CHAPTER 9

Cost of Capital

1
Topics in Chapter
 Cost of capital components
 Debt
 Preferred stock
 Common equity
 WACC
 Factors that affect WACC
 Adjusting cost of capital for risk

2
 COST OF CAPITAL
Why? Business Application
 Key to understanding cost  Min Req’d return needed
of raising $ on Project
 Risk  Reflects blended costs of
 Financing costs raising capital
Discount Rate

 Relevant “i ”
 Discount rate used to
determine Project’s NPV
or to disct FCFs by
 Hurdle rate

3
 Determinants of Intrinsic Value:
The Weighted Average Cost of Capital

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Firm’s debt/equity mix

Cost of debt
Market risk aversion Cost of equity Firm’s business risk
What types of long-term
capital do firms use?
 Long-term debt
 Preferred stock
 Common equity

5
Capital Components
 Cap. components are sources of funding that
come from investors.
 A/P, accruals, and deferred taxes are not
sources of funding that come from investors,
& not included in the calculation of the cost of
capital.
 These items are adjusted for when calculating
project cash flows, not when calculating the
cost of capital.
6
Before-tax vs. After-tax Capital
Costs
 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
after-tax costs.
 Only cost of debt is affected.

7
Historical (Embedded) Costs
vs. New (Marginal) Costs
 The cost of capital is used primarily to
make decisions which involve raising
and investing new capital. So, focus on
marginal (incremental) costs.

8
 COST of CAPITAL
Raising $ & its Costs
Debt Equity
 Cost of Borrowing  Internal
 Interest Rate  RE

 External
 Common Stock
 Prfd Stock

9
 Cost of Capital
Raising $ & its Costs
 Debt & Equity

 Cost Return
 Int. pd. Int. recd.
 Divids pd. Divids Recd

10
 EQUITIES
Why? Business Application
 Key to understanding  For Investor:
valuations  Determine value of
 What is investment worth asset/business/company
today?
 Value of:  For Firm:
 Enterprise  Determine cost of
 Entity attracting investors &
 Company/Firm raising equity capital
 Selling ownership stake to
raise $

11
Weighted Average Cost of
Capital (WACC)
 WACC: Blended cost or raising capital
considering mix of debt & equity
 WACC = (Wt of Debt)(After-tax cost of
Debt) + Wt of Eqty)(Cost of Eqty) +
(Wt of Prfd)(Cost of Prfd)

12
Cost of Equity
 Know: = P0 = D1/ (rs –g)

 So then: rs = D1/P0 + g

13
Cost of Equity
 Cost of External Equity: Function of Dvids,
growth, & net proceeds after adjusting for
flotation costs

 Cost of Internal Equity: Function of opp.

Costs of divids not pd out but retained in firm
to grow internally (no flot. req’d)

14
Cost of Preferred Stock
 r = D1/P0 + g
 g= 0, so cost of prfd = function of
divids pd. & flot cost to issue

15
Determining Cost of Debt

 Method 1: Ask an investment banker

what coupon rate would be on new
debt.
 Method 2: Find bond rating for the
company and use yield on similarly
rated bonds.
 Method 3: Find yield on the company’s
existing debt.

16
Current vs. Historical Cost of
Debt
 For cost of debt, don’t use coupon rate
on existing debt, which represents cost
of past debt.
 Use the current interest rate on new
debt (think YTM).

(More…)
17
 A 15-year, 13.25% semiannual bond sells
for $1,250. Tax = 40%. 60,000 Bonds
o/s. What’s rd?

0 1 2 30
rd = ?
...
1,250.00 -66.25 -66.25 <66.25 + 1,000>

INPUTS 30 1250 -66.25 -1000

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

18
Component Cost of Debt
 Interest is tax deductible, so the after
tax (AT) cost of debt is:
rd AT = rd BT(1 – T)
rd AT = 10%(1 – 0.40) = 6%.
 Use nominal rate.
 Flotation costs small, so ignore.

