The Cost of Capital

 It is possible to finance a firm entirely with common equity; however, most firms employ several types of capital,
called capital components - debt, preferred stock, and common equity.

 All capital components have one feature in common: The investors who provided the funds expect to receive a
return on their investment.

 The cost of common equity (also called cost of common stock), rs, is the rate of return required by the firm’s
stockholders, estimated by three methods:
1) the Capital Asset Pricing Model (CAPM) approach: rs  rRF + (RPM )b i
D1
2) the Dividend-Yield-plus-Growth-Rate or Discounted Cash Flow (DCF) approach: rs  g
P0
3) the Bond-Yield-plus-Risk-Premium approach: rs  Bond yield + Bond RP

a. The required rate of return on each capital component The cost of capital used to analyze capital budgeting is a
is called its component cost. weighted average of the after-tax component costs of capital,
called Weighted Average Cost of Capital (WACC).

e. Most firms set target percentages for the different financing sources. This is its optimal (or target) capital structure
For example, National Computer Corporation (NCC) plans to raise 30% – relative amount of debt, preferred stock,
of its required capital as debt, 10% as preferred stock, and 60% as and common equity that the firm desires.
common equity.
 Each weighting factor (30/10/60) is the proportion (or percentage) of that type of capital.
 The WACC should be based on these target weights.

b. The after-tax cost of debt, rd(1 - T), is the relevant cost to the firm of new debt financing,
where, T = firm’s marginal tax rate

Since interest is deductible from taxable income, The component cost of debt (in the weighted average cost of capital)
the after-tax cost of debt to the firm is less is the after-tax cost of new debt, found by: rd (1 - T)
than the before-tax cost. where rd = Cost of new debt

c. The component cost of preferred stock (rps) is the cost to the firm of issuing new preferred stock.
( )
For perpetual preferred, ( )
, where Net Issuing price (Pn) is the price the firm receives
after deducting floatation costs.
Note that no tax adjustments are made when calculating unlike interest payments on debt, dividend payments
the component cost of preferred stock because, on preferred stock are not tax deductible.

f. There are considerable costs when a company issues a new security, including fees to an investment banker and
legal fees. These costs are called flotation costs.

d. The cost of new common equity (re) is  the cost to the firm of equity obtained by selling new common stock.
 essentially, the cost of retained earnings adjusted for flotation costs.

Flotation costs are the costs that the firm incurs when it issues new securities.
Funds actually available to the firm for capital investment from the sale of new securities
= Sales price of the securities less flotation costs
Note that flotation costs consist of
1) direct expenses such as printing costs and brokerage commissions,
2) any price reduction due to increasing the supply of stock,
3) any drop in price due to informational asymmetries.

g. The cost of new common equity is higher than that of common equity raised internally by reinvesting earnings.
Project’s financed with external equity must earn a higher rate of return, since they project must cover the
flotation costs.
 The WACC is an average cost because it is a weighted average of the firm's component costs of capital. However,
each component cost is a marginal cost; that is, the cost of new capital. Thus, the WACC is the weighted average
marginal cost of capital.