FIN303
Vicentiu Covrig
Cost of Capital
(chapter 10)
1
FIN303
Vicentiu Covrig
What sources of capital do firms use?
Capital
Debt
Notes
Payable
Preferred
Stock
Common
Equity
Retained
Earnings
Long-Term
Debt
2
New Common
Stock
FIN303
Vicentiu Covrig
Should our analysis focus on before-tax or aftertax capital costs?

Stockholders focus on A-T CFs.
Therefore, we should focus on A-T capital
costs, i.e. use A-T costs of capital in
WACC. Only rd needs adjustment,
because interest is tax deductible.
3
FIN303
Vicentiu Covrig
How are the weights determined?
WACC = wdrd(1 – T) + wprp + wcrs
•
•
•
d is for debt;
s is for common equity and
p is for the preferred stock
4
FIN303
Vicentiu Covrig
Overview of Coleman Technologies

Firm calculating cost of capital for major expansion
program.
- Tax rate = 40%.
- 15-year, 12% coupon, semiannual payment noncallable
bonds sell for $1,153.72. New bonds will be privately
placed with no flotation cost.
- 10%, $100 par value, quarterly dividend, perpetual
preferred stock sells for $111.10.
- Common stock sells for $50. D0 = $4.19 and g = 5%.
- b = 1.2; rRF = 7%; RPM = 6%.
- Bond-Yield Risk Premium = 4%.
- Target capital structure: 30% debt, 10% preferred, 60%
common equity.
5
FIN303
Vicentiu Covrig
Component Cost of Debt
WACC = wdrd(1 – T) + wprp + wcrs
•
•
rd is the marginal cost of debt capital.
•
Why tax-adjust; i.e., why rd(1 – T)?
The yield to maturity on outstanding L-T debt is
often used as a measure of rd.
6
FIN303
Vicentiu Covrig
A 15-year, 12% semiannual coupon bond
sells for $1,153.72. What is the cost of
debt (rd)?

Remember, the bond pays a semiannual
coupon, so rd = 5.0% x 2 = 10%.
INPUTS
30
N
OUTPUT

I/YR
-1153.72
60
1000
PV
PMT
FV
5
Interest is tax deductible, so
A-T rd = B-T rd(1 – T)
= 10%(1 – 0.40) = 6%
7
FIN303
Vicentiu Covrig
Component Cost of Preferred Stock
WACC = wdrd(1 – T) + wprp + wcrs
 rp

is the marginal cost of preferred stock, which is
the return investors require on a firm’s preferred
stock.
Preferred dividends are not tax-deductible, so no
tax adjustments necessary. Just use nominal rp.
8
FIN303
Vicentiu Covrig
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
FIN303
Vicentiu Covrig
Is preferred stock more or less risky to
investors than debt?
More risky; company not required to pay
preferred dividend.
 However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred stockholders
may gain control of firm.

10
FIN303
Vicentiu Covrig
Component Cost of Equity
WACC = wdrd(1 – T) + wprp + wcrs
•
•
rs is the marginal cost of common equity
The rate of return investors require on the firm’s
common equity using new equity is re.
11
FIN303
Vicentiu Covrig
Component cost of equity

WACC = wdrd(1-T) + wc rs
rs is the cost of common equity
CAPM:
ks = kRF + (kM – kRF) β
If the kRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the
cost of common equity based upon the CAPM? 14.2%

DCF:
ks = D1 / P0 + g section 10-5c in the text
^
D1
P

0
[ This formula above is a rearrangement of
ks - g
If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common
equity based upon the DCF approach? 13.8%

12
]
FIN303
Vicentiu Covrig
What factors influence a company’s
composite WACC?
Market conditions.
 The firm’s capital structure and dividend
policy.
 The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.

13
FIN303
Vicentiu Covrig
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.
Next slide illustrates importance of risk-adjusting cost
of capital.
14
FIN303
Vicentiu Covrig
Exam type question
Wyden Brothers has no retained earnings. The company uses the CAPM to
calculate the cost of equity capital. The company’s capital structure consists
of common stock and debt. Which of the following events will reduce the
company’s WACC?
a. A reduction in the market risk premium. *
b. An increase in the company’s credit risk.
c. An increase in the company’s beta.
d. An increase in expected inflation.
15
FIN303
Vicentiu Covrig
Exam type question
Billick Brothers is estimating its WACC. The company has collected the following
information:
Its capital structure consists of 40 percent debt and 60 percent common equity.
The company has 20-year bonds outstanding with a 9 percent annual coupon that
are trading at par.
The company’s tax rate is 40 percent.
The risk-free rate is 5.5 percent.
The market risk premium is 5 percent.
The stock’s beta is 1.4.
What is the company’s WACC?
a. 9.71%
b. 9.66% *
c. 8.31%
d. 11.18%
16
FIN303
Vicentiu Covrig
Learning objectives




Know how to calculate the WACC based on the equity and debt components
Discuss several factors that can affect the composite cost of capital (see slide 8)
Floatation costs and sections 10-5b and 10.6 will NOT be on the exam
Recommended end-of-chapter problems: 10-1,10-3, 10-4 (without floatation),
10-8
17