The Cost of Capital

Timothy R. Mayes, Ph.D. FIN 3300: Chapter 11

What is the Cost of Capital?

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When we talk about the cost of capital, we are talking about the required rate of return on invested funds It is also referred to as a hurdle rate because this is the minimum acceptable rate of return Any investment which does not cover the firms cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth)

The Appropriate Hurdle Rate: An Example

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The managers of Rocky Mountain Motors are considering the purchase of a new tract of land which will be held for one year. The purchase price of the land is $10,000. RMMs capital structure is currently made up of 40% debt, 10% preferred stock, and 50% common equity. This capital structure is considered to be optimal, so any new funds will need to be raised in the same proportions. Before making the decision, RMMs managers must determine the appropriate require rate of return. What minimum rate of return will simultaneously satisfy all of the firms capital providers?

RMM Example (cont.)

Because the current capital structure is optimal, the firm will raise funds as follows:

RMM Example (Cont.)

The following table shows three possible scenarios:

Obviously, the firm must earn at least 9.8%. Any less, and the common shareholders will not be satisfied.

The Weighted Average Cost of Capital

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We now need a general way to determine the minimum required return Recall that 40% of funds were from debt. Therefore, 40% of the required return must go to satisfy the debtholders. Similarly, 10% should go to preferred shareholders, and 50% to common shareholders This is a weighted-average, which can be calculated as:

Calculating RMMs WACC

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Using the numbers from the RMM example, we can calculate RMMs Weighted-Average Cost of Capital (WACC) as follows:
WACC = 0.40(0.07 ) + 0.10(010) + 0.50(012 ) = 0.098 . .

Note that this is the same as we found earlier

Finding the Weights

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The weights that we use to calculate the WACC will obviously affect the result Therefore, the obvious question is: where do the weights come from? There are two possibilities:
Book-value weights Market-value weights

Book-value Weights
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One potential source of these weights is the firms balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

Book-value Weights (cont.)

The following table shows the calculation of the book-value weights for RMM:

Market-value Weights
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The problem with book-value weights is that the book values are historical, not current, values The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate Calculation of market-value weights is very similar to the calculation of the book-value weights The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital

Calculating the Market-value Weights

The following table shows the current market prices:

Market vs Book Values

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It is important to note that market-values is always preferred over book-value The reason is that book-values represent the historical amount of securities sold, whereas market-values represent the current amount of securities outstanding For some companies, the difference can be much more dramatic than for RMM Finally, note that RMM should use the 10.27 WACC in its decision making process

The Costs of Capital

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As we have seen, a given firm may have more than one provider of capital, each with its own required return In addition to determining the weights in the calculation of the WACC, we must determine the individual costs of capital To do this, we simply solve the valuation equations for the required rates of return

The Cost of Debt

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Recall that the formula for valuing bonds is:

We cannot solve this equation directly for kd, so we must use an iterative trial and error procedure (or, use a calculator) Note that kd is not the appropriate cost of debt to use in calculating the WACC, instead we should use the after-tax cost of debt

The After-tax Cost of Debt

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Recall that interest expense is tax deductible Therefore, when a company pays interest, the actual cost is less than the expense As an example, consider a company in the 34% marginal tax bracket that pays $100 in interest The companys after-tax cost is only $66. The formula is:

The Cost of Preferred Equity

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As with debt, we calculate the cost of preferred equity by solving the valuation equation for kP:

Note that preferred dividends are not taxdeductible, so there is no tax adjustment for the cost of preferred equity

The Cost of Common Equity

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Again, to find the cost of common equity we simply solve the valuation equation for kCS:

Note that common dividends are not taxdeductible, so there is no tax adjustment for the cost of common equity

Flotation Costs
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When a company sells securities to the public, it must use the services of an investment banker The investment banker provides a number of services for the firm, including:
Setting the price of the issue, and Selling the issue to the public

The cost of these services are referred to as flotation costs, and they must be accounted for in the WACC Generally, we do this by reducing the proceeds from the issue by the amount of the flotation

The Cost of Debt with Flotation Costs

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Simply subtract the flotation costs (F) from the price of the bonds, and calculate the cost of debt as usual:

Note that we still must adjust this calculation for taxes

The Cost of Preferred with Flotation Costs

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Simply subtract the flotation costs (F) from the price of preferred, and calculate the cost of preferred as usual:

The Cost of Common Equity with Flotation Costs

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Simply subtract the flotation costs (F) from the price of common, and calculate the cost of common as usual:

A Note on Flotation Costs

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The amount of flotation costs are generally quite low for debt and preferred stock (often 1% or less of the face value) For common stock, flotation costs can be as high as 25% for small issues, for larger issue they will be much lower Note that flotation costs will always be given, but they may be given as a dollar amount, or as a percentage of the selling price

The Cost of Retained Earnings

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The firm may choose to finance new projects using only internally generated funds (retained earnings) These funds are not free because they belong to the common shareholders (i.e., there is an opportunity cost) Therefore, the cost of retained earnings is exactly the same as the cost of new common equity, except that there are no flotation costs: