Corporate Finance Dr.

Ridha ESGHAIER

CHAPTER 3
The Cost of Capital

Dr. Ridha ESGHAIER

Chapter PLAN
Introduction
I- Direct Calculation via the Beta of Assets
II- Indirect Cost of Capital Calculation
1- Sources of capital
A- Cost of Debt (rd)
B- Cost of Preferred Stock (rp)
C- Cost of Common Equity
– Cost of retained earnings (rs)
– Cost of New common stock (re)
2- Adjusting for flotation costs
3- Estimating Weights for the Capital Structure
4- Calculating the WACC
5- WACC and Project’s risk
6- Some Practical Applications
7- Can Corporate Managers influence the Cost of Capital?
2
 Dr. Ridha ESGHAIER

LEARNING OUTCOMES
The student should be able to:
a. calculate and interpret the cost of capital (WACC) of a company using
both the direct and indirect methods;
b. describe how taxes affect the cost of capital from different capital
sources;
c. describe the use of target capital structure in estimating WACC and how
target capital structure weights may be determined;
d. calculate and interpret the cost of debt capital using the yield-to-
maturity approach and the debt-rating approach;
e. calculate and interpret the cost of noncallable, nonconvertible
preferred stock;
f. calculate and interpret the cost of equity capital using the capital asset
pricing model approach, the dividend discount model approach, and the
bond- yield- plus risk- premium approach;
g. explain and demonstrate the correct treatment of flotation costs.
h. Conduct some practical applications of the cost of capital in investment
decisions and valuation for diversified companies, multinational firms,
firms in financial distress and firms with negative net financial debt
3

Introduction Dr. Ridha ESGHAIER

• A company grows by making investments that are expected to

increase revenues and profits. The company acquires the capital
or funds necessary to make such investments by borrowing or
using funds from owners. By applying this capital to investments
with long-term benefits, the company is producing value today.
• The Value produced depends not only on the investments’
expected future cash flows but also on the cost of the funds.
Borrowing is not costless. Neither is using owners’ funds.
• The cost of this capital is an important ingredient in both
investment decision making by the company’s management and
the valuation of the company by investors.
– If a company invests in projects that produce a return in excess of the cost
of capital, the company has created value;
– in contrast, if the company invests in projects whose returns are less than
the cost of capital, the company has actually destroyed value.
 Therefore, an accurate estimation of the company’s cost of
4
capital is a central issue in corporate financial management.
 The weighted average cost of capital
(WACC) Dr. Ridha ESGHAIER

• The cost of capital is the rate of return that the suppliers of capital —
bondholders and owners—require as compensation for their contribution of
capital. Another way of looking at the cost of capital is that it is the opportunity
cost of funds for the suppliers of capital ( A potential supplier of capital will not
voluntarily invest in a company unless its return meets or exceeds what the
supplier could earn elsewhere in an investment of comparable risk).
• Most firms employ different types of capital, including issuing equity, debt, and
instruments that share characteristics of debt and equity. And because of their
differences in risk, the different sources selected have different required rates
of return (different costs).
• The required rate of return on each capital component is called its component
cost.
• The cost of capital is used to determine the firm’s intrinsic value or to analyze
capital budgeting decisions. It is found as a weighted average of the various
components’ costs, called the weighted average cost of capital, or WACC.
• Cost of capital estimation is a challenging task. the cost of capital is not
5
observable but, rather, must be estimated.

Dr. Ridha ESGHAIER

Uses of the Cost of Capital

• In the introductive chapter, we said that managers should strive
to make their firms more valuable. The value of a firm is
determined by the size, timing, and risk of its free cash flows
(FCF). Indeed, a firm’s intrinsic value is found as the present value
of its FCFs, discounted at its cost of capital.
• In addition, the cost of capital is used primarily to make
investment decisions, and these decisions depend on projects’
NPVs computed using the cost of capital required for those
projects.
• In previous chapters, we examined the major sources of
financing (stocks, bonds, and preferred stock) and the costs of
those instruments (the required rates of return by investors).
• In this chapter, we put those pieces together and estimate the
firm’s cost of capital.
6
 Dr. Ridha ESGHAIER

Valuation & the Cost of Capital

Dr. Ridha ESGHAIER

Calculation of the Cost of Capital

• The cost of capital is not just the risk of capital employed. It
exists before the capital structure is even fully assembled or
finalized.
• In fact, creditors and shareholders will determine the rate of
return they require on debt and equity on the basis of the
capital structure and of the risk of capital employed.
• Only for calculation purposes is the cost of capital often
calculated as the weighted average cost of equity and debt.
• The cost of capital can be calculated by:
o Using a direct method on the basis of the β of the
capital employed; or
o Using an indirect method where it is equal to the
weighted average of the values of the cost of equity
and the cost of net debt 8
 I- DIRECT CALCULATION
Via the Beta of Assets
• Since a company's liabilities merely provide a “screen” between the asset
side of the company and the financial market, the rate of return required to
satisfy investors is equal to the risk-free rate plus a risk premium related to
the company's activity.
• Applying the CAPM gives us:
WACC = rRF + βA (rM – rRF)
where WAAC is the weighted average cost of capital, rRF the risk-free rate, rM the
market rate of return and ßA the beta of assets or unlevered beta; that is, the ß
of a debt-free company.
• Just as the beta of a share measures the deviation between its returns and
those of the equity market, so too does the beta of an asset measure the
deviation between its future cash flows and those of the market. Yet these
two betas are not independent. A firm that invests in projects with a high ßA –
in other words, projects that are risky – will have a high ßE on its shares
because its profitability will fluctuate widely.
• On average, asset betas are below 1 as it is equity betas that are on average,
by construction, equal to 1. Excluding the burden of net debt (which is on
average positive for firms), asset betas are lower than equity betas. 9

• The ßA can easily be computed, knowing that it is equal to the weighted average
of the ß of equity and the ß of debt, with the weighting being a function of the
relative importance of shareholders' equity and net debt by value (V) in the
company's financial structure:
βAssets= βEquity × + βDebt ×

• ßA can also be expressed as follows:

βEquity + βDebt×
βAssets=

ßDebt corresponds to the beta of the net debt and it should be computed exactly the
same way as the beta of equity, which is by regressing the Debt returns on listed debt
against market returns. However, it is reasonable to assume that ßDebt is equal to zero
for weakly leveraged companies. Thus, the previous equation can be simplified as
β
follows: βAssets= Equity

• We believe that it is not reasonable to simplify the analysis by assuming that ßDebt
= 0 if the leverage of a company is not negligible. Often, our readers will read that
financial analysts prefer using the following formula in which not only as ßDebt is
assumed to be nil but also because corporate income tax rate (TC) is introduced.
βEquity
βAssets=
( )

