Chapter 8

The Cost of
Capital

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 21

 The Cost of Capital
• The cost of capital acts as a link between the firm’s long-term investment
decisions and the wealth of the owners as determined by investors in the
marketplace.
• It is used to decide whether a proposed investment will increase or decrease
the firm’s stock price.
• Formally, the cost of capital is the rate of return that a firm must earn on the
projects in which it invests to maintain the market value of its stock.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 21

 The Firm’s Capital Structure

Current Current
Assets Liabilities

Long- The Firm’s

Term Capital
Structure
Debt & Cost of
Fixed Capital
Assets Equity

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 21

 The Weighted Average
Cost of Capital
• Capital—refers to the long-term funds used by
a firm to finance its assets.
• Capital components—the types of capital used
by a firm—long-term debt and equity
• WACC—the average percentage cost, based
on the proportion of each type of capital, of all
the funds used by the firm to finance its assets.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 21

 The Cost of Debt
• The pretax cost of debt is equal to the the yield-to-
maturity on the firm’s debt adjusted for flotation costs.
• Recall that a bond’s yield-to-maturity depends upon a
number of factors including the bond’s coupon rate,
maturity date, par value, current market conditions,
and selling price.
• After obtaining the bond’s yield, a simple adjustment
must be made to account for the fact that interest is a
tax-deductible expense.
• This will have the effect of reducing the cost of debt.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 21

 The Cost of Debt - Example
Suppose a company could issue 9% coupon, 20 year debt
face value of €1,000 for €980. Suppose that flotation costs
will amount to 2% of par value. Find the after-tax cost of
debt assuming the company is in the 40% tax bracket.
Finding the Cost of Debt
Par Value -1000
Flotation Costs (% of Par) 2%
Flotation Costs (€) -20
Issue Price 980
Net Proceeds Price 960
Coupon Interest (%) 9%
Coupon Interest (€) -90
Time to maturity 20 EXCEL Formula for
Tax 40% computing the before - tax
Before-tax cost of debt 9,45%
cost of debt
After-tax cost of debt 5,67%
=RATE(B9,B8,B6,B2)
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 21
 The Cost of Equity
 The cost of equity is based on the rate of return
required by the firm’s stockholders.
 Cost of preferred stock - dividends received by preferred
stockholders represent an annuity
 Cost of retained earnings (internal equity)—return that
common stockholders require the firm to earn on the funds
that have been retained, thus reinvested in the firm, rather
than paid out as dividends
 Cost of new (external) equity—rate of return required by
common stockholders after considering the cost associated
with issuing new stock (flotation costs)

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 21

 The Cost of Preferred Stock (kp)
KP = DP/(PP - F) = DP/(NP)

In the above equation, “F” represents flotation costs

(in €). As was the case for debt, the cost of raising
new preferred stock will be more than the yield on the
firm’s existing preferred stock since the firm must pay
investment bankers to sell (or float) the issue.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 21

 The Cost of Preferred Stock (kp) -
Example
KP = DP/(PP - F)
A company can issue preferred stock that pays a €5
annual dividend, sell it for €55 per share, and have
to pay €3 per share to sell it. Then, the cost of
preferred stock would be:

kP = €5/(€55 - €3) = 9.62%

There is no tax adjustment, because dividends are

not a tax-deductible expense.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 21
 The Cost of Retained Earnings
• The firm must earn a return on reinvested
earnings that is sufficient to satisfy existing
common stockholders’ investment demands.
• If the firm does not earn a sufficient return using
retained earnings, then the earnings should be
paid out as dividends so that stockholders can
invest the funds outside the firm to earn an
appropriate rate.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 21

The Cost of Retained Earnings (ks)
Discounted Cash Flow (DCF) approach

kS = (D1/P0) + g.

For example, assume a firm has just paid a dividend

of €2.50 per share, expects dividends to grow at
10% indefinitely, and is currently selling for €50 per
share.
First, D1 = 2.50(1+.10) = 2.75, and
kS = (2.75/50) + .10 = 15.5%.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 21

The Cost of Retained Earnings (kE)
Security Market Line Approach

kE = rF + b(kM - RF).

For example, if the 3-month government bond rate is

currently 5.0%, the market risk premium is 9%, and
the firm’s beta is 1.20, the firm’s cost of retained
earnings will be:
kE = 5.0 + 1.2(9) = 15.8%.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 21

 The Cost of Retained Earnings, ks—
Bond-Yield-Plus-Risk-Premium Approach
• Studies have shown that the return on equity for a
particular firm is approximately 3 to 5 percentage
points higher than the return on its debt.
• As a general rule of thumb, firms often compute the
YTM, or kd, for their bonds and then add 3 to 5 percent.
• In the current example, kd = 6.0%. As a rough
estimate, then, we might say the cost of retained
earnings is
ks  kd + 4% = 6% + 4% = 10.0%

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 21

 The Cost of New Equity
• Rate of return required by common stockholders after considering the costs
associated with issuing new stock, which are called flotation costs.
• Because the firm has to provide the same gross return to new stockholders
as existing stockholders, when the flotation costs associated with a common
stock issue are considered, the cost of new common stock always must be
greater than the cost of existing stock—that is, the cost of retained earnings.
• Modify the DCF approach for computing the cost of retained earnings to
include flotation costs

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 21

 The Cost of New Equity (kn)
Discounted Cash Flow (DCF) approach

Kn = [D1/(P0 - F)] + g = D1/Nn - g

Αssume a firm has just paid a dividend of €2.50 per

share, expects dividends to grow at 10%
indefinitely, and is currently selling for €50 per
share.Ηow much would it cost the firm to raise new
equity if flotation costs amount to €4.00 per share?
Kn = [2.75/(50 - 4)] + .10 = 15.97% or 16%.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 21

The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

Capital Structure Weights

The weights in the above equation are intended to

represent a specific financing mix (where w i = % of
debt, wp = % of preferred, and ws= % of common).

Specifically, these weights are the target percentages

of debt and equity that will minimize the firm’s overall
cost of raising funds.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 21
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

Capital Structure Weights

One method uses book values from the firm’s

balance sheet. For example, to estimate the weight
for debt, simply divide the book value of the firm’s
long-term debt by the book value of its total assets.
To estimate the weight for equity, simply divide the
total book value of equity by the book value of total
assets.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 21
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

Capital Structure Weights

A second method uses the market values of the firm’s

debt and equity. To find the market value proportion
of debt, simply multiply the price of the firm’s bonds
by the number outstanding. This is equal to the total
market value of the firm’s debt.
Next, perform the same computation for the firm’s
equity by multiplying the price per share by the total
number of shares outstanding.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 21
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

Capital Structure Weights

Finally, add together the total market value of the

firm’s equity to the total market value of the firm’s
debt. This yields the total market value of the firm’s
assets.
To estimate the market value weights, simply divide
the market value of either debt or equity by the
market value of the firm’s assets .
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 21
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

Capital Structure Weights

For example, assume the market value of the firm’s

debt is €40 million, the market value of the firm’s
preferred stock is €10 million, and the market value of
the firm’s equity is €50 million.
Dividing each component by the total of €100 million
gives us market value weights of 40% debt, 10%
preferred, and 50% common.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 21
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

Capital Structure Weights

Using the costs previously calculated along with the

market value weights, we may calculate the weighted
average cost of capital as follows:
WACC = .4(5.67%) + .1(9.62%) + .5 (15.8%)
= 11.13%
This assumes the firm has sufficient retained
earnings to fund any anticipated investment projects.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 21