1
Cost of Capital
Chapter 12
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
3
4
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project
0
1
-1,000
+1,100
5
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project
0
1
-1,000
+1,100
If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17
(1+ .09 )
6
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project
0
1
-1,000
+1,100
If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17
(1+ .09 )
Accept Project since NPV > 0
7
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project
0
1
-1,000
+1,100
If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17
(1+ .09 )
Accept Project since NPV > 0
If Required Rate = 11%:
NPV = -1,000 + 1,100 = –$9.01
(1+ .11 )
8
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project
0
1
-1,000
+1,100
If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17
(1+ .09 )
Accept Project since NPV > 0
NPV = -1,000 + 1,100 = –$9.01
(1+ .11 )
Reject Project since NPV < 0
If Required Rate = 11%:
9
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project
0
1
-1,000
+1,100
If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17
(1+ .09 )
Accept Project since NPV > 0
If Required Rate = 11%:
NPV = -1,000 + 1,100 = –$9.01
(1+ .11 )
In order to estimate correct required rate, companies
must find their own unique cost of raising capital
Factors Affecting Cost of Capital
General Economic Conditions--inflation, investment
opportunities
Affect interest rates
The Following Factors affect risk premium
Market Conditions
Operating and Financing Decisions
Affect business risk
Affect financial risk
Amount of Financing
Affect flotation costs and market price of security
10
Model Assumptions
Weighted Average Cost of Capital Model
Here, we determine the average cost of capital of a
firm by assuming that the firm continues with its
business, financing and dividend policies.
11
Computing Weighted Cost of Capital
Weighted Average Cost of Capital (WACC)
Average cost of capital of the firm.
To find WACC
1. Compute the cost of each source of capital
2. Determine percentage of each source of capital
3. Calculate Weighted Average Cost of Capital
12
Computing Cost of Each Source
1. Compute Cost of Debt
Required rate of return for creditors
Same cost found in Chapter 7 as “required rate for
debtholders (kd) = YTM”
13
Computing Cost of Each Source
1. Compute Cost of Debt
Required rate of return for creditors
Same cost found in Chapter 7 as “required rate for
debtholders (kd)”
n
P0 =
It
 (1  k
t 1
d
)
n
+
$M
(1+kd)n
where:
It = Dollar Interest Payment
Po = Market Price of Debt
M = Maturity Value of Debt
14
Computing Cost of Each Source
15
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
Computing Cost of Each Source
16
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
n
P0 =
It
 (1  k
t 1
d
)
n
+
$M
(1+kd)n
Computing Cost of Each Source
17
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
n
P0 =
It
 (1  k
t 1
12
938.55 =
d
$90
 (1  k
t 1
)
n
12
)
d
+
$M
(1+kd)n
$1,000
+
(1+kd)10
Computing Cost of Each Source
18
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
The before tax cost of debt is 10%
Interest is tax deductible
Computing Cost of Each Source
19
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
The before tax cost of debt is 10%
Interest is tax deductible
Marginal Tax Rate = 40%
After tax cost of bonds = kd(1 - T)
Computing Cost of Each Source
20
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
The before tax cost of debt is 10%
Interest is tax deductible
Marginal Tax Rate = 40%
After tax cost of bonds = kd(1 - T)
= 10.0%(1– 0.40) = 6 %
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
21
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
From Chapter 8:
Required rate kps =
Dividend (D)
Market Price (P0)
22
Computing Cost of Each Source
23
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
From Chapter 8:
Required rate kps =
Dividend (D)
Market Price (P0)
However, there are floatation costs of issuing preferred stock:
Computing Cost of Each Source
24
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
From Chapter 8:
Required rate kps =
Dividend (D)
Market Price (P0)
However, there are floatation costs of issuing preferred stock:
Cost of Preferred Stock with floatation costs
kps = Dividend (D)
Net Price (NP0)
Computing Cost of Each Source
25
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
Computing Cost of Each Source
26
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
Cost of Preferred Stock
kps =
$5.00
$42.00
Computing Cost of Each Source
27
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
Cost of Preferred Stock
kps =
$5.00
$42.00
= 11.90%
Computing Cost of Each Source
28
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
Cost of Preferred Stock
kps =
$5.00
$42.00
= 11.90%
No adjustment is made for taxes as
dividends are not tax deductible.
Computing Cost of Each Source
3. Compute Cost of Common Equity
Two kinds of Common Equity
Retained Earnings (internal common equity)
Issuing new shares of common stock
29
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
30
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
31
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
Cost of internal equity must equal common
stockholders’ required rate of return.
32
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
Cost of internal equity must equal common
stockholders’ required rate of return.
