Financial Modeling Chapter 2 Calculating Cost of Capital 2015

Chapter 2: Cost of Capital
To accompany
Financial Modeling, 3rd Edition
Simon Benninga
MIT Press, 2008
© Copyright 2009. Not to be used without

permission of the author,
[email protected]
Weighted Average Cost of Capital, WACC
E D
WACC  rE  rD  1  TC 
ED ED
where
rE  firm's cost of equity
rD  firm's cost of debt
E  market value of the firm ' s equity
D  market value of the firm ' s debt
TC  firm ' s corporate tax rate
FM3: Chapter 2 Cost of capital 2

Why WACC?
Risk-adjusted discount rate for the firm’s free cash
flows (FCF)
Enterprise value  PV  Future FCFs , discounted @ WACC 

FCFt
   1  WACC 
t 1
t
Average cost of funds for the company

 rE is the return expected by shareholders
 rD is the return expected by bondholders
 TC is firm’s tax rate—cost of debt is a tax-deductible expense

Mid-year discounting
In Chapter 3 we explain mid-year discounting.
Assumes that FCFs occur on average in the middle of
the year.
Gives Enterprise Value formula:
Enterprise value  PV  Future FCFs , discounted @ WACC 

FCFt
   1  WACC 
t 1
t  0.5

FCFt
  1  WACC    1  WACC 
0.5
t
t 1
      

Can be computed with
FM3: Chapter 2 Excel's
Cost ofNPV formula
capital 4
Bad news for El Salvador
Only U.S., Europe, can you do this
Means: Everyone bases calculations on U.S.
Typical: “My company in E.S. looks like”
[Intel, GM, Courier, Taco Bell] “therefore …”
Even in U.S., hard calculation

Erwin Friend vs. Merton Miller
Wharton vs Chicago
Erwin Friend: “Cost of capital (WACC) in U.S.
is 12%”
Merton Miller: 10%

Five problems in WACC determination
From easiest to hardest

Determine market value of equity E
Determine market value of debt D
Determine corporate tax rate TC
Find cost of debt rD
Find cost of equity rE
A note before we begin
The illustrations in this Powerpoint concentrate
on individual firms
BUT: You should use industry data (average of
firms in industry) to determine the WACC for a
specific firm.

Asset beta approach to WACC
Could use Asset Beta
E D
 Asset  E   D  1  TC 
ED ED
where
 E  equity beta
 D  debt beta
E  market value of the firm ' s equity
D  market value of the firm ' s debt
TC  firm ' s corporate tax rate
 E  rM
WACC  rf   Asset    rf 

Problems with asset beta
How is debt beta D determined?
A technique can be seen in almost all finance
text book, but it is very tedious and probably not
worthwhile for this purpose (it’s a neat
technique to determine the expected return on a
bond!)
In practice: most professors seem to use either
D=0.2 or D=0 (without much justification)
D in principle
Suppose you knew the expected return on debt, E(rD).
Then
E  rD   rf   D   E  rM   rf 

E  rD   rf
D 
E  rM   rf
Problem: How do we determine E(rD)?

A note on terminology
Infinance “cost” often means “rate of return”
Thus: other names for cost of equity
 Required rate of equity return
 Expected rate of equity return (used in CAPM)
 Opportunity cost
 Discount rate for equity cash flows
In all cases: the rate of return expected by a
firm’s shareholders
12
Back to five problems:
Finding market value of equity, E
E: number of shares * market price per share
13
Finding market value of debt, D
D
 Should be: market price of firm’s debts
 Almost always replaced by book value of firm’s debts
 Reasons
o Most firms have many kinds of debt
o Much debt (most?) is not listed on a market
o Difficult to value debt
o Maybe it doesn’t matter much!
14
D: one more note
For
WACC purposes, Debt = net debt
D=Debt – cash & marketable securities
◦ Exception: where cash needed for production
◦ Exception: banks (Chapter 5)

Finding tax rate, TC
TC should be marginal tax rate: rate paid by firm
on additional $ of profit before taxes
In practice
 TC often estimated by average historic tax rate
 TC sometimes estimated by ballpark figure
 In U.S. TC ≈ 37% - 40%
 Federal tax rate = 35%
 Plus state & local taxes
 Average tax rate for U.S. industrial corporation ≈ 37%
Finding cost of debt, rD
rD ought to be the marginal borrowing cost of the
firm
But: Hard to determine!
Plausible alternatives:
 rD = current interest payments ÷ Average debt
 rD imputed from rating-adjusted yield curve
 rD = expected return on firm’s bonds (complicated! See
FM3, Chapter 28)
Finding cost of equity, rE
Two leading models
 Gordon dividend model: rE derived from shareholder
anticipations of future dividends
 CAPM/SML: rE derived from firm’s equity beta

Gordon dividend model
Div0  1  g 
rE  g
P0
Div0  current firm dividend
g  anticipated future dividend growth
P0  current firm share price
A B C
1 THE GORDON MODEL COST OF EQUITY
2 Current share price, P0 60
3 Current dividend, D0 3
4 Anticipated dividend growth rate 12%
5 Gordon model cost of equity, rE 17.60% <-- =B3*(1+B4)/B2+B4

