Cost of Capital

An Overview of the Cost of Capital

The cost of capital acts as a link between the firms
long-term investment decisions and the wealth of the
owners as determined by investors in the
marketplace.
It is the magic number that is used to decide
whether a proposed investment will increase or
decrease the firms stock price.
Formally, the cost of capital is the rate of return that
a firm must earn on the projects in which it invests to
maintain the market value of its stock.

11-2

The Firms Capital Structure

Some Key Assumptions

Business Riskthe risk to the firm of being

unable to cover operating costsis assumed to be
unchanged. This means that the acceptance of a
given project does not affect the firms ability to
meet operating costs.

Financial Riskthe risk to the firm of being

unable to cover required financial obligationsis
assumed to be unchanged. This means that the
projects are financed in such a way that the firms
ability to meet financing costs is unchanged.

After-tax costs are considered relevantthe cost

of capital is measured on an after-tax basis.

The Basic Concept

Why do we need to determine a companys overall

weighted average cost of capital?

Assume the ABC company has the following investment opportunity:

- Initial Investment = $100,000
- Useful Life = 20 years
- IRR = 7%
- Least cost source of financing, Debt = 6%
Given the above information, a firms financial manger would be inclined to
accept and undertake the investment.

The Basic Concept (cont.)

Why do we need to determine a companys overall

weighted average cost of capital?

Imagine now that only one week later, the firm has another available investment
opportunity
- Initial Investment = $100,000
- Useful Life = 20 years
- IRR = 12%
- Least cost source of financing, Equity = 14%
Given the above information, the firm would reject this second, yet clearly more
desirable investment opportunity.

The Basic Concept (cont.)

Why do we need to determine a companys overall

weighted average cost of capital?

As the above simple example clearly illustrates, using

this piecemeal approach to evaluate investment
opportunities is clearly not in the best interest of the
firms shareholders.

Over the long haul, the firm must undertake

investments that maximize firm value.

This can only be achieved if it undertakes projects that

provide returns in excess of the firms overall weighted
average cost of financing (or WACC).

Should we focus on before

before--tax or
after--tax capital costs?
after
Tax effects associated with financing can
be incorporated either in capital budgeting
cash flows or in cost of capital.
Most firms incorporate tax effects in the
cost of capital. Therefore, focus on aftertax costs.
Only cost of debt is affected.

Specific Sources of Capital:

The Cost of LongLong - Term Debt

The pretax cost of debt is equal to the yield-to-maturity on the

firms debt adjusted for flotation costs.

Recall that a bonds yield-to-maturity depends upon a number

of factors including the bonds coupon rate, maturity date, par
value, current market conditions, and selling price.

After obtaining the bonds yield, a simple adjustment must be

made to account for the fact that interest is a tax-deductible
expense.

This will have the effect of reducing the cost of debt.

Specific Sources of Capital:

The Cost of LongLong -Term Debt (cont.)
P9-17 Dillon Labs has asked its financial manager to measure the cost
of each specific type of capital as well as the weighted average cost of
capital. The weighted average cost of capital to be measured by using
the following weights: 40% Long Term Debt, 50% Common Stock
Equity (Retained Earnings, New Common Stock or Both). The Firm 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

Specific Sources of Capital:

The Cost of LongLong -Term Debt (cont.)

Before-Tax Cost of Debt

Using Cost Quotations

When the net proceeds from the sale of a bond equal its par
value, the before-tax cost equals the coupon interest rate.

A second quotation that is sometimes used is the yield-tomaturity (YTM) on a similar risk bond.

Specific Sources of Capital:

The Cost of LongLong -Term Debt (cont.)

Before-Tax Cost of Debt

Calculating the Cost

This approach finds the before-tax cost of debt by

calculating the internal rate of return (IRR).

As discussed in earlier in the text, YTM can be calculated

using: (a) trial and error, (b) a financial calculator, or (c) a
spreadsheet.

Specific Sources of Capital:

The Cost of LongLong -Term Debt (cont.)

Before-Tax Cost of Debt

Approximating the Cost

Specific Sources of Capital:

The Cost of LongLong -Term Debt (cont.)

Find the after-tax cost of debt for Dillon Lab

assuming it has a 40% tax rate:
ri = 9.4% (1-.40) = 5.6%

This suggests that the after-tax cost of raising debt

capital for Dillon Lab is 6.50%

Specific Sources of Capital:

The Cost of Preferred Stock

Dillon Lab is contemplating the issuance of a 8% (annual

dividend) preferred stock having a par value $100 that is
expected to sell for its $65-per share value. An additional fee
of $2 per share must be paid to underwriters
rP = DP/Np = $8/$63 12.70%

Specific Sources of Capital:

The Cost of Common Stock

There are two forms of common stock financing: retained

earnings and new issues of common stock.

In addition, there are two different ways to estimate the cost

of common equity: any form of the dividend valuation model,
and the capital asset pricing model (CAPM).

The dividend valuation models are based on the premise that

the value of a share of stock is based on the present value of all
future dividends.

Why is there a cost for reinvested earnings?

Earnings can be reinvested or paid out as dividends.

Investors could buy other securities, earn a return.

Thus, there is an opportunity cost if earnings are

reinvested.