• This way of computing ßAssets is based on the work of F. Modigliani and M. Miller
in 1963 (see chapter 6)
10
 Assets Beta by industry

11

Dr. Ridha ESGHAIER

II- INDIRECT CALCULATION

via The Weighted Average Cost of Capital
it is possible to reconstitute the cost of capital of a company by seeking which
rate of return is required for each type of financial security and by weighting
each rate by its relative share in value in the financing of the company. The
result is the weighted average cost of capital formula:
WACC = wdrd(1-T) + wprp + wsrs + were

• wd , wp ,ws and we refer, respectively, to the proportion of debt,

preferred stock, retained earnings and new common stock the firm
plans to use in its capital structure (weights).
• The r ’s refer to the cost of each component.
– rd: the cost of LT debt
– rp: the cost of Preferred stock
– rs: the cost of retained earnings
– re: the cost of new common stock issued (external equity)
• T is the firm’s marginal Tax rate 12
 1- What sources of long-termDr. Ridha ESGHAIER
capital do firms use?
• Capital components are sources of funding that come from
investors. They include: Long-Term
Capital

– Long-term debt Long-Term Preferred Common

– Preferred stock Debt Stock Stock

– Common equity (retained earnings and/or New common stock) Retained

Earnings
New Common
Stock

• Accounts payable, accruals, and deferred taxes are not sources

of funding that come from investors. Instead, they arise from
operating relationships with suppliers and employees so they
are not included in the calculation of the cost of capital. Such
funds are not included when calculating free cash flows, and
they are not included when we calculate the amount of capital
needed in a capital budgeting analysis. Therefore, they should
not be included when we calculate the WACC.
13

Dr. Ridha ESGHAIER

Should our analysis focus on before-

tax or after-tax capital costs?

– Tax effects associated with financing can be

incorporated either in capital budgeting cash flows
or in cost of capital.
• Stockholders focus on A-T cash flows. Therefore,
we should focus on A-T capital costs, i.e. use A-T
costs of capital in WACC.
• Only cost of debt is affected. rd needs
adjustment, because interest is tax deductible.

14
 Dr. Ridha ESGHAIER
Should we focus on historical (embedded) costs
or new (marginal) costs?
• Because we are using the cost of capital in the evaluation of
investment opportunities, we are dealing with a marginal
cost—what it would cost to raise additional funds for the
potential investment project. Therefore, the cost of capital that
the investment analyst is concerned with is a marginal cost.
• In financial management the cost of capital (WACC) is used
primarily to make investment decisions, and these decisions
depend on projects’ expected future returns versus the cost of
the new, or marginal, capital that will be used to finance those
projects
So, we should focus on marginal costs.
• The WACC is also referred to as the Marginal Cost of Capital
(MCC) because it is the cost that a company incurs for
additional capital. 15

Dr. Ridha ESGHAIER

A- Component cost of debt,

rd(1-T)
WACC = wdrd(1-T) + wprp + wsrs + were
• The cost of debt is the cost of debt financing to a
company when it issues a bond or takes out a bank
loan*.
• We use two methods to estimate the marginal
before- tax cost of debt, rd:
– The yield-to-maturity approach
– The debt-rating approach.

* If the company uses leasing as a source of capital, the cost of these

leases should be included in the cost of capital. The cost of this form
of borrowing is similar to that of the company’s other long- term
borrowing. 16
 Dr. Ridha ESGHAIER
• If the firm raising new debt already has bonds
outstanding, then we can use:
– the yield (YTM) on those bonds as the market
required rate of return for the firm’s LT debt
• If the firm has no existing debt:
– the required return on its new debt is best estimated
by the YTM of bonds currently traded for firms in a
similar product market with a similar risk level (and
similar time to maturity).
• Note that the coupon rate was the cost of debt for the company when the bond was
issued (at that time, the coupon rate was chosen to be equal to YTM on similar
outstanding bonds – bonds with similar risk and maturity) .
• However, when we estimate the cost of debt at a later time, we are interested in the
rate we would have to pay on newly issued debt in the current market conditions,
which could be very different from past rates. That is why the cost of debt should be
estimated using the YTM and not the coupon rate paid by the firm to its bondholders.
17

Dr. Ridha ESGHAIER

Why tax-adjust?
why rd (1-T)?
• The required return to debtholders, rd, is not equal to the cost
of debt for the company because interest payments are
deductible, which means the government in effect pays part of
the total cost.
• The marginal cost of debt financing is the cost of debt
after considering the allowable deduction for interest on
debt based on the country’s tax law.
• As a result, the weighted average cost of capital is calculated
using the after-tax cost of debt, rd(1 −T), which is the interest
rate on debt, rd, less the tax savings that result because interest
is deductible. Here T is the firm’s marginal tax rate

18
 Dr. Ridha ESGHAIER
Component Cost of Debt
After-tax component cost of debt = Before tax Interest rate (1− Tax rate)

A-T rd = B-T rd (1-T)

Example :
• Suppose a company pays $1 million in interest on its $10 million
of debt. The cost of this debt for the company is not $1 million
because this interest expense reduces taxable income by
$1 million, resulting in a lower tax (since EBT = EBIT – Interest
charges).
• If the company has a marginal tax rate of 40%, this $1 million of
interest costs the company ($1 million)(1 - 0.4) = $0.6 million
because the interest reduces the company’s tax bill by
$0.4 million (= interest x T). In this case,
o the before-tax cost of debt is: $1million)/(€10 million) = 10%,
o whereas the after- tax cost of debt is ($0.6 million)/(€10 million)
= 6%, which can also be calculated as 10%(1 – 0.4).
19

Dr. Ridha ESGHAIER

A.1- Yield- to- Maturity Approach

The yield to maturity (YTM) is the annual

return that an investor earns on a bond if the
investor purchases the bond today and holds it
until maturity. In other words, it is the yield, rd,
that equates the present value of the bond’s
promised payments to its market price.
Must find the discount rate YTM that solves this model
INT INT INT Par Value
Market Price Bond = + + ... + +
(1 + YTM ) 1
(1 + YTM ) 2
(1 + YTM ) N
(1 + YTM ) N
 1 - (1 + YTM ) - N  Par Value
Market Price Bond = INT   +
 (1 + YTM )
N
 YTM
20
 Application 1: A company issues a bond to finance a new
project. It offers a 15-year, $1,000 face value, 12% semiannual
coupon bond. Upon issue, the bond sells for $1,153.72. Tax=40%.
1. What is the cost of debt (rd)? Dr. Ridha ESGHAIER
2. Calculate the After-Tax cost of debt.
Solution 1:
1. Cost of bond is rd solving:
INT  1 - (1 + rd /2) -2N  Par Value
PV B =   + (1 + r /2) 2N
2  rd /2  d