Implementation issues: Kellogg
A B C
1 KELLOGG DIVIDENDS, MAY1996 - MAY2006
2 Dividend growth rate, quarterly
3 last 5 years 0.47% <-- =(B51/B31)^(1/20)-1
4 last 10 years 0.89% <-- =(B51/B11)^(1/40)-1
5
6 Dividend growth rate, annualized
7 Last 5 years 1.90% <-- =(1+B3)^4-1
8 Last 10 years 3.61% <-- =(1+B4)^4-1
9
10 Date Dividends
11 29-May-96 0.195
12 28-Aug-96 0.210 Note
13
43
26-Nov-96
27-May-04
0.210
0.253
hidden
44 27-Aug-04 0.253 rows
45 23-Nov-04 0.253
46 25-Feb-05 0.253
47 27-May-05 0.253
48 30-Aug-05 0.278
49 29-Nov-05 0.278
50 27-Feb-06 0.278
51 30-May-06 FM3: Chapter
0.278 2 Cost of capital 20
Gordon rE for Kellogg
A B C
COMPUTING KELLOGG'S rE
1 WITH THE GORDON MODEL
2 Kellogg stock price, P0, 30 May 2006 48.28
3 Current dividend
4 Quarterly 0.278
5 Annualized dividend, Div0 1.112 <-- =B4*4
6 Dividend growth rate, g
7 Last 5 years 1.90%
8 Last 10 years 3.61%
9
10 Gordon model cost of equity rE
11 Using last 5 years' growth 4.25% <-- =B5*(1+B7)/B2+B7
12 Using last 10 years' growth 6.00% <-- =B5*(1+B8)/B2+B8
Choice of period (5 years? 10 years?) is important!

Gordon derivation
Div0  1  g  Div0 *  1  g  Div0 *  1  g  Div0 *  1  g 

2 3 4
P0     
1  rE  1  rE   1  rE   1  rE 
2 3 4
Div0 *  1  g  Div0 *  1  g 
 t
 
t 1  1  rE 
t

rE  g
Div0 *  1  g 
Take P0  and solve for rE :
rE  g
Div0 *  1  g 
rE  g
P0

Variation on Gordon: use cash flow to
equity instead of dividends
Variation on model: Use all equity payouts
instead of dividends (basically: dividends +
repurchases … more details to come)
Cash flow to equity0  1  g 
rE  g
Market value of equity

A B C D E F G
1
JOHNSON & JOHNSON, CASH FLOW TO EQUITY, 1995-2005
Repurchase of Cash flow to Year on
Year ending Dividends Stock issues
2 common stock equity year growth
3 31-Dec-95 827,000,000 322,000,000 -112,000,000 1,037,000,000 <-- =SUM(B3:D3)
4 31-Dec-96 974,000,000 412,000,000 -149,000,000 1,237,000,000 19.29% <-- =E4/E3-1
5 31-Dec-97 1,137,000,000 628,000,000 -225,000,000 1,540,000,000 24.49% <-- =E5/E4-1
6 31-Dec-98 1,305,000,000 930,000,000 -269,000,000 1,966,000,000 27.66% <-- =E6/E5-1
7 31-Dec-99 1,479,000,000 840,000,000 -221,000,000 2,098,000,000 6.71%
8 31-Dec-00 1,724,000,000 973,000,000 -387,000,000 2,310,000,000 10.10%
9 31-Dec-01 2,047,000,000 2,570,000,000 -514,000,000 4,103,000,000 77.62%
10 31-Dec-02 2,381,000,000 6,538,000,000 -390,000,000 8,529,000,000 107.87%
11 31-Dec-03 2,746,000,000 1,183,000,000 -311,000,000 3,618,000,000 -57.58%
12 31-Dec-04 3,251,000,000 1,384,000,000 -642,000,000 3,993,000,000 10.36%
13 31-Dec-05 3,793,000,000 1,717,000,000 -696,000,000 4,814,000,000 20.56%
14
15 End 2005 equity data
16 Stock price 61.07
17 Number of shares 3,119,842,000
18 Equity value 190,528,750,940 <-- =B16*B17
19
20 Equity cash flow, end 2005 4,814,000,000 <-- =E13
21 Future growth rate
22 Based on 10-year growth rate 16.59% <-- =(E13/E3)^(1/10)-1
23 Based on 5-year growth rate 15.82%
24
25 Gordon cost of equity, rE
26 Based on 10-year growth rate 19.54% <-- =B20*(1+B22)/B18+B22
27 Based on 5-year growth rate 18.75% <-- =B20*(1+B23)/B18+B23

9,000,000,000 JNJ, CASH FLOW TO EQUITY, 1995-2005
8,000,000,000
7,000,000,000
Total dividends
6,000,000,000
Stock repurchases
5,000,000,000 Stock issues
Cash flow to equity
4,000,000,000
3,000,000,000
2,000,000,000
1,000,000,000
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
-1,000,000,000
Dividends are smooth, repurchases much less so

(used to soak up extra corporate cash?)

Cash flow to equity is necessary
for Gordon model
Dividends are much less important
◦ “Apart from those firms that continue to pay dividends
and make regular repurchases, dividend payers are no
longer economically important.”
◦ “Over the period from 1980 to 2005, firms that only pay
dividends decline from 13% to 7% of firms and from
8% to 2% of all payouts.”
Repurchases are taking over
This and previous slides: Skinner, Douglas J., "The Evolving Relation Between Earnings, Dividends, and Stock
Repurchases" . Journal of Financial Economics, Forthcoming . Available at SSRN: ttp://ssrn.com/abstract=1027059

Variation on Gordon model:
Two dividend growth rates
High dividend growth rate (typically in coming
years)
Lower dividend growth rate (long-term)
rE is IRR of future anticipated dividends wrt to
current stock price
Details to come

Wachovia’s Total Cash Flow to Equity:
Implausibly high growth?
A B C D E F
WACHOVIA BANK--DIVIDENDS, STOCK ISSUED AND STOCK REPURCHASED

