Chapter 9:
The Cost of Capital
The Cost of Capital:
2
Chapter Outline:
 The Purpose of the Cost of Capital
 Capital Components
 Calculating Component Costs of Capital
 Calculating the WACC
 Factors that affect the cost of capital
 Problem areas in cost of capital
3
The Purpose of the Cost of
Capital:
The cost of capital—the average rate paid for the
use of capital.
 Primarily used in capital budgeting
Used as the ‘hurdle rate,’ or benchmark for
projects
 Compare IRR to this rate
 Discount cash flows at this rate to find NPV
If a project cannot earn above this return, it is not
worthwhile
4
The Purpose of the Cost of
Capital:
 It is important to estimate the cost of
capital as accurately as possible in order to
effectively manage the firm
Firm’s cost of capital can be viewed as its
required rate of return on projects of
average risk
5
Required Rate of Return
(Opportunity Cost Rate):
 The return that must be raised on invested
funds to cover the cost of financing such
investments
6
Capital Components:
Components of firm’s capital are:
 Debt:
Borrowed money, either loans or bonds
 Common equity:
From sale of common shares or from retained
earnings
 Preferred shares:
Cross between debt and common equity
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Capital Components:
Capital structure is mix of three capital
components
Target Capital Structure
Mix of capital components that management
considers optimal and strives to maintain
8
Basic Definitions:
 Capital Component:
Types of capital used by firms to raise money
kd = before tax interest cost
kdT = kd(1-T) = after tax cost of debt
kps = cost of preferred stock
ke = cost of retained earnings
ks = cost of issuing new stocks
9
Basic Definitions:
 WACC:
Weighted Average Cost of Capital
 Capital Structure:
A combination of different types of
capital(debt and equity) used by a firm
10
After-Tax Cost of Debt:
The relevant cost of new debt
Taking into account the tax deductibility of
interest
Used to calculate the WACC
kdT = bondholders’ required rate of return minus
tax savings
kdT = kd(1-T).
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Cost of Debt:
Interest is tax deductible, so
kdT = kd (1-T)
= 10% (1 - 0.40) = 6%
Use nominal rate.
Flotation costs are small, so ignore them.
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Cost of Preferred Stock:
 Rate of return investors require on the
firm’s preferred stock
 The preferred dividend divided by the net
issuing price
k ps 
D ps
NP

D ps
P0  Flotation costs

D ps
P0 (1  F)
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Cost of Preferred Stock:
The cost of preferred stock can be solved
by using this formula:
kp = Dp / Pp
= $10 / $111.10
= 9%
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Cost of Retained Earnings:
 Rate of return investors require on the
firm’s common stock
D̂
k k
 RP  1  g  k̂
s
RF
s
P
0
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Why there is 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 ks.
Firm could repurchase its own stock and earn ks.
Therefore, ks is the cost of retained earnings.
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Three ways to determine the
cost of common equity:
 The CAPM Approach.
 The Discounted Cash Flow Approach.
 The Bond-Yield-Plus-Premium Approach.
17
The CAPM Approach:
k s  k RF  ( kM - kRF
)bs
ks = kRF + (kM – kRF) β
= 7.0% + (6.0%)1.2 = 14.2%
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The Discounted Cash Flow
Approach:
 Price and expected rate of return on a share of
common stock depend on the dividends expected
on the stock.
P 
0
D̂
1
1
1  k 


s

D̂

2
1  k 


s

D̂

t
 
t
t 1

1  k 
s

2

D̂

1  k 


s


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The Discounted Cash Flow
Approach:
P 
0
D̂
1
1


1  k 
s


D̂
2

1  k 

s

2

D̂


1  k 

s


D̂
D̂

t
1
 

if g is constant
t
k g
t 1

s
1  k 
s

D̂
1
k  k̂ 
g
s
s
P
0
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The Discounted Cash Flow
Approach:
ks
= D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%
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The Bond-Yield-PlusPremium Approach:
 Estimating a risk premium above the bond
interest rate
 Judgmental estimate for premium
 “Ballpark” figure only
k  Bon dyi e l d Ri sk pre m i u m
s
 10%  4%  14%
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The Bond-Yield-PlusPremium Approach:
ks = kd + RP
ks = 10.0% + 4.0% = 14.0%
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Cost of Newly Issued
Common Stock:
 External equity, ke
Based on the cost of retained earnings
Adjusted for flotation costs (the expenses of
selling new issues)
D̂
D̂
1 g 
1
k 
g
s
NP
P 1  F 
0
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Flotation costs:
Flotation costs depend on the risk of the firm and
the type of capital being raised.
The flotation costs are highest for common equity.
However, since most firms issue equity
infrequently, the per-project cost is fairly small.
We will frequently ignore flotation costs when
calculating the WACC.
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The Weighted Average Cost of
Capital—The WACC:
A firm’s WACC is the average of the costs of the
separate sources weighted by the proportion of each
source used
WACCfirm 
n
 weight sourcecost source
source  1
To compute a WACC, we need two things: the
mix of the capital components in use and the cost
of each component
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Weighted Average Cost of
Capital, WACC:
A weighted average of the component costs
of debt, preferred stock, and common equity
 Proportion   After - tax   Proportion   Cost of   Proportion   Cost of 
   cost of    of preferred    preferred    of common   common
 
of
 debt   debt   stock   stock   equity   equity 

wd
k dT

w ps

k ps

ws

ks
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Example 15.1: Computing the
WACC:
Q: Calculate the WACC given the following capital structure.
Capital Component
Example
Debt
Value
$60,000
Cost
6%
Preferred shares
50,000
4
Common shares
90,000
10
$200,000
A: First calculate the capital structure weights. For debt this weight is $60,000 
$200,000 = 30%. Next, multiply each component’s cost by its weight.
Capital Component
Weight
Cost
$60,000
30%
6%
1.8%
Preferred shares
50,000
25%
4
1.0%
Common shares
90,000
45%
10
4.5%
$200,000
100%
Debt
Value
WACC =
7.3%
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