Principles of Managerial Finance: Fifteenth Edition, Global Edition

Principles of Managerial Finance
Fifteenth Edition, Global Edition
Chapter 9
The Cost of Capital
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Learning Goals (1 of 2)
LG 1 Understand the basic concept of the cost of capital.
LG 2 List the primary sources of capital available to firms.
LG 3 Determine the cost of long-term debt, and explain why
the after-tax cost of debt is the relevant cost of debt.
LG 4 Determine the cost of preferred stock.

Learning Goals (2 of 2)
LG 5 Calculate the required return on a company’s common
stock, and explain how it relates to the cost of retained
earnings and the cost of new issues of common stock.
LG 6 Calculate the weighted average cost of capital
(WACC), and discuss alternative weighting schemes.

9.1 Overview of the Cost of Capital (1 of 3)
• Cost of Capital
– Represents the firm’s cost of financing and is the minimum
rate of return that a project must earn to increase the firm’s
value
• The Basic Concept
– Capital
 A firm’s long-term sources of financing, which include both
debt and equity
– Capital Structure
 The mix of debt and equity financing that a firm employs

• The Basic Concept
– Weighted Average Cost of Capital (WACC)
 A weighted average of a firm’s cost of debt and equity
financing, where the weights reflect the percentage of each
type of financing used by the firm

Table 9.1 Capital Structures of Well-
Known Companies in 2017
Value of Value of
Outstanding Debt Outstanding Total Capital
Company ($ billions) % Debt Equity ($ billions) % Equity ($ billions)
Alphabet $ 3.9 1% $ 643.5 99% $ 647.40
Johnson & Johnson 23.5 6 341.6 94 365.10
Procter & Gamble 30.5 12 220.4 88 250.90
Dow Chemical 19.3 20 75.0 80 94.30
General Electric 250.2 51 244.3 49 494.50
General Motors 55.0 53 49.6 47 104.60

Example 9.1 (1 of 3)
A firm is currently considering two investment opportunities. Two
financial analysts, working independently of each other, are
evaluating these opportunities. Assume the following information
about investments A and B.
Investment A
Cost $100,000
Life 20 years
Expected Return 7%
The analyst studying this investment recalls that the company

recently issued bonds paying a 6% rate of return. He reasons that
because the investment project earns 7% while the firm can issue
debt at 6%, the project must be worth doing, so he recommends
that the company undertake this investment.
Investment B
Cost $100,000
Life 20 years
Expected Return 12%
The analyst assigned to this project knows that the firm has
common stock outstanding and that investors who hold the
company’s stock expect a 14% return on their investment.
The analyst decides that the firm should not undertake this
investment because it produces only a 12% return while the
company’s shareholders expect a 14% return.
In this example, each analyst is making a mistake by
focusing on one source of financing rather than on the
overall financing mix. What if instead the analysts used a
combined cost of financing? By weighting the cost of each
source of financing by its relative proportion in the firm’s
capital structure, the firm can obtain a weighted average cost
of capital (WACC). Assuming this firm desires a 50–50 mix of
debt and equity, the WACC is 10% [(0.50 × 6% debt) + (0.50
× 14% equity)]. With this average cost of financing, the firm
should reject the first opportunity (7% expected return < 10%
WACC) and accept the second (12% expected return > 10%
WACC).

• Sources of Long-Term Capital
– Long-term capital for firms derives from four basic sources:
long-term debt, preferred stock, common stock, and
retained earnings
– Not every firm will use all of these financing sources

9.2 Cost of Long-Term Debt (1 of 4)
• Cost of Long-Term Debt
– The financing cost associated with new funds raised through
long-term borrowing
• Net Proceeds
– Net Proceeds
 The funds actually received by the firm from the sale of a
security
– Flotation Costs
 The total costs of issuing and selling a security

Example 9.2
Duchess Corporation, a major hardware manufacturer, is
contemplating selling $10 million worth of 20-year, 6%
coupon bonds, each with a par value of $1,000. Because
bonds with similar risk earn returns equal to 6%, Duchess’s
bonds will sell in the market at par value, and they will have
a yield to maturity (YTM) equal to the coupon rate, 6%.
However, Duchess will incur flotation costs equal to 2% of
the par value of the bond (0.02 × $1,000), or $20. The net
proceeds to the firm from the sale of each bond are therefore
$980.