1
Does historical growth overstate the cost of equity?
Total Common
Common Dividend stock Total equity
2 stock issued payments repurchased cash flow
3 1991 16,462,000 150,730,000 1,215,000 135,483,000 <-- =D3+C3-B3
4 1992 29,717,000 170,756,000 31,197,000 172,236,000 <-- =D4+C4-B4
5 1993 24,961,000 191,488,000 98,804,000 265,331,000
6 1994 25,339,000 210,503,000 52,908,000 238,072,000
7 1995 24,115,000 235,495,000 65,032,000 276,412,000
8 1996 25,826,000 254,458,000 376,716,000 605,348,000
9 1997 59,281,000 327,303,000 532,682,000 800,704,000
10 1998 80,375,000 381,798,000 531,122,000 832,545,000
11 1999 59,478,000 418,447,000 634,623,000 993,592,000
12
13 Compound growth rate 17.42% 13.61% 118.65% 28.28% <-- =(E11/E3)^(1/8)-1
14
Cost of capital using the Gordon Model
15 Using total equity payout and total equity value
16 End 1999 stock price 68.00 Use of historical average 28.28%
Number of shares
17 outstanding, end 1999
18 Future dividend growth, g?
202,795,000
28.28% <-- =E13
leads to very high cost of equity!
19 End 1999 equity value, P0 13,790,060,000 <-- =B16*B17
Projected next total
20 equity cash flow, D1 1,274,598,774 <-- =E11*(1+B18) Perhaps 28.28% is unsustainable?
Gordon model cost
21 of equity, rE 37.52% <-- =B20/B19+B18

Two-stage Gordon model
Share value today  Present value of dividends Given two
t m
m
Div0 * (1  g1 ) t 
Div5 * (1  g2 ) growth rates g1
  
1 r  1 r 
t t
t 1
     E  
t  m 1
      E   and g2, find rE
 
PV of m years
of high-growth g1
dividends
PV of remaining
normal-growth g 2
dividends
to make P0
m
Div0 * (1  g1 )t 1 
Divm * (1  g 2 )t equal to last
  
t 1  1  rE 
t
 1  rE 
m
t 1  1  rE 
t
line.
rE has to  1  g1    1  g1  
m
Div0 *   *  1   1  r  
make  1  rE    E 
 1 
Divm * (1  g 2 )t
 
these 1
1  g1  1  rE 
m
t 1  1  rE 
t
1  rE
two
 1  g1    1  g1  
m
equal Div0 *   *  1   1  r  
 1  rE    E   Div0  1  g1   1  g2 
m
1
 
1  g1  1  rE 
m
rE  g 2
1
1  rE

Applied to Wachovia
A B C
1 WACHOVIA, 2-STAGE GORDON MODEL
2 End-1999 equity value, P0 13,790,060,000
3 End 1999 total equity payout 993,592,000
4
5 High growth rate, ghigh 28.28%
6 Number of high-growth years, m 3
7 Normal growth rate, g normal 4%
8
Cost of equity, rE
9 using the function twostagegordon 17.251% <-- =twostagegordon(B2,B3,B5,B6,B7)
TwoStageGordon is a VBA function on Excel

notebook fm2_chapter02.xls .

Function TwoStageGordon(P0, Div0, Highgrowth,
Highgrowthyrs, Normalgrowth)
High = 4
Low = 0
Do While (High - Low) > 0.0000001

Estimate = (High + Low) / 2
factor = (1 + Highgrowth) / (1 + Estimate)
Term1 = Div0 * factor * (1 - factor ^ Highgrowthyrs) /
_
(1 - factor)
Term2 = Div0 * factor ^ Highgrowthyrs * _
(1 + Normalgrowth) / (Estimate - Normalgrowth)
If (Term1 + Term2) > P0 Then
Low = (High
See “Adding + Low) /to 2
GetFormula your spreadsheet” (Word document on
Else: High = (High + Low) /to2your spreadsheet.
FM3 disk for how to add this function
End If
Data table on Wachovia rE
A B C D E F G H
1 WACHOVIA, TWO-STAGE GORDON MODEL
2 End-1999 equity value, P0 13,790,060,000
3 End 1999 total equity payout 993,592,000
4
5 High growth rate, ghigh 28.28%
6 Number of high-growth years, m 3
7 Normal growth rate, gnormal 4%
8
Cost of equity, rE
9 using the function TwoStageGordon 17.251% <-- =twostagegordon(B2,B3,B5,B6,B7)
10
11 Data Table: Wachovia r E as function of high-growth years
Cell B14 contains formula =B9
12 m and normal growth rate g normal.
13 Number of high-growth years, m ↓
14 17.251% 1 2 3 4 5 6
15 0% 9.24% 11.59% 14.11% 16.66% 19.09% 21.32%
16 1% 10.24% 12.48% 14.89% 17.31% 19.63% 21.77%
17 2% 11.24% 13.39% 15.67% 17.98% 20.18% 22.22%
18 Normal growth rate, gnormal --> 3% 12.24% 14.29% 16.46% 18.64% 20.74% 22.68%
19 4% 13.24% 15.19% 17.25% 19.32% 21.31% 23.15%
20 5% 14.24% 16.10% 18.05% 20.00% 21.88% 23.63%
21 6% 15.24% 17.00% 18.85% 20.69% 22.46% 24.12%
22 7% 16.24% 17.91% 19.65% 21.39% 23.06% 24.61%
23 8% 17.24% 18.82% 20.46% 22.09% 23.66% 25.12%

Variation on Gordon: Use P/E
a *1 g
rE  g
P0 / EPS0
a  dividend payout ratio
P0 / EPS0 is firm ' s price /earnings ratio
We will use this model as one way to determine

E(rM) for the CAPM

CAPM:  E  rM   rf 
rE  rf    
A B C
COMPUTING THE COST OF EQUITY FOR INTEL

1
Classic CAPM: rE = rf + b *[ E(rM)-rf ]
2 Intel beta 2.2516
3 Risk free rate, rf 4.93%
4 Expected market return, E(rM) 9.98%
5 Intel cost of equity, rE,Intel 16.31% <-- =B3+B2*(B4-B3)

