10-1
Chapter 10:
The Cost of
Capital
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10-2
Cost of Capital
 The firm’s average cost of funds, which is
the average return required by the firm’s
investors
 What must be paid to attract funds
Copyright (C) 2000 by Harcourt, Inc. All rights
reserved.
10-3
The Logic of the Weighted
Average Cost of Capital
The use of debt impacts on 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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reserved.
10-4
Basic Definitions
Capital Component
Types of capital used by firms to raise
money
kd
= before tax interest cost
kdT
= kd(1-T) = after tax cost of debt
kps
= cost of preferred stock
ks
ke
= cost of retained earnings
= cost of external equity (new stock)
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reserved.
10-5
Basic Definitions
WACC = weighted average cost of capital
Capital Structure
A combination of different types of capital
used by a firm
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reserved.
10-6
After-Tax Cost of Debt
 The relevant cost of new debt
 Taking into account the tax deductibility
of interest
 Used to calculate the WACC
kdT = bondholders’ required rate of return
minus tax savings
kdT = kd - (kd x T) = kd(1-T)
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reserved.
10-7
Cost of Preferred Stock
 Rate of return investors require on the
firm’s preferred stock
 The preferred dividend divided by the net
issuing price
D
D
ps
ps
k 

ps NP P - Flotationcosts
0
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reserved.
10-8
Cost of Retained Earnings
 Rate of return investors require on the
firm’s common stock
D̂
k k
 RP  1  g  k̂
s
RF
s
P
0
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reserved.
10-9
The CAPM Approach


k k
 k - k
β
s
RF  M
RF  s
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reserved.
10-10
The Bond-Yield-Plus-Premium
Approach



Estimating a risk premium above the
bond interest rate
Judgmental estimate for premium
“Ballpark” figure only
k  Bon dyie ld Riskpre m iu m
s
 10%  4%  14%
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reserved.
10-11
The Discounted Cash Flow (DCF)
Approach
 Price and expected rate of return on a
share of common stock depend on the
dividends expected on the stock
D̂
D̂
D̂
1 
2  ... 

P 
0 1 k 1 1 k 2

1 k
s
s
s
D̂

t
 
t
1

k
t 1
s

 





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reserved.
10-12
The Discounted Cash Flow (DCF)
Approach
D̂
D̂
D̂
1
2

P 

 ... 
0 1 k 1 1 k 2

1 k
s
s
s
D̂
D̂

t 
1 if g is constant
 
t
k

g
1

k
t 1
s
s

 





D̂
k  k̂  1  g
s
s P
0
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reserved.
10-13
Cost of Newly Issued
Common Stock
External equity, ke
 based
on the cost of retained earnings
 adjusted for flotation costs (the expenses
of selling new issues)
D̂
D̂
1 g
k  1 g 
s NP
P 1  F 
0
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reserved.
10-14
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
Copyright (C) 2000 by Harcourt, Inc. All rights
reserved.
10-15
Weighted Average Cost of Capital,
WACC
A weighted average of the component costs
of debt, preferred stock, and common equity
 Proportion   After - tax   Proportion   Cost of   Proportion   Cost of 
 
 
 
 
 


 
of

cost
of

of
preferred

preferred

of
common

common
 
 
 
 
 

 debt   debt   stock   stock   equity   equity 

 
 


W
d

k
dT

W
ps

k
ps

W
s

k
s
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reserved.
10-16
Marginal Cost of Capital
 MCC


The cost of obtaining another dollar
of new capital
The weighted average cost of the
last dollar of new capital raised
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reserved.
10-17
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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reserved.
10-18
MCC Schedule
Weighted Average Cost
of Capital (WACC) (%)
WACC3=11.5%
11.5 WACC2=11.0%
11.0 -
10.5 -
WACC1=10.5%
100
150
New Capital
Raised (millions
of dollars)
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reserved.
10-19
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
Total amount of lower cost capital of a given type
Break

Point Proportion of this type of capital in the capital structure
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reserved.
10-20
MCC Schedule
Weighted Average Cost
of Capital (WACC) (%)
WACC3=11.5%
11.5 WACC2=11.0%
11.0 10.5 -
WACC1=10.5%
BPRE
100
BPDebt
150
New Capital
Raised (millions of
dollars)
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reserved.
10-21
MCC Schedule
 Schedule and break points depend
on capital structure used
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reserved.
10-22
MCC Schedule
Weighted Average Cost
of Capital (WACC) (%)
Smooth, or Continuous,
Marginal Cost of Capital
Schedule
WACC
0-
Dollars of New Capital Raised
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reserved.
10-23
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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reserved.
10-24
Combining the MCC and
Investment Opportunity
Schedules
Percent
12.0 -
IRRC = 12.0%
IRRB = 11.6%
11.5 -
WACC3=11.5%
IRRD = 11.5%
IRRE = 11.3%
WACC2=11.0%
11.0 -
MCC
IRRA = 10.8%
WACC1=10.5%
10.5 -
Optimal Capital
Budget - $139
20
40
60
80
100 120 140
IOS
160
180
New Capital Raised and invested
(millions of dollars)
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reserved.
10-25
End of Chapter 10
The Cost of Capital
Copyright (C) 2000 by Harcourt, Inc. All rights
reserved.