CHAPTER 13

The Cost of
Sources of capital

Capital
Component costs
WACC
Cost of Capital

The cost of capital represents the overall cost

of financing to the firm
The cost of capital is normally the relevant
discount rate to use in analyzing an
investment
The overall cost of capital is a weighted
average of the various sources, including
debt, preferred stock, and common equity:
WACC = Weighted Average Cost of Capital
WACC = After-tax costs x weights
 What sources of long-term
capital do firms use?
Long-Term Capital

Long-Term Debt Preferred Stock Common Stock

Retained Earnings New Common Stock

 Calculating the weighted
average cost of capital
WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs

The xs refer to the firms capital structure weights.

The ks refer to the cost of each component.
Should our analysis focus on
before-tax or after-tax costs?
Stockholders focus on After-Tax CFs.
Therefore, we should focus on A-Tax
capital costs.
Only cost of debt needs adjustment,
because interest is tax deductible.
Should our analysis focus on historical
costs or new (marginal) costs?
Thecost of capital is used primarily to
make decisions that involve raising new
capital. So, focus on todays marginal
costs (for WACC).
 How are the weights
determined?
WACC = xd(pretax kd)(1-Tax rate) + xpkp + xcskcs

As a percentage of total financing

Weighting example
Bonds 40
Pref. Stock 100
Common 100
Ret. Earn. 160
Total L & E 400
What is weight of each component?
Weighting example
Bonds 40
Pref. Stock 100
Common 100
Ret. Earn. 160
Total L & E 400

Bonds = 40/400 = 10%

Pref. Stock = 100/400 = 25%
 Component cost of debt
WACC = xd(pretax kd)(1-T) + xpkp + xcskcs

kdis the marginal cost of debt capital.

The yield to maturity on outstanding L-T debt is often
used as a measure of kd.
Why tax-adjust, i.e. why kd(1-Tax rate)?
If tax rate is 40% then
10% before tax = 6% after tax

Sales 1,000 1,000

Interest 100* 0

EBT 900 1,000

Tax 40% 360 400
EAT 540 600 60 difference
Component cost of debt
Interestis tax deductible, so
aftertax kd = pretax kd (1-T)
= 10% (1 - 0.40) = 6%

T = tax rate = 40%

Cost of debt
What is the current cost of debt for a firm
that has a 9% coupon bond with 5 years
to maturity and a current price of $962?
What is the after tax cost if it is in the 40%
tax bracket?
Component cost of
preferred stock
WACC = xdkd(1-T) + xpkp + xcskcs

kpis the marginal cost of preferred stock.

The rate of return investors require on the firms
preferred stock.
What is the cost of
preferred stock?
Thecost of preferred stock can be solved
by using this formula:

kp = Dp / Pp

= $8 / $111
= 7.2%
Component cost of
preferred stock
Preferred
dividends are not
tax-deductible, so no tax adjustments
necessary.
 Component cost of equity
WACC = xd(pretax kd)(1-T) + xpkp + xcskcs

kcs is the marginal cost of common equity

 Why is there a cost for
retained earnings?
Earnings can be reinvested or paid out as
dividends.
Investors could buy other securities, earn a
return.
If earnings are retained, there is an
opportunity cost (the return that
stockholders could earn on alternative
investments of equal risk).
Investors could buy similar stocks and earn kcs.
Firm could repurchase its own stock and earn kcs.
Therefore, kcs is the cost of retained earnings.
 Two ways to determine the
cost of common equity, kcs
1. CAPM: kcs = RRF + x (Mkt. risk premium [E(RM) RRF])

RRF =Risk Free Rate (now around 2.7%)

RM = Return on the market
= Beta - the relation of its returns with that of the
stock market e.g.
0 not correlated
1 - moves with the market
2 twice as volatile
Two ways to determine the
cost of common equity, kcs
2. DCF: P0 = (D1 / r - g)

r = kcs

kcs = (D1 / P0)+ g

If the market premium is 6%, risk-free rate is
2.7% and the firms beta is 1.48, whats the
cost of common equity based upon the
CAPM?

kcs = RRF + (mkt premium)

= 2.7% + 1.48(6.0%) = 11.58%
If D0 = $1.72, P0 = $43, and g = 5%, whats
the cost of common equity based upon
the DCF approach?
D1 = D0 (1+g)
D1 = $1.72 (1 + .05)
D1 = $1.81

kcs = (D1 / P0)+ g

= ($1.81 / $43) + 0.05
= 9.2%
What is a reasonable final
estimate of kcs?
Method Estimate
CAPM 11.58%
DCF 9.2%

Average 10.4%
Calculate WACC
If 40% of your financing is from debt at an
after tax cost of 8% and 60% is from pref.
stock at 10%, what is the WACC?
It will be between what two numbers?
 40% (.08) + 60% (.10)
.032 + .06 = .092
9.2%
 Balance Sheet
use costs that were just calculated

Market values

Cash 5,000 LT Debt 3,000

Equipment 5,000 Pref. Stock 1,000

Stock 6,000

Tot. Assets 10,000 Tot. Debt & Eq. 10,000

 Ignoring issuance costs, what is
the firms WACC?
WACC = xd(pretax kd)(1-Tax) + xpkp + xcskcs

= .3(10%)(0.6) + .1(7.2%) + .6(10.4%)

= 1.8% + 0.72% + 6.2%

= 8.7%
WACC
You are analyzing the cost of capital for a
firm that is financed with 60 percent
equity and 40 percent debt. The after-tax
cost of debt capital is 10 percent, while
the cost of equity capital is 20 percent for
the firm. What is the overall cost of capital
for the firm?
(.6 x .2) + (.4 x .1) = 16%
Equity + Debt
 Cardinal Health has bonds outstanding
with 15 years to maturity and are currently
priced at $800. If the bonds have a
coupon rate of 8.5 percent, then what is
the after-tax cost of debt for Beckham if
its marginal tax rate is 30%?
7.9%
Should the company use the
composite WACC as the hurdle rate
for each of its projects?
NO! The composite WACC reflects the
risk of an average project undertaken
by the firm. Therefore, the WACC only
represents the hurdle rate for a typical
project with average risk.
Different projects have different risks.
The projects WACC should be adjusted
to reflect the projects risk.
Optimum Capital Structure
Theoptimal (best) situation is associated with the
minimum overall cost of capital:
Optimum capital structure means the lowest WACC
Usually occurs with 30-50% debt in a firms capital
structure
WACC is also referred to as the required rate of
return or the discount rate
 Optimal Capital Structure
Cost (After-tax) Weights Weighted
Cost
Financial Plan A:
Debt 6.5% 20% 1.3%
Equity. 12.0 80 9.6
10.9%
Financial Plan B:
Debt 7.0% 40% 2.8%
Equity. 12.5 60 7.5
10.3%
Financial Plan C:
Debt 9.0% 60% 5.4%
Equity. 15.0 40 6.0
11.4%
Cost of capital curve