A B C D E F G
COMPUTING THE BETA FOR INTEL
1 monthly returns for Intel and S&P 500, 2001-2006
2 Alpha -0.0029 <-- =INTERCEPT(E13:E72,F13:F72)
3 Beta
4 Using Excel's Slope function 2.2516 <-- =SLOPE(E13:E72,F13:F72)
5 Using Cov/Var 2.2516 <-- =COVAR(E13:E72,F13:F72)/VARP(F13:F72)
6 R-squared 0.5304 <-- =RSQ(E13:E72,F13:F72)
7 t-statistic for alpha -0.2438 <-- =tintercept(E13:E72,F13:F72)
8 t-statistic for beta 8.0942 <-- =tslope(E13:E72,F13:F72)
9
10 Prices Returns
11 Date Intel SP500 Intel SP500
12 9-Jan-01 35.38 1366.01
13 1-Feb-01 27.32 1239.94 -25.85% -9.68% <-- =LN(C13/C12)
14 1-Mar-01 25.17
Intel Returns 1160.33 -8.20%
vs SP500, 2001-2006 -6.64% <-- =LN(C14/C13)
15 2-Apr-01 29.57 1249.46 16.11% 7.40% <-- =LN(C15/C14)
25%
16 1-May-01 25.86 1255.82 -13.41% 0.51%
17 1-Jun-01 28 1224.38 7.95% -2.54%
18 2-Jul-01 28.54 1211.23 15% 1.91% -1.08%
19 1-Aug-01 26.78 1133.58 -6.37% -6.63%
20 4-Sep-01 19.58 1040.94 5% -31.31% -8.53%
21 1-Oct-01 23.39 1059.78 17.78% 1.79%
22 1-Nov-01 31.31 1139.45 29.16% 7.25%
23 -13% -11%
3-Dec-01 -9% -7% -5%
30.15 -3%
1148.08 -1%
-5% 1% -3.78%3% 5%
0.75% 7%
24 2-Jan-02 33.59 1130.2 10.80% -1.57%
25 1-Feb-02 27.38 1106.73 -15% -20.44% SP500 returns
-2.10%
26 1-Mar-02 29.17 1147.39 6.33% 3.61%
In te l re tu r n s
27 1-Apr-02 27.44 1076.92 -6.11% -6.34%
-25%
28 1-May-02 26.51 1067.14 y = 2.2516x
-3.45% -0.91%- 0.0029
-41.30% R -7.52%
= 0.5304
2
29 3-Jun-02 17.54 989.82
30 1-Jul-02 18.04 911.62 -35% 2.81% -8.23%
31 1-Aug-02 16.02 916.07 -11.88% 0.49%
32 3-Sep-02 13.35 815.28 -45% -18.23% -11.66%
33 1-Oct-02 16.62 885.76 21.91% 8.29%
34 1-Nov-02 20.09 936.31 18.96% 5.55%
35 2-Dec-02 14.98 879.82 FM3: Chapter 2 Cost
-29.35% of capital
-6.22% 37
CAPM issues
rf : short-term or long-term
 Short-term
E(rM) ?
 Historical average of market returns
 Forward-looking using Gordon E(rM) P/E formula
Incorporating taxes into SML
rE  rf  1  TC    
 E  rM   rf  1  TC  


Why rf short-term?
SML should apply to all risky assets
This includes bonds
 E  rM   rf 
rBond  rf   Bond  
This means that rf has to be short-term (otherwise,
non-risky short-term bond would have long-term
interest rate)
Another way of saying this: The  incorporates the
time risk of the asset
rf from Yahoo

Measuring E(rM): Historical average
A B C D
MEASURING E(rM) USING HISTORICAL DATA

Derived from prices for the Vanguard 500 Index Fund
(symbol: VFINX)
These prices include dividends; April 1987 - August 2006
1
2 Average monthly return 0.83% <-- =AVERAGE(C10:C241)
3 Monthly standard deviation 4.34% <-- =STDEVP(C10:C241)
4
5 Annualized return 9.98% <-- =12*B2
6 Annualized standard deviation 15.05% <-- =SQRT(12)*B3
7
8 Date Price Return
9 1-Apr-87 17.32
10 1-May-87 17.49 0.98% <-- =LN(B10/B9)
11 1-Jun-87 18.37 4.91% <-- =LN(B11/B10)
12 1-Jul-87 19.28 4.83% <-- =LN(B12/B11)
13 3-Aug-87 20.02 3.77% <-- =LN(B13/B12)
14 1-Sep-87 19.56 -2.32%
15 1-Oct-87 15.31 -24.50%
16 2-Nov-87 14.06 -8.52%
17 1-Dec-87 15.12 7.27%
18 4-Jan-88 15.75 4.08%
19 1-Feb-88 16.48 4.53%
20 1-Mar-88 15.98 -3.08%
21 4-Apr-88 FM3: Chapter 2 1.00%
16.14 Cost of capital 41
Variation on historical approach:
Estimating E(rM) – rf directly
A B C D E F
MEASURING THE MARKET RISK PREMIUM E(r M) - rf USING HISTORICAL DATA
Vanguard 500 Index Fund (symbol: VFINX) minus Treasury Bills
April 1987 - August 2006
1
All measurements relate to monthly returns on SP500, rMt, and the Treasury bill rate rft
2 Average monthly risk premium 0.46% <-- =AVERAGE(E10:E241) Methodological note: I have used the St. Louis FRED
3 Monthly standard deviation 4.34% <-- =STDEVP(E10:E241) data for 3-month Treasury Bills; this data is
4 annualized, and I have divided it by 12 to get the
5 Annualized risk premium 5.50% <-- =12*B2 monthly returns. Since the data can be taken as an
6 Annualized standard deviation 15.04% <-- =SQRT(12)*B3 ex-ante return, the April 1987 rate is attributed to May
7 1987.
Market
Treasury
risk I've use 3-month instead of 1-month, because there
bill rate
8 Date Price Return premium are lots of data problems with the latter.
9 1-Apr-87 17.32
10 1-May-87 17.49 0.98% 0.47% 0.51% <-- =C10-D10
11 1-Jun-87 18.37 4.91% 0.47% 4.44% <-- =C11-D11
12 1-Jul-87 19.28 4.83% 0.47% 4.36%
13 3-Aug-87 20.02 3.77% 0.47% 3.29%
14 1-Sep-87 19.56 -2.32% 0.50% -2.83%
15 1-Oct-87 15.31 -24.50% 0.53% -25.03%
16 2-Nov-87 14.06 -8.52% 0.51% -9.03%