19
 Cost of Debt - Practice
The Heuser Company’s currently
outstanding bonds have a 10 percent
coupon and a 12 percent yield to
maturity. Heuser believes it could issue
new bonds at par that would provide a
similar yield to maturity. If its marginal
tax rate is 35 percent, what is Heuser’s
after-tax cost of debt?
20
 Cost of Debt - Practice
rd(1 – T) = 0.12(0.65)
= 7.80%.

21
Component cost of preferred
stock
WACC = wdkd(1-T) + wpkp + wcks

 kp is the marginal cost of preferred

stock.
 The rate of return investors require on
the firm’s preferred stock.
What is the cost of preferred
stock?
 The cost of preferred stock can be
solved by using this formula:

kp = Dp / Pp
= $10 / $111.10
= 9%
Component cost of preferred
stock
 Preferred dividends are not tax-
deductible, so no tax adjustments
necessary. Just use kp.
 Nominal kp is used.
 Our calculation ignores possible
flotation costs.
 Cost of preferred stock: Pps = $125;
10.26% Div; Par = $100; F = 8.8%

Use :
Dps
rps = =
Pps (1 – F)

25
 Cost of preferred stock: Pps = $125;
10.26% Div; Par = $100; F = 8.8%

Use :
Dps .0126($100)
rps = =
Pps (1 – F) $125.00(1 – 0.088)
$10.26
= = 0.090 = 9.0%
$114.

26
Note:
 Flotation costs for preferred are
significant, so are reflected. Use net
price.
 Preferred dividends are not deductible,
so no tax adjustment. Just rps.
 Nominal rps is used.

27
 Cost of Preferred Stock -
Practice
Tunney Industries can issue
perpetual preferred stock at a price
of $47.50 a share. The stock would
pay a constant annual dividend of
$3.80 a share.
What is the company’s cost of
preferred stock, rp?

28
 Cost of Preferred Stock -
Practice

Pp = $47.50; Dp = $3.80; rp = ?

Dp $3.80
rp = = = 8%.
Pp $47.50

29
 Cost of Preferred Stock -
Practice
 Trivoli Industries plans to issue
perpetual preferred stock with an
$11.00 dividend. The stock is
currently selling for $97.00; but
flotation costs will be 5% of the
market price, so the net price will
be $92.15 per share. What is the
cost of the preferred stock,
including flotation? 30
 Cost of Preferred Stock -
Practice

$11
rp = = 11.94%.
$92.15

31
Is preferred stock more or less
risky to investors than debt?
 More risky; company not required to
pay preferred dividend.
 However, firms want to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, and (3) preferred
stockholders may gain control of firm.

32
Why is yield on preferred
lower than rd?
 Corporations own most preferred stock,
because 70% of prfd divids nontaxable to
corps.
 T/4, prfd often has a lower
B-T yield than the B-T yield on debt.
 The A-T yield to investors and A-T cost to the
issuer are higher on prfd than on debt, which
is consistent w/ higher risk of prfd.

33
 Example:
rps = 9%, rd = 10%, T = 40%

rps, AT = rps – rps(1 – 0.7)(T)

34
 Example:
rps = 9%, rd = 10%, T = 40%

rps, AT = rps – rps(1 – 0.7)(T)

= 9% – 9%(0.3)(0.4) = 7.92%
rd, AT = 10% – 10%(0.4) = 6.00%
A-T Risk Premium on Preferred =

35
 Example:
rps = 9%, rd = 10%, T = 40%

rps, AT = rps – rps(1 – 0.7)(T)

= 9% – 9%(0.3)(0.4) = 7.92%
rd, AT = 10% – 10%(0.4) = 6.00%
A-T Risk Premium on Preferred = 1.92%

36
Component cost of equity
WACC = wdkd(1-T) + wpkp + wcks

 ks is the marginal cost of common

equity using retained earnings.
 The rate of return investors require on
the firm’s common equity using new
equity is ke.
What are the two ways that
companies can raise common equity?

