Chapter 11The Cost of Capital

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Learning OutcomesChapter 11

Compute the component cost of capital for (a) debt, (b) preferred stock, (c) retained earnings, and (d) new common equity.

Describe the weighted average cost of capital (WACC) and discuss the logic of using WACC to make informed financial decisions.

Describe how the marginal cost of capital (MCC) is used to make capital budgeting decisions.

Discuss the relationship between the firm’s weighted average cost of capital (WACC) and investor’s’ required rates of return.

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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

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Required Rate of Return(Opportunity Cost Rate)

The return that must be raised on invested funds to cover the cost of financing such investments

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Basic Definitions Capital Component

Types of capital used by firms to raise money• rd = before tax interest cost• rdT = rd(1-T) = after tax cost of debt• rps = cost of preferred stock• rs = cost of retained earnings• re = cost of external equity (new

stock)

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Basic Definitions WACC

Weighted Average Cost of Capital

Capital StructureA combination of different types of capital(debt and equity) used by a firm

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After-Tax Cost of Debt The relevant cost of new debt Taking into account the tax deductibility

of interest Used to calculate the WACC

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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

F = percentage flotation costs as a decimalNP0 = per share net proceeds firm receives from the issue

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Cost of Retained Earnings Rate of return investors require on the

firm’s common stock

rs = required rate of return RPs = risk premium for Stock S= expected rate of return g = constant growth rate

rRF = risk-free rate of return P0 = current stock price= next period’s expected dividend

sr

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The CAPM Approach

rs = cost of retained earningsrRF = risk-free rate of returnrM = risk-free rate of returnRPs = risk premium for Stock Sβs = beta coefficient for Stock S

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The Discounted Cash Flow Approach(Expected Rate of Return)

Price and expected rate of return on a share of common stock depends on the dividends expected on the stock.

rs = cost of retained earnings P0 = current stock price= expected rate of return g = constant growth rate= next period’s expected dividend

sr

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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

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Cost of Newly Issued Common Stock External equity, re

Based on the cost of retained earningsAdjusted for flotation costs (the expenses of selling

new issues)

re = cost of new equityg = constant growth rate

= next period’s expected dividend F = percentage flotation cost stated as a decimalP0 = current stock price

1D

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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

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Weighted Average Cost of Capital, WACC

A weighted average of the component costs of debt, preferred stock, and common equity

wd = proportion of debt in firm’s capital structurewps = proportion of preferred stock in firm’s capital structurews = proportion of common stock in firm’s capital structure

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The Logic of the Weighted Average Cost of Capital

The use of debt impacts 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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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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MCC Schedule for Unilate Textiles

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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

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MCC Schedule Using Retained Earnings, New Common Stock and Higher-Cost Debt

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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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Combining the MCC and Investment Opportunity Schedules