9 The Cost of Capital

Learning Goals Why This Chapter Matters to You

LG 1 Understand the basic concept and In your professional life
sources of capital associated with
the cost of capital. ACCOUNTING You need to understand the various sources of capital
and how their costs are calculated to provide the data necessary to
LG 2 Explain what is meant by the determine the firm’s overall cost of capital.
marginal cost of capital.
INFORMATION SYSTEMS You need to understand the various sources
LG 3 Determine the cost of long-term of capital and how their costs are calculated to develop systems that
debt, and explain why the after- will estimate the costs of those sources of capital, as well as the overall
tax cost of debt is the relevant cost of capital.
cost of debt. MANAGEMENT You need to understand the cost of capital to select
long-term investments after assessing their acceptability and relative
LG 4 Determine the cost of preferred rankings.
stock.
MARKETING You need to understand the firm’s cost of capital because
LG 5 Calculate the cost of common proposed projects must earn returns in excess of it to be acceptable.
stock equity, and convert it into
the cost of retained earnings and OPERATIONS You need to understand the firm’s cost of capital to
assess the economic viability of investments in plant and equipment
the cost of new issues of common
needed to improve or grow the firm’s capacity.
stock.

LG 6 Calculate the weighted average

Knowing your personal cost of cap-
cost of capital (WACC), and In your personal life ital will allow you to make informed
discuss alternative weighting
decisions about your personal consuming, borrowing, and investing.
schemes.
Managing your personal wealth is a lot like managing the wealth of a
business—you need to understand the trade-offs between consuming
wealth and growing wealth and how growing wealth can be
accomplished by investing your own monies or borrowed monies.
Understanding the cost of capital concepts will allow you to make
better long-term decisions and maximize the value of your personal
wealth.

356
General Electric
Falling Short of Expectations

F or years, General Electric was perhaps the most

admired company in the world. From 1990
through 2000, its stock rose more than 800 percent,
making it one of the world’s most valuable companies
and earning its long-time CEO, Jack Welch, the title of
“Manager of the Century” from Fortune magazine.
GE’s stock price peaked in August 2000 at $60.50.
Since then, however, GE stock has lost its luster, falling
by roughly 50 percent and trailing far behind benchmarks such as the Standard & Poor’s 500
Stock Index. In 2009, GE cut its dividend for the first time since the Great Depression and lost its
coveted AAA credit rating.
Why did GE perform so poorly? A simple answer is that GE’s business investments failed
to earn a return sufficient to meet the expectations of investors. When a firm’s operating results
disappoint investors, its stock price will fall as investors sell their shares and move to a more
attractive investment. As one expert explained, “GE has been destroying shareholder capital for
years. Their cost of capital is about 5 percent, and their return on assets is about 1 percent. That
mathematic equation can’t remain too much longer.”1
For companies to succeed, their investments have to earn a rate of return that exceeds
investors’ expectations. But how do companies know what investors expect? The answer is that
companies have to measure their cost of capital. Read on to learn how firms do that.

1. Pros Say, December 15, 2009, cnbc.com, www.cnbc.com/id/34440926.

357
 358 PART 4 Risk and the Required Rate of Return

LG 1 LG 2 9.1 Overview of the Cost of Capital

Chapter 1 established that the goal of the firm is to maximize shareholder wealth,
and it told us that financial managers achieve this goal by investing in risky proj-
ects that add value to the firm. In this chapter, you will learn about the cost of
capital, which is the rate of return that financial managers use to evaluate all pos-
sible investment opportunities to determine which ones to invest in on behalf of
cost of capital the firm’s shareholders. The cost of capital represents the firm’s cost of financing
Represents the firm’s cost of and is the minimum rate of return that a project must earn to increase firm value.
financing and is the minimum In particular, the cost of capital refers to the cost of the next dollar of financing
rate of return that a project
necessary to finance a new investment opportunity. Investments with a rate of
must earn to increase firm
value.
return above the cost of capital will increase the value of the firm, and projects
with a rate of return below the cost of capital will decrease firm value.
The cost of capital is an extremely important financial concept. It acts as a major
link between the firm’s long-term investment decisions and the wealth of the firm’s
owners as determined by the market value of their shares. Financial managers are
ethically bound to invest only in projects that they expect to exceed the cost of cap-
ital; see the Focus on Ethics box for more discussion of this responsibility.

THE BASIC CONCEPT

A firm’s cost of capital is estimated at a given point in time and reflects the expected
average future cost of funds over the long run. Although firms typically raise

focus on ETHICS
The Ethics of Profit
in practice Business Week once Merck’s experience with the drug, costing the firm its coveted AAA rating.
referred to Peter Vioxx. Introduced in 1999, Vioxx was The company’s bottom line also suf-
Drucker as “The Man Who Invented an immediate success, quickly reaching fered, as net income fell 21 percent in
Management.” In his role as writer and $2.5 billion in annual sales. However, the final three months of 2004.
management consultant, Drucker a Merck study launched in 1999 even- The recall dealt a major blow to
stressed the importance of ethics to tually found that patients who took Merck’s reputation. The company was
business leaders. He believed that it Vioxx suffered from an increased risk of criticized for aggressively marketing
was the ethical responsibility of a busi- heart attacks and strokes. Despite the Vioxx despite its serious side effects.
ness to earn a profit. In his mind, prof- risks, Merck continued to market and Questions were also raised about the
itable businesses create opportunities, sell Vioxx. By the time Vioxx was with- research reports Merck had submitted
while unprofitable ones waste society’s drawn from the market, an estimated in support of the drug. Lawsuits fol-
resources. Drucker once said, “Profit is 20 million Americans had taken the lowed. In 2008, Merck agreed to fund
not the explanation, cause, or rationale drug, 88,000 had suffered Vioxx- a $4.85 billion settlement to resolve
of business behavior and business deci- related heart attacks, and 38,000 had approximately 50,000 Vioxx-related
sions, but rather the test of their validity. died. lawsuits. The company had also
If archangels instead of businessmen News of the 2004 Vioxx with- incurred $1.53 billion in legal costs by
sat in directors’ chairs, they would still drawal hit Merck’s stock hard. The the time of the settlement.
have to be concerned with profitability, company’s shares fell 27 percent on
3 The Vioxx recall increased Merck’s
despite their total lack of personal inter- the day of the announcement, slashing
cost of capital. What effect would
est in making profits.”a $27 billion off the firm’s market capital-
an increased cost of capital have on
But what happens when businesses ization. Moody’s, Standard & Poor’s,
a firm’s future investments?
abandon ethics for profits? Consider and Fitch cut Merck’s credit ratings,
a
Peter F. Drucker, The Essential Drucker (New York: Collins Business Essentials, 2001).
 CHAPTER 9 The Cost of Capital 359

money in lumps, the cost of capital reflects the entirety of the firm’s financing activ-
ities. For example, if a firm raises funds with debt (borrowing) today and at some
future point sells common stock to raise additional financing, then the respective
costs of both forms of capital should be reflected in the firm’s cost of capital. Most
firms attempt to maintain an optimal mix of debt and equity financing. In practice,
this mix is commonly a range, such as 40 percent to 50 percent debt, rather than a
point, such as 55 percent debt. This range is called a target capital structure—a
topic that will be addressed in Chapter 13. Here, it is sufficient to say that although
firms raise money in lumps, they tend toward some desired mix of financing.
To capture all of the relevant financing costs, assuming some desired mix of
financing, we need to look at the overall cost of capital rather than just the cost
of any single source of financing.

Example 9.1 3 A firm is currently faced with an investment opportunity. Assume the following:
Best project available today
Cost = $100,000
Life = 20 years
Expected Return = 7%
Least costly financing source available
Debt = 6%
Because it can earn 7% on the investment of funds costing only 6%, the firm
undertakes the opportunity. Imagine that 1 week later a new investment opportu-
nity is available:
Best project available 1 week later
Cost = $100,000
Life = 20 years
Expected Return = 12%
Least costly financing source available
Equity = 14%
In this instance, the firm rejects the opportunity because the 14% financing cost
is greater than the 12% expected return.
What if instead the firm used a combined cost of financing? By weighting the
cost of each source of financing by its relative proportion in the firm’s target cap-
ital structure, the firm can obtain a weighted average cost of capital. Assuming
that a 50–50 mix of debt and equity is targeted, the weighted average cost here
would be 10% 3(0.50 * 6% debt) + (0.50 * 14% equity)4. With this average
cost of financing, the first opportunity would have been rejected (7% expected
return 6 10% weighted average cost), and the second would have been accepted
(12% expected return 7 10% weighted average cost).