Market risk premium of
5.50% estimated from
previous slide
A B C
COMPUTING THE COST OF EQUITY FOR INTEL USING THE
MARKET RISK PREMIUM E(rM) - rf
1
2 Intel beta 2.2516
3 Historical market risk premium 5.50%
4 Intel tax rate, T C 31.29% <-- Computed from Intel financials
6 Intel cost of equity, rE,Intel
7 Classic CAPM 17.31% <-- =B5+B2*B3
8 Tax-adjusted CAPM 19.24% <-- =B5*(1-B4)+B2*(B3+B4*B5)
9
Note: The tax-adjusted model in cell B8 uses the equivalence:
E(rM) - rf (1-T C) = E(rM) - rf + TC*rf
10

Measuring E(rM): Gordon P/E model
a * EPS0  1  g  a * 1 g 
E  rM   g  g
P0 P0 / EPS0
A B C
COMPUTING THE COST OF EQUITY FOR INTEL USING THE MARKET
PRICE/EARNINGS MULTIPLE TO COMPUTE E(rM)
1
2 Market price/earnings multiple, August 2006 17
3 Equity cash flow payout ratio 50.00%
4 Anticipated growth of market equity cash flow 6.00%
5 Expected market return, E(r M) 9.12% <-- =B3*(1+B4)/B2+B4
6
7 Intel cost of equity calculations
8 Intel beta 2.2516
9 Intel tax rate, T C 31.29% <-- Computed from Intel financials
11 Intel cost of equity, rE,Intel
12 Classic CAPM 14.36% <-- =B10+B8*(B5-B10)
13 Tax-adjusted CAPM 16.29% <-- =B10*(1-B9)+B8*(B5-B10*(1-B9))
14
15 Note: Price/Earnings ratio for S&P 500 from http://www.bullandbearwise.com

Where to get market P/E?

From the
same
website

Computing the cost of debt rD
A B C D
1 COMPUTING THE COST OF DEBT FOR KRAFT
2 2005/12/31 2004/12/31
3 Cash and cash equivalents 316,000,000 282,000,000
4
5 Short-term borrowings 805,000,000 1,818,000,000
6 Current portion of long-term debt 1,268,000,000 750,000,000
7 Due to Altria Group, Inc. and affiliates 652,000,000 227,000,000
8 Long-term debt 8,475,000,000 9,723,000,000
9
10 Interest and other debt expense, net 636,000,000 666,000,000
11
12 Net debt 10,884,000,000 12,236,000,000 <-- =SUM(C5:C8)-C3
13 Net interest cost 5.50% <-- =B10/AVERAGE(B12:C12)
14
15 Total debt 11,200,000,000 12,518,000,000
16 Cash paid:
17 Interest 679,000,000 633,000,000
18
19 Interest cost 5.73% <-- =B17/AVERAGE(B15:C15)
Method 1: Kraft’s cost of debt based on

interest/average debt.
A B C
COMPUTING KRAFT'S rD FROM A YIELD CURVE

1
YTM=0.0001*time 3-0.0023*time2+0.0152*time+0.0221
2 Average time to maturity (years) 5
3 Yield 5.31% <-- =0.0001*B2^3-0.0023*B2^2+0.0152*B2+0.0221
Method 2: Kraft’s cost of debt based on rating-adjusted

yield curve and average debt maturity.
3 cases in WACC
Kraft
 Big difference between Gordon and CAPM rE
Tyson
 No dividend growth
 Large variability in equity payout
 Pre-tax: rE < rD
Cascade
 Negative leverage
Kraft: Gordon model A B C
1 KRAFT: COST OF EQUITY r E BASED ON DIVIDENDS
2 Stock price, end 2005 27.75
3 Current dividend, D0 0.92 <-- =B25*4
5 Using growth rate Dec01-Dec05 19.15% <-- =B3*(1+B29)/B2+B29
6 Using growth rate Dec03-Dec05 16.79% <-- =B3*(1+B32)/B2+B32
7
Dividends
8 Date per share
9 20-Dec-01 0.130
10 13-Mar-02 0.130
11 26-Jun-02 0.130
12 12-Sep-02 0.150
13 19-Dec-02 0.150
14 12-Mar-03 0.150
15 25-Jun-03 0.150
16 11-Sep-03 0.180
17 18-Dec-03 0.180
18 11-Mar-04 0.180
19 23-Jun-04 0.180
20 10-Sep-04 0.205
21 20-Dec-04 0.205
22 11-Mar-05 0.205
23 24-Jun-05 0.205
24 2-Sep-05 0.230
25 22-Dec-05 0.230
26
27 Computing the growth rate of dividends
28 Quarterly growth, Dec01-Dec05 3.63% <-- =(B25/B9)^(1/16)-1
29 Annualized 15.33% <-- =(1+B28)^4-1
30
31 Quarterly growth, Dec03-Dec05 3.11% <-- =(B25/B17)^(1/8)-1
32 Annualized FM3: Chapter 2 =(1+B31)^4-1
13.04% <-- Cost of capital 51
Kraft: Gordon based on equity payouts
A B C D E F
1
KRAFT: COST OF EQUITY rE BASED ON CASH FLOW TO EQUITY
2 Shares outstanding 1,669,880,755
3 Share price, end 2005 27.75
4 Equity value, E 46,339,190,951 <-- =B2*B3
5 End 2005 total equity payout 2,612,000,000 <-- =E18
6
7 High growth rate, ghigh 10.00% <-- Guess
8 Number of high-growth years 3 <-- Guess
9 Normal growth rate, gnormal 6% <-- Guess
10
Cost of equity, rE, using the
11 function twostagegordon 12.64% <-- =twostagegordon(B4,B5,B7,B8,B9)
12
Stock Cash flow to
Dividends paid Stock issuance
13 Date repurchases equity holders
14 31-Dec-01 170,000,000 225,000,000 395,000,000 <-- =B14+C14-D14
15 31-Dec-02 372,000,000 936,000,000 8,425,000,000 -7,117,000,000 <-- =B15+C15-D15
16 31-Dec-03 372,000,000 1,089,000,000 1,461,000,000
17 31-Dec-04 688,000,000 1,280,000,000 1,968,000,000
18 31-Dec-05 1,175,000,000 1,437,000,000 2,612,000,000
19 Growth rates
20 Four year 62.14% 58.97% 60.36% <-- =(E18/E14)^(1/4)-1
21 Two year 77.72% 14.87% 33.71% <-- =(E18/E16)^(1/2)-1

