The Cost of Capital

Chapter 10

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 Overview

Sources of Capital

Component Costs

Adjusting for Flotation Costs

WACC

Adjusting for Risk

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 What sources of capital do firms use?

Capital
Capital

Preferred
Preferred Common
Common
Debt
Debt Stock
Stock Equity
Equity

New
New
Notes
Notes Long-Term
Long-Term Retained
Retained
Payable Debt Common
Common
Payable Debt Earnings
Earnings Stock
Stock

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 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.

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 Should our analysis focus on before-tax or
after-tax capital costs?

Stockholders focus on after-tax CFs. Therefore,

we should focus on after-tax capital costs; i.e.,
use after-tax costs of capital in WACC. Only rd
needs adjustment, because interest is tax
deductible.

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 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).

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 How are the weights determined?

WACC = wdrd(1 – T) + wprp + wcrs

 Use accounting numbers or market value (book

vs. market weights)?

 Use actual numbers or target capital structure?

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 Overview of Coleman Technologies Inc.

 Firm calculating cost of capital for major expansion

program.
• Tax rate = 40%.
• 15-year, 12% coupon, semiannual payment noncallable bonds
sell for $1,153.72. New bonds will be privately placed with no
flotation cost.
• 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.

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 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.

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 Component Cost of Debt

WACC = wdrd(1 – T) + wprp + wcrs

 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)?

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 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
INPUTS 30
30 -1153.72
-1153.72 60
60 1000
1000
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 55

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 Component Cost of Debt

 Interest is tax deductible, so

AT rd = BT rd(1 – T)
= 10%(1 – 0.40) = 6%
 Use nominal rate.
 Flotation costs are small, so ignore them.

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 Component Cost of Preferred Stock

WACC = wdrd(1 – T) + wprp + wcrs

 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 rp.
 Our calculation ignores possible flotation costs.
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 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%

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 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.

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 Why is the yield on preferred stock lower than debt?

 Preferred stock will often have a lower BT yield

than the BT yield on debt.
• Corporations own most preferred stock, so 70%
of preferred dividends are excluded from
corporate taxation.

 The AT yield to an investor, and the AT cost to

the issuer, are higher on preferred stock than
on debt. Consistent with higher risk of preferred
stock.

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 Component Cost of Equity

WACC = wdrd(1 – T) + wprp + wcrs

 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.

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 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 rs.
• Firm could repurchase its own stock and earn rs.

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 Three Ways to Determine the Cost of Common Equity, rs

 CAPM: rs = rRF + (rM – rRF)b

 DCF: rs = (D1/P0) + g

 Bond-Yield-Plus-Risk-Premium:
rs = rd + RP

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 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%

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 Find the Cost of Common Equity Using the
DCF Approach

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 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 calculate.

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 Find rs Using the
Bond-Yield-Plus-Risk-Premium Approach

rd = 10% and RP = 4%.

 This RP is not the same as the CAPM RPM.

 This method produces a ballpark estimate of rs,
and can serve as a useful check.

rs = rd + RP
rs = 10.0% + 4.0% = 14.0%

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 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%.

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 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.

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 If new common stock issue incurs a flotation cost of 15% of the
proceeds, what is re?

D 0 (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%

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 What is the firm’s WACC (ignoring flotation costs)?

WACC = wdrd(1 – T) + wprp + wcrs

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

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 What factors influence a company’s
composite WACC?

Factors the firm cannot control:

 Market conditions such as interest rates and tax
rates.

Factors the firm can control:

 Firm’s capital structure.
 Firm’s dividend policy.
 The firm’s investment policy. Firms with riskier
projects generally have a higher WACC.

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 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.

 The next slide illustrates the importance of risk-adjusting

the cost of capital. Note, if the company correctly risk-
adjusted the WACC, then it would select Project L and
reject Project H. Alternatively, if the company didn’t risk-
adjust and instead used the composite WACC for all
projects, it would mistakenly select Project H and reject
Project L.

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 Divisional Cost of Capital

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 End of Chapter 10

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