SOURCES OF LONG-TERM CAPITAL

In this chapter, our concern is only with the long-term sources of capital available to
a firm because these are the sources that supply the financing necessary to support
the firm’s capital budgeting activities. Capital budgeting is the process of evaluating
360 PART 4 Risk and the Required Rate of Return

and selecting long-term investments. This process is intended to achieve the firm’s
goal of maximizing shareholders’ wealth. Although the entire capital budgeting
process is discussed throughout Part 5, at this point it is sufficient to say that cap-
ital budgeting activities are chief among the responsibilities of financial managers
and that they cannot be carried out without knowing the appropriate cost of cap-
ital with which to judge the firm’s investment opportunities.
There are four basic sources of long-term capital for firms: long-term debt, pre-
ferred stock, common stock, and retained earnings. All entries on the right-hand
side of the balance sheet, other than current liabilities, represent these sources:

Balance Sheet

Current liabilities

Long-term debt

Assets Stockholders’ equity

Sources of
Preferred stock
long-term capital
Common stock equity
Common stock
Retained earnings

Not every firm will use all of these sources of financing, but most firms will have
some mix of funds from these sources in their capital structures. Although a firm’s
existing mix of financing sources may reflect its target capital structure, it is ulti-
mately the marginal cost of capital necessary to raise the next marginal dollar of
financing that is relevant for evaluating the firm’s future investment opportunities.

6 REVIEW QUESTIONS
9–1 What is the cost of capital?
9–2 What role does the cost of capital play in the firm’s long-term invest-
ment decisions? How does it relate to the firm’s ability to maximize
shareholder wealth?
9–3 What does the firm’s capital structure represent?
9–4 What are the typical sources of long-term capital available to the firm?

LG 3 9.2 Cost of Long-Term Debt

cost of long-term debt The cost of long-term debt is the financing cost associated with new funds raised
The financing cost associated through long-term borrowing. Typically, the funds are raised through the sale of
with new funds raised through corporate bonds.
long-term borrowing.

NET PROCEEDS
net proceeds
Funds actually received by the The net proceeds from the sale of a bond, or any security, are the funds that the
firm from the sale of a security. firm receives from the sale. The total proceeds are reduced by the flotation costs,
 CHAPTER 9 The Cost of Capital 361

flotation costs which represent the total costs of issuing and selling securities. These costs apply
The total costs of issuing and to all public offerings of securities—debt, preferred stock, and common stock.
selling a security. They include two components: (1) underwriting costs—compensation earned by
investment bankers for selling the security—and (2) administrative costs—issuer
expenses such as legal, accounting, and printing.

Example 9.2 3 Duchess Corporation, a major hardware manufacturer, is contemplating selling

$10 million worth of 20-year, 9% coupon (stated annual interest rate) bonds,
each with a par value of $1,000. Because bonds with similar risk earn returns
greater than 9%, the firm must sell the bonds for $980 to compensate for the
lower coupon interest rate. The flotation costs are 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 $960 ($980 minus $20).

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. A firm’s before-tax cost of debt for bonds can be found in any of
three ways: quotation, calculation, or approximation.

Using Market Quotations

A relatively quick method for finding the before-tax cost of debt is to observe the
yield to maturity (YTM) on the firm’s existing bonds or bonds of similar risk
issued by other companies. The market price of existing bonds reflects the rate of
return required by the market. For example, if the market requires a YTM of 9.7
percent for a similar-risk bond, then this value can be used as the before-tax cost
of debt, rd, for new bonds. Bond yields are widely reported by sources such as
The Wall Street Journal.

Calculating the Cost

This approach finds the before-tax cost of debt by calculating the YTM generated
by the bond cash flows. From the issuer’s point of view, this value is the cost to
maturity of the cash flows associated with the debt. The cost to maturity can be
calculated by using a financial calculator or an electronic spreadsheet. It repre-
sents the annual before-tax percentage cost of the debt.

Example 9.3 3 In the preceding example, $960 were the net proceeds of a 20-year bond with a
$1,000 par value and 9% coupon interest rate. The calculation of the annual cost
is quite simple. The cash flow pattern associated with this bond’s sales consists of
an initial inflow (the net proceeds) followed by a series of annual outlays (the
interest payments). In the final year, when the debt is retired, an outlay repre-
senting 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 $ 960
1–20 - $ 90
20 - $1,000
362 PART 4 Risk and the Required Rate of Return

The initial $960 inflow is followed by annual interest outflows of $90 (9%
coupon interest rate * $1,000 par value) over the 20-year life of the bond. In
year 20, an outflow of $1,000 (the repayment of the principal) occurs. We can
determine the cost of debt by finding the YTM, which is the discount rate that
equates the present value of the bond outflows to the initial inflow.
Calculator Use (Note: Most calculators require either the present value [net
Input Function
20 N
proceeds] or the future value [annual interest payments and repayment of prin-
960 PV
cipal] to be input as negative numbers when we calculate yield to maturity. That
approach is used here.) Using the calculator and the inputs shown at the left, you
–90 PMT
should find the before-tax cost of debt (yield to maturity) to be 9.452%.
–1000 FV
CPT Spreadsheet Use The before-tax cost of debt on the Duchess Corporation bond
I can be calculated using an Excel spreadsheet. The following Excel spreadsheet
shows that by referencing the cells containing the bond’s net proceeds, coupon
Solution
9.452 payment, years to maturity, and par value as part of Excel’s RATE function you
can quickly determine that the appropriate before-tax cost of debt for Duchess
Corporation’s bond is 9.452%.

A B
1 FINDING THE YTM ON A 20-YEAR BOND
2 Net proceeds from sale of bond $960
3 Coupon payment $90
4 Years to maturity 20
5 Par value (principal) $1,000
6 Before-tax cost of debt 9.452%
Entry in Cell B6 is =RATE(B4,–B3,B2,–B5).
A minus sign appears before B3 and B5 because coupon payment
and par value are treated as cash outflows.

Although you may not recognize it, both the calculator and the Excel function are
using trial-and-error to find the bond’s YTM—they just do it faster than you can.

Approximating the Cost

Although not as precise as using a calculator, there is a method for quickly approx-
imating the before-tax cost of debt. The before-tax cost of debt, rd, for a bond with
a $1,000 par value can be approximated by using the following equation:

$1,000 - Nd
I +
n
rd = (9.1)
Nd + $1,000
2

where
I = annual interest in dollars
Nd = net proceeds from the sale of debt (bond)
n = number of years to the bond’s maturity
 CHAPTER 9 The Cost of Capital 363

Example 9.4 3 Substituting the appropriate values from the Duchess Corporation example into
the approximation formula given in Equation 9.1, we get:
$1,000 - $960
$90 +
20 $90 + $2
rd = =
$960 + $1,000 $980
2
$92
= = 0.09388 or 9.388%
$980
This approximate value of before-tax cost of debt is close to the 9.452%, but it
lacks the precision of the value derived using the calculator or spreadsheet.

AFTER-TAX COST OF DEBT

Unlike the dividends paid to equityholders, the interest payments paid to bond-
holders are tax deductable for the firm, so the interest expense on debt reduces
the firm’s taxable income and, therefore, the firm’s tax liability. To find the firm’s
net cost of debt, we must account for the tax savings created by debt and solve
for the cost of long-term debt on an after-tax basis. The after-tax cost of debt, ri,
can be found by multiplying the before-tax cost, rd, by 1 minus the tax rate, T, as
stated in the following equation:

ri = rd * (1 - T) (9.2)

Example 9.5 3 Duchess Corporation has a 40% tax rate. Using the 9.452% before-tax debt cost
calculated above, and applying Equation 9.2, we find an after-tax cost of debt of
5.67% [9.452% * (1 - 0.40)]. Typically, the cost of long-term debt for a given
firm is less than the cost of preferred or common stock, partly because of the tax
deductibility of interest.

