9. cost of capital

Chapter 9
Cost of Capital

Copyright © 2011 Pearson Prentice Hall.
All rights reserved.

Learning Objectives

1. Describe the concepts underlying the firm’s cost of
capital.
2. Calculate the after-tax cost of debt, preferred stock,
and common equity.
3. Calculate a firm’s weighted average cost of capital.
4. Describe the procedure used by PepsiCo to
estimate the cost of capital for a multidivisional firm.
5. Use the cost of capital to evaluate new investment
opportunities.
6. Calculate equivalent interest rates for different
countries.
© 2011 Pearson Prentice Hall. All rights
reserved. 9-2

Slide Contents

 Cost of Capital: Key Definitions and Concepts
 Determining the Cost of Individual Sources of Capital
 The Weighted Average Cost of Capital
 Calculating Divisional Costs of Capital for PepsiCo, Inc.
 Cost of Capital and New Investment
 Shareholder Value-Based Management
 Multinational Firms and Interest Rates

reserved. 9-3

1. Cost of Capital:
Key Definitions and Concepts

Capital
 Capital represents the funds used to finance
a firm's assets and operations. Capital
constitutes all items on the right hand side of
balance sheet i.e. liabilities and common
equity.
 Main sources: Debt, Preferred stock,
Retained earnings and Common Stock
reserved. 9-4

Investor’s Required
Rate of Return

 Investor’s Required Rate of Return – is the
minimum rate of return necessary to attract
an investor to purchase or hold a security.
 Investor’s required rate of return is not the
same as cost of capital due to taxes and
transaction costs.
 Impact of taxes: For example, a firm may pay 8%
interest on debt but due to tax benefit on interest
expense, the net cost to the firm will be lower than
8%.
reserved. 9-5

Investor’s Required
Rate of Return
 Impact of transaction costs on cost of capital: For
example, If a firm sells new stock for $50.00 a
share and incurs $5 in flotation costs, and the
investors have a required rate of return of 15%,
what is the cost of capital?
 The firm has only $45.00 to invest after
transaction cost.
.15 × $50.00 = $7.5
k = $7.5/($45.00)
= .1667 or 16.67% (rather than 15%)

reserved. 9-6

Financial Policy

 A firm’s financial policy indicates the
desired sources of financing and the
particular mix in which it will be used.
 For example, a firm may choose to
raise capital by issuing stocks and
bonds in the ratio of 6:4 (60% stocks
and 40% bonds). The choice of mix
may impact the cost of capital.
reserved. 9-7

2. Determining the Costs of the
Individual Sources of Capital

The Cost of Debt
The bondholder’s required rate of return on debt is the
return that bondholders demand. As seen in Chapter 7,
this can be estimated using the bond price equation:

reserved. 9-8

The Cost of Debt

Since firms must pay floatation costs when they sell bonds,
the net proceeds per bond received by firm is less than the
market price of the bond. Hence, the cost of debt capital (Kd)
will be higher than the bondholder’s required rate of return. It
can be calculated using the following equation:

reserved. 9-9

The Cost of Debt

See Example 9-1
 Investor’s required rate of return = 9%
 However, due to floatation cost, the before-
tax cost of capital for the firm is = 9.73%
 After-tax cost of debt =
Cost of debt*(1-tax rate)
 At 34% tax bracket = 9.73*(1 – .34) = 6.422%

reserved. 9-10

The Cost of Preferred Stock

 Similar to bond issue, since floatation costs are
incurred, preferred stockholder’s required rate of
return will be less than the cost of preferred capital to
the firm.
 Thus, in order to determine the cost of preferred
stock, we adjust the price of preferred stock for
floatation cost to give us the net proceeds.
 Net proceeds = issue price per share – floatation cost
per share.

reserved. 9-11

The Cost of Preferred Stock

 Cost of Preferred Stock:
 Pn = net proceeds (i.e. Issue price – Floatation costs)
 Dp = Preferred stock dividend per share

Example: Determine the cost for a preferred stock that
pays annual dividend of $4.25, has current stock price
$58.50 and incurs flotation costs of $1.375 per share
Cost = $4.25/(58.50 – 1.375) = .074 or 7.44%

reserved. 9-12

The Cost of Common Equity

 Cost of equity is more challenging to estimate
than the cost of debt or the cost of preferred
stock because common stockholder’s rate of
return is not fixed as there is no stated
coupon rate or dividend.
 Furthermore, the costs will vary for two
sources of equity (i.e. retained earnings and
new issue).

reserved. 9-13

The Cost of Common Equity

 There is no flotation costs on retained
earnings but the firm incurs costs when it
sells new common stock.
 Note retained earnings are not a free source
of capital. There is an opportunity cost.

reserved. 9-14

Cost estimation techniques

 Two commonly used methods for
estimating common stockholder’s
required rate of return are:
 The Dividend Growth Model
 The Capital Asset Pricing Model

reserved. 9-15

The Dividend Growth Model

 Investors’ required rate of return
(For Retained Earnings):

 D1 = Dividends expected one year hence
 Pcs = Price of common stock;
 g = growth rate
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 Investors’ required rate of return
(For new issues)

 D1 = Dividends expected one year hence
 Pcs = Net proceeds per share
 g = growth rate
reserved. 9-17


