Chapter 8
The Cost of
Capital
© 2005 Thomson/South-Western
Cost of Capital
Firm’s average cost of funds, which is
the average return required by firm’s
investors
What must be paid to attract funds
2
Required Rate of Return
(Opportunity Cost Rate)
 The return that must be raised on
invested funds to cover the cost of
financing such investments
3
The Logic of the Weighted
Average Cost of Capital =
WACC
The use of debt impacts the ability to use
equity, and vice versa.
The weighted average cost must be used to
evaluate projects, regardless of the specific
financing used to fund a particular project.
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 = cost of retained earnings
ke = cost of external equity (new stock)
5
Basic Definitions
 WACC
Weighted Average Cost of Capital
 Capital Structure
A combination of different types of
capital (debt and equity) used by a firm
6
After-Tax Cost of Debt
The relevant cost of new debt
Takes 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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Cost of Preferred Stock
 Rate of return investors require on the
firm’s preferred stock
 The preferred dividend divided by the
net issuing price
k ps 
D ps
NP

D ps
P0  Flotation costs

D ps
P0 (1  F)
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Cost of Retained Earnings
 Rate of return investors require on the
firm’s common stock
D̂
1
k k
 RP 
 g  k̂
s
RF
s
P
0
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The CAPM Approach
k s  k RF  ( kM - kRF
b
)s
10
The Discounted Cash Flow
Approach
 Price and expected rate of return on a share of common
stock depend on the dividends expected on the stock.
 Can use when growth (g) is constant
D̂
1
k  k̂ 
g
s
s P
0
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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%
12
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)
D̂1
D̂1
ke 
g 
g
NP
P0 1  F
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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
14
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 
   cost of    of preferred    preferred    of common   common
 
of
 debt   debt   stock   stock   equity   equity 

wd
k dT

w ps

k ps

ws

ks
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Marginal Cost of Capital
 MCC
Cost of obtaining another dollar of new
capital
Weighted average cost of the last dollar
of new capital raised
16
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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Marginal Cost of Capital (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
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of dollars)
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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Break Point Formulas
Total amount of lower cost capital of a given type
Break

Point Proportion of this type of capital in the capital structure
 BPdebt = debt/% debt
 BPret earn = retained earnings/% equity
 If the capital budget $ > breakpoint $, the
cost of capital will be at the next higher
interest rate
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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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MCC Schedule
 Schedule and break points depend on
capital structure used.
22
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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Percent
12.0 -
Combining the MCC and Investment
Opportunity Schedules
IRRC = 12.1%
IRRB = 11.7%
IRRD = 11.5%
IRRE = 11.3%
WACC3=11.0%
11.0 -
MCC
WACC2=10.5%
IRRA = 10.2% IOS
10.0 -
WACC1=10.0%
Optimal Capital
Budget - $115
New Capital Raised and invested
(millions of dollars)
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20
40
60
80
100 120 140
160
Before Next Class:
1. Review Chapter 8
2. Do chapter 8 homework
3. Prepare for Chapter 8 quiz
4. Read chapter 9
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