The Cost of

Capital
2 An Overview of the Cost of
Capital
– The cost of capital acts as a link between the firm’s 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 firm’s 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.

Managerial Accounting 2
3 The Firm’s Capital Structure

Managerial Accounting 2
4 Some Key Assumptions

– Business Risk—the risk to the firm of being unable to cover

operating costs—is assumed to be unchanged. This means that
the acceptance of a given project does not affect the firm’s ability
to meet operating costs.
– Financial Risk—the risk to the firm of being unable to cover
required financial obligations—is assumed to be unchanged. This
means that the projects are financed in such a way that the firm’s
ability to meet financing costs is unchanged.
– After-tax costs are considered relevant—the cost of capital is
measured on an after-tax basis.

Managerial Accounting 2
5 The Basic Concept

– Why do we need to determine a company’s 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 firm’s financial manger would be inclined to accept
and undertake the investment.

Managerial Accounting 2
6 The Basic Concept (cont.)

– Why do we need to determine a company’s 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.

Managerial Accounting 2
7 The Basic Concept (cont.)

– Why do we need to determine a company’s 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 firm’s 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 firm’s overall weighted average cost of
financing (or WACC).

Managerial Accounting 2
 Cost of Long Term Debt

Specific Sources of Capital

8 Managerial Accounting 2
9 Specific Sources of Capital:
The Cost of Long-Term Debt

– The cost of long term debt is the financing cost associated with new
funds raised through long term borrowing.
– The pretax cost of debt is equal to the yield-to-maturity on the firm’s
debt adjusted for flotation costs.
– Recall that a bond’s yield-to-maturity depends upon a number of factors
including the bond’s coupon rate, maturity date, par value, current
market conditions, and selling price.
– After obtaining the bond’s 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.

Managerial Accounting 2
10 Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

– Net Proceeds: funds actually received by the firm from the sale of a security.
– Flotation costs: the total costs of issuing and selling a security.
– Underwriting costs: compensation earned by investment bankers for selling the
security.
– Administrative costs: issuer expenses such as legal, accounting and printing

Duchess Corporation, a major hardware manufacturer, is contemplating selling $10 million

worth of 20-year, 9% coupon bonds with a par value of $1,000. Because current market
interest rates are greater than 9%, the firm must sell the bonds at $980. Flotation costs are
2% or $20. The net proceeds to the firm for each bond is therefore $960 ($980 - $20).

Managerial Accounting 2
11 Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

– Before-Tax Cost of Debt

– The before-tax cost of debt can be calculated in any one of three ways:
– Using cost quotations
– Calculating the cost
– Approximating the cost

Managerial Accounting 2
12 Specific Sources of Capital:
The Cost of Long-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-to-maturity (YTM) on a
similar risk bond.

Managerial Accounting 2
13 Specific Sources of Capital:
The Cost of Long-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.

Managerial Accounting 2
14 Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

– Before-Tax Cost of Debt

– Calculating the Cost

Managerial Accounting 2
15 Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

– Before-Tax Cost of Debt

– Calculating the Cost

Managerial Accounting 2
16 Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

– Before-Tax Cost of Debt

– Approximating the Cost

Managerial Accounting 2
17 Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

Find the after-tax cost of debt for Duchess 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 Duchess is 5.6%.

Managerial Accounting 2
 Cost of Preferred Stock

Specific Sources of Capital

18 Managerial Accounting 2
19 Specific Sources of Capital:
The Cost of Preferred Stock

– Cost of Preferred Stock: the ratio of the preferred stock dividend to the firm’s
net proceeds from the sale of preferred stock.

Duchess Corporation is contemplating the issuance of a 10% preferred stock that is

expected to sell for its $87-per share value. The cost of issuing and selling the stock
is expected to be $5 per share. The dividend is $8.70 (10% x $87). The net proceeds
price (Np) is $82 ($87 - $5).

rP = DP/Np = $8.70/$82 = 10.6%

Managerial Accounting 2
 Cost of Common Stock

Specific Sources of Capital

20 Managerial Accounting 2
21 Specific Sources of Capital:
The Cost of Common Stock

– The cost of common stock is the return required on the stock by

investors in the marketplace.

– There are two forms of common stock financing: retained

earnings and new issues of common stock.

Managerial Accounting 2
22 Specific Sources of Capital:
The Cost of Common Stock
– The cost of common stock equity, rs, is the rate at which investors discount the
expected common stock dividends of the firm to determine its share value.

– 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.

Managerial Accounting 2
23 Specific Sources of Capital:
The Cost of Common Stock
– Constant growth valuation (Gordon growth) model: assumes that the value of a
share of stock equals the present value of all future dividends (assumed to grow
at a constant rate) that it is expected to provide over an infinite period or time.