Personal Finance Example 9.6 3 Kait and Kasim Sullivan, a married couple in the 28% federal
income-tax bracket, wish to borrow $60,000 to pay for a new
luxury car. To finance the purchase, they can either borrow the $60,000
through the auto dealer at an annual interest rate of 6.0%, or they can take a
$60,000 second mortgage on their home. The best annual rate they can get on
the second mortgage is 7.2%. They already have qualified for both of the loans
being considered.
If they borrow from the auto dealer, the interest on this “consumer loan” will
not be deductible for federal tax purposes. However, the interest on the second
mortgage would be tax deductible because the tax law allows individuals to
deduct interest paid on a home mortgage. To choose the least-cost financing, the
Sullivans calculated the after-tax cost of both sources of long-term debt. Because
interest on the auto loan is not tax deductible, its after-tax cost equals its stated
364 PART 4 Risk and the Required Rate of Return

cost of 6.0%. Because the interest on the second mortgage is tax deductible, its
after-tax cost can be found using Equation 9.2:
After-tax cost of debt = Before-tax cost of debt * (1 - Tax rate)
7.2% * (1 - 0.28) = 7.2% * 0.72 = 5.2%
Because the 5.2% after-tax cost of the second mortgage is less than the 6.0% cost
of the auto loan, the Sullivans should use the second mortgage to finance the auto
purchase.

6 REVIEW QUESTIONS
9–5 What are the net proceeds from the sale of a bond? What are flotation
costs, and how do they affect a bond’s net proceeds?
9–6 What methods can be used to find the before-tax cost of debt?
9–7 How is the before-tax cost of debt converted into the after-tax cost?

LG 4 9.3 Cost of Preferred Stock

Preferred stock represents a special type of ownership interest in the firm. It gives
preferred stockholders the right to receive their stated dividends before the firm
can distribute any earnings to common stockholders. The key characteristics of
preferred stock were described in Chapter 7. However, the one aspect of pre-
ferred stock that requires review is dividends.

PREFERRED STOCK DIVIDENDS

Most preferred stock dividends are stated as a dollar amount: “x dollars per year.”
When dividends are stated this way, the stock is often referred to as “x-dollar pre-
ferred stock.” Thus a “$4 preferred stock” is expected to pay preferred stockholders
$4 in dividends each year on each share of preferred stock owned.
Sometimes preferred stock dividends are stated as an annual percentage
rate. This rate represents the percentage of the stock’s par, or face, value that
equals the annual dividend. For instance, an 8 percent preferred stock with a
$50 par value would be expected to pay an annual dividend of $4 per share
(0.08 * $50 par = $4). Before the cost of preferred stock is calculated, any divi-
dends stated as percentages should be converted to annual dollar dividends.

CALCULATING THE COST OF PREFERRED STOCK

cost of preferred stock, rp The cost of preferred stock, rp, is the ratio of the preferred stock dividend to the
The ratio of the preferred stock firm’s net proceeds from the sale of the preferred stock. The net proceeds repre-
dividend to the firm’s net sent the amount of money to be received minus any flotation costs. Equation 9.3
proceeds from the sale of
gives the cost of preferred stock, rp, in terms of the annual dollar dividend, Dp,
preferred stock.
and the net proceeds from the sale of the stock, Np:

Dp
rp = (9.3)
Np
 CHAPTER 9 The Cost of Capital 365

Example 9.7 3 Duchess Corporation is contemplating issuance of a 10% preferred stock that
they expect to sell for $87 per share. The cost of issuing and selling the stock will
be $5 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 $8.70 (0.10 * $87).
The net proceeds per share from the proposed sale of stock equals the sale price
minus the flotation costs ($87 - $5 = $82). Substituting the annual dividend,
Dp, of $8.70 and the net proceeds, Np, of $82 into Equation 9.3 gives the cost of
preferred stock, 10.6% ($8.70 , $82).

The cost of Duchess’s preferred stock (10.6%) is much greater than the cost
of its long-term debt (5.67%). This difference exists both because the cost of
long-term debt (the interest) is tax deductible and because preferred stock is
riskier than long-term debt.

6 REVIEW QUESTION
9–8 How would you calculate the cost of preferred stock?

LG 5 9.4 Cost of Common Stock

In more depth The cost of common stock is the return required on the stock by investors in the
marketplace. There are two forms of common stock financing: (1) retained earn-
To read about Subjective ings and (2) new issues of common stock. As a first step in finding each of these
Techniques, go to costs, we must estimate the cost of common stock equity.
www.myfinancelab.com
FINDING THE COST OF COMMON STOCK EQUITY
The cost of common stock equity, rs, is the rate at which investors discount the
cost of common stock expected common stock dividends of the firm to determine its share value. Two tech-
equity, rs niques are used to measure the cost of common stock equity. One relies on the con-
The rate at which investors stant-growth valuation model, the other on the capital asset pricing model (CAPM).
discount the expected
dividends of the firm to Using the Constant-Growth Valuation (Gordon Growth) Model
determine its share value. In Chapter 7 we found the value of a share of stock to be equal to the present
constant-growth valuation value of all future dividends, which in one model were assumed to grow at a con-
(Gordon growth) model stant annual rate over an infinite time horizon. This is the constant-growth valu-
Assumes that the value of a ation model, also known as the Gordon growth model. The key expression
share of stock equals the derived for this model was presented as Equation 7.4 and is restated here:
present value of all future
dividends (assumed to grow at
D1
a constant rate) that it is P0 = (9.4)
expected to provide over an rs - g
infinite time horizon.
where
P0 = value of common stock
D1 = per-share dividend expected at the end of year 1
rs = required return on common stock
g = constant rate of growth in dividends
366 PART 4 Risk and the Required Rate of Return

Solving Equation 9.4 for rs results in the following expression for the cost of
common stock equity:

D1
rs = + g (9.5)
P0

Equation 9.5 indicates that the cost of common stock equity can be found by
dividing the dividend expected at the end of year 1 by the current market price of
the stock (the “dividend yield”) and adding the expected growth rate (the “cap-
ital gains yield”).

Example 9.8 3 Duchess Corporation wishes to determine its cost of common stock equity, rs. The
market price, P0, of its common stock is $50 per share. The firm expects to pay a
dividend, D1, of $4 at the end of the coming year, 2013. The dividends paid on the
outstanding stock over the past 6 years (2007 through 2012) were as follows:

Year Dividend

2012 $3.80
2011 3.62
2010 3.47
2009 3.33
2008 3.12
2007 2.97

Using a financial calculator or electronic spreadsheet, in conjunction with the tech-

nique described for finding growth rates in Chapter 5, we can calculate the annual
rate at which dividends have grown, g, from 2007 to 2012. It turns out to be
approximately 5% (more precisely, it is 5.05%). Substituting D1 = $4, P0 = $50,
and g = 5% into Equation 9.5 yields the cost of common stock equity:
$4
rs = + 0.05 = 0.08 + 0.05 = 0.130 or 13.0%
$50
The 13.0% cost of common stock equity represents the return required by
existing shareholders on their investment. If the actual return is less than that,
shareholders are likely to begin selling their stock.

Using the Capital Asset Pricing Model (CAPM)

capital asset pricing model Recall from Chapter 8 that the capital asset pricing model (CAPM) describes the
(CAPM) relationship between the required return, rs, and the nondiversifiable risk of the
Describes the relationship firm as measured by the beta coefficient, b. The basic CAPM is:
between the required return, rs,
rs = RF + 3b * (rm - RF)4
and the nondiversifiable risk of
(9.6)
the firm as measured by the
beta coefficient, b.
where
RF = risk-free rate of return
rm = market return; return on the market portfolio of assets
 CHAPTER 9 The Cost of Capital 367

Using the CAPM indicates that the cost of common stock equity is the return
required by investors as compensation for the firm’s nondiversifiable risk, meas-
ured by beta.

Example 9.9 3 Duchess Corporation now wishes to calculate its cost of common stock equity, rs,
by using the CAPM. The firm’s investment advisors and its own analysts indicate
that the risk-free rate, RF, equals 7%; the firm’s beta, b, equals 1.5; and the
market return, rm, equals 11%. Substituting these values into Equation 9.6, the
company estimates the cost of common stock equity, rs, to be:
rs = 7.0% + 31.5 * (11.0% - 7.0%)4 = 7.0% + 6.0% = 13.0%
The 13.0% cost of common stock equity represents the required return of
investors in Duchess Corporation common stock. It is the same as that found by
using the constant-growth valuation model.