 Directly, by issuing new shares of

common stock.
 Indirectly, by reinvesting earnings that
are not paid out as dividends (i.e.,
retaining earnings).

38
Why is there a cost for
reinvested earnings?
 Earnings can be reinvested or paid out
as dividends.
 Investors could buy other securities,
earning a return.
 Thus, there is an opportunity cost if
earnings are reinvested.

39
Cost for Reinvested Earnings
(Continued)
 Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
 They could buy similar stocks and earn
rs, or company could repurchase its own
stock and earn rs. So, rs, is cost of
reinvested earnings and is cost of
common equity.
40
Three ways to determine
the cost of equity, rs:

1. CAPM: rs = rRF + (rM – rRF)b

= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Judgmental-
Risk Premium: rs = rd + Bond RP.

41
Equity Cost Components
 Risk free = 5.6%
 Mrkt Risk Prem = 6%
 Beta = 1.2
 Div today = $3.12
 Price today = $50
 Growth = 5.8%
 Cost of Debt = 10%
 Risk prem = 3.2%
 3,000,000 shs outstanding
42
CAPM Cost of Equity: rRF = 5.6%,
RPM = 6%, b = 1.2

rs = rRF + (RPM )b

= 5.6% + (6.0%)1.2 = 12.8%.

43
Issues in Using CAPM
 Most analysts use the rate on a
long-term (10 to 20 years)
government bond as an estimate
of rRF.
 Can use Bloomberg.com to obtain
US Treasuries Quotes

(More…)
44
Issues in Using CAPM
(Continued)
 Most analysts use a rate of 3.5% to
6% for the market risk premium
(RPM)
 Estimates of beta vary, and
estimates are “noisy” (they have a
wide confidence interval).

45
DCF Cost of Equity, rs:
D0 = $3.12; P0 = $50; g = 5.8%

D1 D0(1 + g)
rs = +g= +g
P0 P0

= $3.12(1.058) + 0.058
$50
=

46
DCF Cost of Equity, rs:
D0 = $3.12; P0 = $50; g = 5.8%

D1 D0(1 + g)
rs = +g= +g
P0 P0

= $3.12(1.058) + 0.058
$50
= 6.6% + 5.8%
= 12.4%
47
Estimating the Growth Rate
 Use historical growth rate if believe
future be like past.
 Obtain analysts’ estimates: Value Line,
Zacks, Yahoo!Finance.
 Use earnings retention model.

48
Earnings Retention Model
 Suppose company has been earning
15% on equity (ROE = 15%) and
been paying out 62% of its earnings.
 If expected to continue as is, what’s
the expected future g?

49
Earnings Retention Model
(Continued)
 Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.

Close to g = 5.8% given earlier.

50
Could DCF methodology be
applied if g is not constant?
 YES, nonconstant g stocks are
expected to have constant g at some
point, generally in 5 to 10 years.

51
The Own-Bond-Yield-Plus-Judgmental-Risk-
Premium Method: rd = 10%, RP = 3.2%

 rs = rd + Judgmental risk premium

 rs = 10.0% + 3.2% = 13.2%

 This over-own-bond-judgmental-risk
premium  CAPM equity risk premium,
RPM.
 Produces ballpark estimate of rs.
Useful check.
52
Final estimate of rs?
Method Estimate
CAPM 12.8%
DCF 12.4%
Bond Yld + risk prem 13.2%

Average 12.8%

53
Why is the cost of retained earnings
cheaper than the cost of issuing new
common stock?
 When a company issues new common
stock they also have to pay flotation costs
to the underwriter.
 Issuing new common stock may send a
negative signal to the capital markets,
which may depress the stock price.
If D0 = $4.19, P0 = $50, and g = 5%,
what’s the cost of common equity based
upon the DCF approach?