Opportunity cost: The return stockholders could earn

on alternative investments of equal risk.

They could buy similar stocks and earn ks, or company

could repurchase its own stock and earn ks. So, ks, is
the cost of reinvested earnings and it is the cost of
equity.

Specific Sources of Capital:

The Cost of Common Stock (cont.)
Using the constant growth model, we
rS = (D1/P0) + g

We can also estimate the cost of common equity

using the CAPM:
rE = rF + b(rM - rF).

Specific Sources of Capital:

The Cost of Common Stock (cont.)

The CAPM differs from dividend valuation models in that it

explicitly considers the firms risk as reflected in beta.

On the other hand, the dividend valuation model does not

explicitly consider risk.

Dividend valuation models use the market price (P0) as a

reflection of the expected risk-return preference of investors in
the marketplace.

Specific Sources of Capital:

The Cost of Common Stock (cont.)

Although both are theoretically equivalent, dividend

valuation models are often preferred because the data
required are more readily available.

The two methods also differ in that the dividend

valuation models (unlike the CAPM) can easily be
adjusted for flotation costs when estimating the cost
of new equity.

This will be demonstrated in the examples that follow.

Specific Sources of Capital:

Cost of Retained Earnings (r
( rE)

Constant Dividend Growth Model

rs = D1/P0 + g

The firms common stock is currently selling for $50/ 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

rS = ($4/$50.00) + 7.10%15.10%.

Specific Sources of Capital:

The Cost of Common Stock (cont.)

Cost of Retained Earnings (rE)

Security Market Line Approach

rs = rF + b(rM - rF).
For example, if the 3-month T-bill rate is currently 5.0%, the market
risk premium is 9%, and the firms beta is 1.20, the firms cost of
retained earnings will be:
rs = 5.0% + 1.2 (9.0%) = 15.8%.

Specific Sources of Capital:

The Cost of Common Stock (cont.)

Cost of Retained Earnings (rE)

The previous example indicates that our estimate of the cost

of retained earnings is somewhere between 15.5% and 15.8%.
At this point, we could either choose one or the other estimate
or average the two.
Using some managerial judgment and preferring to err on the
high side, we will use 15.10% as our final estimate of the cost
of retained earnings.

Specific Sources of Capital:

The Cost of Common Stock (cont.)

Cost of New Equity (rn)

Constant Dividend Growth Model

rn = D1/Nn + g
Continuing with the previous example, it is expected that to
attract buyers new common stock must be underpriced $5 per
share, an the firm also paid $3 per share in flotation cost.
Dividend payments are expected to continue at 60% of earnings
rn = [$4/($45.00 - $3.00)] + 7.10% 16.62

The Weighted Average Cost of Capital

WACC = ra = wiri + wprp + wsrr or n

Capital Structure Weights

The weights in the above equation are intended to represent a

specific financing mix (where wi = % of debt, wp = % of preferred, and
ws= % of common).
Specifically, these weights are the target percentages of debt and
equity that will minimize the firms overall cost of raising funds.

The Weighted Average Cost of Capital

WACC = ra = wiri + wprp + wsrr or n

Capital Structure Weights

One method uses book values from the firms balance sheet. For example, to estimate
the weight for debt, simply divide the book value of the firms long-term debt by the
book value of its total assets.
To estimate the weight for equity, simply divide the total book value of equity by the
book value of total assets.

The Weighted Average Cost of Capital

WACC = ra = wiri + wprp + wsrr or n

Capital Structure Weights

A second method uses the market values of the firms debt and
equity. To find the market value proportion of debt, simply multiply
the price of the firms bonds by the number outstanding. This is
equal to the total market value of the firms debt.
Next, perform the same computation for the firms equity by
multiplying the price per share by the total number of shares
outstanding.

The Weighted Average Cost of Capital

WACC = ra = wiri + wprp + wsrr or n

Capital Structure Weights

Using the costs previously calculated along with the market
value weights, we may calculate the weighted average cost of
capital as follows:
WACC = .40(10.77%) + .10(12.70%) + .50(15.10%)
11.35%
This assumes the firm has sufficient retained earnings to fund
any anticipated investment projects. Or 12.11% if the firm
issuing new stock

The Marginal Cost

& Investment Decisions (cont.)
WMCC

11.76%
11.75%
11.66%
11.50%

11.25%
11.13%

$2.5

$4.0

Total Financing (millions)

The Marginal Cost

& Investment Decisions (cont.)

Investment Opportunities Schedule (IOS)

Now assume the firm has the following investment

opportunities available:
Initial

Cumulative

Ivestment

Investment

Project

IRR

13.0%

1,000,000

1,000,000

12.0%

1,000,000

2,000,000

11.5%

1,000,000

3,000,000

11.0%

1,000,000

4,000,000

10.0%

1,000,000

5,000,000

The Marginal Cost

& Investment Decisions (cont.)
13.0%

12.0%

WACC
B

11.66%
This indicates
that the firm can
accept only
Projects A & B.

11.5%
C

11.13%
11.0%

D
$1.0

$2.0 $2.5 $3.0 $4.0

Total Financing (millions)

Figure 1 WMCC Schedule

Table 3 Investment Opportunities Schedule

(IOS) for Duchess Corporation

Figure 2 IOS and WMCC Schedules