INT/2 = 12%x1,000 /2 =60 ; 2N = 2x15 = 30 ; PVB= $1,153.72 ; par value = 1,000

 1 - (1 + rd /2) -30  1, 000
$ 1,153 . 72 = 60   +
 (1 + rd /2 )
30
 rd / 2
rd/2 = 5%  The bond’s annual Cost= 2x5% = 10%.
2. interest is tax deductible, so:
A-T rd = B-T rd (1-T)
= 10% (1 - 0.40) = 6% 21

Excel Application 1
Answer Application 1 using Excel (1. Pricing & YTM Calculation).. Recall
that in Excel, we can compute the Bond’s YTM is using the function:
RATE (nper, +coupon pmt, -price, +face value)

22
 Dr. Ridha ESGHAIER
A.2- Debt- Rating Approach

When a reliable current market price for a company’s debt is

not available, the debt-rating approach can be used to
estimate the before-tax cost of debt.
Based on a company’s debt rating, we estimate the before-tax
cost of debt by using the yield on comparably rated bonds for
maturities that closely match that of the company’s existing
debt.
• Suppose a company’s capital structure includes debt with
an average maturity (or duration) of 10 years and the
company’s marginal tax rate is 35%. If the company’s rating
is AAA and the yield on debt with the same debt rating and
similar maturity is 5%, the company’s after-tax cost of debt
is : rd(1 – t) = 5% x (1 – 0.35) = 3.25 %

23

Dr. Ridha ESGHAIER

B- Component cost of
preferred stock rP
WACC = wdrd(1-T) + wprp + wsrs + were

• rp is the marginal cost of preferred stock, which is the

Nominal return investors require on a firm’s preferred
stock.
• The cost of preferred stock is the cost that a company has
committed to pay preferred stockholders as a preferred
dividend when it issues preferred stock.
• Preferred dividends are not tax-deductible, so no tax
adjustments necessary. Just use nominal rp.

24
 Dr. Ridha ESGHAIER

Comments about
Preferred Stocks

• Preferred stock trades the same way as common stock, usually

through a brokerage firm and with the same transaction costs.
Because the properties generally associated with these stocks will
affect the way investors value them, the prices of common and
preferred stocks offered by the same company will differ.
Preferred stocks tend to be more stable because of the regular
income stream, while common stock can be more volatile.
• Because the dividends received by preferred stockholders are
fixed at the outset, the value of preferred stock is affected more
by interest rate fluctuations than by the company’s performance.

25

Dr. Ridha ESGHAIER

What is the cost of preferred stock?

In the case of nonconvertible, noncallable preferred stock
that has a fixed dividend rate and no maturity date (pays a
fixed dividend in perpetuity) : fixed rate perpetual
preferred stock, we can use the formula for the value of a
preferred stock:
Pp = Dp / rp
where
Pp = the current preferred stock price per share
Dp = the preferred stock dividend per share
rp = the cost of preferred stock

We can rearrange this equation to solve for the cost of preferred

stock:

rp = Dp / Pp
26
 Dr. Ridha ESGHAIER

Application 2 : What’s the cost of a preferred

stock if its current price PP = $111.10 and it pays
quarterly dividend DQ of $2.5?
Solution 2
0
rp = ?
1/4 1/2 3/4 1year ∞
...
PP=$111.1 2.50 2.50 2.50 2.50 2.50
DQ $ 2 .50
PP =  $ 111 .10 =
rP rP
$ 2 . 50
Quartely rP = = 2 . 25 %
$ 111 . 10
 Annual rp = 4 × 2.25% = 9%
annual Div 4 × $ 2 . 50
or annual rP = = = 9% 27
PP $ 111 . 10
Dr. Ridha ESGHAIER
Application 3:
You have been asked by a company to calculate its cost of
preferred equity and have recently obtained the following
information:
• The issue price of preferred stock was $3.5 million and the
preferred dividend is 5%.
• If the company issued new preferred stock today, the preferred
coupon rate would be 6.5%.
• The company’s marginal tax rate is 40%.
What is the cost of preferred equity?
Solution 3:
If the company were to issue new preferred stock today, the
coupon rate would be close to 6.5%. The current terms thus
prevail over the past terms when evaluating the actual cost of
preferred stock. The cost of preferred stock is, therefore, 6.5%.
Because preferred dividends offer no tax shield, there is no
adjustment made based upon the marginal tax rate. 28
 Dr. Ridha ESGHAIER

C- Component cost of
Common equity
Companies can raise common equity in two ways:
(1) Indirectly, by reinvesting earnings that are not
paid out as dividends (retaining earnings).
(2) Directly, by issuing and selling new shares of
common stock to the public.

We use the symbol rs to designate the cost of retained

earnings and re to designate the cost of new common stock
issued (e for external equity)
29

Cost of new Common stock re

and retained earnings rS
WACC = wdrd(1-T) + wprp + wsrs + were

• re is the rate of return investors require on the

firm’s common equity using new common
stocks.
• rs is the marginal cost of common equity using
retained earnings.

As we will see, re is equal to rs plus a factor that

reflects the cost of issuing new stock
30
Dr. Ridha ESGHAIER
 Dr. Ridha ESGHAIER

Why is there a cost for

retained earnings?
Some have argued that retained earnings should be “free” because
they represent money that is “left over” after dividends are paid.
While it is true that no direct costs are associated with retained
earnings, this capital still has a cost, an opportunity cost.
The firm’s after-tax earnings belong to its stockholders. Bondholders
are compensated by interest payments; preferred stockholders, by
preferred dividends.
But the net earnings remaining after interest and preferred dividends
belong to the common stockholders, and these earnings serve to
compensate them for the use of their capital. The managers, who
work for the stockholders, can either pay out earnings in the form of
dividends or retain earnings for reinvestment in the business.
31

Dr. Ridha ESGHAIER

When managers make decision, they should recognize that

there is an opportunity cost involved. Stockholders could
have received the earnings as dividends and invested this money
in other stocks, in bonds, in real estate, or in anything else.
Therefore, the firm needs to earn at least as much on any
earnings retained as the stockholders could earn on alternative
investments of equivalent risk.
Therefore, if the firm cannot invest retained earnings to earn at
least the required rate of return on an equivalent risk stock, it
should pay those funds to its stockholders and let them invest
directly in stocks or other assets that will provide that return.

32
 Dr. Ridha ESGHAIER

Remember…

• Earnings can be reinvested or paid out as dividends.

• Investors could buy other securities and earn a
return.
• Thus, if earnings are retained, there is an
opportunity cost
• The opportunity cost is the return that stockholders
could earn on alternative investments of equal risk.