D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.3995

ks = D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%
If issuing new common stock incurs a
flotation cost of 15% of the proceeds,
what is ke?

D0 (1  g)
ke  g
P0 (1 - F)
$4.19(1.05)
  5.0%
$50(1 - 0.15)
$4.3995
  5.0%
$42.50
 15.4%
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.
Cost of Common Equity -
Practice
 The future earnings, dividends, and common stock price of
Carpetto Technologies Inc. are expected to grow 7% per year.
Carpetto’s common stock currently sells for $23.00 per share;
its last dividend was $2.00; and it will pay a $2.14 dividend at
the end of the current year.
a) Using the DCF approach, what is its cost of common equity?
b) If the firm’s beta is 1.6, the risk-free rate is 9%, and the
average return on the market is 13%, what will be the firm’s
cost of common equity using the CAPM approach?
c) If the firm’s bonds earn a return of 12%, based on the bond-
yield-plus-risk-premium approach, what will be rs? Use the
midpoint of the risk premium range
d) If you have equal confidence in the inputs used for the three
approaches, what is your estimate of Carpetto’s cost of
common equity?
58
 Cost of Common Equity -
Practice
D1 $2.14
rs = +g= + 7% = 9.3% + 7% = 16.3%.
P0 $23

b. rs = rRF + (rM – rRF)b

= 9% + (13% – 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

c. rs = Bond rate + Risk premium = 12% + 4% = 16%.

16.3%  15.4%  16%

d. rs = = 15.9%.
3 59
 Cost of Common Equity -
Practice
 The Evanec Company’s next expected
dividend, D1, is $3.18; its growth rate is 6%;
and its common stock now sells for $36.00.
New stock (external equity) can be sold to net
$32.40 per share.
a) What is Evanec’s cost of retained earnings, rs?
b) What is Evanec’s percentage flotation cost, F?
c) What is Evanec’s cost of new common stock,
re?

60
 Cost of Common Equity -
Practice

D1
a. rs = +g
P0
$3.18
= + 0.06
$36
= 14.83%.

61
Cost of Common Equity -
Practice

F = ($36.00 – $32.40)/$36.00
= $3.60/$36.00
= 10%.

62
Cost of Common Equity -
Practice

re = D1/[P0(1 – F)] + g
= $3.18/$32.40 + 6%
= 9.81% + 6%
= 15.81%.

63
 Cost of Common Equity -
Practice
 Ballack Co.’s common stock currently sells for
$46.75 per share. The growth rate is a constant
12%, and the company has an expected dividend
yield of 5%. The expected long-run dividend
payout ratio is 25%, and the expected return on
equity (ROE) is 16%. New stock can be sold to the
public at the current price, but a flotation cost of
5% would be incurred. What would be the cost of
new equity?

64
 Cost of Common Equity -
Practice
If the firm's dividend yield is 5% and its stock price is
$46.75, the next expected annual dividend can be
calculated.
Dividend yield = D1/P0
5% = D1/$46.75
D1 = $2.3375.
Next, the firm's cost of new common stock can be
determined from the DCF approach for the cost of equity.
re = D1/[P0(1 – F)] + g
= $2.3375/[$46.75(1 – 0.05)] + 0.12
= 17.26%
65
 Cost of Common Equity -
Practice
The Bouchard Company’s EPS was $6.50 in 2008, up
from $4.42 in 2003. The company pays out 40% of its
earnings as dividends, and its common stock sells for
$36.00.
a) Calculate the past growth rate in earnings. (Hint:
This is a 5-year growth period.)
b) The last dividend was D0 = 0.4($6.50) = $2.60.
Calculate the next expected dividend, D1, assuming
that the past growth rate continues.
c) cWhat is Bouchard’s cost of retained earnings, rs?