• Before-Tax Cost of Debt
– The before-tax cost of debt, rd, is simply the rate of return
the firm must pay on new borrowing
– Using Market Quotations
 A relatively quick method for finding the before-tax cost of debt
is to observe the yield to maturity (YTM) on the firm’s existing
bonds or bonds of similar risk issued by other companies
– Calculating the Cost
 Managers can calculate the cost of debt associated with a
particular bond issue by calculating the bond’s YTM

In the preceding example, Duchess receives proceeds of
$980 by issuing a 20-year bond with a $1,000 par value and
6% coupon interest rate. To calculate the before-tax cost of
debt, begin by writing down the cash flows associated with
this bond issue. The cash flow pattern consists of an initial
inflow (the net proceeds) followed by a series of annual
outflows (the interest payments). In the final year, when the
debt is retired, an outflow representing the repayment of the
principal also occurs. The cash flows associated with
Duchess Corporation’s bond issue are as follows:

End of year(s) Cash flow
0 $980
1–20 −60
20 −1,000
Duchess can determine the before-tax cost of debt by finding the
YTM, which is the discount rate that equates the present value of
the bond outflows to the initial inflow.
Calculator use (Note: Most calculators require
either the present value [net proceeds] or the future
value [annual interest payments and repayment of
principal] to be input as negative numbers when we
calculate yield to maturity. That approach is used
here.) Using the calculator and the inputs shown at
the left, you should find the before-tax cost of debt
(yield to maturity) to be 6.177%.
Spreadsheet use The before-tax cost of debt on the
Duchess Corporation bond can be calculated using an Excel
spreadsheet. The following Excel spreadsheet shows that by
referencing the cells containing the bond’s net proceeds,
coupon payment, years to maturity, and par value as part of
Excel’s RATE function, you can quickly determine that the
appropriate before-tax cost of debt for Duchess
Corporation’s bond is 6.177%.


• Before-Tax Cost of Debt
– Approximating the Cost
 The before-tax cost of debt, rd, for a bond with a $1,000 par
value can be approximated by:
$1, 000  N d
I
rd  n (9.1)
N d  $1, 000
2
 Where:
– I = Annual interest in dollars
– Nd = Net proceeds from the sale of debt (bond)
– n = Number of years to the bond’s maturity
Example 9.4
Substituting the appropriate values from the Duchess
Corporation example into the approximation formula given in
Equation 9.1, we get
$1, 000  $980
$60 
20 $60  $1
rd  
$980  $1, 000 $990
2
$61
  0.06162 or 6.162%
$990
This approximate value of before-tax cost of debt is close to

6.177%, but it lacks the precision of the value derived using
the calculator or spreadsheet.

• After-Tax Cost of Debt
– The interest payments paid to bondholders are tax
deductible for the firm, so the interest expense on debt
reduces the firm's taxable income
After-Tax Cost of Debt = rd × T (9.2)
– where T = The tax rate
– With the passage of the Tax Cuts and Jobs Act of 2017, the
top marginal corporate tax rate fell from 35% to a flat 21%

Example 9.5
Duchess Corporation has a 21% tax rate. Using the 6.177% before-tax
debt cost calculated above and applying Equation 9.2, we find an after-
tax cost of debt of 4.88% [6.177% × (1 – 0.21)]. If Duchess’ interest
expense reaches 30% of EBIT, then any additional interest expense is
not deductible and for any additional borrowing the before- and after-tax
cost of debt are equal. Recall that when bondholders purchase a
Duchess bond at par value, they expect to earn a 6% YTM. Incorporating
the issuance costs and the tax benefit of debt, the firm’s after-tax cost of
debt is just 4.88%, quite a bit less than the 6% return offered to
bondholders. In most cases, debt is the least expensive form of financing
available to a firm. Debt is a relatively inexpensive form of financing for
two main reasons. First, debt is less risky than preferred or common
stock. That alone makes debt a low-cost form of financing because
investors accept lower returns on bonds than on stock. Second, the firm
enjoys a tax benefit from issuing debt that it does not receive when it
uses equity capital.
Personal Finance Example 9.6 (1 of 2)
Kait and Kasim Sullivan, a married couple in the 28%
income-tax bracket, wish to borrow $60,000 to pay for a new
luxury car. To finance the purchase, either they can borrow
the $60,000 through the auto dealer at an annual interest
rate of 4.5%, or they can take a $60,000 second mortgage
on their home. The best annual rate they can get on the
second mortgage is 5.5%. They already have qualified for
both loans being considered.

