WACC

10 - 1
 Capital components: debt, preferred stock,

and common stock.
 Any increase in total assets must be financed
by an increase in one or more of these capital
components
 Kd: the interest rate on the firm’s new debt
Kps: the cost of preferred stock
Ks: the cost of retained earnings
Ke:the cost of common equity (equity obtained
by issuing new common stock as apposed to
retaining eanings
Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 2
1. The cost of debt
Kd(1-T) is the after tax cost of debt. The
relevant cost of new debt, taking into
account the tax deductibility of interest.
In effect, the government pays part of the
cost of debt because interest is
deductible.
Note that the cost of debt is the interest

rate on new debt, not the interest rate
paid on existing or old debt.
10 - 3
A 15-year, 12% semiannual bond sells

for $1,153.72. What’s kd?
0 1 2 30
i=? ...
-1,153.72 60 60 60 + 1,000
INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5.0% x 2 = kd = 10%

10 - 4
Component Cost of Debt
Interest is tax deductible, so

kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.

10 - 5
2. The cost of preferred stock (Kp)

The rate of return investors require on the
firm’s preferred stock.
Preferred stock is a perpetuity that pays a
fixed dividend (Dp) forever.
Kp = Preferred dividend / the current price
of the preferred stock

10 - 6
What’s the cost of preferred stock?

Pp = $111.10; $10 dividend/share
Use this formula:
Dp $10
kp    0.090  9.0%.
Pp $111.10

10 - 7
Note:
Preferred dividends are not tax

deductible, so no tax adjustment.
Just kp.
Nominal kp is used.
Our calculation ignores flotation
costs.

10 - 8
Why is there a cost for retained

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 retained.

10 - 9
Opportunity cost: The return
stockholders could earn on
alternative investments of equal risk.
They could buy similar stocks and
earn ks. So, ks is the cost of retained
earnings. The rate of return required by
stockholders on a firm’s common stock

10 - 10
Three ways to determine cost of

common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
2. The bond-yield plus risk-premium approach:
Ks= bond yield + firm’s risk premium
firms with risky, low-rated, and consequently

high-interest-rate debt will also have risky, high-
cost equity. The risk premium over a firm’s own
bond yield has generally ranged from 3 to 5
percentage.
10 - 11
3. Discount Cash Flow model

(Constant dividend growth model)
Ks = (D1/Po) + g
How to estimate g?
g = (1- dividend pay out ratio)*ROE

10 - 12
What’s the cost of common equity
based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM – kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.

10 - 13
What’s the DCF cost of common

equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
D1 D0(1 + g)
ks = +g= +g
P0 P0
= $4.19(1.05) + 0.05
$50
= 0.088 + 0.05
= 13.8%.
10 - 14
Suppose the company has been

earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout =
65%), and this situation is expected to
continue.
What’s the expected future g?

10 - 15
Retention growth rate:
g = (1 – Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 – Payout) = Fraction retained.

10 - 16
Find ks using the own-bond-yield-plus-

risk-premium method.
(kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%

This RP  CAPM RP.
Produces ballpark estimate of ks.

10 - 17
What’s a reasonable final estimate of ks?
Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%

10 - 18
Why is the cost of retained earnings

(ks) cheaper than the cost of issuing
new common stock (ke)?
1. When a company issues new common
stock they also have to pay flotation costs
to the underwriter.
2. Issuing new common stock may send a
negative signal to the capital markets,
which may depress stock price.

10 - 19
Two approaches that can be used to

account for flotation costs:
Include the flotation costs as part of the

project’s up-front cost. This reduces the
project’s estimated return.
Adjust the cost of capital to include
flotation costs. This is most commonly
done by incorporating flotation costs in
the DCF model.

10 - 20
Ke = [D1/Po(1-F) ] + g
F is the percentage flotation cost incurred in

selling the new stock.
So, Po (1-F) is the net price per share

received by the company.

10 - 21
New common, F = 15%:
D0 (1  g)
ke  g
P0 (1  F)
$4.191.05 
  5 .0 %
$501  0.15 
$4.40
  5.0%  15.4%.
$42.50

10 - 22
 Because of flotation costs, dollars raised by
selling new stock must “work harder” than
dollars raised by retaining earnings.
Moreover, since no flotation costs are
involved, retained earnings have a lower cost
than new stock.
 Therefore, the firms should utilize retained
earnings to the extent possible to avoid the
costs of new common stock.
 However, if a firm has more good investment
opportunities, issuing new common stock is
necessary.
10 - 23
The retained earnings breakpoint represents
the total amount of financing that can be
raised before the firm is forced to sell new
common stock.
Retained earnings breakpoint

= addition to retained earnings/equity fraction

10 - 24
E.g) Suppose a firm estimates its

earnings to be $100M next year and
has a payout ratio of 40%. Its capital
structure consists of 45% debt, 2%
preferred, and 53% equity.
The break point will be $60M/0.53 =

$113.2M; After the firm has raised
total capital of $113.2M, the firm will
be forced to issue new common
stock.
10 - 25
Comments about 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.
10 - 26
5. Weighted Average Cost of Capital (WACC)
If all new equity will come from retained earnings:
WACC = Wd [Kd(1-t)] + Wp(Kps) + Wc(Ks)
Wd, Ws, Wc are the weights used for debt, preferred
stock, and common equity.
Assume that the firm has established such a target

and will finance all new investments so as to
maintain a constant target capital structure.
Weights should be based on the market value.

