The Cost of Capital

Sources of capital
Component costs
WACC

What sources of long-term capital do firms use?

Calculating the weighted average cost of capital

WACC = wd rd(1-T) + wp rp + wcrs

The w’s refer to the firm’s capital structure weights.

The r’s refer to the cost of each component.

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

Stockholders focus on After Tax (AT) Cash Flows. Therefore, we should

focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only
kd needs adjustment, because interest is tax deductible.

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).

Component cost of debt

WACC = wd rd(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)?

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%.

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Component cost of debt

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.

Component cost of preferred stock

WACC = wd rd(1-T) + wp rp + wc rs

rp is the marginal cost of preferred stock.

The rate of return investors require on the firm’s preferred stock.

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%

Component cost of preferred stock

Preferred dividends are not tax-deductible, so no tax adjustments

necessary. Just use rp.

Nominal rp is used.

Our calculation ignores possible flotation costs.

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.

Why is the yield on preferred stock lower than debt?

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Corporations own most preferred stock, because 70% of preferred
dividends are nontaxable to corporations.

Therefore, preferred stock often has a lower Before Tax (BT) yield than
the B-T yield on debt.

The After Tax (AT) 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.

Illustrating the differences between A-T costs of debt and preferred

stock

Recall, that the firm’s tax rate is 40%, and its before-tax costs of debt
and preferred stock are rd = 10% and rp = 9%, respectively.

A-T rp = rp – rp (1 – 0.7)(T)
= 9% - 9% (0.3)(0.4) = 7.92%
A-T rd = 10% - 10% (0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%

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.

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.
Therefore, rs is the cost of retained earnings.

Three ways to determine the cost of common equity, rs

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CAPM: rs = rRF + (rM – rRF) β

DCF: rs = D1 / P0 + g

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

If the rRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of
common equity based upon the CAPM?

rs = rRF + (rM – rRF) β

= 7.0% + (6.0%)1.2 = 14.2%

If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity

based upon the DCF approach?

D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.3995

rs = D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%

If rd = 10% and RP = 4%, what is rs using the own-bond-yield-plus-

risk-premium method?

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%

What is a reasonable final estimate of rs?

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 Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%

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.

Percy Motors has a target capital structure of 40 percent debt and 60 percent equity. The
yield to maturity on the company's outstanding bonds is 9 percent, and the company's
tax rate is 40 percent. Percy's CFO has calculated the company's WACC as 9.96
percent. What is the company's cost of common equity?

10-1 The Heuser Company's currently outstanding 10 percent coupon bonds have a yield to
maturity of 12 percent. Heuser believes it could issue at par new bonds that would
provide a similar yield to maturity. If its marginal tax rate is 35 percent, what is
Heuser's after-tax cost of debt?

10-2 Tunney Industries can issue perpetual preferred stock at a price of $47.50 a share. The
issue is expected to pay a constant annual dividend of $3.80 a share. What is the
company's cost of preferred stock, rp?

10-8 Patton Paints Corporation has a target capital structure of 40 percent debt and 60 percent
common equity. The company's before-tax cost of debt is 12 percent and its marginal
tax rate is 40 percent. The current stock price is Po = $22.50; the last dividend was Do =
$2.00; and the dividend is expected to grow at a constant rate of 7 percent. What will
be the firm's cost of common equity and its WACC?

What factors influence a company’s composite WACC?

Market conditions.
The firm’s capital structure and dividend policy.
The firm’s investment policy. Firms with riskier projects generally have
a higher WACC.

Should the company use the composite WACC as the hurdle rate for
each of its projects?

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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.

How are risk-adjusted costs of capital determined for specific projects

or divisions?

Subjective adjustments to the firm’s composite WACC.

Attempt to estimate what the cost of capital would be if the
project/division were a stand-alone firm. This requires estimating
the project’s beta.

Finding a divisional cost of capital:

Using similar stand-alone firms to estimate a project’s cost of capital

Comparison firms have the following characteristics:

Target capital structure consists of 40% debt and 60% equity.

rd = 12%
rRF = 7%
RPM = 6%
βDIV = 1.7
Tax rate = 40%

Calculating a divisional cost of capital

Division’s required return on equity

rs = rRF + (rM – rRF)β
= 7% + (6%)1.7 = 17.2%

Division’s weighted average cost of capital

WACC = wd rd ( 1 – T ) + wc rs
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
Typical projects in this division are acceptable if their returns exceed
13.2%.