09 Zutter Smart PMF 16e ch09

Principles of Managerial Finance
Sixteenth Edition, Global Edition
Chapter 9
The Cost of Capital
Copyright © 2022 Pearson Education, Ltd.

Learning Goals (1 of 2)
LG 1 Understand the 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
– Managers use the cost of capital
 To discount an investment’s future cash flows to
decide if an investment is worth undertaking
 As a benchmark against which they can judge their
performance
 To value entire companies, when a firm engages in
mergers and acquisitions

• The Basic Concept
– Capital
 Refers to a firm’s long-term sources of financing, which
include debt and equity
 Firms raise capital by selling securities such as common
stock, preferred stock, and bonds to investors and
reinvesting profits back into the firm
– Capital Structure
 The mix of debt and equity financing that a firm employs
– 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 2020
Value of Value of
Outstanding Outstanding Total Capital
Company Debt ($ billions) % Debt Equity ($ billions) % Equity ($ billions)
Alphabet $ 1 0% $ 911 100% $ 912
Johnson & Johnson 29 7 386 93 415
Procter & Gamble 31 10 282 90 313
Facebook 6 1 580 99 586
General Electric 99 66 51 34 150
General Motors 105 77 31 23 136

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. The following information is for
investment A:
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%, it must be worth doing, so he recommends that the
company undertake investment A.
Investment B
Cost $100,000
Life 20 years
Expected Return 12%
The analyst assigned to investment B knows that the firm

has common stock outstanding and that investors who hold
the company’s stock expect a 14% return on equity. 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 (and ignoring taxes for the moment), 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 5)
• Before-Tax Cost of Long-Term Debt
– The before-tax financing cost associated with new funds
raised through long-term borrowing
• Net Proceeds
– Net Proceeds
 Funds actually received by the firm from the sale of a
security
– Flotation Costs
 The total costs of issuing and selling a security
 Two components
– Underwriting costs
– Administrative costs

Example 9.2
Duchess Corporation, a major hardware manufacturer, plans
to sell $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 simple way to estimate a firm’s before-tax cost of debt is to
go to a financial web site and look up the yield to maturity
(YTM) on the firm’s existing bonds or on bonds of similar risk
issued by other companies.
– Calculating the Cost Directly
 Rather than using the YTMs on other bonds to estimate the
costs associated with a new bond issue, it is possible to do
a YTM calculation to calculate the costs of a new bond issue
directly.

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
The before-tax cost of debt associated with this bond issue

is the YTM, which is the discount rate that equates the
present value of the bond’s coupon and principal payments
to the initial net proceeds.

Calculator use With the calculator inputs

shown at the left, the before-tax cost of debt
(yield to maturity) equals 6.177%. Most
calculators require inputting negative
numbers for either the present value (net
proceeds) or the future value (annual
interest payments and repayment of
principal), so the image at the left takes the
latter approach.

Spreadsheet use The following Excel spreadsheet shows
that Excel’s RATE function calculates the 6.177% YTM by
referencing the cells containing the bond’s net proceeds,
coupon payment, years to maturity, and par value.


• After-Tax Cost of Debt
– Unlike dividends on stock, interest payments on bonds
are tax deductible, so the interest expense on debt
reduces taxable income (as long as interest does not
exceed 30% of EBIT) and, therefore, the firm’s tax
liability
After-Tax Cost of Debt = rd × (1 - T) (9.1)
Where:
– T is the tax rate
– rd is the before-tax cost of debt

Example 9.4
Duchess Corporation pays a 21% tax rate. Using the 6.177%
before-tax debt cost calculated above and applying Equation
9.1, 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.

– For two main reasons, debt is usually the least
expensive form of financing available to a firm
– Debt is less risky than preferred or common stock
– Investors accept lower returns on bonds than on
stock
– The firm enjoys a tax benefit from issuing debt that it
does not receive when it uses equity capital

Personal Finance Example 9.5 (1 of 2)
Kait and Kasim Sullivan, a married couple in the 28%
income-tax bracket, wish to borrow $60,000 to pay for
improvements to their home. To finance the purchase, either
they can borrow from a relative at an annual interest rate of
4.5%, or they can take a second mortgage on their home.
The best annual rate they can get on the second mortgage is
5.5%.
If they borrow from the relative, the interest will not be
deductible for federal tax purposes. However, the interest on
the second mortgage would be deductible because the tax
law allows individuals to deduct home mortgage interest.

Personal Finance Example 9.5 (2 of 2)
To choose the least-cost financing, the Sullivans calculate
the after-tax cost of both loans. Because interest on the loan
from a relative is not deductible, its after-tax cost equals its
before-tax cost of 4.5%. Equation 9.1 shows that the after-
tax cost of the second mortgage is 3.96%:
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 4.5%, the Sullivans may decide to use the second
mortgage to finance the home improvement project.