10 - 27
What’s the firm’s WACC (ignoring

flotation costs)?
WACC = wdkd(1 – T) + wpkp + wcks

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.

10 - 28
The company has a target capital
structure of 40 percent debt and 60
percent equity
Bonds pay 10% coupon (semiannual),
mature in 20 years and sell for $849.54
the company stock beta is 1.2
rf = 10%, market risk premium = 5%
the company is a constant growth firm
that just paid a dividend of $2, sells for
$27 per share, and a growth rate of 8%
marginal tax rate is 40%.
10 - 29
What factors influence a company’s

composite WACC?
Market conditions. (the level of interest

rates, tax rates…)
The firm’s capital structure and dividend
policy.
The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.

10 - 30
WACC Estimates for Some Large

U. S. Corporations, Nov. 1999
Company WACC
Intel 12.9%
General Electric 11.9
Motorola 11.3
Coca-Cola 11.2
Walt Disney 10.0
AT&T 9.8
Wal-Mart 9.8
Exxon 8.8
H. J. Heinz 8.5
BellSouth 8.2
10 - 31
Should the company use the

composite WACC as the hurdle rate for
each of its projects?
NO! The composite WACC reflects the

risk of an average project undertaken
by the firm. Therefore, the WACC only
represents the “hurdle rate” for a
typical project with average risk.
Different projects have different risks.
The project’s WACC should be adjusted
to reflect the project’s risk.
10 - 32
What procedures are used to determine

the risk-adjusted cost of capital for a
particular project or division?
Subjective adjustments to the

firm’s composite WACC.
Attempt to estimate what the cost
of capital would be if the
project/division were a stand-alone
firm. This requires estimating the
project’s beta.
10 - 33
Find the division’s market risk and cost

of capital based on the CAPM, given
these inputs:
Target debt ratio = 40%.

kd = 12%.
kRF = 7%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.
10 - 34
Beta = 1.7, so division has more market

risk than average.
Division’s required return on equity:
ks = kRF + (kM – kRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdkd(1 – T) + wcks
= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.
10 - 35
How does the division’s market risk

compare with the firm’s overall market
risk?
Division WACC = 13.2% versus

company WACC = 11.1%.
Indicates that the division’s market risk
is greater than firm’s average project.
“Typical” projects within this division
would be accepted if their returns are
above 13.2%.

WACC

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10 - 1

 Capital components: debt, preferred stock,

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Note that the cost of debt is the interest

A 15-year, 12% semiannual bond sells

INPUTS 30 -1153.72 60 1000

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Component Cost of Debt

Interest is tax deductible, so

Copyright © 2001 by Harcourt, Inc. All rights reserved.

2. The cost of preferred stock (Kp)

Copyright © 2001 by Harcourt, Inc. All rights reserved.

What’s the cost of preferred stock?

Use this formula:

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Preferred dividends are not tax

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Why is there a cost for retained

Earnings can be reinvested or paid

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Three ways to determine cost of

firms with risky, low-rated, and consequently

3. Discount Cash Flow model

Copyright © 2001 by Harcourt, Inc. All rights reserved.

ks = kRF + (kM – kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

Copyright © 2001 by Harcourt, Inc. All rights reserved.

What’s the DCF cost of common

Suppose the company has been

What’s the expected future g?

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Retention growth rate:

Here (1 – Payout) = Fraction retained.

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Find ks using the own-bond-yield-plus-

= 10.0% + 4.0% = 14.0%

Copyright © 2001 by Harcourt, Inc. All rights reserved.

What’s a reasonable final estimate of ks?

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Why is the cost of retained earnings

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Two approaches that can be used to

Include the flotation costs as part of the

Copyright © 2001 by Harcourt, Inc. All rights reserved.

F is the percentage flotation cost incurred in

So, Po (1-F) is the net price per share

Copyright © 2001 by Harcourt, Inc. All rights reserved.

New common, F = 15%:

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Retained earnings breakpoint

Copyright © 2001 by Harcourt, Inc. All rights reserved.

E.g) Suppose a firm estimates its

The break point will be $60M/0.53 =

Comments about flotation costs:

Flotation costs depend on the risk of

Assume that the firm has established such a target

Copyright © 2001 by Harcourt, Inc. All rights reserved.

What’s the firm’s WACC (ignoring

WACC = wdkd(1 – T) + wpkp + wcks

Copyright © 2001 by Harcourt, Inc. All rights reserved.

What factors influence a company’s

Market conditions. (the level of interest