Three methods to determine
Dividend Growth Model
Capital Asset Pricing Model
Risk Premium Model
33
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
34
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
kcs
D1
=
P0
+ g
35
Computing Cost of Each Source
36
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
kcs
D1
=
P0
+ g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
Computing Cost of Each Source
37
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
kcs
D1
=
P0
+ g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
kcs = 3(1+0.10) + .10
60
Computing Cost of Each Source
38
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
kcs
D1
=
P0
+ g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
kcs = 3(1+0.10) + .10 = .155 = 15.5%
60
Computing Cost of Each Source
39
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
kcs
D1
=
P0
+ g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
kcs = 3(1+0.10) + .10 = .155 = 15.5%
60
The main limitation in this method is estimating growth accurately.
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
40
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM
kcs = krf + b(km – krf)
41
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM
kcs = krf + b(km – krf)
Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.
42
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM
kcs = krf + b(km – krf)
Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.
kcs = 5% + 1.2(13% – 5%)
43
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM
kcs = krf + b(km – krf)
Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.
kcs = 5% + 1.2(13% – 5%) = 14.6%
44
Computing Cost of Each Source
45
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Computing Cost of Each Source
46
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc
RPc = Common stock
risk premium
Computing Cost of Each Source
47
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc
RPc = Common stock
risk premium
Example
If the risk premium is 5% and kd is 10%
Computing Cost of Each Source
48
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc
RPc = Common stock
risk premium
Example
If the risk premium is 5% and kd is 10%
kcs = 10% + 5%
Computing Cost of Each Source
49
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc
RPc = Common stock
risk premium
Example
If the risk premium is 5% and kd is 10%
kcs = 10% + 5% = 15%
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
50
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
Dividend Growth Model--Must adjust for floatation
costs of the new common shares.
51
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
Dividend Growth Model--must adjust for floatation
costs of the new common shares.
Cost of new common stock
kcs =
D1
+ g
NP0
52
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
knc
D1
=
+ g
NP0
53
Computing Cost of Each Source
54
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
knc
D1
=
+ g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
Computing Cost of Each Source
55
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
knc
D1
=
+ g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80
Floatation
Costs
Computing Cost of Each Source
56
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
knc
D1
=
+ g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80
kcs = 3(1+0.10) + .10
52.80
Computing Cost of Each Source
57
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
knc
D1
=
+ g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80
kcs = 3(1+0.10) + .10 = .1625 = 16.25%
52.80
Capital Structure Weights
Long Term Liabilities and Equity
Weights of each source should reflect expected
financing mix
Assume a stable financial mix–so use Balance Sheet
percentages to calculate the weighted average cost
of capital.
58
59
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Liabilities
Current Liabilities
$2,000
Bonds
4,000
Preferred Stock
1,000
Common Stock
5,000
Total Liabilities and
Owners Equity
$12,000
Firm Raises $10,000 of capital from long term sources
60
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Liabilities
Current Liabilities
$2,000
Bonds
4,000
Preferred Stock
1,000
Common Stock
5,000
Total Liabilities and
Owners Equity
$12,000
Compute Firm’s Capital Structure (% of each source)
Amount of Bonds
4,000
= 40%
Bonds:
10,000
Total Capital Sources
61
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Liabilities
Current Liabilities
$2,000
Bonds
4,000
Preferred Stock
1,000
Common Stock
5,000
Total Liabilities and
Owners Equity
$12,000
Compute Firm’s Capital Structure (% of each source)
Amount of Preferred Stock
1,000
= 10%
Preferred Stock:
10,000
Total Capital Sources
62
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Liabilities
Current Liabilities
$2,000
Bonds
4,000
Preferred Stock
1,000
Common Stock
5,000
Total Liabilities and
Owners Equity
$12,000
Compute Firm’s Capital Structure (% of each source)
Amount of Common Stock
5,000
= 50%
Common Stock:
10,000
Total Capital Sources
63
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Liabilities
Current Liabilities
$2,000
Bonds
4,000
Preferred Stock
1,000
Common Stock
5,000
Total Liabilities and
Owners Equity
$12,000
40%
10%
50%
When money is raised for capital projects, approximately
40% of the money comes from selling bonds, 10%
comes from selling preferred stock and 50% comes from
retaining earnings or selling common stock
64
Computing WACC
Green Apple Company estimates the following costs
for each component in its capital structure:
Source of Capital
Cost
Bonds
Preferred Stock
Common Stock
Retained Earnings
New Shares
kd = 10%
kps = 11.9%
kcs = 15%
knc = 16.25%
Green Apple’s tax rate is 40%
Computing WACC
If using retained earnings to finance the common
stock portion the capital structure
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
65
Computing WACC - using Retained Earnings
66
Balance Sheet
Assets
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Tax Rate = 40%
Liabilities
Current Liabilities
$2,000
Bonds (9%)
4,000
Preferred Stock (10%) 1,000
Common Stock(13%) 5,000
Total Liabilities and
Owners Equity
$12,000
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
40%
10%
50%
Computing WACC - using Retained Earnings
67
Balance Sheet
Assets
Liabilities
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Current Liabilities
$2,000
Bonds (10%)
4,000
Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Total Liabilities and
Owners Equity
$12,000
Tax Rate = 40%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
40%
10%
50%
Computing WACC - using Retained Earnings
68
Balance Sheet
Assets
Liabilities
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Current Liabilities
$2,000
Bonds (10%)
4,000
Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Total Liabilities and
Owners Equity
$12,000
Tax Rate = 40%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
40%
10%
50%
Computing WACC - using Retained Earnings
69
Balance Sheet
Assets
Liabilities
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Current Liabilities
$2,000
Bonds (10%)
4,000
Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Total Liabilities and
Owners Equity
$12,000
Tax Rate = 40%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15%
40%
10%
50%
Computing WACC - using Retained Earnings
70
Balance Sheet
Assets
Liabilities
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Current Liabilities
$2,000
Bonds (10%)
4,000
Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Total Liabilities and
Owners Equity
$12,000
Tax Rate = 40%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15% = 11.09%
40%
10%
50%
71
Computing WACC
If use newly issued common stock, use knc rather
than kcs for the cost of the equity portion.