Personal Finance Example 9.6 (2 of 2)
If they borrow from the auto dealer, the interest on this loan will not
be deductible for federal tax purposes. However, the interest on the
second mortgage would be tax deductible because the tax law
allows individuals to deduct interest paid on a home mortgage. To
choose the least-cost financing, the Sullivans calculated the after-
tax cost of both sources of long-term debt. Because interest on the
auto loan is not tax deductible, its after-tax cost equals its before-
tax cost of 4.5%. Because the interest on the second mortgage is
tax deductible, its after-tax cost can be found using Equation 9.2:
After-tax cost of debt = 5.5% × (1 – 0.28) = 5.5% × 0.72 = 3.96%
Because the 3.96% after-tax cost of the second mortgage is less
than the 4.5% cost of the auto loan, the Sullivans may decide to
use the second mortgage to finance the auto purchase.
9.3 Cost of Preferred Stock
• Preferred Stock Dividends
– When companies issue preferred shares, the shares usually
pay a fixed dividend and have a fixed par value
• Calculating the Cost of Preferred Stock
– Cost of Preferred Stock, rp
Dp
rp  (9.3)
Np
 where:
– Dp = Annual dollar dividend
– Np = Net proceeds from the sale of the stock

Example 9.7
Duchess Corporation is contemplating issuance of an 8%
preferred stock they expect to sell at par value for $80 per
share. The cost of issuing and selling the stock will be $2.50
per share. The first step in finding the cost of the stock is to
calculate the dollar amount of the annual preferred dividend,
which is $6.40 (0.08 × $80). The net proceeds per share
from the proposed sale of stock equals the sale price minus
the flotation costs ($80 – $2.50 = $77.50). Substituting the
annual dividend, Dp, of $6.40 and the net proceeds, Np, of
$77.50 into Equation 9.3 gives the cost of preferred stock,
8.258% ($6.4 ÷ $77.50).

9.4 Cost of Common Stock (1 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 The costs associated with using common stock equity
financing
 The cost of common stock equity is equal to the required
return on the firm’s common stock in the absence of flotation
costs
 Thus, the cost of common stock equity is the same as the cost
of retained earnings, but the cost of issuing new common
equity is higher

 Constant-Growth Valuation (Gordon Growth) Model
D1
P0  (9.4)
rs  g
 where:
– P0 = Current value of common stock
– D1 = Dividend expected in 1 year
– rs = Required return on common stock
– g = Constant rate of growth in dividends
 Constant-Growth Valuation (Gordon Growth) Model
– Solving for rs results in the following expression for the
required return on common stock:
D1
rs   g (9.5)
P0

Duchess Corporation wishes to determine the required
return on its common stock, rs. The market price, P0, of its
common stock is $50 per share. Duchess recently paid a
$3.80 dividend. The company has increased its dividend for
several consecutive years. Just 5 years ago, Duchess paid a
dividend of $2.98 on its common stock.

Using a financial calculator or electronic spreadsheet, in
conjunction with the technique described earlier in this text
for finding growth rates, we can calculate the average annual
dividend growth rate, g, over the past 5 years. The average
dividend growth rate is about 5%. If Duchess continues to
increase the dividend at this rate, then next year’s dividend
will be 5% more than the $3.80 dividend that it just paid, or
$3.99. Substituting D1 = $3.99, P0 = $50, and g = 5% into
Equation 9.5 yields the cost of common stock equity:
$3.99
rs   0.05  0.0798  0.05  0.1298  12.98%
$50

Because this estimate depends on a somewhat imprecise
forecast of the company’s long-run dividend growth rate, a
kind of false precision arises in concluding that the required
return on equity is 12.98%, so we will just round up to 13%.

 Using the Capital Asset Pricing Model (CAPM)
– Capital Asset Pricing Model (CAPM)
• Describes the relationship between the required
return, rs, and the nondiversifiable risk of the firm as
measured by the beta coefficient, βj
rj  RF    j   rm  RF   (9.6)

 where
– rj = Expected return or required return on asset j
– RF = Risk-free rate of return
– βj = Beta coefficient for asset j
– Rm = Market return; expected return on the market portfolio
of assets

Duchess Corporation now wishes to calculate the required
return on its common stock, rs, by using the CAPM. The
firm’s investment advisors and its own analysts indicate that
the risk-free rate, RF, equals 3%; the firm’s beta, β, equals
1.5; and the market return, rm, equals 9%. Substituting these
values into Equation 9.6, the company estimates that the
required return on its common stock, rs, is 12%:
rs = 3.0% + [1.5 × (9.0% – 3.0%)] = 3.0% + 9% = 12.0%

Notice that this estimate of the required return on Duchess
stock does not line up exactly with the estimate obtained
from the constant-growth model. That is to be expected
because the two models rely on different assumptions. In
practice, analysts at Duchess might average the two figures
to arrive at a final estimate for the required return on
common stock.

