Chapter 14

 Principle 1: Money Has a Time Value.

 Principle 2: There is a Risk-Return Tradeoff.
 Principle 3: Cash Flows Are the Source of
Value.
 Principle 4: Market Prices Reflect Information.
 Principle 5: Individuals Respond to Incentives.
1. Understand the concepts underlying the
firm’s overall cost of capital and the purpose
for its calculation.
2. Evaluate a firm’s capital structure, and
determine the relative importance (weight) of
each source of financing.
3. Calculate the after-tax cost of debt,
preferred stock, and common equity.

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4. Calculate a firm’s weighted average cost of
capital.
5. Discuss the pros and cons of using multiple,
risk-adjusted discount rates and describe
the divisional cost of capital as a viable
alternative for firms with multiple divisions.
6. Adjust the NPV for the costs of issuing new
securities when analyzing new investment
opportunities

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 A firm’s Weighted Average Cost of Capital, or
WACC is the weighted average of the required
returns of the securities that are used to
finance the firm.

 WACC incorporates the required rates of

return of the firm’s lenders and investors and
also accounts for the firm’s particular mix of
financing.
The riskiness of a firm affects its WACC as:
◦ Required rate of return on securities will
be higher if the firm is riskier, and
◦ Risk will influence how the firm chooses to
finance i.e. proportion of debt and equity.
WACC is useful in a number of settings:
◦ WACC is used to value the entire firm.
◦ WACC is often used for determining the discount
rate for investment projects
◦ WACC is the appropriate rate to use when
evaluating firm performance
1. Define the firm’s capital structure by
determining the weight of each source of
capital.
2. Estimate the opportunity cost of each source of
financing. These costs are equal to the
investor’s required rates of return.
3. Calculate a weighted average of the costs of
each 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 each source. The sum of
these products is the WACC.
The weights are based on the following sources
of financing:
Debt (short-term and long-term),
Preferred Stock
Common Equity.
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?
16%

14%

12%

10%

8%

6%

4%

2%

0%
Debt Prefered Stock Common Stock
Capital Structure Weights

37.5%
Debt

62.5%,
Common stock
We need to determine the WACC based on the
given information:

◦ Weight of debt = 37.5%;

◦ Cost of debt = 6%
◦ Weight of common stock = 62.5%;
◦ Cost of common stock =15%
We can compute the WACC based on the
following equation:
The WACC is equal to 11.625% as calculated
below.
We observe that as Templeton chose to increase
the level of debt to 37.5% and retire the
preferred stock, the WACC decreased marginally
from 12.125% to 11.625%.
Thus altering the weights will change the
WACC.
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)

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%?
Enter:
◦ N = 10; PV = -900; PMT = 50; FV =1000
◦ I/Y = 6.38%

◦ After-tax cost of Debt = Yield (1-tax rate)

= 6.38 (1-.3)
= 4.47%
It is not easy to find the market price of a
specific bond.
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.
The cost of preferred equity is the rate of return
investors require of 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%?

Using equation 14-2a

kps = $1.40 ÷ $25 = .056 or 5.6%
The cost of common equity is the rate of return
investors expect to receive from investing in
firm’s stock.
This return comes in the form of dividends and
proceeds from the sale of the stock).
There are two approaches to estimating the cost
of equity:
1. The dividend growth model (from chapter 10)
2. CAPM (from chapter 8)
1. Estimate the expected stream of dividends
that the common stock is expected to
provide.

2. Using these estimated dividends and the

firm’s current stock price, calculate the
internal rate of return on the stock
investment.
 Pros – easy to use

 Cons – severely dependent upon the quality of

growth rate estimates
- Assumption of constant dividend growth rate
may be unrealistic
 Recall that the dividend growth model is
 Pcs = D1/(kcs – g)

 Then the required return on the stock is

 kcs = D1/Pcs + g

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Prepare two estimates of Pearson’s cost of
common equity using the dividend growth
model where you use growth rates in dividends
that are 25% lower than the estimated 6.25%
(i.e., for g equal to 4.69% and 7.81%)
We are given the following:

◦ Price of common stock (Pcs ) = $19.39

◦ Growth rate of dividends (g) = 4.69% and 7.81%
◦ Dividend (D0) = $0.49 per share

◦ Cost of equity is given by dividend yield + growth

rate.
We can determine the cost of equity using
At growth rate of 4.69% At growth rate of 7.81%

kcs = kcs =
{$0.49(1.0469)/$19.39} {$0.49(1.0781)/$19.39}
+ .0469 + .0781
= .0733 or 7.33% = .1053 or 10.53 %
 Pearson’s cost of equity is estimated at 7.33%
and 10.53% based on the different
assumptions for growth rate.
 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

◦ websites that post analysts forecasts,
and
◦ using historical data to compute the
CAAR (geometric average).
CAPM (from chapter 8) was designed to
determine the expected or required rate of
return for risky investments.
The expected return on common stock is
determined by three key ingredients:
◦ The risk-free rate of interest,
◦ The beta of the common stock returns,
and
◦ The market risk premium.
Pros – easy to use, does not depend on
dividend o growth assumptions.

