Cost of Capital

Chapter 10
The Cost of Capital
Sources of Capital
Component Costs
WACC
Adjusting for Flotation Costs
Adjusting for Risk
10-1
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What sources of capital do firms use?
10-2
Capital Structure
• Capital structure refers to the specific mix of

debt and equity used to finance a
company's assets and operations. ...
10-3
Calculating the Weighted Average Cost of Capital
WACC = wdrd(1 – T) + wprp + wcrs
•The w’s refer to the firm’s capital structure weights.

•The r’s refer to the cost of each component.
Proposed Capital Structure
CAPITAL VALUE WEIGHTS
Equity 12 lakhs 0.60
Preferred Stock 3 lakhs 0.15
Debentures 5 lakhs 0.25
Total 20 lakhs 1.00
10-4
Should our analysis focus on before-tax or after-
tax capital costs?
• Stockholders focus on A-T CFs. Therefore, we

should focus on A-T capital costs, i.e. use A-T costs
of capital in WACC. Only rd needs adjustment,
because interest is tax deductible.
EBIT-EPS Analysis
EBIT xxxx
Less: Interest xxx
EBT xxxx
Less: Taxes xxx
EAT xxxx
Less: Pref Dividend xxx
Earning available for ESH xxx
10-5
Should our analysis focus on historical (embedded)
costs or new (marginal) costs?
• The cost of capital is used primarily to make

decisions that involve raising new capital. So, focus
on today’s marginal costs (for WACC).
10-6
How are the weights determined?
• Use accounting numbers or market value (book vs.

market weights)?
• Use actual numbers or target capital structure?
• Target Capital Structure – The mix of debt,
preferred stock and common equity the firm plans
to raise to fund its future projects.
10-7
Component Cost of Debt
• rd is the marginal cost of debt capital.

• The yield to maturity on outstanding L-T debt is
often used as a measure of rd.
• Why tax-adjust; i.e., why rd(1 – T)?
10-8
Component Cost of Debt
• Cost of debt (rd) = Interest Payment / Market Value

• Interest is tax deductible, so
A-T rd = B-T rd(1 – T)
= 10%(1 – 0.40) = 6%
• Use nominal rate.
• Flotation costs are small, so ignore them.
10-9
Practice Session
1. A company has an outstanding debt of 20-year

noncallable bonds with a face value of $1000, an 11%
annual coupon, and a market price of $1294.54. If the
company was to issue new debt, what would be the
interest rate on debt? If the tax rate is 40% what is its
after-tax cost of debt?
Solution:
(B-T)rd = Interest Payment / Market Value = 110 /
1294.54 = 8.5%
(A-T) rd = (B-T) rd * (1- tax rate) = 0.85 * (1-0.4) = 5.5%
10-10
Practice Session 01
2. A company has an outstanding debt of 20-year

noncallable bonds with a face value of $10,000 an 8%
annual coupon, and a market price of $22,000. If the
company was to issue new debt, what would be the
interest rate on debt? If the tax rate is 35% what is its
after-tax cost of debt?
B-T Cost of debt =
Interest Payment / Market Value = 800/22,000 = 3.6%
A-T Cost of debt = 3.6%(1-0.35) = 2.34%
10-11
Component Cost of Preferred Stock
• rp is the marginal cost of preferred stock, which is

the return investors require on a firm’s preferred
stock.
• Preferred dividends are not tax-deductible, so no
tax adjustments necessary. Just use nominal r p.
• Our calculation ignores possible flotation costs.
10-12
What is the cost of preferred stock?
• The cost of preferred stock can be solved by using

this formula:
rp = Dp/Pp
Dp = Preferred Dividend
Pp = Current price of the preferred stock
10-13
Practice Session 02
1. A Company is planning to issue some preferred

stock and would have $10.00 dividend per share,
and it would be priced $97.50 per share. Estimate
the cost of preferred stock.
Solution: Cost of preferred stock = D/P =10 / 97.5
= 0.1025
= 10.25%
10-14
Practice Session 02
10-15
10-16
Is preferred stock more or less risky to investors than
debt?
• More risky; company not required to pay

preferred dividend.
• However, firms try to pay preferred dividend.
Otherwise, (1) cannot pay common dividend,
(2) difficult to raise additional funds, (3)
preferred stockholders may gain control of firm.
10-17
Why is the yield on preferred stock lower than debt?
• Preferred stock will often have a lower B-T yield

