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**The Cost of Capital
**

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 11

2

What is the “Cost” of Capital?

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 firm’s 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)

3

The Appropriate Hurdle Rate: An Example

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. RMM’s 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, RMM’s managers must determine

the appropriate require rate of return. What minimum rate of

return will simultaneously satisfy all of the firm’s capital

providers?

4

RMM Example (cont.)

Source of

Funds

Amount Dollar

Cost

After-tax

Cost

Debt $4,000 $280 7%

Preferred $1,000 $100 10%

Common $5,000 $600 12%

Total $10,000 $980 9.8%

Because the current capital structure is optimal, the

firm will raise funds as follows:

5

RMM Example (Cont.)

Rate of Return 8% 9.8% 11%

Total Funds Available $10,800 $10,980 $11,100

Less: Debt Costs $4,280 $4,280 $4,280

Less: Preferred Costs $1,100 $1,100 $1,100

= Remainder to Common $5,420 $5,600 $5,720

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.

6

The Weighted Average Cost of Capital

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:

WACC w k w k w k

d d p p cs cs

= + +

7

Calculating RMM’s WACC

Using the numbers from the RMM example, we can

calculate RMM’s Weighted-Average Cost of Capital

(WACC) as follows:

Note that this is the same as we found earlier

WACC = + + = 040 007 010 010 050 012 0098 . ( . ) . ( . ) . ( . ) .

8

Finding the Weights

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

9

Book-value Weights

One potential source of these weights is the firm’s

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

10

Book-value Weights (cont.)

Source Total Book Value % of Total

Long-term Debt $400,000 40%

Preferred Equity $100,000 10%

Common Equity $500,000 50%

Grand Totals $1,000,000 100%

The following table shows the calculation of the

book-value weights for RMM:

11

Market-value Weights

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

12

Calculating the Market-value Weights

Source Price per

Unit

Units Total Market

Value

% of

Total

Debt $ 905 400 $362,000 31.15%

Preferred $ 100 1,000 $100,000 8.61%

Common $ 70 10,000 $700,000 60.24%

Totals $1,162,000 100.00%

The following table shows the current market prices:

( ) ( ) ( )

WACC = + + = = 0 3115 0 07 0 0861 010 0 6024 012 01027 10 27% . . . . . . . .

13

Market vs Book Values

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

14

The Costs of Capital

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

15

The Cost of Debt

Recall that the formula for valuing bonds is:

( )

( )

V Pmt

k

k

FV

k

B

d

N

d

d

N

=

÷

+

¸

(

¸

(

(

(

(

+

+

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 company’s 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

**What is the “Cost” of Capital?
**

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 firm’s 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)

2

What minimum rate of return will simultaneously satisfy all of the firm’s capital providers? 3 .000. so any new funds will need to be raised in the same proportions. Before making the decision. RMM’s capital structure is currently made up of 40% debt. RMM’s managers must determine the appropriate require rate of return. 10% preferred stock. This capital structure is considered to be optimal.The Appropriate Hurdle Rate: An Example 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. and 50% common equity.

) Because the current capital structure is optimal.000 $1.000 Dollar Cost $280 $100 $600 $980 After-tax Cost 7% 10% 12% 9.8% 4 .000 $10.000 $5. the firm will raise funds as follows: Source of Funds Debt Preferred Common Total Amount $4.RMM Example (cont.

RMM Example (Cont.280 $4.600 Obviously. and the common shareholders will not be satisfied.8% 11% $11. the firm must earn at least 9.800 $10. Any less.) The following table shows three possible scenarios: Rate of Return Total Funds Available Less: Debt Costs Less: Preferred Costs = Remainder to Common 8% 9.100 $5.8%.100 $5. 5 .280 $1.100 $4.420 $5.100 $1.720 $10.980 $4.280 $1.

10% should go to preferred shareholders. Therefore. Similarly. and 50% to common shareholders This is a weighted-average. 40% of the required return must go to satisfy the debtholders.The Weighted Average Cost of Capital We now need a general way to determine the minimum required return Recall that 40% of funds were from debt. which can be calculated as: WACC w d k d w p k p w cs k cs 6 .