Cons – Choice of risk-free is not clearly defined,

- Estimates of beta and market risk premium
will vary depending on the data used.
 Estimating the Cost of Common Equity Using the
CAPM
Prepare two additional estimates of Pearson’s cost of
common equity using the CAPM where you use the
most extreme values of each of the three factors
that drive the CAPM.
CAPM describes the relationship between the
expected rates of return on risky assets in
terms of their systematic risk. Its value depends
on:
◦ The risk-free rate of interest,
◦ The beta or systematic risk of the common stock
returns, and
◦ The market risk premium.
However, there can be wide variation in the
estimates for each one of these variables. Here
we are given the following estimates:
◦ The risk-free rate of interest (.01% or 2.80%)
◦ The beta or systematic risk of the common stock
returns (.8 or 1.2)
◦ The market risk premium (4% or 8%)
The cost of equity can be estimated using the
CAPM equation:
Since we have been given the estimates for
market factors (risk-free rate and risk premium)
and firm-specific factor (beta), we can
determine the cost of equity using CAPM.
kcs = 0.01 + 0.8(4) = 3.21%

kcs = 2.80 + 1.2(8) = 12.40%

 Pearson’s cost of equity is shown to be
sensitive to the estimates used for risk-free
rate of interest, beta and market risk
premium.

 Based on the estimates used, the cost of

common equity ranges from 3.21% to
12.40%.
When estimating the firm’s WACC, following
issues should be kept in mind:
◦ Weights should be based on market rather
than book values of the firm’s securities.
◦ Use market based opportunity costs rather
than historical rates (such as coupon rates).
◦ Use forward-looking weights and
opportunity costs.
 Should the firm’s WACC be used to evaluate
all new investments?

 In theory, No … since all projects may have

unique risk. However, in practice, many firms
use a single firm WACC for all projects.
Figure 14.4 illustrates the danger of using a
single discount rate to evaluate investment
projects with different levels of risk.
There will be a tendency to take on too many
risky investment projects, and pass up good
investment projects that are relatively safe.
1. It may be difficult to trace the source of
financing for individual project since most
firms raise money in bulk for all the projects.

2. It adds to the time and cost in getting

approval for new projects.
 If a firm undertakes investment with very
different risk characteristics, it will try to
estimate divisional WACCs.

 The divisions are generally defined either by

geographical regions (e.g., Asian region
versus European region) or industry (e.g.,
pipeline, exploration and production)
 Here a firm with multiple divisions may
identify a comparable firm with only one
division (called a “pure play” comparison
firms or “comps”).

 The estimate of pure play firm’s cost of

capital can then be used as a proxy for that
particular division’s cost of capital.
While divisional WACC is a significant
improvement over the single, company-wide
WACC, it has a number of potential limitations
that arise due to the challenge of finding
comparable firms.
Floatation costs are fees paid to an investment
banker and costs incurred when securities are
sold at a discount to the current market price.
Because of floatation costs, the firm will have to
raise more than the amount it needs.
Example If a firm needs $100 million to finance
its new project and the floatation cost is
expected to be 5.5%, how much should the firm
raise by selling securities?
= $100 million ÷ (1-.055) = $105.82 million

 Thus the firm will raise $105.82 million, which

includes floatation cost of $5.82 million.
Before Tricon could finalize the financing for
the new project, stock market conditions
changed such that new stock became more
expensive to issue.
In fact, floatation costs rose to 15% of new
equity issued and the cost of debt rose to 3%.
Is the project still viable (assuming the present
value of future cash flows remain unchanged)?
The NPV will be equal to the present value of
the future cash flows less the initial outlay and
floatation costs.

NPV = PV(inflows)
– Initial outlay
– Floatation costs
We need to first estimate the average floatation
costs that Tricon will incur when raising the
funds. This can be done using equation 14-5.
Next, the “grossed-up” investment outlay can
be estimated using equation 14-6 and
subtracted from the present value of the
expected future cash flows to determine
whether the project has a positive NPV.
We can use equation 14-5 to estimate the
weighted average floatation cost as follows:

= .40 × .03 + .60 × .15

= .102 or 10.2%
The “grossed up” initial outlay for $100 million
project can be estimated using equation 14-6:

= $100 million ÷ (1- 0.102) = $111.36 million

 Thus, floatation costs is equal to $11.36
million.

 NPV = $115 million - $111.36 million

= $3.64 million
 The project is feasible even after
consideration of higher floatation costs as the
NPV is positive at $3.64 million.

 However, the problem illustrates that

floatation costs can be significant and cannot
be ignored while evaluating projects.