The Cost of Capital
Corporate Finance
Dr. A. DeMaskey
1
Learning Objectives
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Questions to be answered:
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What is the cost of capital?
What are the component costs?
What is the target capital structure?
How is each of the component costs and
weights estimated?
How is the weighted average cost of
capital used?
2
Basic Concepts
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Minimum Acceptable Rate of Return
Discount Rate (NPV)
Hurdle Rate (IRR, MIRR)
Marginal Cost of Capital (MCC)
Weighted Average Cost of Capital
(WACC)
3
Basic Assumptions
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Equal Risk
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Target Capital Structure
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Reflects Average Risk
4
Capital Components
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What types of long-term capital do
firms use?
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Long-term debt
Preferred stock
Common equity
5
Component Costs
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Should we focus on before-tax or
after-tax capital costs?
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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 aftertax costs.
Only cost of debt is affected.
6
Component Costs
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Should we focus on historical
(embedded) costs or new (marginal)
costs?
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The cost of capital is used primarily to
make decisions which involve raising and
investing new capital. So, we should focus
on marginal costs.
7
Determining the Cost of
Capital
Determine the proportion of each
capital component.
Determine the marginal cost of each
source of capital.
Calculate the weighted average cost of
capital.
8
The Weighted Average Cost of
Capital (WACC)
WACC
= wdkd(1 - T) + wpskps + wsks
where: wi = proportion of source of capital used in the
capital structure;
ki = marginal cost of source of capital;
T = corporate tax rate.
9
Determining the Proportion of
Each Capital Component
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Capital structure of the firm.
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Future capital structure of the firm.
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Optimal capital structure.
10
Component Cost of Debt
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Find either YTM or YTC as estimate of
kd.
Interest is tax deductible, so
kd,AT = kd,BT(1 - T).
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Use nominal rate.
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Flotation costs are small, so ignore.
11
Component Cost of Preferred
Stock
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Solve for kps in the following formula:
k ps 
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Note:
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Dps
Pn
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.
12
Common Equity
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Companies can issue new shares of
common stock.
Companies can reinvest earnings.
13
Component Cost of Equity
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. Bond-Yield-Plus-Risk Premium:
ks = kd + RP.
14
Capital Asset Pricing Model
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Investors are risk averse.
Investors hold diversified portfolios.
Drawbacks of the CAPM
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Requires historical returns to determine beta.
Assumes beta will be the same in the future as it
has been in the past.
Requires estimation of a riskfree rate of return.
15
Dividend Valuation Model
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The greater is the current dividend yield, the
greater is the cost of equity.
The greater is the growth in dividends, the
greater is the cost of equity.
Drawbacks of the DVM
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Assumes constant growth in dividends.
Requires dividends in the near future.
Requires a market value for a share of stock.
16
Retention Growth Rate Method
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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 is the expected future g?
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Retention growth rate:
g = b(ROE) = 0.35(15%) = 5.25%.
Here b = Fraction retained.
This is close to g = 5% given earlier.
17
New Common Equity
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When a company issues new common stock
they also have to pay flotation costs to the
underwriter.
Issuing new common stock may send a
negative signal to the capital markets, which
may depress stock price.
Thus, the cost of internal equity from
reinvested earnings is cheaper than the cost
of issuing new common stock.
18
Comments About Flotation
Costs
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Flotation costs depend on the risk of the firm
and the type of capital being raised.
The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
We will frequently ignore flotation costs when
calculating the WACC.
Factors That Affect a Firm’s
WACC
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Market conditions
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Level of interest rates
Market risk premium
Tax rates
The firm’s capital structure and dividend
policy.
The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.