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 or cost of common stock equity. The constant-growth model does not look
at risk; it uses the market price, P0, as a reflection of the expected risk–return
preference of investors in the marketplace. The constant-growth valuation and
CAPM techniques for finding rs are theoretically equivalent, though in practice
estimates from the two methods do not always agree. The two methods can pro-
duce different estimates because they require (as inputs) estimates of other quan-
tities, such as the expected dividend growth rate or the firm’s beta.
Another difference is that when the constant-growth valuation model is used to
find the cost of common stock equity, it can easily be adjusted for flotation costs to
find the cost of new common stock; the CAPM does not provide a simple adjust-
ment mechanism. The difficulty in adjusting the cost of common stock equity cal-
culated by using the CAPM occurs because in its common form the model does not
include the market price, P0, a variable needed to make such an adjustment.
Although the CAPM has a stronger theoretical foundation, the computational
appeal of the traditional constant-growth valuation model justifies its use
throughout this text to measure financing costs of common stock. As a practical
matter, analysts might want to estimate the cost of equity using both approaches and
then take an average of the results to arrive at a final estimate of the cost of equity.

COST OF RETAINED EARNINGS

As you know, dividends are paid out of a firm’s earnings. Their payment, made in
cash to common stockholders, reduces the firm’s retained earnings. Suppose a
firm needs common stock equity financing of a certain amount. It has two
choices relative to retained earnings: It can issue additional common stock in that
amount and still pay dividends to stockholders out of retained earnings, or it can
cost of retained earnings, rr
increase common stock equity by retaining the earnings (not paying the cash divi-
The same as the cost of an
equivalent fully subscribed
dends) in the needed amount. In a strict accounting sense, the retention of earnings
issue of additional common increases common stock equity in the same way that the sale of additional shares of
stock, which is equal to the cost common stock does. Thus the cost of retained earnings, rr , to the firm is the same
of common stock equity, rs. as the cost of an equivalent fully subscribed issue of additional common stock.
368 PART 4 Risk and the Required Rate of Return

Stockholders find the firm’s retention of earnings acceptable only if they expect
that it will earn at least their required return on the reinvested funds.
Viewing retained earnings as a fully subscribed issue of additional common
stock, we can set the firm’s cost of retained earnings, rr , equal to the cost of
common stock equity as given by Equations 9.5 and 9.6.

rr = rs (9.7)

It is not necessary to adjust the cost of retained earnings for flotation costs because
by retaining earnings the firm “raises” equity capital without incurring these costs.

Example 9.10 3 The cost of retained earnings for Duchess Corporation was actually calculated in
the preceding examples: It is equal to the cost of common stock equity. Thus rr
equals 13.0%. As we will show in the next section, the cost of retained earnings
is always lower than the cost of a new issue of common stock because it entails
no flotation costs.

Matter of fact
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. For example, a 2010 survey of CEOs by the Australian Industry Group
and Deloitte reported that the vast majority of Australian firms see retained earnings as their most
important source of finance. Almost 65% of CEOs surveyed said that retained earnings was their
most preferred source of financing, with bank debt coming in as a distant second choice.2

COST OF NEW ISSUES OF COMMON STOCK

Our purpose in finding the firm’s overall cost of capital is to determine the after-
cost of a new issue of tax cost of new funds required for financing projects. The cost of a new issue of
common stock, rn common stock, rn, is determined by calculating the cost of common stock, net of
The cost of common stock, net underpricing and associated flotation costs. Normally, when new shares are issued
of underpricing and associated they are underpriced—sold at a discount relative to the current market price, P0.
flotation costs.
Underpricing is the difference between the market price and the issue price, which
underpriced is the price paid by the primary market investors discussed in Chapter 2.
Stock sold at a price below its We can use the constant-growth valuation model expression for the cost of
current market price, P0.
existing common stock, rs, as a starting point. If we let Nn represent the net pro-
ceeds from the sale of new common stock after subtracting underpricing and
flotation costs, the cost of the new issue, rn, can be expressed as follows:3

D1
rn = + g (9.8)
Nn

2. Australian Industry Group and Deloitte, National CEO Survey: Growth Strategies for Business, Report, October
2010.
3. An alternative, but computationally less straightforward, form of this equation is
D1
rn = + g (9.8a)
P0 * (1 - f )
where f represents the percentage reduction in current market price expected as a result of underpricing and flota-
tion costs. Simply stated, Nn in Equation 9.8 is equivalent to P0 * (1 - f ) in Equation 9.8a. For convenience,
Equation 9.8 is used to define the cost of a new issue of common stock, rn.
 CHAPTER 9 The Cost of Capital 369

The net proceeds from sale of new common stock, Nn, will be less than the
current market price, P0. Therefore, the cost of new issues, rn, will always be
greater than the cost of existing issues, rs, which is equal to the cost of retained
earnings, rr. The cost of new common stock is normally greater than any other
long-term financing cost.

Example 9.11 3 In the constant-growth valuation example, we found Duchess Corporation’s cost
of common stock equity, rs, to be 13%, using the following values: an expected
dividend, D1, of $4; 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 has
estimated that on average, new shares can be sold for $47. The $3-per-share
underpricing is due to the competitive nature of the market. A second cost asso-
ciated with a new issue is flotation costs of $2.50 per share that would be paid to
issue and sell the new shares. The total underpricing and flotation costs per share
are therefore $5.50.
Subtracting the $5.50-per-share underpricing and flotation cost from the cur-
rent $50 share price results in expected net proceeds of $44.50 per share ($50.00
minus $5.50). Substituting D1 = $4, Nn = $44.50, and g = 5% into Equation 9.8
results in a cost of new common stock, rn, as follows:
$4.00
rn = + 0.05 = 0.09 + 0.05 = 0.140 or 14.0%
$44.50
Duchess Corporation’s cost of new common stock is therefore 14.0%. This is the
value to be used in subsequent calculations of the firm’s overall cost of capital.

6 REVIEW QUESTIONS
9–9 What premise about share value underlies the constant-growth valua-
tion (Gordon growth) model that is used to measure the cost of common
stock equity, rs?
9–10 How do the constant-growth valuation model and capital asset pricing
model methods for finding the cost of common stock differ?
9–11 Why is the cost of financing a project with retained earnings less than
the cost of financing it with a new issue of common stock?

LG 6 9.5 Weighted Average Cost of Capital

Now that we have calculated the cost of specific sources of financing, we can
weighted average cost of determine the overall cost of capital. As noted earlier, the weighted average cost
capital (WACC), ra of capital (WACC), ra, reflects the expected average future cost of capital over the
Reflects the expected average long run. It is found by weighting the cost of each specific type of capital by its
future cost of capital over the proportion in the firm’s capital structure.
long run; found by weighting
the cost of each specific type of
capital by its proportion in the CALCULATING WEIGHTED AVERAGE COST OF CAPITAL (WACC)
firm’s capital structure.
Calculating the weighted average cost of capital (WACC) is straightforward:
Multiply the individual cost of each form of financing by its proportion in the
370 PART 4 Risk and the Required Rate of Return

firm’s capital structure and sum the weighted values. As an equation, the weighted
average cost of capital, ra, can be specified as follows:

ra = (wi * ri) + (wp * rp) + (ws * rr or n) (9.9)

where
wi = 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
wi + wp + ws = 1.0
Three important points should be noted in Equation 9.9:
1. For computational convenience, it is best to convert the weights into decimal
form and leave the individual costs in percentage terms.
2. The weights must be nonnegative and sum to 1.0. Simply stated, WACC
must account for all financing costs within the firm’s capital structure.
3. The firm’s common stock equity weight, ws, is multiplied by either the cost of
retained earnings, rr , or the cost of new common stock, rn. Which cost is used
depends on whether the firm’s common stock equity will be financed using
retained earnings, rr , or new common stock, rn.