than the B-T yield on debt.
– Corporations own most preferred stock, because 70%
of preferred dividends are excluded from corporate
taxation.
• The A-T yield to an investor, and the A-T cost to the
issuer, are higher on preferred stock than on debt.
Consistent with higher risk of preferred stock.
10-18
Component Cost of Equity
• rs 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 re.
10-19
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 r . s
– Firm could repurchase its own stock and earn r . s
10-20
Three Ways to Determine the Cost of Common
Equity, rs
•
Beta is a measure of a stock's volatility
CAPM: rs = rRF + (rM – rRF)b in relation to the overall market. ... If a
stock moves less than the market, the
stock's beta is less than 1.0. High-beta
stocks are supposed to be riskier but
•
provide higher return potential; low-beta
DCF: rs = (D1/P0) + g stocks pose less risk but also lower returns.
• Bond-Yield-Plus-Risk-Premium:
rs = rd + RP
Ex: 8% - RFR ; Equity = 12% RP=4%
10-21
Find the Cost of Common Equity Using the CAPM
Approach
The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.
rs = rRF + (rM – rRF)b

= 7.0% + (6.0%)1.2 = 14.2%
10-22
Practice Session 03
1. Assume that in today’s market, r RF = 5.6%, the

market risk premium is 5%, and company’s beta is 1.48.
Using CAPM approach, estimate the cost of equity.
10-23
Find the Cost of Common Equity Using the DCF
Approach
D0 = $4.19, P0 = $50, and g = 5.
D1 = D0(1 + g)
= $4.19(1 + 0.05)
= $4.3995
rs = (D1/P0) + g
= ($4.3995/$50) + 0.05
= 13.8%
10-24
Can DCF methodology be applied if growth is not
constant?
• Yes, nonconstant growth stocks are expected to

attain constant growth at some point, generally in 5
to 10 years.
• May be complicated to compute.
10-25
Find rs Using the Bond-Yield-Plus-Risk-Premium
Approach
rd = 10% and RP = 4%.
• This RP is not the same as the CAPM RP M.

• This method produces a ballpark estimate of r s, and
can serve as a useful check.
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
10-26
What is a reasonable final estimate of rs?
Method Estimate
CAPM
14.2%
DCF 13.8
rd + RP 14.0
Range = 13.8%-14.2%, might use midpoint of

range, 14%.
10-27
Why is the cost of retained earnings cheaper than the
cost of issuing new common stock?
• When a company issues new common stock they

also have to pay flotation costs to the underwriter.
• Issuing new common stock may send a negative
signal to the capital markets, which may depress
the stock price.
10-28
If new common stock issue incurs a flotation cost of
15% of the proceeds, what is re?
D0 (1  g)
re  g
P0 (1  F)
$4.19(1.05)
  5.0%
$50(1  0.15)
$4.3995
  5.0%
$42.50
 15.4%
10-29
Flotation Costs – The percentage cost of issuing new
common stock
• Flotation costs depend on the firm’s risk and the

type of capital being raised.
• Flotation costs are highest for common equity.
However, since most firms issue equity infrequently,
the per-project cost is fairly small.
• We will frequently ignore flotation costs when
calculating the WACC.
10-30
Ignoring flotation costs, what is the firm’s WACC?

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
10-31
What factors influence a company’s composite
WACC?
• Market conditions.
• The firm’s capital structure and dividend policy.
• The firm’s investment policy. Firms with riskier
projects generally have a higher WACC.
10-32
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 project’s
WACC should be adjusted to reflect the project’s
risk.
• Next slide illustrates importance of risk-adjusting
cost of capital.
10-33
Practice Session
10-34
10-35
10-36
10-37
10-38
Divisional Cost of Capital
9-39
Overview of Coleman Technologies Inc.
• Firm calculating cost of capital for major expansion

program.
– Tax rate = 40%.
– 15-year, 12%, noncallable bonds.
– 10%, $100 par value, quarterly dividend, perpetual
preferred stock sells for $111.10.
– Common stock sells for $50. D0 = $4.19 and g = 5%.
– b = 1.2; rRF = 7%; RPM = 6%.
– Bond-Yield Risk Premium = 4%.
– Target capital structure: 30% debt, 10% preferred,
60% common equity.
9-40
Self-Test
• Cost of capital; debt; preferred stock; retained

earning; new equity
• Floatation cost
• Opportunity cost
• CAPM Model
• Beta
• Risk Premium: CAPM & BY+RP Approach
• Factors affecting a firm’s Cost of Capital
• What is hurdle rate?
• Marginal Capital Structure
10-41
Review of Coleman’s Capital Structure
Book Market Target

