•Cost of Capital

•WACC
•WMCC

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

 The Cost of Capital

An Overview Of The Cost Of Capital

The Cost Of Long-Term Debt
The Cost Of Preferred Stock
The Cost Of Common Stock
The Weighted Average Cost Of Capital
(WACC)
The Marginal Cost And Investment
Decisions
 An Overview Of The Cost Of
Capital

The cost of capital has two

important definitions
– The rate of return a firm must earn on its
projects or investments to maintain the
market value of its stock, assuming
constant risk
– The rate of return required by the
market suppliers of capital to attract
their funds to the firm
 Basic Concept
Cost of Capital :
Is measured at a given point in time
Reflects the cost of funds over the long run
Reflects the interrelatedness of financing activities
Assumes a deliberate financing mix called a
target capital structure
Given the target capital structure, the firm’s
overall cost of capital - often measured as the
"weighted average cost of capital" - is of greatest
importance
 Example
A firm that has a target capital structure of 40% debt
and 60% equity should consider the long run overall
cost of capital when making capital budgeting
decisions.
If, for example, debt financing is available at a cost
of 8% (after tax) and equity financing is available at
a cost of 15%, the weighted average long-term cost
of capital is [(.40 x 8%) + (.60 x 15%)] = 12.2%,
reflecting the interrelatedness of financing decisions.
Decisions made with the weighted average cost of
capital in mind generally are in the best interests of
the firm and its shareholders.
 The Cost of Specific Sources of
Capital
There are four basic sources of long-term funds
– Long-term debt
– Preferred stock
– Common stock
– Retained earnings

The specific cost of each source of financing is the

after-tax cost of obtaining the financing today
The techniques used to determine specific costs of
capital generate rough approximations due to their
numerous assumptions and underlying forecasts
Cost of Debt

The cost of debt to the firm is the effective

yield to maturity (or interest rate) paid to its
bondholders
Since interest is tax deductible to the firm,
the actual cost of debt is less than the yield
to maturity:
After-tax cost of debt = yield x (1 - tax rate)
 Cost of Debt

After tax cost of debt = kd(1-Tc)

Before tax cost of capital less the effect of tax
savings

Example:
Debt at 9.75% and tax rate of 34%
After-tax cost of debt = .0975(1-.34) =
6.435%
 The Cost of Long-Term Debt
(Bonds)
Preliminary Assumptions:
– Funds are raised through the issuance and sale of
bonds
– The bonds pay annual interest
Net Proceeds
» Net Proceeds are the funds the firm actually
receives from the sale of a security
» Flotation Costs are the total costs incurred by
the firm in issuing and selling a security
» Net proceeds = selling price of the security -
flotation costs
 Before-Tax Cost of Debt
The Before-Tax Cost of Debt must be
obtained first, by the following method
Using cost quotations
» If net proceeds are equal to the bond's par value, the
before-tax cost is equal to the bond's coupon interest
rate
» The yield-to-maturity of similar-risk bonds can also be
used as an estimate of before-tax cost
Calculating the cost, using the cost-to-maturity, which is the
internal rate of return on the bond’s cash flows from the
issuers point of view
 Example
A firm sells some 25-year bonds at par of $1,000.
Flotation costs are 1 1/2% of par. The coupon interest
rate is 12%. Find the before-tax cost of debt (kd). [net
proceeds = $1,000-[.015 x ($l,000) = $985]

Relevant Cash Flows

End of Year(s) Cash Flow
0 $ 985
1-25 $ (120)
25 $(1,000)
Thus kd = 12.19%
 After-Tax Cost of Debt

The after-tax cost of debt is calculated

as:

ki = kd x (1-T)

WHERE:
T = Tax rate of the firm
 Example
Using the 12.2% before-tax cost of debt from the
previous example's cost-to-maturity approach and
a tax rate of 40%, the after-tax cost of debt is

ki = (12.19%) (1-.40) = 7.32%

 The Cost of Preferred Stock

Preferred Stock Dividends

– Preferred stockholders receive a stated dividend prior
to the distribution of earnings to common stockholders
Preferred stock has an implied infinite life
Preferred stock dividends are usually a
stated dollar amount
Alternatively, preferred stock dividends
may be stated as an annual percentage
rate, e.g., 7%
Cost of Preferred Stock (Existing)

