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CHAPTER 10
The Cost of Capital

 Sources of capital
 Component costs
 WACC

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What sources of long-term capital do

firms use?

Long-Term
Capital

Long-Term Preferred Stock Common Stock

Debt

Retained New Common

Earnings Stock

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How do you calculate the weighted

average cost of capital?

WACC = wdkd(1 – T) + wpkp + wcks.

 The w’s refer to the capital structure

weights.
 The k’s refer to the cost of each
component.
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Component Cost of Debt

WACC = wdkd(1 – T) + wpkp + wcks.

 kd is the marginal cost of debt

capital.
 Why tax-adjust, i.e., why kd(1 - T)?

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Component Cost of Debt

 Interest is tax deductible, so

kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.

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Component Cost of Preferred Stock

WACC = wdkd(1 – T) + wpkp + wcks.

 The rate of return investors require

on the firm’s preferred stock.

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What’s the cost of preferred stock?

Pp = $111.10; 10%Q; Par = $100.

Use this formula:

Dp $10
kp 
0.090 9.0%.
Pp $111.10

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Component Cost of Equity

WACC = wdkd(1 – T) + wpkp + wcks.

 ks is the marginal cost of common

equity using retained earnings.
 The rate of return investors require
on the firm’s common equity using
new equity is ke.
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Three ways to determine cost of

common equity, ks:

1. CAPM: ks = kRF + (kM – kRF)b.

2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium:
ks = kd + RP.
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 10 - 10
What’s the cost of common equity
based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.

ks = kRF + (kM – kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

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What’s the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.

D1 D0(1 + g)
k s = P0 + g = P0 +g
$4.19(1.05)
= $50 + 0.05

= 0.088 + 0.05
= 13.8%.
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Find ks using the own-bond-yield-plus-
risk-premium method.
(kd = 10%, RP = 4%.)

ks = kd + RP

= 10.0% + 4.0% = 14.0%

 This RP  CAPM RP.
 Produces ballpark estimate of ks.
Useful check.
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What’s a reasonable final estimate

of ks?

Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%
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Suppose new common stock had a

flotation cost of 15%. What is ke?

D0(1 + g)
ke = +g
P0(1 – F)
$4.19(1.05)
= + 5.0%
$50(1 – 0.15)
$4.40
= + 5.0% = 15.4%.
$42.50
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What’s the firm’s WACC (ignoring

flotation costs)?

WACC = wdkd(1 – T) + wpkp + wcks

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

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