33

Dr. Ridha ESGHAIER

What is the opportunity cost?

• The answer is the required rate of return on the company’s
common stocks, because stockholders could presumably earn
that return by simply buying the stock of the firm in question or
that of a similar firm. Therefore, the cost of common equity
raised internally as reinvested earnings rs is approximated by
the required return on the company’s common stocks.
• The firm needs to earn on its retained earnings at least as much
as stockholders could earn on alternative investments of
comparable risk.
• If a company can’t earn at least rs on reinvested earnings, then
it should pass those earnings on to its stockholders and let
them invest the money themselves in assets that do yield rs
34
 Dr. Ridha ESGHAIER
Methods to estimate the cost of equity
from retained earnings rs
As we have mentioned previously, the cost of retained
earnings is linked to the required rate of return on the
company’s common stocks rs. Three ways to determine
the cost of common equity from retained earnings, rs.
• (1) CAPM: rs = RRF + β(RM – RRF)
• (2) DCF: rs = (D1 / P0) + g
• (3) Own-Bond-Yield Plus Risk-Premium:
rs = rd + RP

35

(1) Capital Asset Pricing Model Approach

In the capital asset pricing model (CAPM) approach, we use the basic relationship from
the capital asset pricing model theory that the expected return on a stock, E(Ri), is the
sum of the risk- free rate of interest, RRF, and a premium for bearing the stock’s market
risk, βi(E(RM) – RRF). Dr. Ridha ESGHAIER
E(Ri)= RRF + βi(E(RM) – RRF )
• βi = the return sensitivity of stock i to changes in the market return
• E(RM) = the expected return on the market
• E(RM) – RRF = the expected market risk premium
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk
 The time value of money is represented by the risk-free rate (RRF) in the formula and
compensates the investors for placing money in a riskless investment over a period
of time. RRF usually refers to an asset that has no default risk (the Treasury bonds
yield)
 The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking an additional risk. This is calculated by
taking a risk measure (beta) based on how the returns of the stock co-move with
the overall market over a period of time, multiplied by the market premium (RM –
RRF).
In general, the selection of the appropriate risk- free rate should be guided by the
duration of projected cash flows. If we are evaluating a project with an estimated useful
36
life of 10 years, we may want to use the rate on the 10- year Treasury bond.
 Dr. Ridha ESGHAIER

The CAPM Approach

Application 4: If the treasury bond yield as
estimation of the risk free rate rRF is 7%, the
market risk premium RPM = (RM – RRF) is 6%,
and the firm’s beta is 1.2, what’s the cost of
its common equity based upon the CAPM?

Solution 4:
rs = RRF + β(RM – RRF)

rS = 7.0% + 1.2x (6.0%) = 14.2%

37

Dr. Ridha ESGHAIER

What effect does increasing debt have

on the cost of equity for the firm?
• If the level of debt (D) increases, the riskiness
of the firm increases, so the riskiness of the
firm’s equity (E) also increases, resulting in a
higher rs.
• Because the increased use of debt causes both
the costs of debt (rd) and equity (rs) to
increase, we need to estimate the new cost of
equity.

38
 Dr. Ridha ESGHAIER

Levered Vs. Unlevered Beta

• Beta is one of the key inputs in computing the WACC which
is used as a discount rate in fundamental valuation models
(DCF analysis);
• Sometimes, we are interested in the value of a company
without the impact of leverage (or debt) which adds more
risk. To do this, we compute the unlevered beta;
• Unlevered beta (or asset beta) measures the market risk of
the company without the impact of debt.
• If βU is the beta of a firm when it has no debt (the
unlevered beta), βL is the firm’s levered beta computed
using the Hamada’s Equation (after Robert Hamada):
βL = βU x [1 + (1 - T)(D/E)]
βU = βL / [1 + (1 - T)(D/E)]
39

Dr. Ridha ESGHAIER

In the Application 4, if the unlevered Beta is 1.04,

recompute the Levered beta and the cost of Equity for
a debt ratio of 20% assuming a Tax rate of 40%.

• Using Hamada’s equation to find beta:

βL= βU [1 + (1 - T)(D/E)]
= 1.04 x [1 + (1-0.4) (20% / 80%) ]
= 1.2
• Using CAPM to find the cost of equity:
rs= rRF + βL (rM - rRF)
= 7% + 1.2x (6%) = 14.2%
40
 Dr. Ridha ESGHAIER

(2) The Discounted CF approach

• In the previous chapter, we saw that if the marginal investor expects
dividends to grow at a constant rate “g” and if the company makes all
payouts in the form of dividends, then the price of a stock, P0, can be
found as follows: D1
P0 =
r̂ s - g
• Assuming the stock is in equilibrium, we can solve for rs to obtain the
required rate of return on common equity, which for the marginal
investor is also equal to the expected rate of return:
D1
 r̂s = rs = + expected g
P0
 Could DCF methodology be applied if g is not constant?
YES, non-constant g stocks are expected to have constant g at some
point, generally in 5 to 10 years. (use the multistage technique)

41

Dr. Ridha ESGHAIER

Application 5: If D0 =$4.19, P0=$50, and g=5%,

what’s the cost of common equity based upon the
DCF approach?
Solution 5:
D1 = D0 (1 + g) =$4.19 (1 + 5%)
D1 = $4.3995

rs = (D1 / P0) + g
= ($4.3995 / $50) + 0.05
= 13.8%
42
 Dr. Ridha ESGHAIER

Estimating the expected sustainable growth

rate “g”

The expected sustainable growth rate is difficult to

estimate, this can be done using:
• The historical growth rate if you believe the
future will be like the past.
• The analysts’ estimates and forecasts (forecasted
growth rate from a published source or vendor)
• The earnings retention model, illustrated on next
slide.

43

Dr. Ridha ESGHAIER

The expected sustainable growth rate using the
Earning Retention Model
• Most firms pay out some of their net income as dividends and
reinvest, or retain, the rest. The more they retain, and the
higher the earned rate of return on those retained earnings,
the larger their growth rate.
• the earnings growth rate depends on the amount of income
the firm retains and the rate of return it earns on those
retained earnings, and the retention growth equation can be
expressed as follows:
g = ROE x Retention ratio
= ROE x ( 1 – Payout ratio)
= ROE x ( 1 – D/EPS)
where D/EPS represents the assumed stable dividend payout
ratio (dividend/earnings per share) and ROE is the historical
return on equity
44
 Dr. Ridha ESGHAIER

Application 6:
The firm has been earning 15% on equity (ROE = 15%)
and retaining 35% of its earnings (dividend payout =
65%). This situation is expected to continue.
Calculate the earnings (and Dividend) growth rate
Solution 6:
g = ROE x ( 1 – Payout )
= 15% x (0.35)
= 5.25%
 Very close to the g that was given before.

