CHAPTER 11
The Cost of Capital
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

Sources of capital
Component costs
WACC
9-1
Cost of Capital


The cost of capital represents the overall cost of
financing to the firm
The overall cost of capital is a weighted average of
the various sources, including debt, preferred
stock, and common equity (retained earnings):
WACC = Weighted Average Cost of Capital
WACC = After-tax cost x weights
9-2
What sources of long-term
capital do firms use?
Long-Term Capital
Long-Term Debt
Preferred Stock
Common Stock
Retained Earnings
New Common Stock
9-3
Calculating the weighted
average cost of capital
WACC = wdrd(1-T) + wpsrps + wers


The w’s refer to the firm’s capital
structure weights.
The r’s refer to the cost
of each component.
9-4
Should our analysis focus on
before-tax or after-tax capital costs?


Stockholders focus on After-Tax CFs.
Therefore, we should focus on A-Tax
capital costs.
Only cost of debt needs adjustment,
because interest is tax deductible.
9-5
Should our analysis focus on
historical (embedded) costs or new
(marginal) costs?

The cost of capital is used primarily to
make decisions that involve raising new
capital. So, focus on today’s marginal
costs (for WACC).
9-6
How are the weights determined?
WACC = wdrd(1-T) + wprp + wers

As a percentage of total financing
9-7
Weighting example
Bonds
40
Pref. Stock
100
Common
100
Ret. Earn.
160
Total L & E
400
What is weight of each component?
9-8
Weighting example
Bonds
Pref. Stock
Common
Ret. Earn.
Total L & E
40
100
100
160
400
Bonds = 40/400 = 10%
Pref. Stock = 100/400 = 25%
9-9
Component cost of debt
WACC = wdrd(1-T) + wprp + wers



rd is the marginal cost of debt capital.
The yield to maturity on outstanding
L-T debt is often used as a measure
of rd.
Why tax-adjust, i.e. why rd(1-T)?
9-10
10% before tax = 6% after tax
Sales
1,000
1,000
Interest
100*
0
EBT
900
1,000
Tax 40%
360
400
EAT
540
600
60 difference
*10% coupon rate for one bond
9-11
Component cost of debt

Interest is tax deductible, so
A-T rd = B-T rd (1-T)
= 10% (1 - 0.40) = 6%
T = tax rate = 40%
9-12
Component cost of preferred
stock
WACC = wdrd(1-T) + wprp + wers


rp is the marginal cost of preferred
stock.
The rate of return investors require on
the firm’s preferred stock.
9-13
What is the cost of preferred
stock?

The cost of preferred stock can be
solved by using this formula:
rp = Dp / Pp
= $10 / $111.10
= 9%
9-14
Component cost of preferred
stock

Preferred dividends are not taxdeductible, so no tax adjustments
necessary. Just use rp.
9-15
Component cost of equity
WACC = wdrd(1-T) + wprp + wers


rs is the marginal cost of common
equity using retained earnings.
Issuing new stock would cost a little
more due to flotation (selling) costs.
9-16
Why is there a cost for
retained earnings?



Earnings can be reinvested or paid out as
dividends.
Investors could buy other securities, earn a
return.
If earnings are retained, there is an
opportunity cost (the return that
stockholders could earn on alternative
investments of equal risk).


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Investors could buy similar stocks and earn rs.
Firm could repurchase its own stock and earn rs.
Therefore, rs is the cost of retained earnings.
9-17
Two ways to determine the
cost of common equity, ks

CAPM: rs = rRF + β(rM – rRF)

DCF:
rs = (D1 / P0)+ g
9-18
If the rRF = 7%, rM = 13% and the firm’s
beta is 1.2, what’s the cost of common
equity based upon the CAPM?
rs = rRF + (rM – rRF) β
= 7.0% + (6.0%)1.2 = 14.2%
(rm- rRF) = market risk premium
9-19
If D0 = $4.19, P0 = $50, and g = 5%,
what’s the cost of common equity based
upon the DCF approach?
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.4
rs = (D1 / P0)+ g
= ($4.4 / $50) + 0.05
= 13.8%
9-20
What is a reasonable final
estimate of rs?
Method
CAPM
DCF
Average
Estimate
14.2%
13.8%
14.0%
9-21
Flotation costs



Flotation costs depend on the risk of the
firm and the type of capital being raised.
The flotation costs are highest for
common equity.
To adjust rs = (D1/(P0 – F)) + g
9-22
Calculate WACC


If 40% of your financing is from debt at
an after tax cost of 8% and 60% is
from pref. stock at 10%, what is the
WACC?
It will be between what two numbers?
9-23


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40% (.08) + 60% (.10)
.032 + .06 = .092
9.2%
9-24
Balance Sheet
Cash
5,000
LT Debt
3,000
Equipment
5,000
Pref. Stock
1,000
Stock
6,000
Tot. Debt & Eq.
10,000
Tot. Assets
10,000
9-25
Ignoring floatation costs, what is
the firm’s WACC?
WACC =
=
=
=
wdrd(1-T) + wprp + wers
0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
1.8% + 0.9% + 8.4%
11.1%
9-26
Should the company use the
composite WACC as the hurdle rate
for each of its projects?


NO! The composite WACC reflects the risk
of an average project undertaken by the
firm. Therefore, the WACC only represents
the “hurdle rate” for a typical project with
average risk.
Different projects have different risks. The
project’s WACC should be adjusted to
reflect the project’s risk.
9-27
Optimum Capital Structure

The optimal (best) situation is associated
with the minimum overall cost of capital:



Optimum capital structure means the lowest
WACC
Usually occurs with 30-50% debt in a firm’s
capital structure
WACC is also referred to as the required
rate of return or the discount rate
9-28
Optimal Capital Structure
Cost
Financial Plan A:
Debt…………………………
Equity……………………….
Cost (After-tax)
Weights
Weighted
6.5%
12.0
20%
80
1.3%
9.6
10.9%
Financial Plan B:
Debt…………………………
Equity……………………….
7.0%
12.5
40%
60
2.8%
7.5
10.3%
Financial Plan C:
Debt…………………………
Equity……………………….
9.0%
15.0
60%
40
5.4%
6.0
11.4%
9-29
Draw a graph representing the
cost of debt and equity
Cost of Capital
10%
5%
0
40%
Debt to Asset Mix
80%
9-30
Cost of capital curve
9-31