9-1

CHAPTER 9
The Cost of Capital
Sources of capital
Component costs
WACC
9-2
What sources of long-term
capital do firms use?
Long-Term Capital
Long-Term Debt Preferred Stock Common Stock
Retained Earnings New Common Stock
9-3
Calculating the weighted
average cost of capital
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
s
k
s


The ws refer to the firms capital
structure weights.
The ks refer to the cost of each
component.
9-4
Should our analysis focus on
before-tax or after-tax capital costs?
Stockholders focus on A-T CFs.
Therefore, we should focus on A-T
capital costs, i.e. use A-T costs of
capital in WACC. Only k
d
needs
adjustment, because interest is tax
deductible.
9-5
Should our analysis focus on
historical (embedded) costs or new
(marginal) costs?
The cost of capital is used primarily to
make decisions that involve raising new
capital. So, focus on todays marginal
costs (for WACC).
9-6
Component cost of debt
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


k
d
is the marginal cost of debt capital.
The yield to maturity on outstanding
L-T debt is often used as a measure
of k
d
.
Why tax-adjust, i.e. why k
d
(1-T)?
9-7
Biaya modal utang (cost of debt)
Biaya modal utang (kd) dapat dihitung dengan rumus:

n It + Pt
Po = ------------------
t=1 (1 + kd )t

Po = harga jual surat utang pada saat diterbitkan
n = jangka waktu jatuh tempo
It = besarnya bunga yang dibayarkan pada periode t
Pt = Nilai pelunasan pokok utang pada periode t
kd = biaya modal utang sebelum pajak

kd* = kd ( 1 t )
kd* = biaya modal utang setelah pajak


9-8
A 15-year, 12% semiannual coupon
bond sells for $1,153.72. What is
the cost of debt (k
d
)?
Remember, the bond pays a semiannual
coupon, so k
d
= 5.0% x 2 = 10%.
INPUTS
OUTPUT
N I/YR PMT PV FV
30
5
60 1000
-1153.72
9-9
Component cost of preferred
stock
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


k
p
is the marginal cost of preferred
stock.
The rate of return investors require on
the firms preferred stock.
9-10
What is the cost of preferred
stock?
The cost of preferred stock can be
solved by using this formula:

k
p
= D
p
/ P
p

= $10 / $111.10
= 9%
9-11
Component cost of preferred
stock
Preferred dividends are not tax-
deductible, so no tax adjustments
necessary. Just use k
p
.
Nominal k
p
is used.
Our calculation ignores possible
flotation costs.
9-12
Is preferred stock more or less
risky to investors than debt?
More risky; company not required to
pay preferred dividend.
However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred
stockholders may gain control of firm.
9-13
Component cost of equity
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


k
s
is the marginal cost of common
equity using retained earnings.
The rate of return investors require on
the firms common equity using new
equity is k
e
.
9-14
Three ways to determine the
cost of common equity, k
s

CAPM: k
s
= k
RF
+ (k
M
k
RF
)

DCF: k
s
= D
1
/ P
0
+ g

Own-Bond-Yield-Plus-Risk Premium:
k
s
= k
d
+ RP
9-15
If the k
RF
= 7%, RP
M
= 6%, and the
firms beta is 1.2, whats the cost of
common equity based upon the CAPM?

k
s
= k
RF
+ (k
M
k
RF
)
= 7.0% + (6.0%)1.2 = 14.2%
9-16
If D
0
= $4.19, P
0
= $50, and g = 5%,
whats the cost of common equity based
upon the DCF approach?
D
1
= D
0
(1+g)
D
1
= $4.19 (1 + .05)
D
1
= $4.3995

k
s
= D
1
/ P
0
+ g
= ($4.3995 / $50) + 0.05
= 13.8%
9-17
If k
d
= 10% and RP = 4%, what is k
s

using the own-bond-yield-plus-risk-
premium method?
This RP is not the same as the CAPM
RP
M
.
This method produces a ballpark
estimate of k
s
, and can serve as a
useful check.

k
s
= k
d
+ RP
k
s
= 10.0% + 4.0% = 14.0%
9-18
What is a reasonable final
estimate of k
s
?
Method Estimate
CAPM 14.2%
DCF 13.8%
k
d
+ RP 14.0%
Average 14.0%
9-19
Ignoring floatation costs, what is
the firms WACC?
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%

9-20
What factors influence a
companys composite WACC?
Market conditions.
The firms capital structure and
dividend policy.
The firms investment policy. Firms
with riskier projects generally have a
higher WACC.