Preferred stock:
– has a fixed dividend (similar to debt)
– has no maturity date
– dividends are not tax deductible to the firm and are
expected to be perpetual or infinite
Cost of preferred stock = dividend
price
Cost of Preferred Stock (New)

Preferred stock:
– has a fixed dividend (similar to debt)
– has no maturity date
– dividends are not tax deductible to the firm and are
expected to be perpetual or infinite
Cost of preferred stock = dividend
price-flotation cost
 Calculating the Cost of
Preferred Stock (New)
Calculating the cost of preferred stock is
straightforward:

Dp
kp =
WHERE:
Np
kp = Cost of preferred stock
Dp = Annual dollar dividend per share
Np = Net proceeds per share
 Example
An issue of preferred stock was sold for $78 per share.
The stock will pay $8 per year in dividends.
Flotation costs of $3 per share were incurred by the
firm. Find kp

kp = $8 = $ 8 = .1067 or 10.67%
$78-$3 $75
 Cost of Preferred Stock-
Example 2
Stock dividend/Net proceeds per share

Example:
Annual dividend $4.25, Stock price $58.50
and flotation costs of $1.375 per share
Cost = $4.25/(58.50 -1.375) = .0744
or
Cost of preferred stock = 7.44%
 The Cost of Common Stock

– Retained earnings
» No flotation costs on retained earnings

– Newissues of common
stock
 Finding the Cost of Common
Stock Equity

The Cost Of Common Equity (ks) is the

rate at which investors discount
expected dividends to determine the
share value of the firm
More difficult to estimate than cost of debt or
cost of preferred stock because common
stockholder’s rate of return not observable.
Two techniques for measuring the cost
of common stock equity capital are
available. Either the Gordon Model or
CAPM can be used to determine it
Cost of Common Equity:
Retained Earnings
Common stock equity is available through retained
earnings (R/E) or by issuing new common stock:
Common equity = R/E + New common stock
The cost of common equity in the form of retained
earnings is equal to the required rate of return on
the firm’s common stock (this is the opportunity
cost)
 The Cost of Retained Earnings

– Retained earnings increase the stockholders' equity in

the same way as a new issue of common stock
– Stockholders accept the firm's retention of earnings as
long as they expect those earnings to return to them a
rate equal to their required return on the reinvested
funds
– Thus, the cost of retained earnings (kr) is equal to ks,
and either the Gordon Model or CAPM can be used to
determine it
Cost of Common Equity:
New Common Stock

The cost of new common stock is higher than the

cost of retained earnings because of flotation
costs

Flotation costs:
selling and distribution costs (such as sales
commissions) for the new securities
 The Cost of New Issues of
Common Stock

Must consider:
Underpricing
Flotation Costs

Nn = Po - Underpricing - Flotation Costs

 Constant Growth Valuation
(Gordon) Model

D1
Can Be Rewritten As
Po =
ks - g

D1
ks = + g (Dividend Yield + Growth Rate)
Po
Cost of a new stock issue (kn) is
calculated as:

D1
kn = +g
Nn

NOTE: Since Nn is always less

than Po, kn is always greater than
kr
 Example
A firm's stock is currently selling for $22 per share, it
expects to pay a dividend of $1.76 per share next
year, and dividends have been growing at a
compound annual rate of 5%. Find ks?

ks = $1.76 + .05 = .08 + .05 = .13 or 13%

$ 22
 Example

The firm in the previous example will have to

underprice the new shares by $1.00 each from their
current price of $22, plus incur a $2.00 per share
flotation cost in order to sell them. Find kn

Nn = $22 - $1 - $2 = $19.00
D1 = $1.76
g = 5%
kn = $1.76 + .05 = .0926 + .05 = .1426 or 14.26%
$ 19
 Dividend Growth Model – Example
#2