Example 9.12 3 In earlier examples, we found the costs of the various types of capital for Duchess
Corporation to be as follows:

Cost of debt, ri = 5.6%

Cost of preferred stock, rp = 10.6%
Cost of retained earnings, rr = 13.0%
Cost of new common stock, rn = 14.0%

The company uses the following weights in calculating its weighted average cost
of capital:

Source of capital Weight

Long-term debt 40%

Preferred stock 10
Common stock equity 50
Total 100%

Because the firm expects to have a sizable amount of retained earnings avail-
able ($300,000), it plans to use its cost of retained earnings, rr , as the cost of
common stock equity. Duchess Corporation’s weighted average cost of capital is
calculated in Table 9.1. The resulting weighted average cost of capital for
Duchess is 9.8%. Assuming an unchanged risk level, the firm should accept all
projects that will earn a return greater than 9.8%.
 CHAPTER 9 The Cost of Capital 371

Calculation of the Weighted Average Cost

TA B L E 9 . 1
of Capital for Duchess Corporation

Weighted cost
Weight Cost [(1) : (2)]
Source of capital (1) (2) (3)
Long-term debt 0.40 5.6% 2.2%
Preferred stock 0.10 10.6 1.1
Common stock equity 0.50 13.0 6.5
Totals 1.00 WACC = 9.8%

focus on PRACTICE
Uncertain Times Make for an Uncertain Weighted Average
Cost of Capital
in practice As U.S. financial mar- inaccessible, and the great recession on those projects that have immediate
kets experienced and saw Treasury bond yields fall to historic returns,” Mr. Domanico is quoted
recovered from the 2008 financial lows, making cost of equity projections saying.a
crisis and 2009 “great recession,” appear unreasonably low. With these Part of Caraustar’s motivation for
firms struggled to keep track of their key components in flux, it is exceedingly implementing this two-pronged
weighted average cost of capital. difficult, if not impossible, for firms to approach was to account for the exces-
The individual component costs were get a handle on a cost of long-term sively large spread between short- and
moving rapidly in response to the capital. long-term debt rates that emerged dur-
financial market turmoil. Volatile finan- According to CFO Magazine, at ing the financial market crisis. Mr.
cial markets can make otherwise man- least one firm resorted to a two- Domanico reported that during the cri-
ageable cost-of-capital calculations pronged approach for determining its sis Caraustar could borrow short-term
exceedingly complex and inherently cost of capital during the uncertain funds at the lower of Prime plus 4 per-
error prone—possibly wreaking times. Ron Domanico is the chief finan- cent or LIBOR plus 5 percent—where
havoc with investment decisions. If a cial officer (CFO) at Caraustar either rate was reasonable for making
firm underestimates its cost of capital Industries, Inc., and he reported that his short-term investment decisions.
it risks making investments that are company dealt with the cost-of-capital Alternatively, long-term investment deci-
not economically justified, and if a uncertainty by abandoning the conven- sions were being required to clear
firm overestimates its financing costs it tional one-size-fits-all approach. “In the Caraustar’s long-term cost-of-capital cal-
risks foregoing value-maximizing past, we had one cost of capital that culation accounting for borrowing rates
investments. we applied to all our investment deci- in excess of 12 percent.
Although the WACC computation sions . . . today that’s not the case. We
3 Why don’t firms generally use
does not change when markets have a short-term cost of capital we
both short- and long-run weighted
become unstable, the uncertainty sur- apply to short-term opportunities, and a
average costs of capital?
rounding the components that comprise longer-term cost of capital we apply to
the WACC increases dramatically. The longer-term opportunities . . . and the
financial crisis pushed credit costs to a reality is that the longer-term cost is so
point where long-term debt was largely high that it has forced us to focus only
a
Randy Myers, “A Losing Formula” (May 2009), www.cfo.com/article.cfm/13522582/c_13526469.
372 PART 4 Risk and the Required Rate of Return

WEIGHTING SCHEMES
Firms can calculate weights on the basis of either book value or market value
using either historical or target proportions.
book value weights
Weights that use accounting Book Value versus Market Value
values to measure the
proportion of each type of Book value weights use accounting values to measure the proportion of each type of
capital in the firm’s financial capital in the firm’s financial structure. Market value weights measure the propor-
structure. tion of each type of capital at its market value. Market value weights are appealing
market value weights because the market values of securities closely approximate the actual dollars to be
Weights that use market values received from their sale. Moreover, because firms calculate the costs of the various
to measure the proportion of types of capital by using prevailing market prices, it seems reasonable to use market
each type of capital in the value weights. In addition, the long-term investment cash flows to which the cost of
firm’s financial structure. capital is applied are estimated in terms of current as well as future market values.
historical weights Market value weights are clearly preferred over book value weights.
Either book or market value
weights based on actual Historical versus Target
capital structure proportions. Historical weights can be either book or market value weights based on actual
target weights capital structure proportions. For example, past or current book value propor-
Either book or market value tions would constitute a form of historical weighting, as would past or current
weights based on desired market value proportions. Such a weighting scheme would therefore be based on
capital structure proportions.
real—rather than desired—proportions.
Target weights, which can also be based on either book or market values,
In more depth reflect the firm’s desired capital structure proportions. Firms using target weights
establish such proportions on the basis of the “optimal” capital structure they
To read about Changes
wish to achieve. (The development of these proportions and the optimal structure
in the Weighted Average are discussed in detail in Chapter 13.)
Cost of Capital, go to When one considers the somewhat approximate nature of the calculation of
www.myfinancelab.com weighted average cost of capital, the choice of weights may not be critical.
However, from a strictly theoretical point of view, the preferred weighting scheme
is target market value proportions, and we assume these throughout this chapter.

Personal Finance Example 9.13 3 Chuck Solis currently has three loans outstanding, all of which
mature in exactly 6 years and can be repaid without penalty
any time prior to maturity. The outstanding balances and annual interest rates on
these loans are noted in the following table.

Outstanding Annual
Loan balance interest rate

1 $26,000 9.6%
2 9,000 10.6
3 45,000 7.4

After a thorough search, Chuck found a lender who would loan him $80,000 for
6 years at an annual interest rate of 9.2% on the condition that the loan proceeds
be used to fully repay the three outstanding loans, which combined have an out-
standing balance of $80,000 ($26,000 + $9,000 + $45,000).
Chuck wishes to choose the least costly alternative: (1) to do nothing or (2)
to borrow the $80,000 and pay off all three loans. He calculates the weighted
 CHAPTER 9 The Cost of Capital 373

average cost of his current debt by weighting each debt’s annual interest cost by
the proportion of the $80,000 total it represents and then summing the three
weighted values as follows:
Weighted average
cost of current debt = 3($26,000 , $80,000) * 9.6%4 + 3($9,000 , $80,000)
* 10.6%4 + 3($45,000 , $80,000) * 7.4%4
= (.3250 * 9.6%) + (.1125 * 10.6%) + (.5625 * 7.4%)
= 3.12% + 1.19% + 4.16% = 8.47% L 8.5%
Given that the weighted average cost of the $80,000 of current debt of 8.5% is
below the 9.2% cost of the new $80,000 loan, Chuck should do nothing, and just
continue to pay off the three loans as originally scheduled.

6 REVIEW QUESTIONS
9–12 What is the weighted average cost of capital (WACC), and how is it cal-
culated?
9–13 What is the relationship between the firm’s target capital structure and
the weighted average cost of capital (WACC)?
9–14 Describe the logic underlying the use of target weights to calculate the
WACC, and compare and contrast this approach with the use of
historical weights. What is the preferred weighting scheme?

Summary
FOCUS ON VALUE
The cost of capital is an extremely important rate of return, particularly in cap-
ital budgeting decisions. It is the expected average future cost to the firm of
funds over the long run. Because the cost of capital is the pivotal rate of return
used in the investment decision process, its accuracy can significantly affect the
quality of these decisions.
Underestimation of the cost of capital can make poor projects look attractive;
overestimation can make good projects look unattractive. By applying the tech-
niques presented in this chapter to estimate the firm’s cost of capital, the financial
manager will improve the likelihood that the firm’s long-term decisions will be
consistent with the firm’s overall goal of maximizing stock price (owner wealth).

REVIEW OF LEARNING GOALS

LG 1
Understand the basic concept and sources of capital associated with the
cost of capital. The cost of capital is the minimum rate of return that a firm must
earn on its investments to grow firm value. A weighted average cost of capital
should be used to find the expected average future cost of funds over the long
run. The individual costs of the basic sources of capital (long-term debt, pre-
ferred stock, retained earnings, and common stock) can be calculated separately.
LG 2
Explain what is meant by the marginal cost of capital. The relevant cost
of capital for a firm is the marginal cost of capital necessary to raise the next
374 PART 4 Risk and the Required Rate of Return

marginal dollar of financing to fund the firm’s future investment opportunities.