. .098 .40(0.07) 010(010) 050(012) 0. Note that this is the same as we found earlier 7 . we can calculate RMM’s Weighted-Average Cost of Capital (WACC) as follows: WACC 0.Calculating RMM’s WACC Using the numbers from the RMM example. .

the obvious question is: “where do the weights come from?” There are two possibilities: • Book-value weights • Market-value weights 8 .Finding the Weights The weights that we use to calculate the WACC will obviously affect the result Therefore.

since it lists the total amount of longterm debt. preferred equity.Book-value Weights One potential source of these weights is the firm’s balance sheet. and common equity We can calculate the weights by simply determining the proportion that each source of capital is of the total capital 9 .

) The following table shows the calculation of the book-value weights for RMM: Source Long-term Debt Preferred Equity Common Equity Grand Totals Total Book Value $400.000 % of Total 40% 10% 50% 100% 10 .000 $100.Book-value Weights (cont.000 $1.000 $500.000.

not current. 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 11 . Therefore.Market-value Weights The problem with book-value weights is that the book values are historical. values The market recalculates the values of each type of capital on a continuous basis.

60240.162.000 60.61% $ 70 10.000 $700.000 8.Calculating the Market-value Weights The following table shows the current market prices: Source Debt Preferred Common Totals Price per Units Total Market % of Unit Value Total $ 905 400 $362.000 100.07 0.0861010 0.27% .31150.15% $ 100 1. 12 .12 01027 10.24% $1. .00% WACC 0.000 31.000 $100.

note that RMM should use the 10.Market vs Book Values 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 marketvalues represent the current amount of securities outstanding For some companies.27 WACC in its decision making process 13 . the difference can be much more dramatic than for RMM Finally.

we simply solve the valuation equations for the required rates of return 14 . we must determine the individual costs of capital To do this.The Costs of Capital 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.

The Cost of Debt Recall that the formula for valuing bonds is: 1 1 N 1 k d FV VB Pmt N kd 1 k d We cannot solve this equation directly for kd. use a calculator) Note that kd is not the appropriate cost of debt to use in calculating the WACC. so we must use an iterative trial and error procedure (or. instead we should use the after-tax cost of debt 15 .

the actual cost is less than the expense As an example.The After-tax Cost of Debt Recall that interest expense is tax deductible Therefore. The formula is: After tax k d Before tax k d 1 t 16 . when a company pays interest. consider a company in the 34% marginal tax bracket that pays $100 in interest The company’s after-tax cost is only $66.

The Cost of Preferred Equity As with debt. so there is no tax adjustment for the cost of preferred equity 17 . we calculate the cost of preferred equity by solving the valuation equation for kP: D kP VP Note that preferred dividends are not tax-deductible.

to find the cost of common equity we simply solve the valuation equation for kCS: k CS D 0 1 g VCS D1 g g VCS Note that common dividends are not tax-deductible. so there is no tax adjustment for the cost of common equity 18 .The Cost of Common Equity Again.

we do this by reducing the proceeds from the issue by the amount of the flotation costs.” and they must be accounted for in the WACC Generally. including: • Setting the price of the issue. and recalculating the cost of capital 19 . and • Selling the issue to the public The cost of these services are referred to as “flotation costs. it must use the services of an investment banker The investment banker provides a number of services for the firm.Flotation Costs When a company sells securities to the public.

and calculate the cost of debt as usual: 1 1 N 1 k d FV VB F Pmt N kd 1 kd Note that we still must adjust this calculation for taxes 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 preferred as usual: D kP VP F 21 .The Cost of Preferred with Flotation Costs Simply subtract the flotation costs (F) from the price of preferred.

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 CS D1 g g VCS F VCS F D 0 1 g 22 .

or as a percentage of the selling price 23 . flotation costs can be as high as 25% for small issues. but they may be given as a dollar amount.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. for larger issue they will be much lower Note that flotation costs will always be given.

the cost of retained earnings is exactly the same as the cost of new common equity.e.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. there is an opportunity cost) Therefore.. except that there are no flotation costs: k RE D 0 1 g VCS D1 g g VCS 24 .

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