Value Value %
Debt (includes notes payable) 48% 25% 30%
Preferred stock 2 5 10
Common equity 50 70 60
Number of shares not given in problem, so actual

calculations cannot be done. Analysis is meant for
illustration. Typically, book value capital structure
will show a higher percentage of debt because a
typical firm’s M/B ratio > 1.
9-42
10-43
A 15-year, 12% semiannual coupon bond sells for
$1,153.72. What is the cost of debt (rd)?
• Remember, the bond pays a semiannual coupon, so

rd = 5.0% x 2 = 10%.
INPUTS 30 -1153.72 60 1000
N I/YR PV PMT FV
OUTPUT 5
10-44
What is the cost of preferred stock?
• The cost of preferred stock can be solved by using

this formula:
rp = Dp/Pp
= $10/$111.10
= 9%
10-45
Find the Cost of Common Equity Using the CAPM
Approach
The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.
rs = rRF + (rM – rRF)b

= 7.0% + (6.0%)1.2 = 14.2%
10-46
Find the Cost of Common Equity Using the DCF
Approach
D0 = $4.19, P0 = $50, and g = 5.
D1 = D0(1 + g)
= $4.19(1 + 0.05)
= $4.3995
rs = (D1/P0) + g
= ($4.3995/$50) + 0.05
= 13.8%
10-47
Find rs Using the Bond-Yield-Plus-Risk-Premium
Approach
rd = 10% and RP = 4%.
• This RP is not the same as the CAPM RP M.

• This method produces a ballpark estimate of r s, and
can serve as a useful check.
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
10-48
What is a reasonable final estimate of rs?
Method Estimate
CAPM
14.2%
DCF 13.8
rd + RP 14.0
Range = 13.8%-14.2%, might use midpoint of

range, 14%.
10-49

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Chapter 10

The Cost of Capital

• Capital structure refers to the specific mix of

WACC = wdrd(1 – T) + wprp + wcrs

•The w’s refer to the firm’s capital structure weights.

• Stockholders focus on A-T CFs. Therefore, we

• The cost of capital is used primarily to make

WACC = wdrd(1 – T) + wprp + wcrs

• Use accounting numbers or market value (book vs.

WACC = wdrd(1 – T) + wprp + wcrs

• rd is the marginal cost of debt capital.

• Cost of debt (rd) = Interest Payment / Market Value

1. A company has an outstanding debt of 20-year

2. A company has an outstanding debt of 20-year

WACC = wdrd(1 – T) + wprp + wcrs

• rp is the marginal cost of preferred stock, which is

• The cost of preferred stock can be solved by using

1. A Company is planning to issue some preferred

• More risky; company not required to pay

• Preferred stock will often have a lower B-T yield

WACC = wdrd(1 – T) + wprp + wcrs

• rs is the marginal cost of common equity using

• Earnings can be reinvested or paid out as dividends.

– Firm could repurchase its own stock and earn r . s

Ex: 8% - RFR ; Equity = 12% RP=4%

rs = rRF + (rM – rRF)b

1. Assume that in today’s market, r RF = 5.6%, the

D0 = $4.19, P0 = $50, and g = 5.

• Yes, nonconstant growth stocks are expected to

rd = 10% and RP = 4%.

• This RP is not the same as the CAPM RP M.

Range = 13.8%-14.2%, might use midpoint of

• When a company issues new common stock they

• Flotation costs depend on the firm’s risk and the

WACC = wdrd(1 – T) + wprp + wcrs

• NO! The composite WACC reflects the risk of an

• Firm calculating cost of capital for major expansion

• Cost of capital; debt; preferred stock; retained

Book Market Target

Number of shares not given in problem, so actual

• Remember, the bond pays a semiannual coupon, so

• The cost of preferred stock can be solved by using

rs = rRF + (rM – rRF)b

D0 = $4.19, P0 = $50, and g = 5.

rd = 10% and RP = 4%.

• This RP is not the same as the CAPM RP M.

Range = 13.8%-14.2%, might use midpoint of

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