A company expects dividends this year to be $2.20,

based upon the fact that $2 were paid last year.
The firm expects dividends to grow 10% next year
and into the foreseeable future. Stock is trading
at $50 a share. Flotation costs are expected to be
15%.
Cost of retained earnings:
Kcs = D1/Pcs+ g
2.20/50 + .10 = .144 or 14.4%
Cost of new stock:
Kncs = D1/NPcs +g
2.20/(50-7.50) + .10 = .1518 or 15.18%
Issues with the Dividend Growth
Model

Simplicity
Assume constant growth rate
Estimating rate of growth
 Earnings Capitalization Model

The cost of equity using the

earnings capitalization model,

Ke = E1
P0
 Capital Asset Pricing Model
Combines:
Risk Free rate krf
Systematic risk or Beta (B)
Market Risk Premium or Expected rate of return for market
or “average security” minus the risk free rate, km – krf
kc = krf + B(km – krf)
 Capital Asset Pricing Model

ks = RF + [b x (km - RF )]
Example:
Beta is 1.4; Risk-free rate is 3.75%; Expected market
rate is 12%

kc = krf + B(km – krf)

.0375 + 1.4(.12 - .0375) = 15.3%

 Issues with the Capital Asset
Pricing Model

Simple/Easy to understand
Variables available from public sources
No reliance upon companies paying dividends or
growth rate assumptions
Wide range of US government securities on which
to base risk-free rate
Estimates of beta available from a wide range of
services
Market risk premium can be estimated by
looking at history of stock returns and premium
earned over risk-free rate
 Comparing the Gordon and
CAPM Techniques

CAPM directly incorporates risk with the

use of Beta to get a required return
Gordon Model uses market price as a
reflection of risk-return preferences of
investors
Optimum Capital Structure

The optimal (best) situation is associated with the

minimum overall cost of capital:
Optimum capital structure means the lowest WACC
Usually occurs with 30-50% debt in a firm’s
capital structure
WACC is also referred to as the required rate of
return or the discount rate
 Calculating the WACC

The weighted average cost of capital

(WACC) is computed with the use of
the corporation's existing capital
structure
– Determine the percentage composition of
each source of capital in the capital structure
(The "Weight")
– Multiply the specific cost of each source of
capital by its weight
– Sum the products and you have the WACC
 Weighing schemes

Book Value Weights

Historic Weights
Target Weights
Market Value Weights
 WACC (ka) is calculated as:

ka = (wi x ki) + (wp x kp) + (ws x kr or kn)

WHERE:

wi = Proportion of L-T debt in the capital structure

wp = Proportion of preferred stock in the capital
structure
ws = Proportion of common equity in the capital
structure
Note: wi + wp + ws = 1.0
 Example
The Reyes Company seeks a target capital structure of
40% long-term debt, 20% preferred stock, and 40%
common stock equity. Assuming that Reyes can obtain
long-term financing at the after tax costs of 7.32% for
debt, 10.67% for preferred stock, and 13% for common
stock equity, find ka
ka = (.40 x .0732) + (.20 x .1067) + (.40 x .1300) =
.02928 + .02134 + .052 = .10262 or 10.26%
If Reyes needs to sell new common stock to maintain the
target capital structure, substitute kn for ks (kn = 14.26%)
ka = (.40 x .0732) + (.20 x .1067) + (.40 x .1426) =
= .02928 + .02134 + .05704 = .10766 or 10.77%
 The Marginal Cost and
Investment Decisions

A firm's financing costs and

investment returns will be affected
by the volume of financing/
investment undertaken.
– Investors' perceptions of rising business risk
– Investors' perceptions of rising financial risk
– Size of the investment(s)
– ^Financing Levels; ^ Uncertainty; ^Risk;
^ Required Returns
 The Marginal Cost and
Investment Decision
• The marginal cost of capital is the cost
of the next dollar of financing obtained
• Investment decisions should be based
upon the criterion that a project's
expected return must be greater than
the weighted marginal cost of capital
(WMCC) for the firm