 Comparing the Constant-Growth and CAPM Techniques
– The CAPM technique differs from the constant-growth
valuation model in that it directly considers the firm’s risk,
as reflected by beta, in determining the required return on
common stock equity
– The constant-growth model does not look at risk directly; it
uses an indirect approach to infer what return
shareholders expect based upon the price they are willing
to pay for the stock today, given estimates of the firm’s
future dividends

 Flotation Costs and the Cost of Common Equity
– Flotation costs increase the cost of common equity
 Cost of a New Issue of Common Stock, rn
– The cost of common stock, net of underpricing and
associated flotation costs
D1
rn   g (9.7)
Nn

 where
– Nn = Risk-free rate of return
– D1 = Dividend expected in 1 year
– g = Constant rate of growth in dividends

In the constant-growth valuation example, we found that
Duchess Corporation’s required return on common stock, rs,
was 13%, using the following values: an expected dividend,
D1, of $3.99; a current market price, P0, of $50; and an
expected growth rate of dividends, g, of 5%.
To determine its cost of new common stock, rn, Duchess
Corporation has estimated that on average, new shares can
be sold for $48. Thus, Duchess’s shares will be underpriced
by $2 per share. A second cost associated with a new issue
is flotation costs of $1.50 per share that would be paid to
issue and sell the new shares. The total underpricing and
flotation costs per share are therefore $3.50.
Subtracting the $3.50-per-share underpricing and flotation
cost from the current $50 share price results in expected net
proceeds of $46.50 per share. Substituting D1 = $3.99, Nn =
$46.50, and g = 5% into Equation 9.7 results in a cost of new
common stock, rn:
$3.99
rn   0.05  0.0858  0.05  0.1358  13.58%
$46.50
Duchess Corporation’s cost of new common stock is

therefore between 13% and 14%.

• Cost of Retained Earnings
– Cost of Retained Earnings, rr
 The cost of retained earnings is equal to the required return on
a firm’s common stock, rs
r r = rs (9.8)

Example 9.11
The cost of retained earnings for Duchess Corporation
equals the required return on equity. Recall that we
calculated the required return using two methods. With the
constant-growth model, we estimated the required return on
equity to be 13% (before accounting for flotation costs and
underpricing), and with the CAPM, the required return on
equity was 12%. Thus, the cost for Duchess Corporation to
finance investments through retained earnings, rr, falls
somewhere in the range of 12.0% to 13.0%. Both estimates
are lower than the cost of a new issue of common stock
because by using retained earnings the firm avoids the
additional costs associated with issuing new equity.

Matter of Fact
Retained Earnings, the Preferred Source of Financing
In the United States and most other countries, firms rely
more heavily on retained earnings than any other financing
source. For example, a 2016 survey of U.K. firms conducted
by the Bank of England found that about 80% of the
companies surveyed listed retained earnings as one of their
primary sources of funds. Bank loans were a distant second
choice, mentioned as a primary source of funds by roughly
58% of the companies.

9.5 Weighted Average Cost of Capital
(1 of 3)
• Calculating the Weighted Average Cost of Capital (WACC)
rwacc  ( wd  rd )(1  T )  ( wp  rp )  ( ws  rs or n ) (9.9)
– where
 wd = proportion of long-term debt in capital structure
 wp = proportion of preferred stock in capital structure
 ws = proportion of common stock equity in capital structure
 wd + wp + ws = 1.0

(2 of 3)
• Calculating the Weighted Average Cost of Capital (WACC)

– Important Points:
 The weights must be nonnegative and sum to 1.0
 The weights are based on the market value of each capital
source as a percentage of the market value of the firm’s total
capital
 We multiply the firm’s common stock equity weight, ws, by
either the required return on the firm’s stock, rs, or the cost of
new common stock, rn
 We multiply the firm’s cost of debt by (1 − T) to capture the tax
deduction tied to interest payments

