CHAPTER 9:
THE COST OF
CAPITAL
2
The Cost of Capital:
Chapter Outline:
3

The Purpose of the Cost of Capital

Capital Components

Calculating Component Costs of Capital
Calculating the WACC
Factors that affect the cost of capital
Problem areas in cost of capital



The Purpose of the Cost of Capital:
4

The cost of capital—the average rate paid for the
use of capital.


Primarily used in capital budgeting
Used as the ‘hurdle rate,’ or benchmark for
projects
Compare IRR to this rate
 Discount cash flows at this rate to find NPV


If a project cannot earn above this return, it is not
worthwhile
The Purpose of the Cost of Capital:
5


It is important to estimate the cost of capital as
accurately as possible in order to effectively
manage the firm
Firm’s cost of capital can be viewed as its
required rate of return on projects of average
risk
Required Rate of Return
(Opportunity Cost Rate):
6

The return that must be raised on invested funds to
cover the cost of financing such investments
Capital Components:
7

Components of firm’s capital are:
Debt:
 Borrowed money, either loans or bonds
 Common equity:
 From sale of common shares or from retained earnings
 Preferred shares:
 Cross between debt and common equity

Capital Components:
8


Capital structure is mix of three capital
components
Target Capital Structure
 Mix
of capital components that management considers
optimal and strives to maintain
Basic Definitions:
9

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
 ke = cost of retained earnings
 ks = cost of issuing new stocks

Basic Definitions:
10

WACC:
Weighted Average Cost of Capital

Capital Structure:
A combination of different types of capital(debt
and equity) used by a firm
Flotation costs
11

DEFINITION of 'Flotation Cost' The costs incurred
by the company when it issues new
securities. Flotation costs are paid by the company
that issues the new securities and includes expenses
such as underwriting fees, legal fees and
registration fees.
Flotation costs:
12


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.
After-Tax Cost of Debt:
13

The relevant cost of new debt and Used to
calculate the WACC.

After-tax Cost of Debt =
Befor- tax Cost of Debt * (1 - Tax Rate)

Taking into account the tax deductibility of interest

Cost of Debt:
14
kdT = kd (1-T)
kdT = 10% (1 - 0.40) = 6%
 Use nominal rate.
 Flotation costs are small, so ignore them.
Cost of debt example
15
Cost of debt
16





Nper
Pmt
Pv
Fv
Type
a\
maturity
coupon rate * face value
- Debt * (1- floatation)
face value
0
Cost of Preferred Stock:
17

Rate of return investors require on the firm’s
preferred stock

After tax cost of preferred =
Dividents / ( price *(1-folatation) )

k ps 
D ps
NP

D ps
P0  Flotation costs

D ps
P0 (1  F )
Cost of Preferred Stock:
18
Cost of Retained Earnings:
19

Cost of retained earnings (ks) is the return
stockholders require on the company's common
stock.
Why there is a cost for retained
earnings?
20




Earnings can be reinvested or paid out as dividends.
Investors could buy other securities, earn a return.
If earnings are retained, there is an opportunity cost
(the return that stockholders could earn on alternative
investments of equal risk).
ks is the cost of retained earnings
 Investors
could buy similar stocks and earn ks.
 Firm could repurchase its own stock and earn ks.
Three ways to determine the
cost of retained earnings:
21



The CAPM Approach.
The Discounted Cash Flow Approach.
The Bond-Yield-Plus-Premium Approach.
The CAPM Approach:
22
k s  k RF + ( kM - kRF
)bs
ks = kRF + (kM – kRF) β
= 7.0% + (6.0%)1.2 = 14.2%
The Discounted Cash Flow
Approach:
23

Price and expected rate of return on a share of
common stock depend on the dividends expected
on the stock.
P 
0
D̂
1
1
1 + k 


s

D̂
+
2
1 + k 


s

D̂

t
 
t
t 1

1 + k 
s

2
++
D̂

1 + k 


s


The Discounted Cash Flow
Approach:
24
P 
0
D̂
1
1


1 + k 
s

+
D̂
2

1 + k 

s

2
++
D̂


1 + k 

s


D̂
D̂

t
1
 

if g is constant
t
k g
t 1

s
1 + k 
s

D̂
1
k  k̂ 
+g
s
s
P
0
The Discounted Cash Flow
Approach:
25
ks
= D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%
The Bond-Yield-Plus-Premium
Approach:
26
ks= long-term bond yield + risk premium
ks = kd + RP
ks = 10.0% + 4.0% = 14.0%

k  Bon dyi e l d+ Ri sk pre m i u m
s
 10% + 4%  14%
Cost of Newly Issued
Common Stock:
27

External equity, ke
Based on the cost of retained earnings
 Adjusted for flotation costs (the expenses of
selling new issues)
 ((Dividends / price) *(1-flotation) ) + growth rate

D̂
D̂
1
1
k

+ g 
+ g
s
NP
P 1  F 
0
28
Cost of Newly Issued
Common Stock:
29

The Weighted Average Cost of
Capital—The WACC:
A firm’s WACC is the average of the costs of the separate
sources weighted by the proportion of each source used
WACCfirm 
n
 weight sourcecost source
source  1
To compute a WACC, we need two things: the
mix of the capital components in use and the cost
of each component
Weighted Average Cost of
Capital, WACC:
30

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
Example 15.1: Computing the WACC:
31
Q: Calculate the WACC given the following capital structure.
Capital Component
Example
Debt
Value
$60,000
Cost
6%
Preferred shares
50,000
4
Common shares
90,000
10
$200,000
A: First calculate the capital structure weights. For debt this weight is $60,000 
$200,000 = 30%. Next, multiply each component’s cost by its weight.
Capital Component
Weight
Cost
$60,000
30%
6%
1.8%
Preferred shares
50,000
25%
4
1.0%
Common shares
90,000
45%
10
4.5%
$200,000
100%
Debt
Value
WACC =
7.3%