12.34 per cent.
 Estimating Deutsche Börse Group’s Cost of
Equity
Our first stop for Deutsche Börse Group is Yahoo! Finance.
Estimating Deutsche Börse Group’s Cost of
Equity

To estimate Deutsche Börse’s cost of equity,

we will assume a market risk premium of 9.1
per cent. Deutsche Börse’s beta on FT.Com
is 1.08.
According to the bond section of FT.com, T-
bills were paying about 0.36 per cent. Using
the CAPM to estimate the cost of equity, we
find:

RE = .0036 + 1.08 (.091) = .1018 or 10.18%

Estimating Deutsche Börse Group’s Cost of
Equity – Growth Rates
Estimating Deutsche Börse Group’s Cost of
Equity

Analysts estimate the growth in earnings

per share for the company will be 2.79
per cent over the next two years. The
estimated cost of equity using the
dividend discount model is 6.8%.
Notice that the estimates for the cost of
equity are different. Averaging the two
estimates for Deutsche Börse’s cost of
equity gives us a cost of equity of 8.49
per cent.
Deutsche Börse Cost of Debt
Deutsche Börse Cost of Debt
Deutsche Börse WACC
Deutsche Börse’s equity and debt are worth €10.51
billion and €1.618 billion, respectively. The capital
structure weights are therefore €10.51 billion/12.128
billion = .87 and €1.618 billion/12.128 billion = .13, so
the equity percentage is much higher. With these
weights, Deutsche Börse’s WACC is:

WACC = .87  8.49% + .13  4.57%  (1  .33) =

7.78%

Thus, using market value weights, we get about 7.78

per cent for Deutsche Börse’s WACC.
Example 13.5
Using the WACC

A firm is considering a project that will result

in initial after-tax cash savings of £5 million
at the end of the first year. These savings
will grow at the rate of 5 per cent per year.
The firm has a debt–equity ratio of .5, a cost
of equity of 29.2 per cent, and a cost of debt
of 10 per cent. The cost-saving proposal is
closely related to the firm’s core business,
so it is viewed as having the same risk as
the overall firm. Should the firm take on the
project?
Example 13.5
Using the WACC
Assuming a 28 per cent tax rate, the firm should take on this project if it costs less than £29.64 million. The WACC is:

WACC = (E/V)  RE + (D/V)  RD  (1  TC)

= 2/3  29.2% + 1/3  10%  (1  .28)
= 21.87%
The NPV will be positive only if the cost is less than £29.64 million.

The PV is thus:

£5 million
PV   £29.64 million
.05
Divisional and Project Costs of Capital

There will clearly be

situations in which the cash
flows under consideration
have risks distinctly different
from those of the overall
firm. What do we do?
The Security Market Line and WACC
The Pure Play Approach

The use of a WACC

that is unique to a
particular project, based
on companies in similar
lines of business
The Subjective Approach
The Subjective Approach
Flotation Costs and WACC

If a company accepts a new

project, it may be required
to issue, or float, new bonds
and shares. This means that
the firm will incur some
costs, which we call flotation
costs
Example 13.6
Weighted Average Flotation Cost

Wendy plc has a target capital structure

that is 80 per cent equity, 20 per cent
debt. The flotation costs for equity
issues are 20 per cent of the amount
raised; the flotation costs for debt issues
are 6 per cent. If Wendy needs £65
million for a new manufacturing facility,
what is the true cost once flotation costs
are considered?
Example 13.6
Weighted Average Flotation Cost

We first calculate the weighted average flotation cost, fA:

fA = (E/V)  fE + (D/V)  fD
= 80%  .20 + 20%  .06
= 17.2%

The weighted average flotation cost is thus 17.2 per cent.

The project cost is £65 million when we ignore flotation
costs. If we include them, then the true cost is £65
million/(1  fA) = £65 million/.828 = £78.5 million, again
illustrating that flotation costs can be a considerable
expense.
Flotation Costs and NPV

suppose Tripleday Printing SA is currently at its target debt–equity

ratio of 100 per cent. It is considering building a new €500,000
printing plant in Lyons. This new plant is expected to generate
after-tax cash flows of €73,150 per year forever. The tax rate is 34
per cent. There are two financing options:

1. A €500,000 new issue of equity: The issuance costs of the new

equity would be about 10 per cent of the amount raised. The
required return on the company’s new equity is 20 per cent.
2. A €500,000 issue of 30-year bonds: The issuance costs of the
new debt would be 2 per cent of the proceeds. The company can
raise new debt at 10 per cent.

What is the NPV of the new printing plant?

Flotation Costs and NPV
WACC = (E/V)  RE + (D/V)  RD  (1  TC)
= .50  20% + .50  10%  (1  .34)
= 13.3%

Because the cash flows are €73,150 per year forever, the PV of the cash flows
at 13.3 per cent per year is:
€73,150
PV   €550, 000
.133
If we ignore flotation costs, the NPV is:

NPV = €550,000  500,000 = €50,000

With no flotation costs, the project generates an NPV that is greater than zero,
so it should be accepted.
Flotation Costs and NPV

Because new financing must be raised, the flotation costs are

relevant. We know that the flotation costs are 2 per cent for debt
and 10 per cent for equity. Because Tripleday uses equal amounts
of debt and equity, the weighted average flotation cost, fA, is:

fA = (E/V)  fE + (D/V)  fD = .50  10% + .50  2%

= 6%

Because Tripleday needs €500,000 to fund the new plant, the true
cost, once we include flotation costs, is €500,000/(1  fA) =
€500,000/.94 = €531,915. Because the PV of the cash flows is
€550,000, the plant has an NPV of €550,000  531,915 =
€18,085, so it is still a good investment.
Internal Equity and Flotation Costs
In reality, most firms rarely sell equity at all. Instead, their
internally generated cash flow is sufficient to cover the equity
portion of their capital spending. Only the debt portion must be
raised externally.
The use of internal equity doesn’t change our approach.
However, we now assign a value of zero to the flotation cost of
equity because there is no such cost. In our Tripleday example,
the weighted average flotation cost would therefore be:

fA = (E/V)  fE + (D/V)  fD = .50  0% + .50  2% = 1%

Notice that whether equity is generated internally or externally

makes a big difference because external equity has a relatively
high flotation cost.
Activities for this Lecture

Reading
• Insert here

Assignment
• Insert here
Thank You