CHAPTER 10
The Cost of Capital
1
Topics in Chapter 10


Individual sources of capital and their
cost
WACC
2
Cost of Capital


Focus on after-tax costs (only debt is
affected).
We are interested in the cost of new
financing (not historical costs).
3
What are the two ways that
companies can raise common equity?


Issue new shares of common stock.
Reinvest earnings that are not paid out
as dividends (i.e., retaining earnings).
4
Is there a cost for retained
earnings?


Earnings can be reinvested or paid out
as dividends.
Unless the firm can earn a rate of
return on retained earnings that is
acceptable to its shareholders, it should
pay dividends instead.
5
Three ways to determine
the cost of equity, rs:
1. CAPM: rs
= rRF + (rM - rRF)b
= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium:
rs = rd + Bond RP.
6
What is the WACC?

The weighted average cost of capital, or
WACC, is the annual percentage cost of
financing a project of average risk (risk
equal to firm’s existing assets).
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Weights for the WACC



The weights are the percentages of
financing from each component.
If possible, use the “target” weights.
Target weights: according to firm’s
target capital structure.
8
Weights for the WACC (Cont.)

If you don’t know the targets, it is
better to estimate the weights using
current market values rather than book
values.
9
What factors influence a
company’s WACC?
1.
2.
3.
Market conditions.
The firm’s capital structure.
The firm’s investment policy. Firms
with riskier assets have a higher
WACC.
10
Is the firm’s WACC correct for
all projects & divisions?


NO! The composite WACC reflects the
risk of an average project undertaken
by the firm.
Different projects and divisions may
have different risks. The WACC should
be adjusted to reflect the risk to get a
risk adjusted discount rate (RADR).
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The Risk-Adjusted Divisional
Cost of Capital

To estimate each division’s cost of
capital, we can:


Estimate the cost of capital the division
would have if it were a stand-alone firm.
OR, Use subjective adjustments to the
firm’s composite WACC.
12
What are the three types of
project risk?



Stand-alone risk
Corporate (within-firm) risk
Market risk
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Corporate Risk


Corporate risk is the impact of a project
on the variability of the firm’s returns.
Corporate risk views the firm’s assets as
a portfolio, recognizing that a portion of
the risk of a new asset will be
diversified away.
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Corporate Risk


If investing in a project will cause the
firm’s returns to be more stable, the
project has low corporate risk.
If it makes returns less stable, it has
high corporate risk.
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How is each type of risk used?




Stand-alone risk is easiest to calculate.
Market risk is theoretically most
important in most situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
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