45

Dr. Ridha ESGHAIER

(3) The own-bond-yield plus risk-premium
method
In situations where reliable inputs for the CAPM and the dividend
discount model approach are not available (as would be true for a
closely held company), some analysts use a subjective, ad hoc
procedure to estimate a firm’s cost of common equity based on the
fundamental tenet in financial theory that the cost of capital of riskier
cash flows is higher than that of less risky cash flows. They simply add
to the before-tax cost of debt, rd, a judgmental risk premium of 3% to
5% that captures the additional yield on a company’s stock relative to
its bonds.
rs = Company’s own + Judgmental risk
bond yield premium

• This Risk Premium is not the same as the CAPM RPM.

• This method produces a ballpark estimate of rs, and can
serve as a useful check. 46
 Dr. Ridha ESGHAIER
Application 7:

If rd = 10% and Risk Premium is 4%, what is rs using

the own-bond-yield plus risk-premium method?

Solution 7:

rs = Company’s own + Judgmental risk

bond yield premium
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%

47

Dr. Ridha ESGHAIER

What is a reasonable final estimate of rs?

Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
 Average rs 14.0%

 These results are unusually close, so it would make little difference which
one we used. However, if the methods produced widely varied estimates, then a
financial analyst would have to use his own best judgment regarding the relative
merits of each estimate and then choose one that seemed reasonable under
the circumstances.
 Recent surveys indicate that the CAPM is by far the most widely used
method. The CAPM is more popular with larger, publicly traded companies,
which is understandable considering the additional analyses and assumptions
required in estimating systematic risk for a private company or project. 48
 Dr. Ridha ESGHAIER

2- Flotation costs
• When a company raises new capital, it generally seeks
the assistance of investment bankers. Investment
bankers charge the company a fee based on the size
and type of offering. This fee is referred to as the
flotation cost. It includes expenses such as
underwriting fees, legal fees and registration fees.
• In the case of debt and preferred stock, we do not
usually incorporate flotation costs in the estimated cost
of capital because the amount of these costs is quite
small, often less than 1%.
• However, with equity issuance, the flotation costs may
be substantial, so we should consider these when
estimating the cost of external equity capital
49

Dr. Ridha ESGHAIER

Why is the cost of retained earnings rs cheaper

than the cost of issuing new common stock re?

• When a company issues new common stock they

also have to pay flotation costs.
• Flotation costs are paid by the company that issues
the new securities.
• Also, issuing new common stock may send a
negative signal to the capital markets, which may
depress the stock price.

50
 Dr. Ridha ESGHAIER

- Because no flotation costs are involved, retained

earnings cost less than new stock. Therefore, firms
should utilize retained earnings to the greatest extent
possible.
- However, if a firm has more good investment
opportunities than can be financed with retained
earnings plus the debt and preferred stock supported by
those retained earnings, it may need to issue new
common stock.

The total cost of the new stocks issued is the

investor’s required return plus the flotation cost
51

Flotation-adjusted cost of Equity

Dr. Ridha ESGHAIER
Example :
Suppose that the required rate of return on the company’s stock (= cost of
retained earnings rs from the CAPM) is 13.6%. Based on this information, and
given an estimated growth rate of dividend g= 8.3% and a D1 = $1.25, the intrinsic
value of the stock P0 = D1/(rs-g) = 1.25/(13.6% - 8.3%) = $23.58
So, the approximated issuing value P0 of new shares = $23.58
Suppose that the flotation costs F represent 10% of the stock price P0.
Therefore, the firm actually keeps only 90% of the amount that investors supplied.
 amount received per issued stock = P0 x(1-F) = $21.222
The question is, given the flotation cost, the firm must earn how much on the
available funds (90% of P0) in order to provide investors with a 13.6% return on
their investment?
• Investor side : rs = D1/P0 + g = 13.6% (= required return from the CAPM);
• Company side : since amount received is only P0 x(1- F)
re = D1/[P0 (1- F)] + g = 1.25/ [23.58(1-0.1)] + 8.3% = 14.19%

In that case, the firm must earn about 14.19% on the available funds in order to
provide investors with a 13.6% return on their investment. This higher rate of
return is the flotation-adjusted cost of equity. 52
 Dr. Ridha ESGHAIER

Application 8:
A company sells its new shares for $50 each and its flotation costs
F=15%. If D0=$4.19, g=5%, Estimate the capital raised by the company
for each new issued share and the cost of new common equity.

Solution 8:
 For each new share the company sells it will
actually raise P0 x (1-F) = 50 x 0.85 = $42.50

 The cost of New common equity re will be:

D 0 (1 + g ) $ 4 .19 (1 .05 )
re = +g= + 5 .0 %
P0 (1 − F ) $ 50 (1 − 0 .15 )
$ 4 .40
= + 5 . 0 % = 15 . 4 % > rs (13.8%) in application 4,
$ 42 . 50 because of the flotation costs 53

Dr. Ridha ESGHAIER

flotation costs for Preferred Stocks

and Debt
• For preferred stock, with F is the flotation cost as a percentage of proceeds,
if Dp is the preferred dividend, Pp is the preferred stock price, the cost of
preferred stock is:
rP = DP / PP (1 - F)
• For Bonds with Flotation cost F, Cost of bond= rd solving:
 1 - [1 + rd ] -N  Par Value
PV B (1 − F) = INT   +
 rd  [1 + rd ] N
The A-T cost of debt = rd (1-T)

• NOTE: instead of finding the pre-tax yield based upon pre-tax cash flows and
then adjusting it to reflect taxes, as we did before, we can find the after-tax,
flotation-adjusted cost of Debt rd(1-T) by using this formula:
 1 - [1 + rd (1 - T)] -N  Par Value
PVB (1 − F) = INT(1 - T)  +
 [1 + r (1 - T)] N
 rd (1 - T)  d
54
 Dr. Ridha ESGHAIER

Comments about flotation costs

• Flotation costs depend on the risk of the firm and

the type of capital being raised.
• Most debt offerings have very low flotation costs,
most analysts ignore them when estimating the
after-tax cost of debt
• The flotation costs are highest for common equity.
However, since most firms issue equity
infrequently, We frequently ignore flotation costs
when calculating the WACC.

55

Dr. Ridha ESGHAIER

3- Determining the Weights for

the WACC
• The weights are the percentages of the firm
that will be financed by each component.
• Ideally, we want to use the proportion of each
source of capital that the company would use
in the project or company. If we assume that a
company has a target capital structure and
raises capital consistent with this target, we
should use this target capital structure (the
one that a company is striving to obtain).

