The Cost of Capital

Chapter 10
Maulana Rizky Faadillah - 195020207111058
• An Overview of the Weighted Average Cost of Capital (WACC)
• Basic Definitions
• Cost of Debt
• Cost of Preferred Stock
• Cost of Retained Earnings
• Cost of New Common Stock
• Composite, or Weighted Average, Cost of Capital, WACC
• Factors That Affect the WACC
• Adjusting the Cost of Capital for Risk
• Some Other Problems with Cost of Capital Estimates
An Overview of the Weighted Average Cost
of Capital (WACC)
When calculating the WACC, our concern is with capital that must be
provided by investors—interest-bearing debt, preferred stock, and
common equity. Accounts payable and accruals, which arise
spontaneously when capital budgeting projects are undertaken, are not
included as part of investor-supplied capital because they do not come
directly from investors. Looking at column 1 of Table 10.1, we see that
using the accounting-based book values, Allied’s capital consists of
47.8% debt and 52.2% equity.
Basic Definitions
The investor-supplied items—debt, preferred stock, and common
equity—are called capital components. Increases in assets must be
financed by increases in these capital components. The cost of each
component is called its component cost; for example, Allied can borrow
money at 10%, so its component cost of debt is 10%.4 These costs are
then combined to form a WACC, which is used in the firm’s capital
budgeting analysis. Throughout this chapter, we concentrate on the
three major capital components. The following symbols identify the
cost and weight of each:
Cost of Debt
The interest rate a firm must pay on its new debt is defined as its before-tax cost of debt, rd. Firms can estimate
rd by asking their bankers what it will cost to borrow or by finding the yield to maturity on their currently
outstanding debt (as we illustrated in Chapter 7). However, the after-tax cost of debt, rd(12T), should be used
to calculate the weighted average cost of capital. This is the interest rate on new debt, rd, less the tax savings
that result because interest is tax deductible:
Cost of Preferred Stock
The rate of return investors require on the firm’s preferred stock; rp is
calculated as the preferred dividend, Dp, divided by the current price,
Pp.
Cost of Retained Earnings
The rate of return required by stockholders on a firm’s common stock.

• CAPM approach
• Bond-yield-plus-risk-premium approach
• Dividend-yield-plus-growth-rate, or discounted cash FLOW (DCF),
approach
• Averaging the alternative estimates
Cost of New Common Stock
Companies generally use an investment banker when they issue new
common stock and sometimes when they issue preferred stock or bonds.
In return for a fee, investment bankers help the company structure the
terms, set a price for the issue, and sell the issue to investors. The
bankers’ fees are called flotation costs, and the total cost of the capital
raised is the investors’ required return plus the flotation cost.

• Add flotation costs to a project’s cost

• Increase the cost OF capital
• When must external equity be used?
Composite, or Weighted Average, Cost of
Capital, WACC
Allied’s target capital structure calls for 45% debt, 2% preferred stock, and 53% common
equity. Earlier we saw that its before-tax cost of debt is 10.0%; its after-tax cost of debt is
rd(1 2 T) 5 10%(0.6) 5 6.0%; its cost of preferred stock is 10.3%; its cost of common equity
from retained earnings is 13.5%; and its marginal tax rate is 40%. Equation 10.1, presented
earlier, can be used to calculate its WACC when all of the new common equity comes from
retained earnings:
Factors That Affect the WACC
The cost of capital is affected by a number of factors. Some are beyond
the firm’s control, but others can be influenced by its financing and
investment decisions.

• Factors the firm cannot control

• Factors the firm can control
Adjusting the Cost of Capital for Risk
Some Other Problems with Cost of Capital
Estimates
A number of issues related to the cost of capital have not been mentioned or were glossed
over in this chapter. These topics are covered in advanced finance courses, but they
deserve mention now to alert you to potential dangers and to provide a preview of some
matters covered in advanced courses.

Depreciation-generated fund.
Privately owned firms.
Measurement problems.
Costs of capital for projects of differing risk.
Capital structure weights.
Thank you