Chapter 9:

The Cost of Capital

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The Cost of Capital:

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Chapter Outline:

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

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The Purpose of the Cost of Capital:

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 projectsCompare IRR to this rateDiscount cash flows at this rate to find NPV

If a project cannot earn above this return, it is not worthwhile

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The Purpose of the Cost of Capital:

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

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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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Capital Components:

Components of firm’s capital are:Debt:

Borrowed money, either loans or bondsCommon equity:

From sale of common shares or from retained earnings

Preferred shares:Cross between debt and common equity

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Capital Components:

Capital structure is mix of three capital components

Target Capital StructureMix of capital components that management

considers optimal and strives to maintain

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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

ke = cost of retained earnings

ks = cost of issuing new stocks

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Basic Definitions:

WACC: Weighted Average Cost of Capital

Capital Structure:A 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 debtTaking into account the tax deductibility of

interestUsed to calculate the WACC

kdT = bondholders’ required rate of return minus tax savings

kdT = kd(1-T).

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Cost of Debt:

Interest is tax deductible, so

kdT = kd (1-T)

= 10% (1 - 0.40) = 6%Use nominal rate.Flotation costs are small, so ignore them.

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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

)F1(P

D

costs FlotationP

D

NP

Dk

0

ps

0

pspsps

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Cost of Preferred Stock:

The cost of preferred stock can be solved by using this formula:

kp = Dp / Pp

= $10 / $111.10

= 9%

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sk̂ g

0P

1D̂

RP RF

ks

k

Cost of Retained Earnings:

Rate of return investors require on the firm’s common stock

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Why there is a cost for retained earnings?

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).Investors could buy similar stocks and earn ks.Firm could repurchase its own stock and earn ks.Therefore, ks is the cost of retained earnings.

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Three ways to determine the cost of common equity:

The CAPM Approach. The Discounted Cash Flow Approach. The Bond-Yield-Plus-Premium Approach.

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The CAPM Approach:

sRFk- Mk

RFk

sk ( )

ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2%

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1t t

sk1

tD̂

sk1

D̂

2

sk1

2D̂

1

sk1

1D̂

0P

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.

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constant is g if g

sk

1D̂

1t t

sk1

tD̂

sk1

D̂

sk1

D̂

sk1

D̂P

2

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10

g

0P

1D̂

sk̂

sk

The Discounted Cash Flow Approach:

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The Discounted Cash Flow Approach:

ks = D1 / P0 + g

= $4.3995 / $50 + 0.05

= 13.8%

2214% 4% 10%

premium Risk yield Bond s

k

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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The Bond-Yield-Plus-Premium Approach:

ks = kd + RP

ks = 10.0% + 4.0% = 14.0%

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gF

0P

1D̂

gNP

1D̂

sk

1

Cost of Newly Issued Common Stock:

External equity, ke

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

selling new issues)

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Flotation costs:

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.

We will frequently ignore flotation costs when calculating the WACC.

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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

n

firm sourcesourcesource 1

WACC weight cost

To compute a WACC, we need two things: the mix of the capital components in use and the

cost of each component

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sspspsdTd k

w

k

w

k

w

equitycommon

of Cost

equitycommon of

Proportion

stockpreferred

of Cost

stockpreferred of

Proportion

debt of cost

tax-After

debtof

Proportion

Weighted Average Cost of Capital, WACC:

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

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Example 15.1: Computing the WACC:

Q: Calculate the WACC given the following capital structure.

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.

$200,000

1090,000Common shares

450,000Preferred shares

6%$60,000Debt

CostValueCapital Component

WACC =

10

4

6%

Cost

100%

45%

25%

30%

Weight

7.3%$200,000

4.5%90,000Common shares

1.0%50,000Preferred shares

1.8%$60,000Debt

ValueCapital Component

Exa

mpl

e

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Factors influence a company’s composite WACC:

The Level of Interest Rates. Tax Rate.The firm’s capital structure policy. Dividend policy.The firm’s investment policy.

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Problem areas in cost of capital:

Depreciation-generated fundsPrivately owned firmsMeasurement problemsAdjusting costs of capital for different

riskCapital structure weights

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