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
knc
Computing WACC - using New Common Shares
Balance Sheet
Assets
Liabilities
Current Assets
$5,000
Plant & Equipment
7,000
Total Assets
$12,000
Current Liabilities
$2,000
Bonds (10%)
4,000
Preferred Stock (11.9%) 1,000
Common Stock(16.25%)5,000
Total Liabilities and
Owners Equity
$12,000
Tax Rate = 40%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 16.25% = 11.72%
72
Weighted Marginal Cost of Capital
A firm’s cost of capital will change as it is raises more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money has been raised
73
Weighted Marginal Cost of Capital
74
A firm’s cost of capital will changes as it is raising more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money raised
Therefore, beyond a point, the WACC will rise.
Calculate the point at which the cost of capital
increases
Weighted Marginal Cost of Capital
75
A firm’s cost of capital will changes as it is raising more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money raised
Calculate the point at which the cost of capital
increases
Amt of lower cost capital that can
Break in cost be =raised before component cost rises
Weight of this kind of capital
of capital curve
in the capital structure
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
Percentage of
of capital curve
common financing
If Green Apple Company has $100,000 of internally
generated common:
76
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
Percentage of
of capital curve
common financing
If Green Apple Company has $100,000 of internally
generated common:
Break in cost = $100,000
.50
of capital curve
77
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
Percentage of
of capital curve
common financing
If Green Apple Company has $100,000 of internally
generated common:
Break in cost = $100,000
.50
of capital curve
= $200,000
78
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
Percentage of
of capital curve
common financing
If Green Apple Company has $100,000 of internally
generated common:
Break in cost = $100,000
.50
of capital curve
= $200,000
Once $200,000 is raised from all sources, the
cost of capital will rise because all the lower
cost retained earnings will be used up.
79
80
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Marginal weighted cost of capital curve:
12%
11.09%
11%
Cost of Capital
using internal
common stock
10%
9%
0
100,000
200,000
Total Financing
300,000
400,000
81
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Marginal weighted cost of capital curve:
12%
11.09%
11%
10%
Break-Point for
common equity
9%
0
100,000
200,000
Total Financing
300,000
400,000
82
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Marginal weighted cost of capital curve:
11.72%
12%
Cost of Capital using
new common equity
11.09%
11%
Cost of Capital
using internal
common stock
10%
9%
0
100,000
200,000
Total Financing
300,000
400,000
83
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Marginal weighted cost of capital curve:
11.72%
12%
11.09%
11%
10%
9%
0
100,000
200,000
Total Financing
300,000
400,000
84
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Weighted Cost of Capital
Marginal weighted cost of capital curve:
12%
Project 1
IRR = 12.4%
11%
10%
Project 2
IRR = 12.1%
Project 3
IRR = 11.5%
9%
0
100,000
200,000
Total Financing
300,000
400,000
85
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital
Weighted Cost of Capital
Marginal weighted cost of capital curve:
12%
Project 1
IRR = 12.4%
11%
10%
Project 2
IRR = 12.1%
Project 3
IRR = 11.5%
9%
0
100,000
200,000
Total Financing
300,000
400,000
86
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital
Choose projects whose IRR is above the weighted
marginal cost of capital
Weighted Cost of Capital
Marginal weighted cost of capital curve:
Accept Projects #1 & #2
12%
Project 1
IRR = 12.4%
11%
10%
Project 2
IRR = 12.1%
Project 3
IRR = 11.5%
9%
0
100,000
200,000
Total Financing
300,000
400,000
87