Chapter 10 The Cost of Capital

Weighted average cost of capital (WACC)

Referred to as the firms cost of capital
Rate that a company is expected to pay on average to all its security holders to finance its assets
Represents the minimum return that a company must earn on an existing asset base to satisfy its
creditors, owners, and other providers of capital, or they will invest elsewhere.
WACC increases: beta and rate of return on equity increase: decrease in valuation: increase in risk

1. Cost of Debt Rd = rd (1 T)
Effective interest rate on new debt, not on already outstanding debt (concerned for the use of capital
budgeting)
Used in calculating WACC: we are interested in maximizing value of stock and stock price depends on
after-tax cash flows
After tax cost of debt (Rd) interest rate of on new debt (rd) less the tax savings (interest is tax
deductible)
New debt (rd) before-tax cost of debt
Used rate to calculate the cost of debt: the yield of maturity on the companys long term debt
But dependent on proportion of long and short-term debt
The yield to maturity on outstanding debt (which reflects current market condition) is a better measure of
the cost of debt than the coupon rate

Rd =r d (1T )
Rd = after tax cost of debt
rd = cost of debt before tax
T = tax rate (%)
Finding rd:

r d =Rf + DM
Rf = risk free rate
DM = debt margin
Risk free rate interest that an investor would expect from an absolutely risk-free investment over a
given period of time; not affected by the cost of market; issued by the government
Risks: default risk/credit risk, currency risk/foreign exchange rate, and inflation risk
Debt Margin issued by the bank

M V
n
rd =
M +V
2
I+

I = Interest (P X i %)
M = Par value of the bond
V = not proceeds of the bond (cost to issue the bond)
n = life of bond

2. Cost of Preferred Stock Rp

Rate of return investors require on firms preferred stock
No tax adjustment rate; not tax deductible

R p=

Dp
Po
Dp = Preferred dividends per share
Po = Net proceeds of preferred share per share

Po=M F
or

Po=M (1F)
M = market cost
F= flotation cost
Flotation cost costs incurred by a publicly traded company when it issues new securities; paid by the
company that issues the new securities (underwriting fees, legal fees and registration fees)

3. Cost of Equity Re
The cost of external equity; based on the cost of RE but increased for flotation cost
New common equity raised in 2 ways:
a.
b.

by retaining some of current years earning

by issuing common stock

Equity raised by issuing stock has higher cost than equity from retained earnings due to the flotation costs
required to sell new common stock

Gordon Growth Model

A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a
constant rate; equates this value to the present value of a stock's future dividends

Re =

D
+g
P o (1F)
D = dividends
Po (1 F) = net proceeds
g = growth rate %

Zero growth model stable population and stable consumption that remain at or below carrying capacity
g%=0%
Constant growth model grow at a constant rate; Gordon Growth Model
g % = fixed rate
*Adjusting the cost of capital rather than increasing the projects investment cost

Arbitrage Pricing Model

An asset pricing model based on the idea that an asset's returns can be predicted using the relationship
between that same asset and many common risk factors; a general theory of asset pricing that holds that
the expected return of a financial asset can be modeled as a linear function of various macro-economic
factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient.

Re =R f 1 + Rf 2 + Rn n
Rf = risk free rate
= beta coefficient
Beta Coefficient how the firm reacts to the industry; indicates whether the investment is more or less
volatile than the market; measure of the volatility, or systematic risk, of a security or a portfolio in
comparison to the market as a whole
It measures the risk of an investment that cannot be reduced by diversification. It does not measure the
risk of an investment held on a stand-alone basis, but the amount of risk the investment adds to an
already-diversified portfolio.

 less than (<) 1 : investment is less volatile than the market; a volatile investment whose price
movements are not highly correlated with the market (e.g treasury bills)
more than (>)1 : the investment is more volatile than the market; tends to move up and down with the
market (e.g. stock)
(+) industry higher; firm higher
( ) industry higher; firm lower

Capital Asset Pricing Model

A model that describes the relationship between risk and expected return and that is used in the pricing of
risky securities; empirical model used to determine a theoretically appropriate required rate of return of an
asset, if that asset is to be added to an already well-diversified portfolio, given that assets non-diversifiable
risk

Re =R f +( R mR f )
Rf = risk free rate
Rm = market return
= beta coefficient
The expected return of a security or a portfolio equals the rate on a risk-free security plus a
risk premium. If this expected return does not meet or beat the required return, then the investment
should not be undertaken. The security market line plots the results of the CAPM for all different risks
(betas).
In the capital asset pricing model, beta risk is the only kind of risk for which investors should receive an
expected return higher than the risk-free rate of interest.

3. Cost of Retained Earnings Rr

Rate of return required by the stockholders on firms common stock

Re =Rr
If the firm cannot invest retained earnings to earn at least R e, it should pay those funds to its stockholders
and let them invest directly in stocks or other assets that will provide the return.

Basis of Weight
a. Target Value
b. Historical Value
1. Book Value
2. Market Value

WACC=W d Rd +W d R p +W d R e +W d R r
Rd =r d ( 1T )
r d =Rf + DM

R p=

M V
n
rd =
M +V
2
I+

Dp
Po

Po=M F

Po=M (1F)

GGM Approach

Re =

D
+g
P o (1F)

APM Approach

Re =R f 1 + Rf 2 + Rn n

CAPM Approach

Re =R f +( R mR f )

Re =Rr

Capital Components investor-supplied items

a. Interest-bearing debt
b. Preferred stock
c. Common equity
Increasing assets: financed by increasing capital components
Capital structure way a corporation finances its assets through some combination of equity, debt, or
hybrid securities
Optimal capital structure best debt-to-equity ratio (mix of debt and equity) for a firm that maximizes its
value and minimizes the firm's cost of capital
In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it
is rarely the optimal structure since a company's risk generally increases as debt increases.