Chapter 14: Cost of Capital

Concept Questions:
4.

WACC and Taxes: Why do we use an after-tax figure for cost of debt but not for
cost of equity?
Interest expense is tax-deductible while dividends are paid in after-tax dollars.
Therefore, there is no difference between pre-tax and after-tax equity costs.

5.

DCF Cost of Equity Estimation: What are the advantages of using the DCF
model for determining the cost of equity capital? What are the disadvantages?
What specific piece of information do you need to find the cost of equity using
this model? What are some of the ways in which you could get this information?
The primary advantage of the DCF model is its simplicity. The method is
disadvantaged in that:
(1) The model is applicable only to firms that actually pay dividends (many firms
do not pay dividends)
(2) Even if a firm does pay dividends, the DCF model requires a constant
dividend growth rate forever
(3) The estimated cost of equity from this method is very sensitive to changes in g,
which is a very uncertain parameter, and
(4) The model does not explicitly consider risk, although risk is implicitly
considered to the extent that the market has impounded the relevant risk of the
stock into its market price.
While the share price and most recent dividend can be observed in the market, the
dividend growth rate must be estimated. Two common methods of estimating g are
to use analysts earnings and payout forecasts or to determine some appropriate
average historical g from the firms available data.

6.

SML Cost of Equity Estimation: What are the advantages of using the Security
Market Line (SML) approach from CAPM to finding the cost of equity capital?
What are the disadvantages? What specific pieces of information are needed to
use this method? Are all of these variables observable, or do they need to be
estimated? What are some of the ways in which you could get these estimates?
Two primary advantages of using the SML equation from CAPM are that the
model explicitly incorporates the relevant risk of the stock and the method is more
widely applicable that is the DCF model, since the SML doesnt make any
assumptions about the firms dividends. The primary disadvantages to the SML
method are:
(1) Three parameters (the risk-free rate, the expected return on the market, and
beta) must be estimated, and
(2) The method essentially uses historical information to estimate these
parameters.

The risk-free rate is usually estimated to be the yield on very short maturity Tbills and is; therefore, observable (at least the proxy is observable). The stock
beta, which is unobservable, is usually estimated be determining some average
historical beta from the firm and the markets return data (usually the last 60
months of return data), or by using beta estimates provided by analysts and
investment firms.
7.

Cost of Debt Estimation: How do you determine the appropriate cost of debt for
a company? Does it make a difference if the companys debt is privately placed as
opposed to being publicly traded? How would you estimate the cost of debt for a
firm whose only debt issues are privately held by institutional investors?
The appropriate after-tax cost of debt to the company is the interest rate it would
have t pay if it were to issue new debt today. Therefore, if the YTM on outstanding
bonds of the company is observed, the company has an accurate estimate of its
cost of debt. If the debt is privately-placed, the firm could still estimate its cost of
debt by:
(1) Looking at the cost of debt for similar firms in similar risk classes (i.e.,
publicly-traded companies debt rated by credit rating agencies)
(2) Looking at the average debt cost for firms with the same credit rating
(assuming the firms private debt is rated), or
(3) Consulting analysts and investment bankers.
Even if the debt is publicly-traded, an additional complication is when the firm
has more than one issue outstanding. These issues rarely have the same YTM
because no two issues are ever completely homogeneous.

10.

Divisional Cost of Capital: Under what circumstances would it be appropriate

for a firm to use different costs of capital for its different operating divisions? If
the overall firm WACC were used as the hurdle rate for all divisions, would the
riskier divisions or the more conservative divisions tend to get most of the
investment projects? Why? If you were to try to estimate the appropriate cost of
capital for different divisions, what problems might you encounter? What are two
techniques you could use to develop a rough estimate for each divisions cost of
capital?
If the different operating divisions were in much different risk classes, then
separate cost of capital hurdle rates should be used for the different divisions.
The use of a single, overall cost of capital would be inappropriate. If the single
hurdle rate were used, riskier divisions would tend to receive more funds for
investment projects, since their return would exceed the hurdle rate despite the
fact that they may actually plot below the SML and, therefore, be unprofitable on
a risk-adjusted basis. The typical problem encountered in estimating the cost of
capital for a division is that it rarely has its own securities traded on the market.
Therefore, it is difficult to observe the markets valuation of the risk of the
division. Two typical ways around this are to use a pure play proxy for the
division, or to use subjective adjustments of the overall firm hurdle rate based on
the perceived risk of the division.

Problems:
12.