– This does not imply that firms should always finance their
investments with debt
 Financing with debt puts the firm’s existing shareholders
in a riskier position because the firm must repay lenders
regardless of whether it is profitable
 Existing shareholders will then demand a higher return,
thus raising the firm’s cost of equity
 The increase in the cost of equity could partially or fully
offset the benefit of using low-cost debt as a financing
source
 Firms must carefully weigh the tradeoffs when using
different sources of capital

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
 The ratio of the preferred stock dividend to the firm’s net
proceeds from the sale of preferred stock
Dp
rp  (9.2)
Np
where:
– Dp = Annual dollar dividend
– Np = Net proceeds from the sale of the stock
Matter of Fact (1 of 2)
Becoming Less Preferred
Preferred stock is in many ways a dying security. Of the 50
largest firms in the United States, only banks such as
JPMorgan and Bank of America raise money through
preferred stock. Banks use preferred shares to meet
regulatory minimum capital requirements without diluting
their common stock ownership. Many companies do not use
preferred stock because it has many of the disadvantages of
debt (e.g., fixed dividend payments that resemble interest
payments on bonds), but it does not enjoy debt’s main
advantage, which is tax deductibility of interest.

Example 9.6
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 9.2 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

 Using the Constant-Growth Valuation (Gordon Growth)
Model
D1
P0  (9.3)
rs  g
 where:
– P0 = Current value of common stock
– D1 = Dividend expected in one year
– rs = Required return on common stock
– g = Constant rate of growth in dividends
 Constant-Growth Valuation (Gordon Growth) Model
– Solving Equation 9.3 for rs results in the following
expression for the required return on common stock:
D1
rs  g (9.4)
P0
• The first term captures the return that
shareholders expect to earn from dividends
• The second term captures the return they expect
to earn from capital gains

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

Using a financial calculator, in

conjunction with the technique described
earlier in this text for finding growth
rates, we find that the average annual
dividend growth rate, g, over the past
five years 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 9.4 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 an 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 or expected return on some asset j,
rj, and the nondiversifiable risk of the firm as
measured by the beta coefficient, βj . The
CAPM says that
rj  RF    j   rm  RF  (9.5)

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

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 9.5, 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 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, P0,
given estimates of the firm’s future dividends
 Flotation Costs and the Cost of Common Equity
– Flotation costs increase the cost of capital to the
firm
 Cost of a New Issue of Common Stock, rn
– The cost of common stock, net of underpricing
and associated flotation costs
D1
rn   g (9.6)
Nn

 where
– Nn = net proceeds per share from sale of new
common stock after subtracting underpricing and
flotation costs
– D1 = Dividend expected in one 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 estimates that new shares will sell 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 9.6 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 using retained earnings as a financing
source
 The cost of retained earnings is equal to the
required return on a firm’s common stock, rs
rr = rs (9.7)

Example 9.10
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 (2 of 2)
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. In 2019 the Federal Reserve conducted a survey of
5,514 small businesses and found that for 77% of
companies, the most important source of financing was
retained earnings.

9.5 Weighted Average Cost of Capital
(1 of 4)
• Calculating the Weighted Average Cost of Capital (WACC)
rwacc  ( wd  rd )(1  T )  ( wp  rp )  ( ws  rs or n ) (9.8)
– 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 4)
• 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 that the costs of the various
types of capital for Duchess Corporation were:
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 values of the firm’s outstanding long-term debt,
preferred stock, and common stock are $400 million, $100
million, and $500 million respectively. 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 Duchess has retained earnings available, its cost of
common equity is the required return on equity, rs (or,
equivalently, the cost of retained earnings, rr). 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%

Table 9.3 WACC Calculations for Well-Known
Companies
Company % Debt Cost of Debt % Equity Beta Cost of WACC

Equity
Procter & Gamble 10% 3.0% 90% 0.4 4.4% 4.2%
General Electric 66 5.0 34 0.9 7.4 5.1
Johnson & Johnson 7 2.0 93 0.7 6.2 5.9
Target 19 3.5 81 0.9 7.4 6.5
General Motors 77 7.5 23 1.3 9.8 6.8
Alphabet 0 NA 100 1.0 8.0 8.0
Apple 8 2.3 92 1.1 8.6 8.1
Amazon 4 3.3 96 1.3 9.8 9.5
Facebook 0 NA 100 1.3 9.8 9.8

(3 of 4)
• 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

(4 of 4)
• WACC as a Hurdle Rate
– WACC is a kind of hurdle rate that a firm’s investments must
clear if they are to create value for investors
– Using the WACC in this way is appropriate as long as the
investment being held to that standard is about as risky as
the average investment that the firm makes
 If the investment is riskier than typical, a higher rate that
reflects the investment’s greater risk is appropriate
 If the investment is atypically low risk, then the WACC is
an inappropriately high hurdle rate and a lower rate is
fitting
 When considering an acquisition, make sure to use a
WACC that is appropriate for the target you are acquiring
Review of Learning Goals (1 of 5)
• LG 1
– Understand the 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 hurdle rate for the firm’s investments
• 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 or calculations (either
by calculator or spreadsheet)
 The after-tax cost of debt is the product of the
before-tax cost of debt and one minus the tax rate
 The after-tax cost of debt is the relevant cost of debt
because it takes into account 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
 In some cases the weights may reflect a firm’s
target capital structure instead

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Principles of Managerial Finance

Sixteenth Edition, Global Edition

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The analyst studying this investment recalls that the company

The analyst assigned to investment B knows that the firm

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The before-tax cost of debt associated with this bond issue

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Calculator use With the calculator inputs

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Using a financial calculator, in

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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 ) (9.8)

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• Calculating the Weighted Average Cost of Capital (WACC)

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Source of capital Weight

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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Company % Debt Cost of Debt % Equity Beta Cost of WACC

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