Kraft: CAPM
A B C
COMPUTING THE COST OF EQUITY rE FOR KRAFT USING THE
1
MARKET PRICE/EARNINGS MULTIPLE TO COMPUTE E(rM)
2 Market price/earnings multiple, December 2005 18
4 Anticipated growth of equity cash flow 6.00%
5 Expected market return, E(rM) 8.94% <-- =B3*(1+B4)/B2+B4
6
7 Kraft cost of equity calculations
8 Kraft beta 0.4700 <-- From Yahoo
9 Kraft tax rate, TC 29.37% <-- Computed from Kraft financials
11 Kraft cost of equity, rE,Kraft

Kraft WACC
A B C
1 COMPUTING THE WACC FOR KRAFT
2 Shares outstanding 1,669,880,755
4 Equity value, E 46,339,190,951
5 Net debt, D 10,884,000,000
6
7 WACC based on Gordon per-share dividends and interest from financial statements
8 Cost of equity, rE 16.79% <-- ='Kraft dividends, Gordon rE'!B6
9 Cost of debt, rD 5.50% <-- ='Kraft cost of debt'!B13
10 Tax rate, TC 29.37% <-- ='Kraft 10K, 2005'!B160
11 WACC 14.33% <-- =$B$4/($B$4+$B$5)*B8+$B$5/($B$4+$B$5)*B9*(1-$B$10)
12
13 WACC based on Gordon equity payouts and interest from financial statements
14 Cost of equity, rE 14.46% <-- ='Kraft equity payouts and rE'!B11
15 Cost of debt, rD 5.50% <-- ='Kraft cost of debt'!B13
17 WACC 12.45% <-- =$B$4/($B$4+$B$5)*B14+$B$5/($B$4+$B$5)*B15*(1-$B$10)
18
19 WACC based on classic CAPM and interest from financial statements
20 Cost of equity, rE
21 Cost of debt, rD
6.82% <-- ='Kraft rE, CAPM'!B12
5.50% <-- ='Kraft cost of debt'!B13
Big differences between
22
23
Tax rate, TC
WACC
29.37% <-- ='Kraft 10K, 2005'!B160 Gordon and CAPM.
6.26% <-- =$B$4/($B$4+$B$5)*B20+$B$5/($B$4+$B$5)*B21*(1-$B$10)
24
25 WACC based on tax-adjusted CAPM and interest from financial statements
27 Cost of debt, rD
6.05% <-- ='Kraft rE, CAPM'!B13
5.50% <-- ='Kraft cost of debt'!B13
Ultimately I prefer CAPM!
29 WACC 5.64% <-- =$B$4/($B$4+$B$5)*B26+$B$5/($B$4+$B$5)*B27*(1-$B$10)
FM3: Chapter 2 WACC:
Cost of capital5-6% 54
Tyson: Gordon model rE,
Dividend-based
A B C
TYSON: COST OF EQUITY rE BASED
1 ON DIVIDENDS
2 Stock price, 11Aug06 13.45
4 Dividend growth rate 0% Dividends per share
5 Gordon cost of equity, rE 1.19% <-- =B3*(1+B4)/B2+B4
6 haven’t changed!
Dividends
7 Date per share
8 29-Aug-01 0.04
9 28-Nov-01 0.04
10 27-Feb-02 0.04
11 29-May-02 0.04
12 28-Aug-02 0.04
13 26-Nov-02 0.04
14 26-Feb-03 0.04
15 28-May-03 0.04
16 27-Aug-03 0.04
17 26-Nov-03 0.04
18 26-Feb-04 0.04
19 27-May-04 0.04
20 30-Aug-04 0.04
21 29-Nov-04 0.04
22 25-Feb-05 0.04
23 30-Aug-05 0.04
24 27-Feb-06 0.04
25 30-May-06 0.04 55
Tyson: Gordon rE based on total equity
payouts
A B C D E F
1
TYSON: COST OF EQUITY rE BASED ON CASH FLOW TO EQUITY
2 Shares outstanding 354,820,000
3 Share price, 11Aug06 13.45
4 Equity value, E 4,772,329,000 <-- =B2*B3
5 Current (Aug06) total equity payout 81,631,562 <-- =E18*(1+B7)^0.75
6
7 High growth rate, ghigh 10.00% <-- Guess
8 Number of high-growth years 3 <-- Guess
9 Normal growth rate, gnormal 2% <-- Guess
10
Cost of equity, rE, using the function
11 twostagegordon 4.18% <-- =twostagegordon(B4,B5,B7,B8,B9)
12
Stock Cash flow to
14 2001 48,000,000 35,000,000 34,000,000 49,000,000 <-- =B14+C14-D14
15 2002 19,000,000 58,000,000 0 77,000,000 <-- =B15+C15-D15
16 2003 41,000,000 54,000,000 0 95,000,000
17 2004 72,000,000 55,000,000 43,000,000 84,000,000
18 2005 45,000,000 55,000,000 24,000,000 76,000,000
19 Growth rates
20 Four year -1.60% 11.96% 11.60% <-- =(E18/E14)^(1/4)-1
21 Two year 4.76% 0.92% -10.56% <-- =(E18/E16)^(1/2)-1