Using the constant growth model or the Gordon growth model,

we
rS = (D1/P0) + g

Managerial Accounting 2
24 Specific Sources of Capital:
The Cost of Common Stock (cont.)

Capital asset pricing model describes the relationship between the required return
the required return, rs, the firm as measured by the beta coefficient, b.

We can also estimate the cost of common equity using the CAPM:

rE = rF + b(rM - rF).

Managerial Accounting 2
25 Specific Sources of Capital:
The Cost of Common Stock (cont.)

– The CAPM differs from dividend valuation models in that it explicitly considers
the firm’s 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.

Managerial Accounting 2
26 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.

Managerial Accounting 2
27 Specific Sources of Capital:
The Cost of Common Stock (cont.)

– Cost of Common Stock Equity (rS)

– Constant Dividend Growth Model

rs = D1/P0 + g

For example, assume a firm has just paid a dividend of $2.50 per share,
expects dividends to grow at 10% indefinitely, and is currently selling for
$50.00 per share.

First, D1 = $2.50(1+.10) = $2.75, and

rS = ($2.75/$50.00) + .10 = 15.5%.

Managerial Accounting 2
28 Specific Sources of Capital:
The Cost of Common Stock (cont.)

– Cost of Common Stock Equity (rS)

– CAPM or 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 firm’s beta is 1.20, the firm’s cost of retained
earnings will be:

rs = 5.0% + 1.2 (9.0%) = 15.8%.

Managerial Accounting 2
29 Specific Sources of Capital:
The Cost of Common Stock (cont.)

– Cost of Common Stock Equity (rS)

The previous example indicates that our estimate of the cost of common stock
equity 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 15.8% as our final estimate of the cost of common stock equity.

Managerial Accounting 2
30 Specific Sources of Capital:
The Cost of Common Stock (cont.)

– Cost of retained earnings, rE, is the same as the cost of an equivalent fully
subscribed issue of additional common stock, which is equal to the cost of
common stock equity, rs

rE = rS

Managerial Accounting 2
31 Specific Sources of Capital:
The Cost of Common Stock (cont.)

– Cost of a new issue of common stock, rn: the cost of common stock, net of
underpricing and associated flotation costs.
– Underpriced: stock sold at a price below its current market price, P0

Managerial Accounting 2
32 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, how much would it cost the firm to
raise new equity if flotation costs amount to $4.00 per share?

rn = [$2.75/($50.00 - $4.00)] + .10 = 15.97% or 16%.

Managerial Accounting 2
 Weighted Average Cost
of Capital

33 Managerial Accounting 2
34 The Weighted Average Cost of
Capital
– Weighted average cost of capital (WACC), ra: reflects the expected average
future cost of capital over the long run; found by weighing the cost of each
specific type of capital by its proportion in the firm’s capital structure.

Managerial Accounting 2
35 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 firm’s overall cost of raising funds.

Managerial Accounting 2
36 The Weighted Average Cost of Capital

– Capital Structure Weights WACC = ra = wiri + wprp + wsrr or n

One method uses book values from the firm’s balance sheet. For example, to estimate the
weight for debt, simply divide the book value of the firm’s 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.
Managerial Accounting 2
37 The Weighted Average Cost of Capital

– Capital Structure Weights WACC = ra = wiri + wprp + wsrr or n

A second method uses the market values of the firm’s debt and equity. To
find the market value proportion of debt, simply multiply the price of the
firm’s bonds by the number outstanding. This is equal to the total market
value of the firm’s debt.

Next, perform the same computation for the firm’s equity by multiplying the
price per share by the total number of shares outstanding.

Managerial Accounting 2
38 The Weighted Average Cost of Capital

– Capital Structure Weights

WACC = ra = wiri + wprp + wsrr or n

Finally, add together the total market value of the firm’s equity to the total market value
of the firm’s debt. This yields the total market value of the firm’s assets.

To estimate the market value weights, simply divide the market value of either debt or
equity by the market value of the firm’s assets .

Managerial Accounting 2
39 The Weighted Average Cost of Capital

– Capital Structure Weights WACC = ra = wiri + wprp + wsrr or n

For example, assume the market value of the firm’s debt is $40 million, the market value of the
firm’s preferred stock is $10 million, and the market value of the firm’s equity is $50 million.

Dividing each component by the total of $100 million gives us market value weights of 40%
debt, 10% preferred, and 50% common.