A firm’s future investment opportunities in expectation will be required to
exceed the firm’s cost of capital.
LG 3
Determine the cost of long-term debt, and explain why the after-tax cost
of debt is the relevant cost of debt. The before-tax cost of long-term debt can be
found by using cost quotations, calculations (either by calculator or spread-
sheet), or an approximation. The after-tax cost of debt is calculated by multi-
plying the before-tax cost of debt by 1 minus the tax rate. The after-tax cost of
debt is the relevant cost of debt because it is the lowest possible cost of debt for
the firm due to 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 cost of common stock equity, and convert it into the cost
of retained earnings and the cost of new issues of common stock. The cost of
common stock equity can be calculated by using the constant-growth valuation
(Gordon growth) model or the CAPM. The cost of retained earnings is equal to
the cost of common stock equity. An adjustment in the cost of 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 reflects the expected average
future cost of funds over the long run. It combines the costs of specific types of
capital after weighting each of them by its proportion. The theoretically pre-
ferred approach uses target weights based on market values.

Opener-in-Review
The chapter opener claimed that GE’s cost of capital in late 2009 was about
5%. Suppose that GE could use $1 billion to make an investment that would
generate positive cash flow of $60 million every year in perpetuity. At a 5 per-
cent discount rate, what would be the value of this cash flow to investors? How
much would such an investment add to GE’s market value? Now suppose that
the investment actually produces just $10 million per year in perpetuity (or
about 1 percent per year relative to the cost of the investment). What is the
value of this investment to shareholders, and by how much would GE’s market
value fall because of this investment?

Self-Test Problem (Solutions in Appendix)

LG 3 LG 4 ST9–1 Individual costs and WACC Humble Manufacturing is interested in measuring its
overall cost of capital. The firm is in the 40% tax bracket. Current investigation has
LG 5 LG 6
gathered the following data:
Debt The firm can raise debt by selling $1,000-par-value, 10% coupon interest
rate, 10-year bonds on which annual interest payments will be made. To sell the
 CHAPTER 9 The Cost of Capital 375

issue, an average discount of $30 per bond must be given. The firm must also
pay flotation costs of $20 per bond.
Preferred stock The firm can sell 11% (annual dividend) preferred stock at its
$100-per-share par value. The cost of issuing and selling the preferred stock is
expected to be $4 per share.
Common stock The firm’s common stock is currently selling for $80 per share.
The firm expects to pay cash dividends of $6 per share next year. The firm’s divi-
dends have been growing at an annual rate of 6%, and this rate is expected to
continue in the future. The stock will have to be underpriced by $4 per share,
and flotation costs are expected to amount to $4 per share.
Retained earnings The firm expects to have $225,000 of retained earnings
available in the coming year. Once these retained earnings are exhausted, the firm
will use new common stock as the form of common stock equity financing.
a. Calculate the individual cost of each source of financing. (Round to the nearest
0.1%.)
b. Calculate the firm’s weighted average cost of capital using the weights shown in
the following table, which are based on the firm’s target capital structure propor-
tions. (Round to the nearest 0.1%.)

Source of capital Weight

Long-term debt 40%

Preferred stock 15
Common stock equity 45
Total 100%

c. In which, if any, of the investments shown in the following table do you recom-
mend that the firm invest? Explain your answer. How much new financing is
required?

Investment Expected rate Initial

opportunity of return investment

A 11.2% $100,000
B 9.7 500,000
C 12.9 150,000
D 16.5 200,000
E 11.8 450,000
F 10.1 600,000
G 10.5 300,000

Warm-Up Exercises All problems are available in .

LG 3 E9–1 A firm raises capital by selling $20,000 worth of debt with flotation costs equal to
2% of its par value. If the debt matures in 10 years and has a coupon interest rate of
8%, what is the bond’s YTM?
376 PART 4 Risk and the Required Rate of Return

LG 4 E9–2 Your firm, People’s Consulting Group, has been asked to consult on a potential pre-
ferred stock offering by Brave New World. This 15% preferred stock issue would be
sold at its par value of $35 per share. Flotation costs would total $3 per share.
Calculate the cost of this preferred stock.

LG 5 E9–3 Duke Energy has been paying dividends steadily for 20 years. During that time, divi-
dends have grown at a compound annual rate of 7%. If Duke Energy’s current stock
price is $78 and the firm plans to pay a dividend of $6.50 next year, what is Duke’s
cost of common stock equity?

LG 6 E9–4 Weekend Warriors, Inc., has 35% debt and 65% equity in its capital structure. The
firm’s estimated after-tax cost of debt is 8% and its estimated cost of equity is 13%.
Determine the firm’s weighted average cost of capital (WACC).

LG 6 E9–5 Oxy Corporation uses debt, preferred stock, and common stock to raise capital. The
firm’s capital structure targets the following proportions: debt, 55%; preferred
stock, 10%; and common stock, 35%. If the cost of debt is 6.7%, preferred stock
costs 9.2%, and common stock costs 10.6%, what is Oxy’s weighted average cost of
capital (WACC)?

Problems All problems are available in .

LG 1 P9–1 Concept of cost of capital Wren Manufacturing is in the process of analyzing its
investment decision-making procedures. The two projects evaluated by the firm
during the past month were projects 263 and 264. The basic variables surrounding
each project analysis and the resulting decision actions are summarized in the fol-
lowing table.

Basic variables Project 263 Project 264

Cost $64,000 $58,000

Life 15 years 15 years
Expected return 8% 15%
Least-cost financing
Source Debt Equity
Cost (after-tax) 7% 16%
Decision
Action Invest Don’t invest
Reason 8% 7 7% cost 15% 6 16% cost

a. Evaluate the firm’s decision-making procedures, and explain why the acceptance of
project 263 and rejection of project 264 may not be in the owners’ best interest.
b. If the firm maintains a capital structure containing 40% debt and 60% equity,
find its weighted average cost using the data in the table.
c. If the firm had used the weighted average cost calculated in part b, what actions
would have been indicated relative to projects 263 and 264?
d. Compare and contrast the firm’s actions with your findings in part c. Which deci-
sion method seems more appropriate? Explain why.
 CHAPTER 9 The Cost of Capital 377

LG 3 P9–2 Cost of debt using both methods Currently, Warren Industries can sell 15-year,
$1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of
current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30
per bond will be incurred in this process. The firm is in the 40% tax bracket.
a. Find the net proceeds from sale of the bond, Nd.
b. Show the cash flows from the firm’s point of view over the maturity of the bond.
c. Calculate the before-tax and after-tax costs of debt.
d. Use the approximation formula to estimate the before-tax and after-tax costs of
debt.
e. Compare and contrast the costs of debt calculated in parts c and d. Which
approach do you prefer? Why?

Personal Finance Problem

LG 3 P9–3 Before-tax cost of debt and after-tax cost of debt David Abbot is interested in
purchasing a bond issued by Sony. He has obtained the following information on
the security:

Sony bond

Par value $1,000 Coupon interest rate 6% Tax bracket 20%

Cost $ 930 Years to maturity 10

Answer the following questions.

a. Calculate the before-tax cost of the Sony bond.
b. Calculate the after-tax cost of the Sony bond given David’s tax bracket.

LG 3 P9–4 Cost of debt using the approximation formula For each of the following $1,000-par-
value bonds, assuming annual interest payment and a 40% tax rate, calculate the
after-tax cost to maturity using the approximation formula.

