Eugene F. Brigham & Joel F.

Houston

Fundamentals of Financial
Management Concise 8E

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

Chapter 10

The Cost of Capital

Sources of Capital
Component Costs
Adjusting for Flotation Costs
WACC
Adjusting for Risk
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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

What sources of capital do firms use?

Capital

Preferred Common
Debt
Stock Equity

Notes Long-Term Retained New Common

Payable Debt Earnings Stock

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

Component Cost of Debt (cont.)

• 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.

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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 r p.
• Our calculation ignores possible flotation costs.

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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, so 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.

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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 r e.

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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%
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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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%

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

Approaches for Flotation Adjustment

• Include costs as part of the project’s upfront cost.

– This reduces the project’s estimated return.
• Adjust cost of capital to include flotation in DCF
model.
– Commonly done by incorporating flotation in DCF
model. (See slide 10-26.)

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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%

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

Flotation Costs

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

type of capital 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.

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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

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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 INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

Divisional Cost of Capital

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