Book Value versus Market Value: Filer Manufacturing has 11 million shares of
common stock outstanding. The current share price is $68, and the book value per
share is $6. Filer Manufacturing also has two bond issues outstanding. The first
bond issue has a face value of $70 million, has a 7 percent coupon, and sells for
93 percent of par. The second issue has a face value of $55 million, has a 8
percent coupon, and sells for 104 percent of par. The first issue matures in 21
years, the second in 6 years.
a. What are Filers capital structure weights on a book value basis?
The book value of equity is the book value per share times the number of
shares outstanding, and the book value of debt is the face value of the firms
bonds:
BVE $6 PerShare 11,000,000 SharesOuts t $66,000,000
BVD $70,000,000 $55,000,000 $125,000,000

The book value of Filer is the sum of the book value of equity and book value
of debt:
VFiler $66,000,000 $125,000,000 $191,000,000

The book value weights of equity and debt are:

E / V wE

BVE
$66,000,000

0.34554974
V
$191,000,000

D / V wD

BVD $125,000,000

0.65445026
V
$191,000,000

b. What are Filers capital structure weights on a market value basis?

The market value of equity is the market value per share times the number of
shares outstanding, and the market value of debt is the face value of the firms
bonds times the market value percent of par value:
MVE $68 PerShare 11,000,000SharesOuts t $748,000,000

MVD $70,000,000 0.93 $55,000,000 1.04 $122,300,000

The market value of Filer is the sum of the market value of equity and market
value of debt:
VFiler $748,000,000 $122,300,000 $870,300,000

The market value weights of equity and debt are:

E / V wE

MVE $748,000,000

0.85947374
V
$870,300,000

D / V wD

MVD $122,300,000

0.14052626
V
$870,300,000

c. Which are more relevant, the book or market value weights? Why?
The market value weights are more relevant. The firms book values represent
historic costs whereas the firms market values represent the markets
expectations of future cash flows discounted back to the present. Since we are
interested in future cash flows, we are interested in market values.
13.

Calculating the WACC: In Problem 12, suppose the most recent dividend was
$4.10 and the dividend growth rate is 6 percent. Assume that the overall cost of
debt is the weighted average of that implied by the two outstanding debt issues.
Both bonds make semiannual payments. The tax rate is 35 percent. What is the
companys WACC?
First, we will find the cost of equity. The information provided allows us to solve
for the cost of equity using the dividend growth model:
RE

D0 (1 g )
$4.10 (1 0.06)
g
0.06 0.1239or12.39%
P0
$68

Next we need to find the YTM on both bond issues:

BondIssue1 : 42n;

70
PMT ;930CHSPV ;1,000 FV ; i 2 7.6764%
2

BondIssue2 : 12n;

80
PMT ;1,040CHSPV ;1,000 FV ; i 2 7.1680%%
2

To calculate the weighted average cost of debt, we need to determine the market
value weight of each bond issue. The market value weight of the first bond issue is
the market value of bond issue 1 divided by the sum of market value of bond issue
1 and bond issue 2. We already know that the market value of both bond issues is
$122,300,000. Therefore:
wD1

MVD1
$70,000,000 0.93

0.5323
MVD1 MVD 2
$122,300,000

wD 2

MVD 2
$55,000,000 1.04

0.4677
MVD1 MVD 2
$122,300,000

The pre-tax weighted average cost of debt is:

wD1 YTM D1 wD 2 YTM D 2

0.5323 7.6764% 0.4677 7.1680% 7.4386%

Using the WACC equation:

WACC wE RE wD RD (1 tc )
WACC 0.8595 12.39% 0.1405 7.4386%(1 0.35) 11.3285%

15.

Finding the WACC: Given the following information for Evenflow Power Co.,
find the WACC. Assume the companys tax rate is 35 percent.
Debt:

8,000 6.5 percent coupon bonds outstanding, $1,000 par value, 20

year to maturity, selling for 92 percent of par; the bonds make
semiannual payments
250,000 common shares outstanding, selling for $57 per share; the
beta is 1.05
15,000 shares of 5 percent preferred stock outstanding, currently
selling for $93 per share (par value equals $100 per share)
8 percent market risk premium and 4.5 percent risk-free rate

Common:
Preferred:
Market:

The market values for each component are:

MVD 8,000 Bonds $1,000 ParValue 0.92 $7,360,000

MVE 250,000 SharesOuts t $57 PerShare $14,250,000

MVP 15,000SharesOuts t $93PerShare $1,395,000

The total market value of the firm is:

V $7,360,000 $14,250,000 $1,395,000 $23,005,000

The market value weights of each component cost of capital are:

wD

MVD
$7,360,000

0.31993045
V
$23,005,000

wE

MVE $14,250,000

0.61943056
V
$23,005,000

wP

MVP
$1,395,000

0.06063899
V
$23,005,000

The pre-tax cost of debt is the YTM on the bonds:

40n;

65
PMT ;920CHSPV ;1,000 FV ; i 2 7.2647%
2

We have information to use the CAPMs SML equation for the cost of equity:

RE R f [ RM R f ] 4.5% 1.05[8%] 12.9%

The cost of preferred stock is:

RP

DP $5

5.3763%
PP $93

Therefore, the WACC is:

WACC (0.31993045)(7.2647%)(1 0.35) (0.61943056)(12.9%) (0.06063899)(5.3763%) 9.8274%