Discount (  ) or Coupon
Bond Life (years) Underwriting fee premium (  ) interest rate

A 20 $25 - $20 9%
B 16 40 + 10 10
C 15 30 - 15 12
D 25 15 Par 9
E 22 20 - 60 11

LG 3 P9–5 The cost of debt Gronseth Drywall Systems, Inc., is in discussions with its invest-
ment bankers regarding the issuance of new bonds. The investment banker has
informed the firm that different maturities will carry different coupon rates and sell
at different prices. The firm must choose among several alternatives. In each case,
the bonds will have a $1,000 par value and flotation costs will be $30 per bond. The
company is taxed at a rate of 40%. Calculate the after-tax cost of financing with
each of the following alternatives.
378 PART 4 Risk and the Required Rate of Return

Coupon Time to Premium or

Alternative rate maturity (years) discount

A 9% 16 $250
B 7 5 50
C 6 7 par
D 5 10 - 75

Personal Finance Problem

LG 3 P9–6 After-tax cost of debt Rick and Stacy Stark, a married couple, are interested in pur-
chasing their first boat. They have decided to borrow the boat’s purchase price of
$100,000. The family is in the 28% federal income tax bracket. There are two
choices for the Stark family: They can borrow the money from the boat dealer at an
annual interest rate of 8%, or they could take out a $100,000 second mortgage on
their home. Currently, home equity loans are at rates of 9.2%. There is no problem
securing either of these two alternative financing choices.
Rick and Stacy learn that if they borrow from the boat dealership, the interest
will not be tax deductible. However, the interest on the second mortgage will qualify
as being tax deductible on their federal income tax return.
a. Calculate the after-tax cost of borrowing from the boat dealership.
b. Calculate the after-tax cost of borrowing through a second mortgage on their
home.
c. Which source of borrowing is less costly for the Stark family?

LG 4 P9–7 Cost of preferred stock Taylor Systems has just issued preferred stock. The stock
has a 12% annual dividend and a $100 par value and was sold at $97.50 per share.
In addition, flotation costs of $2.50 per share must be paid.
a. Calculate the cost of the preferred stock.
b. If the firm sells the preferred stock with a 10% annual dividend and nets $90.00
after flotation costs, what is its cost?

LG 4 P9–8 Cost of preferred stock Determine the cost for each of the following preferred
stocks.

Preferred stock Par value Sale price Flotation cost Annual dividend

A $100 $101 $9.00 11%

B 40 38 $3.50 8%
C 35 37 $4.00 $5.00
D 30 26 5% of par $3.00
E 20 20 $2.50 9%

LG 5 P9–9 Cost of common stock equity—CAPM J&M Corporation common stock has a
beta, b, of 1.2. The risk-free rate is 6%, and the market return is 11%.
a. Determine the risk premium on J&M common stock.
b. Determine the required return that J&M common stock should provide.
c. Determine J&M’s cost of common stock equity using the CAPM.
 CHAPTER 9 The Cost of Capital 379

LG 5 P9–10 Cost of common stock equity Ross Textiles wishes to measure its cost of common
stock equity. The firm’s stock is currently selling for $57.50. The firm expects to pay
a $3.40 dividend at the end of the year (2013). The dividends for the past 5 years
are shown in the following table.

Year Dividend

2012 $3.10
2011 2.92
2010 2.60
2009 2.30
2008 2.12

After underpricing and flotation costs, the firm expects to net $52 per share on a
new issue.
a. Determine the growth rate of dividends from 2008 to 2012.
b. Determine the net proceeds, Nn, that the firm will actually receive.
c. Using the constant-growth valuation model, determine the cost of retained earn-
ings, rr.
d. Using the constant-growth valuation model, determine the cost of new common
stock, rn.

LG 5 P9–11 Retained earnings versus new common stock Using the data for each firm shown
in the following table, calculate the cost of retained earnings and the cost of new
common stock using the constant-growth valuation model.

Projected
Current market Dividend dividend per Underpricing Flotation cost
Firm price per share growth rate share next year per share per share

A $50.00 8% $2.25 $2.00 $1.00

B 20.00 4 1.00 0.50 1.50
C 42.50 6 2.00 1.00 2.00
D 19.00 2 2.10 1.30 1.70

LG 3 LG 4 P9–12 The effect of tax rate on WACC Equity Lighting Corp. wishes to explore the effect
LG 5 LG 6
on its cost of capital of the rate at which the company pays taxes. The firm wishes to
maintain a capital structure of 30% debt, 10% preferred stock, and 60% common
stock. The cost of financing with retained earnings is 14%, the cost of preferred
stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate
the weighted average cost of capital (WACC) given the tax rate assumptions in
parts a to c.
a. Tax rate = 40%
b. Tax rate = 35%
c. Tax rate = 25%
d. Describe the relationship between changes in the rate of taxation and the
weighted average cost of capital.
380 PART 4 Risk and the Required Rate of Return

LG 6 P9–13 WACC—Book weights Ridge Tool has on its books the amounts and specific
(after-tax) costs shown in the following table for each source of capital.

Source of capital Book value Individual cost

Long-term debt $700,000 5.3%

Preferred stock 50,000 12.0
Common stock equity 650,000 16.0

a. Calculate the firm’s weighted average cost of capital using book value weights.
b. Explain how the firm can use this cost in the investment decision-making
process.

LG 6 P9–14 WACC—Book weights and market weights Webster Company has compiled the
information shown in the following table.

Source of capital Book value Market value After-tax cost

Long-term debt $4,000,000 $3,840,000 6.0%

Preferred stock 40,000 60,000 13.0
Common stock equity 1,060,000 3,000,000 17.0
Totals $5,100,000 $6,900,000

a. Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value weights.
c. Compare the answers obtained in parts a and b. Explain the differences.

LG 6 P9–15 WACC and target weights After careful analysis, Dexter Brothers has determined
that its optimal capital structure is composed of the sources and target market value
weights shown in the following table.

Target market
Source of capital value weight

Long-term debt 30%

Preferred stock 15
Common stock equity 55
Total 100%

The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to
be 13.5%; the cost of retained earnings is estimated to be 16.0%; and the cost of
new common stock is estimated to be 18.0%. All of these are after-tax rates. The
company’s debt represents 25%, the preferred stock represents 10%, and the
common stock equity represents 65% of total capital on the basis of the market
values of the three components. The company expects to have a significant amount
of retained earnings available and does not expect to sell any new common stock.
 CHAPTER 9 The Cost of Capital 381

a. Calculate the weighted average cost of capital on the basis of historical market
value weights.
b. Calculate the weighted average cost of capital on the basis of target market value
weights.
c. Compare the answers obtained in parts a and b. Explain the differences.

LG 3 LG 4 P9–16 Cost of capital Edna Recording Studios, Inc., reported earnings available to
LG 5 LG 6
common stock of $4,200,000 last year. From those earnings, the company paid a
dividend of $1.26 on each of its 1,000,000 common shares outstanding. The capital
structure of the company includes 40% debt, 10% preferred stock, and 50%
common stock. It is taxed at a rate of 40%.
a. If the market price of the common stock is $40 and dividends are expected to
grow at a rate of 6% per year for the foreseeable future, what is the company’s
cost of retained earnings financing?
b. If underpricing and flotation costs on new shares of common stock amount to
$7.00 per share, what is the company’s cost of new common stock financing?
c. The company can issue $2.00 dividend preferred stock for a market price of
$25.00 per share. Flotation costs would amount to $3.00 per share. What is the
cost of preferred stock financing?
d. The company can issue $1,000-par-value, 10% coupon, 5-year bonds that can be
sold for $1,200 each. Flotation costs would amount to $25.00 per bond. Use the
estimation formula to figure the approximate cost of debt financing.
e. What is the WACC?

LG 3 LG 4 P9–17 Calculation of individual costs and WACC Dillon Labs has asked its financial
LG 5 LG 6
manager to measure the cost of each specific type of capital as well as the weighted
average cost of capital. The weighted average cost is to be measured by using the fol-
lowing weights: 40% long-term debt, 10% preferred stock, and 50% common stock
equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%.
Debt The firm can sell for $980 a 10-year, $1,000-par-value bond paying
annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is
required in addition to the discount of $20 per bond.
Preferred stock Eight percent (annual dividend) preferred stock having a par
value of $100 can be sold for $65. An additional fee of $2 per share must be
paid to the underwriters.
Common stock The firm’s common stock is currently selling for $50 per share.
The dividend expected to be paid at the end of the coming year (2013) is $4. Its
dividend payments, which have been approximately 60% of earnings per share
in each of the past 5 years, were as shown in the following table.

Year Dividend

2012 $3.75
2011 3.50
2010 3.30
2009 3.15
2008 2.85
382 PART 4 Risk and the Required Rate of Return

It is expected that to attract buyers, new common stock must be underpriced $5 per
share, and the firm must also pay $3 per share in flotation costs. Dividend payments
are expected to continue at 60% of earnings. (Assume that rr = rs.)
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock.
d. Calculate the WACC for Dillon Labs.