56
 Dr. Ridha ESGHAIER

Estimating Weights for the

Capital Structure
If we know the company’s target capital structure, then, of
course, we should use this in our analysis. Someone outside the
company, however, such as an analyst, typically does not know
the target capital structure and must estimate it using one of
several approaches:
1. Assume the company’s current capital structure, at market
value weights for the components, represents the company’s
target capital structure.
2. Examine trends in the company’s capital structure or
statements by management regarding capital structure policy to
infer the target capital structure.
3. Use averages of comparable companies’ capital structures as
the target capital structure 57

Dr. Ridha ESGHAIER

Estimating Weights for the
Capital Structure
• If available, always use the target weights for the
percentages of the firm that will be financed with the
various types of capital.
• If you don’t know the targets, it is better to estimate the
weights using current market values than current book
values.
• If you don’t know the market value of debt, then it is
usually reasonable to use the book values of debt,
especially if the debt is short-term.
• If the firm has multiple bonds as is commonly the case, we
would find the market value of each bond issued and then
add them up.
• Finally, we generally ignore current liabilities in our
computations. However, if a company finances a
substantial portion of its assets with current liabilities, it
should be included in the process. 58
 Why Market Values Weights?
• To be precise, we should use the target (optimal) weights in the firm’s
capital structure.

• The book value of debt is its value at maturity (the principal payment).
• The market value of debt is the PV of interest and principal at the
prevailing interest rates.
• If the prevailing interest rates change, the book value of the debt does
not change but its market value (what investors are willing to pay)
will change.
• The book value of equity (common stock plus retained earnings)
reflects the investment that owners have made in the company, and
does not reflect the market value of the assets
• The market value of equity reflects the future cash flows that
investors expect to receive
• The difference between market and book value for common stock
can be so large as to entirely distort any capital cost calculation.
59

Dr. Ridha ESGHAIER

Application 9:
if a company has the following market values for its capital
• Bonds outstanding $5 million
• Preferred stock 1 million
• Common stock 14 million
Calculate each of the capital component weight based on the
information available

Solution 9:
Total capital = $5M + $1M + $14M = $20 million
The weights that we apply would be
• Wd = Bonds value /Total Capital = 0.25
• Wp = Preferred stock /Total Capital = 0.05
• We = Common stock /Total Capital = = 0.70
60
 Dr. Ridha ESGHAIER
Application 10:
Suppose a firm plans to retain $66 million of earnings for the year. It
wants to finance using its current target capital structure of 45% debt, 2%
preferred, and 53% common equity. How large could its capital budget be
before it must issue new common stock?

Solution 10:
• Common equity = 0.53 x Total capital budget
If Common equity is totally composed by retained earnings, we can write:
Retained earnings = 0.53 x Total capital budget
 Total capital budget = Retained earnings / 0.53
= 66/0.53 = 124.5 million
• If the firm has more good investment opportunities (more than that
can be financed with 124.5 million) it will need to issue new common
stock.
Note:
• Debt target amount = 124.5 x 0.45 = 56.025 million
• Preferred stocks target amount = 124.5 x 0.02 = 2.49 million 61

Dr. Ridha ESGHAIER

Application 11:
A financial analyst is in the process estimating the cost of capital of the
company Alpha. The following information is provided concerning
Alpha:
• Market value of debt €50 million
• Market value of equity €60 million
Primary competitors and their capital structures:
Competitor Market Value of Debt Market Value of Equity
A $25M $50M
B €101M €190M
C $40M $60M

What are Alpha Company’s proportions of debt and equity that the analyst
would use if estimating these proportions using the company’s:
1. current capital structure?
2. competitors’ capital structure?
3. Suppose Alpha announces that a debt-to-equity ratio of 0.7 reflects its
target capital structure. What weights should the analyst use in the cost of
capital calculations? 62
 SOLUTION 11: Dr. Ridha ESGHAIER

1. Current capital structure

wd= 50 / (50+60) = 0.4545
we= 60 / (50+60) = 0.5454
2. Competitors’ capital structure: These weights represent the arithmetic
average of the three companies’ debt proportion and equity proportion,
respectively.
$25 + €101 + ( $40 )
$25+$50 €101+€190 $40+$60
wd= = 0.3601
3
$50 + €190 + ( $60 )
$25+$50 €101+€190 $40+$60
we= = 0.6399
3
3. Note that a simple way of transforming a debt/equity ratio D/E into a
weight—that is, D/(D + E)—is to divide D/E by 1 + D/E.
A debt/equity ratio of 0.7 represents a weight on debt of 0.7/1.7 = 0.4118
so that :
• wd = 0.4118 and
• we = 1 - 0.4118 = 0.5882. 63

Dr. Ridha ESGHAIER

4- Calculating the WACC

Application 12:
A firm has a target capital structure of 43% debt, 5% preferred
stocks and 52% common equity (retained earnings 30% ; new
shares 70%).
rd=10%, tax rate =40%,
Net price of preferred stock = $48, preferred dividend = $6.
the risk free rate RRF = 3%, the expected return of the market
E(RM)= 13.5% and the company’s beta =1.3.
The price of new issued shares is approximated by the constant
dividend growth model with a P0 based on the CAPM, g =3%
and D1=$2.8. flotation costs on new issued stocks are 8% of P0.

Calculate each of the component cost and the company WACC

64
 Dr. Ridha ESGHAIER
SOLUTION 12:
• Debt:
– wd = 0.43
– rd (1-t) = 0.1 (1- 0.4) = 0.06
• Preferred stock:
– wp = 0.05
– rp = pref. D/ price of pref. stock = 6/48 = 0.125
• Retained earnings:
– ws = 0.52 (0.3) = 0.156
– rs = rRF + ß [E(rM) – rRF] = 0.03 + 1.3 [0.135 – 0.03] = 0.1665
• External equity:
– we= 0.52 (0.7) = 0.364
P0 = D1/(rs –g) = 2.8/(0.1665 – 0.03) = $20.51
– re = (D1/[P0(1-F)]) + g = 2.8/[20.51 (1-0.08)] +0.03= 0.1784
WACC= wdrd(1-T) + wprp + wsrs + were = 12.3%
This is the weighted average cost of the hole capital used by the firm and, thus,
could be used as the required return on the total assets of a firm or the
required return for all new projects with similar risk to that of the existing
firm 65

Dr. Ridha ESGHAIER

What factors influence a company’s

composite WACC?

• Factors the firm cannot control:

– Market conditions (stock and bond prices, interest rates,
investors aversion to risk, tax rates)
• Factors the firm can control:
– The firm’s capital structure (mix between debt and
Equity) and dividend policy (payout ratio).
– The firm’s investment policy. Firms with riskier projects
generally have a higher WACC.

