The Cost of Capital

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 11

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
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)

2
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. 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?

3
RMM Example (cont.)

Because the current capital structure is optimal, the

firm will raise funds as follows:

4
 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.

5
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:

6
Calculating RMMs WACC

Using the numbers from the RMM example, we

can calculate RMMs Weighted-Average Cost of
Capital (WACC) as follows:

WACC 0.40(0.07) 010 . ) 0.50(012

. (010 . ) 0.098

Note that this is the same as we found earlier

7
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

8
Book-value Weights

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