Personal Finance Problem

LG 6 P9–18 Weighted average cost of capital John Dough has just been awarded his degree in
business. He has three education loans outstanding. They all mature in 5 years and
can be repaid without penalty any time before maturity. The amounts owed on each
loan and the annual interest rate associated with each loan are given in the following
table.

Annual
Loan Balance due interest rate

1 $20,000 6%
2 12,000 9
3 32,000 5

John can also combine the total of his three debts (that is, $64,000) and create a
consolidated loan from his bank. His bank will charge a 7.2% annual interest rate
for a period of 5 years.
Should John do nothing (leave the three individual loans as is) or create a con-
solidated loan (the $64,000 question)?

LG 3 LG 4 P9–19 Calculation of individual costs and WACC Lang Enterprises is interested in meas-
LG 5 LG 6
uring its overall cost of capital. Current investigation has gathered the following
data. The firm is in the 40% tax bracket.
Debt The firm can raise debt by selling $1,000-par-value, 8% coupon interest
rate, 20-year bonds on which annual interest payments will be made. To sell the
issue, an average discount of $30 per bond would have to be given. The firm also
must pay flotation costs of $30 per bond.
Preferred stock The firm can sell 8% preferred stock at its $95-per-share par
value. The cost of issuing and selling the preferred stock is expected to be $5 per
share. Preferred stock can be sold under these terms.
Common stock The firm’s common stock is currently selling for $90 per share.
The firm expects to pay cash dividends of $7 per share next year. The firm’s divi-
dends have been growing at an annual rate of 6%, and this growth is expected to
continue into the future. The stock must be underpriced by $7 per share, and
flotation costs are expected to amount to $5 per share. The firm can sell new
common stock under these terms.
Retained earnings When measuring this cost, the firm does not concern itself
with the tax bracket or brokerage fees of owners. It expects to have available
$100,000 of retained earnings in the coming year; once these retained earnings
 CHAPTER 9 The Cost of Capital 383

are exhausted, the firm will use new common stock as the form of common stock
equity financing.
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock.
d. Calculate the firm’s weighted average cost of capital using the capital structure
weights shown in the following table. (Round answer to the nearest 0.1%.)

Source of capital Weight

Long-term debt 30%

Preferred stock 20
Common stock equity 50
Total 100%

LG 6 P9–20 Weighted average cost of capital American Exploration, Inc., a natural gas pro-
ducer, is trying to decide whether to revise its target capital structure. Currently it
targets a 50–50 mix of debt and equity, but it is considering a target capital structure
with 70% debt. American Exploration currently has 6% after-tax cost of debt and a
12% cost of common stock. The company does not have any preferred stock out-
standing.
a. What is American Exploration’s current WACC?
b. Assuming that its cost of debt and equity remain unchanged, what will be
American Exploration’s WACC under the revised target capital structure?
c. Do you think shareholders are affected by the increase in debt to 70%? If so,
how are they affected? Are their common stock claims riskier now?
d. Suppose that in response to the increase in debt, American Exploration’s share-
holders increase their required return so that cost of common equity is 16%.
What will its new WACC be in this case?
e. What does your answer in part b suggest about the tradeoff between financing
with debt versus equity?

LG 1 P9–21 ETHICS PROBLEM During the 1990s, General Electric put together a long string
of consecutive quarters in which the firm managed to meet or beat the earnings fore-
casts of Wall Street stock analysts. Some skeptics wondered if GE “managed” earn-
ings to meet Wall Street’s expectations, meaning that GE used accounting gimmicks
to conceal the true volatility in its business. How do you think GE’s long run of
meeting or beating earnings forecasts affected its cost of capital? If investors learn
that GE’s performance was achieved largely through accounting gimmicks, how do
you think they would respond?

Spreadsheet Exercise
Nova Corporation is interested in measuring the cost of each specific type of capital
as well as the weighted average cost of capital. Historically, the firm has raised capital
in the following manner:
384 PART 4 Risk and the Required Rate of Return

Source of capital Weight

Long-term debt 35%

Preferred stock 12
Common stock equity 53

The tax rate of the firm is currently 40%. The needed financial information and
data are as follows:
Debt Nova can raise debt by selling $1,000-par-value, 6.5% coupon interest
rate, 10-year bonds on which annual interest payments will be made. To sell the
issue, an average discount of $20 per bond needs to be given. There is an associ-
ated flotation cost of 2% of par value.
Preferred stock Preferred stock can be sold under the following terms: The
security has a par value of $100 per share, the annual dividend rate is 6% of the
par value, and the flotation cost is expected to be $4 per share. The preferred
stock is expected to sell for $102 before cost considerations.
Common stock The current price of Nova’s common stock is $35 per share.
The cash dividend is expected to be $3.25 per share next year. The firm’s divi-
dends have grown at an annual rate of 5%, and it is expected that the dividend
will continue at this rate for the foreseeable future. The flotation costs are
expected to be approximately $2 per share. Nova can sell new common stock
under these terms.
Retained earnings The firm expects to have available $100,000 of retained
earnings in the coming year. Once these retained earnings are exhausted, the firm
will use new common stock as the form of common stock equity financing.
(Note: When measuring this cost, the firm does not concern itself with the tax
bracket or brokerage fees of owners.)

TO DO
Create a spreadsheet to answer the following questions:
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of retained earnings.
d. Calculate the cost of new common stock.
e. Calculate the firm’s weighted average cost of capital using retained earnings and
the capital structure weights shown in the table above.
f. Calculate the firm’s weighted average cost of capital using new common stock
and the capital structure weights shown in the table above.

Visit www.myfinancelab.com for Chapter Case: Making Star Products’ Financing/Investment

Decision, Group Exercises, and numerous online resources.
 Integrative Case 4

Eco Plastics Company

ince its inception, Eco Plastics Company has been revolutionizing plastic and trying
S to do its part to save the environment. Eco’s founder, Marion Cosby, developed a
biodegradable plastic that her company is marketing to manufacturing companies
throughout the southeastern United States. After operating as a private company for
six years, Eco went public in 2009 and is listed on the Nasdaq stock exchange.
As the chief financial officer of a young company with lots of investment oppor-
tunities, Eco’s CFO closely monitors the firm’s cost of capital. The CFO keeps tabs
on each of the individual costs of Eco’s three main financing sources: long-term debt,
preferred stock, and common stock. The target capital structure for ECO is given by
the weights in the following table:

Source of capital Weight

Long-term debt 30%

Preferred stock 20
Common stock equity 50
Total 100%

At the present time, Eco can raise debt by selling 20-year bonds with a $1,000
par value and a 10.5% annual coupon interest rate. Eco’s corporate tax rate is 40%,
and its bonds generally require an average discount of $45 per bond and flotation
costs of $32 per bond when being sold. Eco’s outstanding preferred stock pays a 9%
dividend and has a $95-per-share par value. The cost of issuing and selling addi-
tional preferred stock is expected to be $7 per share. Because Eco is a young firm
that requires lots of cash to grow it does not currently pay a dividend to common
stock holders. To track the cost of common stock the CFO uses the capital asset
pricing model (CAPM). The CFO and the firm’s investment advisors believe that the
appropriate risk-free rate is 4% and that the market’s expected return equals 13%.
Using data from 2009 through 2012, Eco’s CFO estimates the firm’s beta to be 1.3.
Although Eco’s current target capital structure includes 20% preferred stock,
the company is considering using debt financing to retire the outstanding preferred
stock, thus shifting their target capital structure to 50% long-term debt and 50%
common stock. If Eco shifts its capital mix from preferred stock to debt, its financial
advisors expect its beta to increase to 1.5.

TO DO
a. Calculate Eco’s current after-tax cost of long-term debt.
b. Calculate Eco’s current cost of preferred stock.
c. Calculate Eco’s current cost of common stock.
d. Calculate Eco’s current weighted average cost capital.
e. (1) Assuming that the debt financing costs do not change, what effect would a
shift to a more highly leveraged capital structure consisting of 50% long-term
debt, 0% preferred stock, and 50% common stock have on the risk premium
for Eco’s common stock? What would be Eco’s new cost of common equity?
(2) What would be Eco’s new weighted average cost of capital?
(3) Which capital structure—the original one or this one—seems better? Why?
385