66
 Dr. Ridha ESGHAIER
5- WACC and project risk
Should the company use the composite WACC as the hurdle
rate for each of its projects?

NO! The composite WACC reflects the risk of an average project

undertaken by the firm. Therefore, the WACC only represents the
“hurdle rate” for a typical project with average risk.
• If the new project is belonging in the same risk category than the
hole company, its NPV should be computed by using the company’s
cost of capital.
• If the risk of the new project is different from the risk of the whole
company, the investors will require a different rate of return. Thus,
The discounting rate used to compute NPV will be different from the
company cost of capital. This discounting rate should reflect the
project risk. That’s why we need to adjust the WACC
 Since different projects have different risks, the project’s WACC
should be adjusted to reflect the project’s risk.
67

Dr. Ridha ESGHAIER

The true cost of capital depends on project risk, not on the
company undertaking the project. So why is so much time spent
estimating the company cost of capital?
There are two reasons:

• First, many (maybe most) projects can be treated as average risk, that
is, neither more nor less risky than the average of the company’s
other assets. For these projects the company cost of capital is the
right discount rate.
• Second, the company cost of capital is a useful starting point for
setting discount rates for unusually risky or safe projects. It is easier
to add to, or subtract from, the company cost of capital than to
estimate each project’s cost of capital from scratch.

Therefore, the WACC is used to evaluate most projects; but if a

project has an especially high or low risk, the WACC will be
adjusted up or down to account for the risk differential.
68
 Dr. Ridha ESGHAIER
Projects are generally classified into several categories. Then with
the firm’s overall WACC as a starting point, a risk-adjusted cost of
capital is assigned to each category.
For example, a firm might establish three risk classes, assign the
corporate WACC to average-risk projects, add a 5% risk premium
for higher-risk projects, and subtract 2% for low-risk projects.
Under this setup, if the company’s overall WACC was 10%, 10%
• would be used to evaluate average-risk projects, 15% for high-risk
projects, and 8% for low-risk projects. While this approach is
probably better than not making any risk adjustments, these
adjustments are highly subjective and difficult to justify.

• Unfortunately, there’s no perfect way to specify how high or low

the adjustments should be.
• We should note that the CAPM approach can be used for
projects provided there are specialized publicly traded firms in the
same business as that of the project under consideration.
69

Dr. Ridha ESGHAIER

6- Some Practical Applications

A- For the Investment Decisions
• If the company is publicly listed, the calculation is based on readily
available market data. If the company is not listed, the calculation
is based on the cost of capital of companies of comparable size and
risk operating in the same sector of activity and geographic region.
• The trick is elsewhere; one should not mix up the cost of capital of
the firm and the cost of capital of the project. The two are the
same only if the risk level of the project is the same as that of the
firm.
• The level or risk of a project can also evolve in time. Usually, the
average WACC over the duration of the project will be retained.
But it may be more accurate to use a different WACC for each
period depending on the maturity and therefore the risk of the
investment.
70
 • The cost of capital of a firm is a global notion. It should be used in
the choice of investment only for projects that bear a risk similar to
that of the operating assets of the firm. If this is not the case, then a
specific cost of capital should be computed, keeping in mind that it
should be disconnected from the sources of financing.
• The cost of the funds that will be used to finance the project
should never be treated as the cost of capital.
• Retaining the cost of the financing source directly instead of the
cost of capital will lead to erroneous investment choices, as
illustrated by the following Example:
Let's take a first investment with an IRR of 8% to be financed with
equity that yields a cost of 10%. As the return of the investment does
not cover its cost of financing, it is rejected.
A second investment with a similar risk has an IRR of 6%, this time to
be financed with debt costing 4%. This investment will then be
undertaken as its return is above the cost of financing.
As a result, this reasoning has led the company to undertake the
investment yielding the lower return (6% vs. 8%) for the same level of
71
risk. This clearly shows that the reasoning is flawed!

Dr. Ridha ESGHAIER

B- For Valuation
• use the parameters associated with a target capital structure, that the
firm should reach in a few years. While being careful to use the costs
of equity and net debt that correspond to the target capital structure,
and not the present costs. This is unfortunately a frequently committed
error
C- For Diversified Companies
• The overall cost of capital of a diversified company can be calculated
similarly to a company with a single business. Conversely, the analyst
should be cautious if the divisions do not show the same risk profile as
the group. In these cases, each division should be analyzed separately
as each division has its own cost of capital.
• For a diversified company, there are as many costs of capital as there
are sectors in which it operates. Diversification does not reduce the
cost of capital because it only considers systematic risk. As unsystematic
risk can be eliminated by diversification; it does not affect the required
rate of return and therefore has no impact on cost of capital.
72
 Dr. Ridha ESGHAIER
D- Multinational Companies
• A similar logic applies to companies operating in different countries.
• A British company investing in Russia, for example, should not use a
discount rate based on British data just because its suppliers of funds are
British.
• A British, German or Chinese company wanting to invest in the exact
same asset in Russia will bear the same cost of capital as it only depends
on the risks of the project and not on the risks of the company investing.
• Every country or economic area has its own specific cost of capital, which
is dependent upon the political landscape and macroeconomic risks.
E- Companies in Financial distress
• It is generally assumed that companies under financial distress have
a very high cost of capital. This is not correct! Bankruptcy risk is a
specific risk and not a systematic risk, and it should therefore not be
taken into account by the cost of capital. If things were not so, the
firm in financial distress could never undertake an investment as it
would require a higher return than other firms in the sector. It could
then never recover. 73

• The cost of capital for a company in financial distress is identical to

that for a company in the same sector that has no difficulties.
• On one hand, its cost of equity can be very high (ß equity between 3 and 10
can be observed), but the value of equity has become negligible compared to
the value of debt. As equity weighs very little in the capital structure, the
influence of cost of equity on cost of capital is minimal.
F- For Companies with a Negative Net Financial Debt (Cash>Debt)
• Consider a firm that, for structural reasons, has a negative net debt of
2 with no banking or financial debt, and equity of 9.
• Assume that the shareholders buying these shares understand that
they are buying both operating assets with a given risk level and have a
cash situation with virtually no risk. In other words, the risk on the
share is lower than the risk on the company given the structurally
positive net cash balance.
The cost of capital of this company can be estimated using the indirect
method, applying a negative value for Debt . So, in this example, if the
cost of equity is 7% and net cash generates 2% after taxes, then the
company’s cost of capital is 8.4%:
−2 9
= × 2% + × 7% = 8.4% 74
9−2 9−2
 Dr. Ridha ESGHAIER
• To offer the 7% return required by shareholders, the company must
invest in projects yielding at least 8.4%. The 7% cost of equity is the
weighted average of the required 8.4% return on capital employed and
the 2% on net cash.
• The cost of capital for a company with a structurally positive cash
balance does not differ from that of a company with the same capital
employed but no cash. The cost of equity changes, but the cost of
capital remains the same.
• Practitioners often use a cost of capital equal to the cost of equity when
the firm holds net cash. This is a mistake, unless you consider that
shareholders do not take into account the security brought by the net
cash.

