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The Cost of Capital: Timothy R. Mayes, Ph.D. FIN 3300: Chapter 11
The Cost of Capital: Timothy R. Mayes, Ph.D. FIN 3300: Chapter 11
(
(
(
(
+
+
1
1
1
1
We cannot solve this equation directly for k
d
, so we
must use an iterative trial and error procedure (or,
use a calculator)
Note that k
d
is not the appropriate cost of debt to use
in calculating the WACC, instead we should use the
after-tax cost of debt
16
The After-tax Cost of Debt
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:
( )
After tax k Before tax k t
d d
= 1
17
The Cost of Preferred Equity
As with debt, we calculate the cost of preferred
equity by solving the valuation equation for k
P
:
k
D
V
P
P
=
Note that preferred dividends are not tax-deductible,
so there is no tax adjustment for the cost of preferred
equity
18
The Cost of Common Equity
Again, to find the cost of common equity we simply
solve the valuation equation for k
CS
:
( )
k
D g
V
g
D
V
g
CS
CS CS
=
+
+ = +
0
1
1
Note that common dividends are not tax-deductible,
so there is no tax adjustment for the cost of common
equity
19
Flotation Costs
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 costs, and
recalculating the cost of capital
20
The Cost of Debt with Flotation Costs
Simply subtract the flotation costs (F) from the price
of the bonds, and calculate the cost of debt as usual:
( )
( )
( )
V F Pmt
k
k
FV
k
B
d
N
d
d
N
=
+
(
(
(
(
+
+
1
1
1
1
Note that we still must adjust this calculation for
taxes
21
The Cost of Preferred with Flotation Costs
Simply subtract the flotation costs (F) from the price
of preferred, and calculate the cost of preferred as
usual:
( )
k
D
V F
P
P
=
22
The Cost of Common Equity with Flotation Costs
Simply subtract the flotation costs (F) from the price
of common, and calculate the cost of common as
usual:
( )
( ) ( )
k
D g
V F
g
D
V F
g
CS
CS CS
=
+
+ =
+
0
1
1
23
A Note on Flotation Costs
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
24
The Cost of Retained Earnings
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:
( )
k
D g
V
g
D
V
g
RE
CS CS
=
+
+ = +
0
1
1