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Cost of Capital

Cost of Capital. Key issues: What do we mean by “cost of capital” How can we come up with an estimate? 1. Vocabulary—the following all mean the same: a. Required return b. Appropriate discount rate c. Cost of capital (or cost of money)

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Cost of Capital

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  1. Cost of Capital • Key issues: • What do we mean by “cost of capital” • How can we come up with an estimate? • 1. Vocabulary—the following all mean the same: a. Required return b. Appropriate discount rate c. Cost of capital (or cost of money) 2. Cost of capital is an opportunity cost—depends on where the money goes, not where it comes from. 3. For now, capital structure (debt/equity mix) is fixed.

  2. Cost of Debt • Cost of debt 1. Cost of debt, RD, is the interest rate on new borrowing. 2. Cost of debt is observable: a. Yield on currently outstanding debt. b. Yields on newly-issued similarly-rated bonds. 3. Historic debt cost is irrelevant.

  3. 0 1 9 10 kd=? 90 90 90 What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? PV1 . . . PV10 PVM 1,000 887 Find kd that “works”!

  4. Find kd

  5. Cost of Equity Capital: Expected Return on Stock: RE • Models of Expected Returns • CAPM: Expected return on stock i = Riskfree rate + (Beta of i with respect to Market)*(Expected return on Market - Riskfree rate) • APT: Expected return on stock i = Riskfree rate + (Beta of i with respect to Factor 1)*(Expected return on Factor 1 - Riskfree rate) + (Beta of i with respect to Factor 2)*(Expected return on Factor 2 - Riskfree rate) + ...

  6. Cost of Equity Capital: Expected Return on Stock: RE • Models of Expected Returns • Historical Industry Returns: Expected Return on stock i = Average historical return of other firms in the same industry as company i.

  7. The Weighted Average Cost of Capital (WACC) • Cost of Capital = WACC • Capital structure weights 1. Let: E = the market value of the equity. D = the market value of the debt. Then: V = E + D 1 = E/V + D/V = 100% 2. Thus, the firm’s capital structure weights are E/V and D/V.

  8. The Weighted Average Cost of Capital (concluded) 3. Interest payments on debt are tax-deductible, so the after-tax cost of debt is the pretax cost multiplied by (1 - corporate tax rate). After-tax cost of debt = RD x (1 - Tc) 4. The weighted average cost of capital that we actually use is thus WACC = (E/V) x RE + (D/V) x RD x (1 - Tc)

  9. ) http://pages.stern.nyu.edu/~adamodar/ Updated Data

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