• Managers virtually no means of lowering the cost of capital

while simultaneously creating value, because if they lower
the cost of capital they will most likely also lower expected returns.
The only way they can do is by providing better information to the
market, which several studies have shown can lower the
75
cost of capital
Dr. Ridha ESGHAIER
7- Can Corporate Managers
influence the Cost of Capital?
• There is little point in using debt and its tax advantages to lower the cost of
capital. While net debt costs less than equity, it tends to increase the risk
to shareholders, who retaliate by raising the required rate of return and
consequently the cost of equity. Debt works to the advantage of the
company, because the interest on the net debt can be deducted from its
tax base (which it cannot do for dividends). The opposite tends to apply to
investors.
• In short, in a perfect world in which investors had diversified portfolios,
one man's gain would be another man's loss.
• Moreover, if debt really did reduce the cost of capital, one would have to
wonder why highly efficient companies – such as L'Oréal, Toyota, Google
and SAP – are not levered, given that they have no reason to fear
bankruptcy.
• Managers virtually no means of lowering the cost of capital while
simultaneously creating value, because if they lower the cost of capital
they will most likely also lower expected returns. The only way they can do
is by providing better information to the market, which several studies
76
have shown can lower the cost of capital
 Dr. Ridha ESGHAIER

Application 13:

A Company is targeting the following capital structure:

- Common equity: 58%
- Preferred stocks: 2%
- Debt : 40%
The marginal cost of each financing source is:
- Cost of Common equity: 14%
- Cost of Preferred stocks: 11%
- Cost of Debt: 9.43%
The company’s marginal tax rate = 30%
1. Compute the company’s WACC
2. The company’s management would like to know if the following
project is profitable. I0 : $68,000; CF1 : $18,000; CF2 : $23,000;
CF3 : $31,000; CF4 : $21,000
Note: The project has a higher risk than the company’s average projects
(a risk premium of 3% should be used) 77

Dr. Ridha ESGHAIER

SOLUTION 13:
1. WACC= wdrd(1-T) + wprp + wsrs + were

WACC = 0.4(9.43%)(1-0.3) + 0.02(11%) + 0.58(14%)

= 10.98%
2. Since the New project is riskier than the company’s avrerage projects, a risk premium of 3%
should be taken into consideration when computing the minimum required return on it.

WACC new project = WACC average + Risk premium

= 10.98% + 3% = 13.98%
To accept the new project, its NPV using the adjusted WACC should be positive, or its
internal rate of return (IRR) should be higher than its required rate of return (the
adjusted WACC)
18000 23000 31000 21000
NPV(13.98% ) = − 68000 + 1
+ 2
+ 3
+ = $ − 1126.24 < 0
(1.1398) (1.1398) (1.1398) (1.1398) 4

At 13.98%, NPV= -1126.24 IRR − 12.98% 0 − 335.56

IRR? , NPV=0 = = 0.2295
13.98% − 12.98% − 1126.24 - 335.56
At 12.98%, NPV= 335.56
IRR = 12.98% + (1% × 0.2295) = 13.21%
IRR < 13.98% and/or NPV<0  refuse the project 78
 Dr. Ridha ESGHAIER
Application 14:
A Corporation is estimating its WACC. Its target capital structure is 30% debt, 10%
preferred stock, and 60% common equity (retained earnings 20% ; new shares 80%).
- Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years,
and sell for $1,000. The firm's marginal tax rate is 40%.
- The firm could sell, at par, $100 preferred stock which pays a 12% annual preferred
dividend. Flotation costs of 5% would be incurred.
- The company’s beta is 1.3, the risk-free rate is 10%, and the market risk premium is
5%. It is a constant-growth firm which just paid a dividend of $2.00 and has a
growth rate of 8%.
- The price of new issued shares is approximated by the constant dividend growth
model with a P0 based on the CAPM, flotation costs on new issued stocks are 5% of
P0.
Calculate the company’s WACC.
1. What is the firm’s component cost of debt?
2. What is its cost of preferred stock?
3. What is its cost of common equity from retained earnings using the CAPM?
4. What is its cost of new common stock knowing that the flotation costs represent 5%
of P0?
5. What is the firm’s WACC?
79

Dr. Ridha ESGHAIER

SOLUTION 14:
1. Cost of debt
Since the bond sells at par of $1,000, its YTM and coupon rate (12%) are equal. Thus, the before-tax
cost of debt is 12%. The after-tax cost of debt equals:
rd,After-tax = 12%(1 – 40%) = 7.2%.
Or N = 40; PVB = 1,000; INT/2 = 60; MV = 1,000;
 1 - (1 + rd /2) -40
 1 , 000
$ 1 , 000 = 60   + ( 1 + r /2 ) 40
 rd / 2  d

rd/2 = 6% so rd = 12%  rd(1 - T) = 12%(1-40%) = 7.2%.

2. Cost of preferred stock
Cost of preferred stock: rp = DP/PP(1-F) = $12/$100(1-5%) =12.6%
3. Cost of common equity from retained earnings:
(CAPM approach): rs = 10% + 1.3x(5%) = 16.5%
The Cost of retained earnings rs = 16.5%
4. Cost of new common stocks :
• P0 = D1/(rs – g) = (2x1.08)/(16.5%-8%) = $25.41
• (DCF approach): re = (2x1.08)/[25.41x(1-5%)] + 8% = 16.95%
5. WACC = wdrd(1 - T) + wprp + wsrs + were
= 0.3(12%)(1-0.4) + 0.1(12.6%) + 0.6x0.2(16.5%) + 0.6x0.8(16.95%)
= 0.0216 + 0.0126 + 0.0198 + 0.08136 = 13.536% 80
 Dr. Ridha ESGHAIER

Excel Application 2

Download and open the Excel File « 2. WACC Calculator - Blank»

and complete the cells in grey
1- Compute the Unlevered and levered Beta of the firm based on
the Median of the comparable companies.
2- compute the cost of Equity, After-Tax cost of debt and the
WACC of the company.

81

Dr. Ridha ESGHAIER

Excel Application 3

Download and open the Excel File « 3. Cyclone Case Study -

Blank»
1- What is your view of the financial health of this group (very
simple financial analysis)?
2- The required return for a risk-free investment is around 6.5%
(before tax) and the average required return for the market
portfolio is 11% (before tax). Calculate the overall cost of capital
for this group (complete the cells in grey)

82