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CHAPTER 11
The Cost of Capital
Cost of Capital Components
Debt
Preferred
Common Equity
WACC
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What types of long-term capital do
firms use?
Long-term debt
Preferred stock
Common equity
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Should we 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.
Most firms incorporate tax effects in
the cost of capital. Therefore, focus
on after-tax costs.
Only cost of debt is affected.
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Should we focus on historical
(embedded) costs or new (marginal)
costs?
The cost of capital is used primarily
to make decisions which involve
raising and investing new capital.
So, we should focus on marginal
costs.
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A 15-year, 12% semiannual bond sells
for $1,153.72. What’s kd?
0
1
2
30
i=?
...
60
-1,153.72
INPUTS
30
-1153.72 60
N
OUTPUT
60
I/YR
PV
PMT
60 + 1,000
1000
FV
5.0% x 2 = kd = 10%
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Component Cost of Debt
Interest is tax deductible, so
kd AT = kd BT(1 - T)
= 10%(1 - 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.
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What’s the cost of preferred stock?
Ps = $113.10; 10%Q; Par = $100; F = $2.
Use this formula:
k ps 
D ps
Ps
0.1 $100 

$113.10  $2.00
$10

 0.090  9.0% .
$111.10
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Note:
Flotation costs for preferred are
significant, so are reflected. Use
net price.
Preferred dividends are not
deductible, so no tax adjustment.
Just kps.
Nominal kps is used.
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What are the two ways that companies
can raise common equity?
Companies can issue new shares
of common stock.
Companies can reinvest earnings.
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Why is there a cost for reinvested
earnings?
Earnings can be reinvested or paid
out as dividends.
Investors could buy other securities,
earn a return.
Thus, there is an opportunity cost if
earnings are reinvested.
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Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
They could buy similar stocks
and earn ks, or company could
repurchase its own stock and
earn ks. So, ks, is the cost of
reinvested earnings and it is the
cost of equity.
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11 - 12
Three ways to determine the
cost of equity, ks:
1. CAPM: ks = kRF + (kM - kRF)b
= kRF + (RPM)b.
2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium:
ks = kd + RP.
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What’s the cost of equity
based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM - kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
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What’s the DCF cost of equity, ks?
Given: D0 = $4.19;P0 = $50; g = 5%.
D 0 1  g
D1
ks 
g
g
P0
P0
$4.19105
. 

 0.05
$50
 0.088  0.05
 13.8%.
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Suppose the company has been
earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout
= 65%), and this situation is
expected to continue.
What’s the expected future g?
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Retention growth rate:
g = b(ROE) = 0.35(15%) = 5.25%.
Here b = Fraction retained.
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Find ks using the own-bond-yieldplus-risk-premium method.
(kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%
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What’s a reasonable final estimate
of ks?
Method
CAPM
DCF
kd + RP
Average
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Estimate
14.2%
13.8%
14.0%
14.0%
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What’s the WACC?
WACC = wdkd(1 - T) + wpskps + wceks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
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What factors influence a company’s
WACC?
Market conditions, especially interest
rates and tax rates.
The firm’s capital structure and
dividend policy.
The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.
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Estimate the cost of new common
equity: P0=$50, D0=$4.19, g=5%, and
F=15%.
ke
D 0 (1  g)

g
P0 (1  F)
$4.191.05 

 5 .0 %
$501  0.15 
$4.40

 5.0%  15.4%.
$42.50
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