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Learning Outcomes
Chapter 11
Compute the component cost of capital for (a) debt, (b) preferred
stock, (c) retained earnings, and (d) new common equity.
Describe the weighted average cost of capital (WACC) and discuss
the logic of using WACC to make informed financial decisions.
Describe how the marginal cost of capital (MCC) is used to make
capital budgeting decisions.
Discuss the relationship between the firm’s weighted average cost
of capital (WACC) and investor’s’ required rates of return.
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Cost of Capital
Firm’s average cost of funds, which is the
average return required by firm’s investors
What must be paid to attract funds
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Required Rate of Return
(Opportunity Cost Rate)
The return that must be raised on invested
funds to cover the cost of financing such
investments
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Basic Definitions
Capital Component
 Types of capital used by firms to raise money
• rd
= before tax interest cost
• rdT = rd(1-T) = after tax cost of debt
• rps = cost of preferred stock
• rs
= cost of retained earnings
• re
= cost of external equity (new stock)
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Basic Definitions
WACC
Weighted Average Cost of Capital
Capital Structure
A combination of different types of
capital(debt and equity) used by a firm
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After-Tax Cost of Debt
The relevant cost of new debt
Taking into account the tax deductibility of
interest
Used to calculate the WACC
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Cost of Preferred Stock
Rate of return investors require on the firm’s
preferred stock
The preferred dividend divided by the net
issuing price
F = percentage flotation costs as a decimal
NP0 = per share net proceeds firm receives from the issue
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Cost of Retained Earnings
Rate of return investors require on the firm’s
common stock
rs = required rate of return
RPs = risk premium for Stock S
r̂s = expected rate of return
g
= constant growth rate
rRF = risk-free rate of return
P0 = current stock price
D̂1 = next period’s expected dividend
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The CAPM Approach
rs
rRF
rM
RPs
βs
= cost of retained earnings
= risk-free rate of return
= risk-free rate of return
= risk premium for Stock S
= beta coefficient for Stock S
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The Discounted Cash Flow Approach
(Expected Rate of Return)
Price and expected rate of return on a share
of common stock depends on the dividends
expected on the stock.
rs = cost of retained earnings
P0 = current stock price
r̂s = expected rate of return
g
= constant growth rate
D̂1 = next period’s expected dividend
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The Bond-Yield-Plus-Premium Approach
Estimating a risk premium above the bond
interest rate
Judgmental estimate for premium
“Ballpark” figure only
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Cost of Newly Issued Common Stock
External equity, re
 Based on the cost of retained earnings
 Adjusted for flotation costs (the expenses of selling new
issues)
re = cost of new equity
g = constant growth rate
D̂1 = next period’s expected dividend
F = percentage flotation cost stated as a decimal
P0 = current stock price
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Target Capital Structure
Optimal Capital Structure
 Percentage of debt, preferred stock, and common equity in
the capital structure that will maximize the price of the firm’s
stock
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Weighted Average Cost of Capital, WACC
A weighted average of the component costs
of debt, preferred stock, and common equity
wd = proportion of debt in firm’s capital structure
wps = proportion of preferred stock in firm’s capital structure
ws = proportion of common stock in firm’s capital structure
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Taxes and the WACC
We are concerned with after-tax cash flows,
so the effect of taxes on the various costs of
capital has to be considered
Interest expense reduces tax liability
 Reduction in taxes reduces cost of debt
 After-tax cost of debt = RD(1-TC)
Dividends are not tax deductible, so there is
no tax impact on the cost of equity
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Taxes and the Value of the Firm
The value of the firm increases by the present
value of the annual interest tax shield
 Value of a levered firm = value of an unlevered firm + PV of
interest tax shield
 Value of equity = Value of the firm – Value of debt
 RU - unlevered cost of capital; D –face value of debt
 VU = EBIT(1-T) / RU
 VL = VU + DTC
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Taxes and the Value of the Firm-Use of
Leverage
 EBIT = $25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%
The WACC decreases as D/E increases
because of the government subsidy on
interest payments
WACC↓ Value ↑
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WACC (1)
Equity Information
 50 million shares
 $80 per share
 Beta = 1.15
 Market risk premium =
9%
 Risk-free rate = 5%
Debt Information
 $1 billion in
outstanding debt (face
value)
 Current quote = 110
 Coupon rate = 9%,
semiannual coupons
 15 years to maturity
Tax rate = 40%
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WACC (2)
1.
What is the cost of equity?
2.
What is the cost of debt?
3.
What is the after-tax cost of debt?
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WACC (3)
What are the capital structure weights?
What is the WACC?
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The Logic of the Weighted Average Cost
of Capital
The use of debt impacts the ability to use
equity, and vice versa, so the weighted
average cost must be used to evaluate
projects, regardless of the specific financing
used to fund a particular project.
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Marginal Cost of Capital
Marginal Cost of Capital Schedule
 A graph that relates the firm’s weighted average
of each dollar of capital to the total amount of
new capital raised
 Reflects changing costs, depending on amounts of
capital raised
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MCC Schedule for Unilate Textiles
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Break Point (BP)
The dollar value of new capital that can be
raised before an increase in the firm’s
weighted average cost of capital occurs
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MCC Schedule Using Retained Earnings, New Common
Stock and Higher-Cost Debt
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Combining the MCC and Investment
Opportunity Schedules
Use the MCC schedule to find the cost of
capital for determining projects’ net present
values.
Investment Opportunity Schedule (IOS)
 Graph of the firm’s investment opportunities ranked in order
of the projects’ internal rate of return
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Combining the MCC and Investment
Opportunity Schedules
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