Example: A company expects dividends this year to be
$1.10, based upon the fact that $1 were paid last year.
The firm expects dividends to grow 10% next year and
into the foreseeable future. Stock is trading at $35 a
share.
Cost of retained earnings:
Kcs = D1/Pcs + g
1.1/35 + .10 = .1314 or 13.14%
Cost of new stock (with a $3 floatation cost):
Kncs = D1/NPcs + g
1.10/(35 – 3) + .10 = .1343 or 13.43%
reserved. 9-18


 Dividend growth model is simple to use
but suffers from the following
drawbacks:
 It assumes a constant growth rate
 It is not easy to forecast the growth rate

reserved. 9-19

The Capital Asset Pricing
Model

rf = Risk Free rate
β = Beta
rm – rf = Market Risk Premium or
Expected rate of return for
“average security” minus the
risk free rate
reserved. 9-20

Capital Asset Pricing Model

Example: If beta is 1.25, risk-free rate is
1.5% and expected return on market is
10%
kc = rrf + β (rm – rf)
= .015 + 1.25(.10 – .015)
= 12.125%
reserved. 9-21

Capital Asset Pricing Model
Variable estimates
 CAPM is easy to apply. Also, the estimates for model
variables are generally available from public sources.
 Risk Free Rate: Wide range of US government
securities on which to base risk-free rate
 Beta: Estimates of beta are available from a wide
range of services, or can be estimated using
regression analysis of historical data.
 Market risk premium: It can be estimated by looking
at history of stock returns and premium earned over
risk-free rate.
reserved. 9-22

3. The Weighted Average
Cost of Capital

Bringing it all together: WACC
 To estimate WACC, we need to know the capital
structure mix and the cost of each of the sources of
capital.
 For a firm with only two sources: debt and common
equity,

reserved. 9-23

WACC Example

 A firm borrows money at 7% after taxes
and pays 12% for equity. The company
raises capital in equal proportions i.e.
50% debt and 50% equity.
 WACC = (.07 × .5) + (.12 × .5)
= .095 or 9.5%

reserved. 9-24

Business world
cost of capital

 In practice, the calculation of cost of
capital may be more complex:
 If firms have multiple debt issues with
different required rates of return.
 If firms also use preferred stock in addition
to common stock financing.

reserved. 9-25

Table 9-1

reserved. 9-26

Table 9-1

reserved. 9-27

Table 9-3

reserved. 9-28

4. Calculating Divisional Costs of
Capital for PepsiCo Inc.

 PepsiCo calculated divisional cost of capital for each
of its three major divisions: restaurants, food, and
beverages.
 The target ratios for debt/equity mix and the pre-tax
cost of debt were different for each division.
 PepsiCo estimated the WACC for each division in a 3
step process:
 Estimate the cost of debt for each division
 Estimate the cost of equity for each division
 Estimate the WACC (with target capital structure) for each
division
reserved. 9-29

Table 9-4
PepsiCo’s Cost of Debt

reserved. 9-30

Table 9-5
PepsiCo’s Cost of Equity

reserved. 9-31

Table 9-6
PepsiCo’s WACC

reserved. 9-32

5. Cost of Capital and
New Investment

 Cost of capital can serve as the
discount rate in evaluating new
investment when the projects offer the
same risk as the firm as a whole.
 If risk differs, it is better to calculate a
different cost of capital for each division.

reserved. 9-33

6. Multinational Firms and
Interest Rates

 In an international setting, there can be
different rates of inflation among
different countries.
 The Fisher Model indicates that the
nominal interest rate in the home or
domestic country is a function of real
interest rates and anticipated rate of
inflation.
reserved. 9-34

Fisher Model and Domestic
Interest Rates

rn,h = (1 + rr,h)(1 + ih) – 1

rn,h = Nominal rate of interest at home, U.S.

rr,h = real interest rate at home, U.S.

Ih = inflation rate at home, U.S
Example: If Real interest rate is 3% and inflation
rate is 5%, nominal rate will be 8.15%
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reserved. 9-35

International or Foreign Rates
and Fisher Effect

rn,h – rn,h = ih – if
Differences in observed nominal rates of
interest between two countries should
equal the difference in expected rates of
inflation between the two countries.

reserved. 9-36

Interest Rate Parity Theorem

 rn,h = Domestic one-period rate of interest
 rn,f = Corresponding rate in foreign country
 E0 & E1 = Exchange rates corresponding to
current period (i.e. spot exchange rate) and
one-period hence (i.e. the one-period forward
exchange rate)
reserved. 9-37

Interest Rate Parity Theorem

Thus,
 Nominal interest rates are tied to
exchange rates
 Differences in nominal interest rates are
tied to expected rates of inflation

reserved. 9-38

Interest Rates and Currency
Exchange Rates

 Example: If domestic one-period
interest rate is 15.5%, and the
Japanese rate of interest is 5%, the
spot exchange rate is $1 to 1 yen and
the forward exchange rate is $1.10 to
1 yen.
1 + .155 / 1 + .05 = 1.1/1= 1.10

reserved. 9-39

Figure 9-1

reserved. 9-40

Key Terms

 Capital Structure
 Financial Policy
 Economic Profit
 Market Value Added
 Weighted Average Cost of Capital

reserved. 9-41

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