Tyson: CAPM rE
A B C
COMPUTING THE COST OF EQUITY rE FOR TYSON USING THE
1
MARKET PRICE/EARNINGS MULTIPLE TO COMPUTE E(rM)
2 Market price/earnings multiple, August 2006 17
6
7 Tyson cost of equity calculations
8 Tyson beta 0.20 <-- From Yahoo
9 Tyson tax rate, TC 29.55% <-- Computed from Tyson financials
11 Tyson cost of equity, rE,Kraft

Tyson, rD
A B C D
1 COMPUTING THE COST OF DEBT FOR TYSON
2 2005 2004
4 Current debt 126,000,000 338,000,000
5 Long term debt 2,869,000,000 3,024,000,000
6 Net debt 2,955,000,000 3,329,000,000 <-- =C5+C4-C3
7
8 Interest paid 227,000,000
9

Tyson, WACC A B C
1 COMPUTING THE WACC FOR TYSON
4 Equity value, E 4,772,329,000
5 Net debt, D 2,955,000,000
6
8 Cost of equity, rE 1.19% <-- ='Tyson dividends, Gordon rE'!B5
9 Cost of debt, rD 7.22% <-- ='Tyson cost of debt'!B10
10 Tax rate, TC 29.55% <-- ='Tyson income statement'!B31
11
12
WACC 2.68% <-- =$B$4/($B$4+$B$5)*B8+$B$5/($B$4+$B$5)*B9*(1-$B$10) We take Tyson
13
14
WACC based on Gordon equity payouts and interest from financial statements
Cost of equity, rE 4.18% <-- ='Tyson equity payouts and rE'!B11
WACC as
15 Cost of debt, rD
16 Tax rate, TC
7.22% <-- ='Tyson cost of debt'!B10
29.55% <-- ='Tyson income statement'!B31
average of
17 WACC
18
4.53% <-- =$B$4/($B$4+$B$5)*B14+$B$5/($B$4+$B$5)*B15*(1-$B$10)
Gordon/payout,
21 Cost of debt, rD
5.77% <-- ='Tyson rE, CAPM'!B12
7.22% <-- ='Tyson cost of debt'!B10
CAPM/Classic,
22
23
Tax rate, TC
WACC
29.55% <-- ='Tyson income statement'!B31
5.51% <-- =$B$4/($B$4+$B$5)*B20+$B$5/($B$4+$B$5)*B21*(1-$B$10)
and CAPM/tax-
24
adjusted: 4.94%
26 Cost of equity, rE 4.60% <-- ='Tyson rE, CAPM'!B13
27 Cost of debt, rD 7.22% <-- ='Tyson cost of debt'!B10
28 Tax rate, TC 29.55% <-- ='Tyson income statement'!B31
29 WACC 4.79% <-- =$B$4/($B$4+$B$5)*B26+$B$5/($B$4+$B$5)*B27*(1-$B$10)
30
31 Estimated WACC? 4.94% <-- =AVERAGE(B29,B23,B17)
59
Cascade, Gordon-dividend rE
A B C D
CASCADE: COST OF EQUITY r E BASED ON DIVIDENDS
1 Dividend growth rate computed on daily basis
2 Share price, 31jan06 50.69
5 Using growth since 16-Feb-99 7.32% <-- =B3*(1+B33)/B2+B33
6 Using growth since 02-Jan-04 18.11% <-- =B3*(1+B36)/B2+B36
7 Using growth since 29-Dec-04 26.10% <-- =B3*(1+B39)/B2+B39
8
Dividends Days between
9 Date per share dividend payments
10 16-Feb-99 0.10
11 18-May-99 0.10 91 <-- =A11-A10
12 17-Aug-99 0.10 91 <-- =A12-A11
23 23-Jun-04 0.11 86
24 20-Sep-04 0.11 89
25 29-Dec-04 0.12 100
26 28-Mar-05 0.12 89
27 1-Jul-05 0.12 95
28 4-Oct-05 0.15 95
29 3-Jan-06 0.15 91
30
31 Computing the growth rate of dividends
32 Daily growth, 16-Feb-99 - 03-Jan-06 0.0161% <-- =(B29/B10)^(1/(A29-A10))-1
33 Annualized 6.07% <-- =(1+B32)^365-1
34
35 Daily growth, 02-Jan-04 - 03-Jan-06 0.0424% <-- =(B29/B21)^(1/(A29-A21))-1
36 Annualized 16.73% <-- =(1+B35)^365-1
37
38 Daily growth, 29-Dec-04 - 03-Jan-06 0.060% <-- =(B29/B25)^(1/(A29-A25))-1
39 Annualized 24.62% <-- =(1+B38)^365-1
60
Cascade, Gordon-payout s
A B C D E F
1
CASCADE: COST OF EQUITY r E BASED ON CASH FLOW TO EQUITY
3 Share price, 31jan06 50.69
4 Equity value, E 635,449,840 <-- =B2*B3
5 2005 total equity payout 3,904,000 <-- =E16
6 Growth rate of payouts 9.78% <-- =E17
7 Cost of equity, rE 10.46% <-- =B5*(1+B6)/B4+B6
8
9
Stock Cash flow to
11 1/31/2001 0 2,448,000 2,448,000
12 1/31/2002 1,354,000 0 1,354,000
13 1/31/2003 1,396,000 1,200,000 73,000 2,523,000
14 1/31/2004 0 4,936,000 1,299,000 3,637,000
15 1/31/2005 5,478,000 1,616,000 3,862,000
16 1/31/2006 6,691,000 2,787,000 3,904,000
17 Growth rate 9.78% <-- =(E16/E11)^(1/5)-1

Cascade, CAPM rE
A B C
COMPUTING THE COST OF EQUITY r E FOR CASCADE USING THE

MARKET PRICE/EARNINGS MULTIPLE TO COMPUTE E(r M)
1
2 Market price/earnings multiple, December 2005 18
6
7 Cascade cost of equity calculations
8 Cascade beta 1.65 <-- From Yahoo
9 Cascade tax rate, TC 32.42% <-- Computed from Cascade financials
11 Cascade cost of equity, rE,Cascade

