Chapter 16 – Cost of Capital

Capital definition:
Mix of long-term financing sources, primarily debt
and equity, used by the company
Opportunity Cost Concept
Cost of capital is an opportunity cost
 The opportunity cost is the return investors could
have expected by investing somewhere else at
equal risk

Weighted Average Concept
The cost of capital is an average of the opportunity
costs of stockholders and creditors
 The average is weighted by the proportion of
funds provided by each source

Marginal Cost Concept
The marginal cost of capital is the rate of return
that must be earned on new capital to satisfy
investors
 The marginal cost of capital is the weighted
average cost of capital that must be earned on new
investments
 The marginal cost of capital is the change in the
amount needed to satisfy investors, divided by the
amount of new capital raised

Cost of Debt
Cost of debt is the interest rate the company would
be required to pay on new debt, adjusted upward
for flotation costs
 Yield to maturity on bonds frequently measures
the marginal cost of debt

 To
sell new bonds, you must pay at least the yield to
maturity for new bonds
 To justify reinvesting existing funds, your internal
investments must be better than the return earned by
buying back your existing debt in the marketplace
After-tax Cost of Debt
Payment of interest results in a tax savings
 After-tax cost of debt:
Kd = before-tax cost of debt X (1 – Tax rate)

Cost of Preferred Stock
Most preferred stock is perpetual; it has no
maturity date
 Cost of preferred stock:
Kp = Dividend per share  Market price per share
 The cost of new preferred stock requires the use of
a net price, the amount that the company will net
after paying flotation costs

Cost of Common Stock
No direct way to observe the return required by
common stockholders; must estimate
 Use

 Dividend
growth model
 Earnings yield
 CAPM
Dividend Growth Model

Ke = (D1/P) + g
Where
D1 = Expected dividend at the end of the next year
P = Current price of the stock
g = Anticipated growth rate of dividends

Applies when dividend growth is stable
Earnings Yield Model
Ke = Earnings per share  Price
 Sometimes used, but

 Ignores
growth
 Not based on cash flow
Mean-variance CAPM

Ke = Rf + s,m[E(Rm) - Rf]
Where
Rf = Risk-free rate
s,m = Beta of the company’s stock with regard to the
market portfolio
E(Rm) = Expected return on the market portfolio
Widely used
 E(Rm) is still widely debated
 Can use similar company betas for a stock that is
not publicly traded

Cost of Existing Equity
Also called the cost of retained earnings
 Some authors argue that the cost of retained
earnings is
Ke(1 – stockholders’ tax rate on dividends)
 Much stock is held by pension funds and
charitable endowments that do not pay taxes on
dividends

Cost of new Equity
No dividend growth anticipated:
Kne = Ke/(1 – f)
where f is flotation cost as a percent of market
price
 With dividend growth anticipated:
Kne = D1/[P/(1 – f)] + g

Weight for Weighted Average Cost
Market value weights are recommended
 Target capital structure is typically used if the the
company is moving toward that target

Additional Issues
Deferred taxes: typically not considered a source
of funds because deferred tax reconciles difference
between accounting records and cash flows
 Accounts payable and accrued expenses: typically
not considered a source of funds because they
reconcile the difference between accounting and
cash flow
 Short-term debt is included if it is used as
permanent capital

Additional Issues
Leases: often used as a direct substitute for debt,
and therefore the implied amount and cost of debt
is included in the WACC calculation (covered in
Ch. 21)
 Convertibles: treat as a straight bond and an
option
 Depreciation-generated funds: It makes sense to
talk about internally generated funds, which have
the cost of existing capital, but not to look
separately at depreciation

Risk Differences and WACC
 The
WACC calculations typically assume that
projects for a company are all of similar risk
 When risks are different, they often vary by
division
 Companies often use division cost of capital,
estimating the betas and cost of equity for each
division if it were a stand-alone company
 Large individual projects are sometimes evaluated
as if they were funded as a stand-alone company
International Investments
Cost of capital should reflect the risk of the project
 Cost of capital should be denominated in the same
currency used to denominate cash flows for capital
investment analysis
 Equity residual method, discussed in Chapter 20,
is sometimes used to evaluate international
investments with multi-country financing.