In earlier examples, we found the costs of the various types of
capital for Duchess Corporation to be as follows:
rd (1 – T ) = 4.880% = 4.88%
rp = 8.258% = 8.26%
rs = 13.00%
Duchess has total capital with a market value of $1 billion. The
market value of the firm’s outstanding long-term debt is $400 million,
the value of its preferred stock is $100 million, and the market value
of its common stock is $500 million. Thus, the weights for the
weighted average cost of capital (WACC) calculation are as follows:

Source of capital Weight
Long-term debt 40%
Preferred stock 10
Common stock equity 50
Total 100%

Because the firm expects to have a sizable amount of
retained earnings available, it plans to use the required
return on equity, rs (or, equivalently, the cost of retained
earnings, rr), as the cost of common stock equity. The
calculation for Duchess Corporation’s WACC appears in
Table 9.2. The resulting WACC for Duchess is 9.28%. This
establishes a hurdle rate for Duchess, meaning that the
company should accept investment opportunities that
promise returns above 9.28% as long as those investment
opportunities are not riskier than the firm’s current
investments.

Table 9.2 Calculation of the Weighted Average
Cost of Capital for Duchess Corporation
Blank Weight Cost Weighted cost
Source of capital w r w×r
Long-term debt 0.40 4.88% 1.95%

Preferred stock 0.10 8.26 0.83
Common stock equity 0.50 13.00 6.50
Totals 1.00 WACC = 9.28%

(3 of 3)
• Capital Structure Weights

– Market Value Weights
 Weights that use market values to measure the proportion of
each type of capital in the firm’s financial structure
 In calculating a firm’s WACC, market value weights should be
used rather than book or par values
– Target Capital Structure
 The mix of debt and equity financing that a firm desires over
the long term
 The target capital structure should reflect the optimal mix of
debt and equity for a particular firm

Review of Learning Goals (1 of 6)
• LG 1
– Understand the basic concept of the cost of capital.
 The cost of capital is the minimum rate of return that a firm
must earn on its investments to increase the firm’s value
 The weighted average cost of capital is a number that blends
the costs of each type of capital that a firm uses and
establishes a minimum rate of return that the firm’s investment
should earn

• LG 2
– List the primary sources of capital available to firms.
 The primary sources of capital for most firms include debt,
preferred stock, common stock, and retained earnings

• LG 3
– Determine the cost of long-term debt, and explain why the
after-tax cost of debt is the relevant cost of debt.
 Managers can find the before-tax cost of long-term debt by
using cost quotations, calculations (either by calculator or
spreadsheet), or an approximation
 The after-tax cost of debt is the product of the before-tax cost
of debt and 1 minus the tax rate
 The after-tax cost of debt is the relevant cost of debt because
it is the lowest possible cost of debt for the firm due to the
deductibility of interest expenses

• LG 4
– Determine the cost of preferred stock.
 The cost of preferred stock is the ratio of the preferred stock
dividend to the firm’s net proceeds from the sale of preferred
stock

• LG 5
– Calculate the required return on a company’s common
stock, and explain how it relates to the cost of retained
earnings and the cost of new issues of common stock.
 The required return on the firm’s stock can be calculated by
using the constant-growth valuation (Gordon growth) model or
the CAPM
 The cost of retained earnings is equal to the required return on
common stock equity
 An adjustment to the required return on common stock equity
to reflect underpricing and flotation costs is necessary to find
the cost of new issues of common stock

• LG 6
– Calculate the weighted average cost of capital (WACC), and
discuss alternative weighting schemes.
 The firm’s WACC is a weighted average of the firm’s cost of
debt and equity capital, where the weights are based on the
market values of each type of financing relative to the total
market value of all financing used by the firm

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Principles of Managerial Finance

Fifteenth Edition, Global Edition

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The analyst studying this investment recalls that the company

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This approximate value of before-tax cost of debt is close to

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Duchess Corporation’s cost of new common stock is

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• Calculating the Weighted Average Cost of Capital (WACC)

rwacc  ( wd  rd )(1  T )  ( wp  rp )  ( ws  rs or n ) (9.9)

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• Calculating the Weighted Average Cost of Capital (WACC)

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Long-term debt 40%

Common stock equity 50

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Long-term debt 0.40 4.88% 1.95%

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• Capital Structure Weights

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