7-43
 The Weighted Marginal Cost Of
Capital (WMCC)
The weighted average cost of capital will rise whenever
there is a rise in the cost of any one of the capital
sources
The level of total financing at which the cost of one of the
capital sources rises is called a breaking point (BPj)
Afj
BPj =
wj
WHERE:
BPj = Breaking point for financing source j
AFj = Amount of funds available from financing
source j at a given cost
wj = Capital structure weight for financing source j
 Example
The Duchess Corporation has $300,000 of retained
earnings available at a cost (kr) of 13%. If it exhausts
retained earnings, it must use new common stock at a
cost (kn) of 14%. Additionally, the firm expects it can
raise up to $400,000 of long-term debt at a cost (ki) of
5.6%; any further use of debt will be at a cost of 8.4%.
The firm can issue an unlimited number of shares of
preferred stock at a cost (kp) of 10.6%. The target capital
structure is 40% L-T debt, 50% common equity, and 10%
preferred stock.

Given the above data, Duchess is facing two breaking

points, one when the $300,000 of retained earnings is
exhausted, and one when the first $400,000 of L-T debt
capacity is exhausted.
 Example
Computing the breaking points is straightforward

$300,000 .
BP Common Equity = .50 = $ 600,000

400,000 .
BP L-T Debt = = $1,000,000
.40
Thus, Duchess will incur its lowest WACC for projects
requiring financing up to $600,000. After that point
the WACC will increase due to substituting higher
cost new common stock for retained earnings. After
project financing exceeds $1,000,000, WACC will
increase again due to the introduction of higher cost
L-T debt into the capital structure
 Weighted Average Cost of Capital for Ranges of
Total New Financing for Duchess Corporation

Range Source of Weighted

of Total New Capital Weight Cost Cost
Financing (1) (2) (3) [(2) x (3)]
(4)
$0 to $600,000 Debt .40 5.6% 2.2%
Preferred .10 10.6 1.1
Common .50 13.0 6.5
Weighted average cost of capital 9.8%
$600,000 to Debt .40 5.6% 2.2%
$1,000,000 Preferred .10 10.6 1.1
Common .50 14.0 7.0
Weighted average cost of capital 10.3%
$1,000,000 and Debt .40 8.4% 3.4%
above Preferred .10 10.6 1.1
Common .50 14.0 7.0
Weighted average cost of capital 11.5%
 Graph The WMCC

11.5%
11.5

11.0
W
A 10.3%
10.5
C
C 9.8%
10.0
%
9.5

0 600 1,000 1,500

Total New Financing ($000)
 IOS and WMCC Schedules
15.5 A
15.0 B
W 14.5
A
C 14.0 C
C 13.5
D
a 13.0
n 12.5
d E
12.0
11.5%
I 11.5 WMCC
R 11.0 F
R 10.3%
10.5
(%) 9.8%
10.0
9.5 G
IOS

0 500 1,000 1,500

1,100
Total New Financing or Investment ($000)
 Cost of Capital and New
Investment

Cost of capital can serve as the discount

rate in evaluating new investment when
the projects offer the same risk as the firm
as a whole.
If risk differs, may calculate a different cost
of capital for each division.
Generally, calculate the cost of capital per
division, not per project, to avoid
overinvestment in high risk projects.
WACC By Divisions: PepsiCo

Calculated divisional cost of capital

Different target ratios for debt/equity mix per
division
Different pretax cost of debt for each division
 Pepsi Co’s Cost of Debt

Division Pretax (1-tax rate) After-tax

Cost of cost of debt
Debt

Rest 8.93% X 0.62 = 5.54%

Snack 8.43% X 0.62 = 5.23%

Foods

Beverages 8.51% X 0.62 = 5.28%

 Pepsi Co’s Cost of Equity
Division Risk Beta (Exp. Mkt ret- Cost of
Free Risk free rate) equity
Rate