Cascade, cost of debt rD
A B C D
1 COMPUTING THE COST OF DEBT rD FOR CASCADE
2 2006/01/31 2005/01/31
4 Marketable securities 23,004,000 1,503,000
5
6
7 Notes payable to banks 4,741,000 2,461,000
8 Current portion of long-term debt 12,681,000 12,916,000
9 Long-term debt, net of current portion 12,500,000 25,187,000
10 Total debt 29,922,000 40,564,000
11
12 Interest expense 2,741,000 3,570,000
13 Interest income 979,000 562,000
14
16 Interest income 2.97% <-- =B13/AVERAGE(B3:C3)
17
18 Debt net of cash -5,571,000 10,082,000 <-- =C10-C3
19 Debt net of cash and marketable securities -28,575,000 8,579,000
Note negative leverage: More cash than

debt.
A
Cascade WACC B C
COMPUTING THE WACC FOR CASCADE
1 The company has negative leverage
2 Shares outstanding 12,536,000 <-- ='Cascade equity payouts and rE'!B2
3 Share price, end 2005 50.69 <-- ='Cascade Gordon rE, quarterly'!B2
4 Equity value, E 635,449,840 <-- =B2*B3
5 Net debt, D -28,575,000 <-- ='Cascade cost of debt'!B19
6
8 Cost of equity, r E 18.11% <-- ='Cascade Gordon rE, daily'!B6
9 Cost of debt, r D 7.78% <-- ='Cascade cost of debt'!B15
10
11
Tax rate, T C
WACC
32.42% <-- ='Cascade rE, CAPM'!B9
18.71% <-- =$B$4/($B$4+$B$5)*B8+$B$5/($B$4+$B$5)*B9*(1-B10)
Cascade WACC
12
13 WACC based on Gordon equity payouts and interest from financial statements
Average of Gordon/payout,
14 Cost of equity, r E 10.46% <-- ='Cascade equity payouts and rE'!B7
15 Cost of debt, r D 7.78% <-- ='Cascade cost of debt'!B15
16 Tax rate, T C
17 WACC
32.42% <-- ='Cascade rE, CAPM'!B9
CAPM/Classic, and CAPM/tax-
10.70% <-- =$B$4/($B$4+$B$5)*B14+$B$5/($B$4+$B$5)*B15*(1-B16)
18
20 Cost of equity, r E 11.55%
adjusted. Gordon/dividend is
21 Cost of debt, r D
22 Tax rate, T C
7.78%
32.42%
out-of-line.
23 WACC 11.85% <-- =$B$4/($B$4+$B$5)*B20+$B$5/($B$4+$B$5)*B21*(1-B22)
24
WACC=11.83%
26 Cost of equity, r E 12.59%
27 Cost of debt, r D 7.78%
28 Tax rate, T C 32.42%
29 WACC 12.94% <-- =$B$4/($B$4+$B$5)*B26+$B$5/($B$4+$B$5)*B27*(1-B28)
30
31 Estimated WACC? 11.83% <-- =AVERAGE(B29,B23,B17)
64

Financial Modeling Chapter 2 Calculating Cost of Capital 2015

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Chapter 2: Cost of Capital

© Copyright 2009. Not to be used without

FM3: Chapter 2 Cost of capital 2

Average cost of funds for the company

FM3: Chapter 2 Cost of capital 3

FM3: Chapter 2 Cost of capital 5

FM3: Chapter 2 Cost of capital 6

From easiest to hardest

FM3: Chapter 2 Cost of capital 8

Problem: How do we determine E(rD)?

FM3: Chapter 2 Cost of capital 15

 CAPM/SML: rE derived from firm’s equity beta

FM3: Chapter 2 Cost of capital 18

FM3: Chapter 2 Cost of capital 19

Choice of period (5 years? 10 years?) is important!

FM3: Chapter 2 Cost of capital 21

Div0  1  g  Div0 *  1  g  Div0 *  1  g  Div0 *  1  g 

FM3: Chapter 2 Cost of capital 22

FM3: Chapter 2 Cost of capital 23

FM3: Chapter 2 Cost of capital 24

Dividends are smooth, repurchases much less so

FM3: Chapter 2 Cost of capital 25

FM3: Chapter 2 Cost of capital 28

FM3: Chapter 2 Cost of capital 29

WACHOVIA BANK--DIVIDENDS, STOCK ISSUED AND STOCK REPURCHASED

FM3: Chapter 2 Cost of capital 30

FM3: Chapter 2 Cost of capital 31

TwoStageGordon is a VBA function on Excel

FM3: Chapter 2 Cost of capital 32

Do While (High - Low) > 0.0000001

FM3: Chapter 2 Cost of capital 34

We will use this model as one way to determine

FM3: Chapter 2 Cost of capital 35

COMPUTING THE COST OF EQUITY FOR INTEL

FM3: Chapter 2 Cost of capital 36

FM3: Chapter 2 Cost of capital 38

FM3: Chapter 2 Cost of capital 40

MEASURING E(rM) USING HISTORICAL DATA

FM3: Chapter 2 Cost of capital 42

FM3: Chapter 2 Cost of capital 43

FM3: Chapter 2 Cost of capital 44

FM3: Chapter 2 Cost of capital 45

FM3: Chapter 2 Cost of capital 46

Method 1: Kraft’s cost of debt based on

COMPUTING KRAFT'S rD FROM A YIELD CURVE

Method 2: Kraft’s cost of debt based on rating-adjusted

FM3: Chapter 2 Cost of capital 52

FM3: Chapter 2 Cost of capital 53

FM3: Chapter 2 Cost of capital 56

FM3: Chapter 2 Cost of capital 57

FM3: Chapter 2 Cost of capital 58

FM3: Chapter 2 Cost of capital 61

COMPUTING THE COST OF EQUITY r E FOR CASCADE USING THE

FM3: Chapter 2 Cost of capital 62

Note negative leverage: More cash than

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