Managerial Accounting 2
40 The Weighted Average Cost of Capital

– Capital Structure Weights WACC = ra = wiri + wprp + wsrr or n

Using the costs previously calculated along with the market value weights, we
may calculate the weighted average cost of capital as follows:

WACC = .40(5.67%) + .10(9.62%) + .50(15.8%)

= 11.13%

This assumes the firm has sufficient retained earnings to fund any anticipated
investment projects.

Managerial Accounting 2
 Marginal Cost
& Investment Decisions

41 Managerial Accounting 2
42 The Marginal Cost
& Investment Decisions

– The Weighted Marginal Cost of Capital (WMCC)

– The WACC typically increases as the volume of new capital raised within a given
period increases.
– This is true because companies need to raise the return to investors in order to entice
them to invest to compensate them for the increased risk introduced by larger
volumes of capital raised.
– In addition, the cost will eventually increase when the firm runs out of cheaper
retained equity and is forced to raise new, more expensive equity capital.

Managerial Accounting 2
43 The Marginal Cost
& Investment Decisions (cont.)

– The Weighted Marginal Cost of Capital (WMCC)

– Finding Break Points
Finding the break points in the WMCC schedule will allow us to
determine at what level of new financing the WACC will increase due to
the factors listed above.

BPj = AFj/wj

where:
BPj = breaking point form financing source j
AFj = amount of funds available at a given cost
wj = target capital structure weight for source j
Managerial Accounting 2
44 The Marginal Cost
& Investment Decisions (cont.)

– The Weighted Marginal Cost of Capital (WMCC)

– Finding Break Points
Assume that in the example we have been using that the firm has $2
million of retained earnings available. When it is exhausted, the firm
must issue new (more expensive) equity. Furthermore, the company
believes it can raise $1 million of cheap debt after which it will cost 7%
(after-tax) to raise additional debt.

Given this information, the firm can determine its break points as
follows:

Managerial Accounting 2
45 The Marginal Cost
& Investment Decisions (cont.)

– The Weighted Marginal Cost of Capital (WMCC)

– Finding Break Points

BPequity = $2,000,000/.50 = $4,000,000

BPdebt = $1,000,000/.40 = $2,500,000

This implies that the firm can fund up to $4 million of new investment
before it is forced to issue new equity and $2.5 million of new investment
before it is forced to raise more expensive debt.
Given this information, we may calculate the WMCC as follows:

Managerial Accounting 2
46 The Marginal Cost
& Investment Decisions (cont.)
WACC for Ranges of Total New Financing
Range of total Source of Weighted
New Financing Capital Weight Cost Cost
$0 to $2.5 million Debt 40% 5.67% 2.268%
Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.130%

$2.5 to $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.662%

over $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 16.00% 8.000%
WACC 11.762%
Managerial Accounting 2
47 The Marginal Cost
& Investment Decisions (cont.)

11.76% WMCC

11.75%
11.66%

11.50%

11.25%
11.13%

Managerial Accounting 2 $2.5 $4.0 Total Financing (millions)

48 The Marginal Cost
& Investment Decisions (cont.)

– Investment Opportunities Schedule (IOS)

– Now assume the firm has the following investment opportunities available:

Initial Cumulative
Project IRR Ivestment Investment
A 13.0% $ 1,000,000 $ 1,000,000
B 12.0% $ 1,000,000 $ 2,000,000
C 11.5% $ 1,000,000 $ 3,000,000
D 11.0% $ 1,000,000 $ 4,000,000
E 10.0% $ 1,000,000 $ 5,000,000
Managerial Accounting 2
 49 The Marginal Cost
& Investment Decisions (cont.)

13.0% A WMCC
12.0% B

11.66%
This indicates
11.5%
C that the firm can
accept only
Projects A & B.

11.13% D
11.0%

$1.0 $2.0 $2.5 $3.0 $4.0 Total Financing (millions)

Managerial Accounting 2
50 Table 11.4 Summary of Key Definitions and
Formulas for Cost of Capital (cont.)

Managerial Accounting 2
51 Table 11.4 Summary of Key Definitions and
Formulas for Cost of Capital

Managerial Accounting 2
52 Table 11.1 Calculation of the Weighted
Average Cost of Capital for Duchess Corporation

Managerial Accounting 2
 Table 11.2 Weighted Average Cost of Capital for
53 Ranges of Total New Financing for Duchess
Corporation

Managerial Accounting 2
54 Figure 11.1 WMCC Schedule

Managerial Accounting 2
55 Table 11.3 Investment Opportunities Schedule
(IOS) for Duchess Corporation

Managerial Accounting 2
56 Figure 11.2 IOS and WMCC
Schedules

Managerial Accounting 2
57 Reference:

– Managerial Finance by Lawrence Gitman

Managerial Accounting 2