Rest 7.28% X 1.17 X (11.48%-7.28%) = 12.19%

Snack 7.28% X 1.02 X (11.48%-7.28%) = 11.56%

Foods

Beverages 7.28% X 1.07 X (11.48%-7.28%) = 11.77%

 Pepsi Co’s Weighted Average
Cost of Capital

Division Cost of After-tax cost of WACC

Equity X debt X the target
Target debt ratio
Equity Ratio

Rest (12.20%) + (5.54%) = 10.20%

(0.70) (0.30)

Snack (11.56%) + (5.23%) = 10.29%

Foods (0.80) (0.20)

Beverages (11.77%) + (5.28%) = 10.08%

(0.74) (0.26)
 DISCUSSION PROBLEMS
A firm expects to have $400,000 in retained earnings
available in the next year. Given the following target
capital structure, at what level of total new financing
will retained earnings be exhausted?
Financing Source Target Proportion
L-T Debt 40%
Preferred Stock 20
Common Stock Equity 40
Total 100%

$400,000 = $1,000,000 (Break Point)

.40
 DISCUSSION PROBLEMS
The Spivey Corporation has just sold, without incurring
floatation costs, some 20-year bonds with a coupon
interest rate of 13% at par. If the corporation is in the
40% tax bracket, what is the after-tax cost of debt?

.13 x (1-.40) = .13 x (.6) = .078 or 7.8%

CLASS DISCUSSION PROBLEM
The Morris Company is attempting to determine its cost of capital in order
to evaluate several proposed capital projects and set its capital budget
for next year. The following information has been made available:
• Target capital structure is 40% debt, 60% common stock equity
• $10 million can be borrowed at a pre-tax cost of 11%
• Additional debt will cost 14% (pre-tax) but is unlimited
• $7,500,000 of retained earnings will be generated next year
• Additional common equity will be raised through issuing new common
stock (no limit foreseen)
• Morris stock currently sells for $12.00 per share
• Last year's dividend was $1.20
• Dividends are expected to grow 4% annually
• New common stock will be sold for $11.00 per share and flotation
costs will be $1.00 per share
• Morris is in the 40% tax bracket

7-57
 Morris’ Cost of Capital:
Determine cost of capital for each financing source:
Cost of Debt:
First $10,000,000 = .11 x (1-.40) = 6.6%
Additional Debt = .14 x (1-.40) = 8.4%

Cost of Common stock Equity:

Retained Earnings = $ 1.20 x (1.04) + .04= $1.248 + .04
$12.00 $12 = 14.4%

New Common Stock. = $ 1.20 x (1.04) = $1.248

$11.00 - $1.00 $10 + .04 = 16.48%
 Cost of Capital:
Determine break points and associated WACCs
$7,500,000
BP = .60 = $12,500,000
Common Equity
$10,000,000
BP = .40 = $25,000,000
LT Debt
 Cost of Capital:
Determine break points and associated WACCs
$7,500,000
BP = .60 = $12,500,000
Common Equity
$10,000,000
BP = .40 = $25,000,000
LT Debt

Weighted Average Cost of Capital

Range WACC
$0 to $12,500,000 (.40 x 6.62%)+(.60 x 14.4%) = 2.64% + 8.64% = 11.28%
$12,500,000 to $25,000,000 (.40 x 6.62%)+(.60 x 16.48%) = 2.64% + 9.89% = 12.53%
$25,000,000 and above (.40 x 8.4%)+(.60 x 16.48%) = 3.36% + 9.89% = 13.25%
 Cost of Capital:
Thus:
1. Morris will be able to accept capital projects
which have IRRs greater than 11.28% and a
cumulative cost less than or equal to $12,500,000
2. It can accept further projects which have IRRs
greater than 12.53% and a cumulative cost less
than or equal to an additional $12,500,000 (up to
$25,000,000)
3. It can accept still further projects which have IRRs
greater than 13.25% (greater than $25,000,000)
4. The major constraint on Morris will be the relative
size of the total investments and its impact on
perceived risk