66
 Cost of Common Equity -
Practice
a)With financial calculator, Inputs:
N = 5,
PV = -4.42,
PMT = 0,
FV = 6.50,
and then solve for
I/YR = g
= 8.02%  8%. 67
 Cost of Common Equity -
Practice
b. D1 = D0(1 + g)
= $2.60(1.08)
= $2.81.

c. rs = (D1/P0 ) + g
= ($2.81/$36.00) + 8%
= 15.81%.
68
 Cost of Common Equity -
Practice
 Sidman Products’ common stock currently sells
for $60.00 a share. The firm is expected to
earn $5.40 per share this year and to pay a
year-end dividend of $3.60, and it finances
only with common equity.
a) If investors require a 9% return, what is the
expected growth rate?
b) If Sidman reinvests retained earnings in
projects whose average return is equal to the
stock’s expected rate of return, what will be
next years’ EPS?
69
 Cost of Common Equity -
Practice
D1
a. rs= +g
P0
$3.60
0.09 = +g
$60.00
0.09 = 0.06 + g
g = 3%.
70
 Cost of Common Equity -
Practice
EPS1
= EPS0(1 + g)
= $5.40(1.03)
= $5.562.

71
Determining Weights for WACC

 Wts are % of firm’s capital to be

financed by each component.
 If possible, always use the target wts
for % financed by each type of
capital.

72
Estimating Weights for the
Capital Structure
 If don’t know targets, better to estimate
wts using current market values than
current book values.
 If don’t know MV of debt, then
reasonable to use BV of debt, especially
if S/T debt.

(More…)
73
Estimating Weights
(Continued)
 Suppose the common stock price is $50
with 3 million shares outstanding; the
firm has 200,000 shs of preferred stock
trading at $125; and 60,000 bonds
outstanding trading at quoted price of
125% of par.

(More…)
74
Estimating Weights
(Continued)
 Vs = $50(3 million) = $150 million.
 Vps = $25 million.
 Vd = $75 million.
 Total value = $150 + $25 + $75
= $250 million.

75
Estimating Weights
(Continued)
 ws = $150/$250 = 0.6
 wps = $25/$250 = 0.1
 wd = $75/$250 = 0.3

 Target wts for this co. are same as these MV

wts, but often MV wts temporarily deviate
from targets due to changes in stock prices.

76
 What’s the WACC using the
target weights?

WACC = wdrd(1 – T) + wpsrps + wsrs

WACC = 0.3(10%)(1 − 0.4) + 0.1(9%)

+ 0.6(12.8%)

WACC = 10.38%

77
 WACC - Practice
 Patton Paints Corporation has a target capital
structure of 40% debt and 60% common
equity, with no preferred stock. Its before-tax
cost of debt is 12%, and its marginal tax rate
is 40%. The current stock price is P0 = $22.50.
The last dividend was D0 = $2.00, and it is
expected to grow at a 7% constant rate. What
is its cost of common equity and its WACC?

78
 WACC - Practice
Debt = 40%, Common equity = 60%.

P0 = $22.50, D0 = $2.00, D1 = $2.00(1.07) = $2.14, g = 7%.

D1 $2.14
rs = +g= + 7% = 16.51%.
P0 $22.50

WACC = (0.4)(0.12)(1 – 0.4) + (0.6)(0.1651)

= 0.0288 + 0.0991 = 12.79%.
79
WACC - Practice
 Klose Outfitters Inc. believes that its optimal capital
structure consists of 60% common equity and 40%
debt, and its tax rate is 40%. Klose must raise
additional capital to fund its upcoming expansion.
The firm will have $2 million of new retained
earnings with a cost of rs= 12%. New common stock
in an amount up to $6 million would have a cost of re
= 15%. Furthermore, Klose can raise up to $3
million of debt at an interest rate of rd = 10% and
an additional $4 million of debt at rd = 12%. The
CFO estimates that a proposed expansion would
require an investment of $5.9 million. What is the
WACC for the last dollar raised to complete the
expansion? 80
 WACC - Practice
 If the investment requires $5.9 million, that
means that it requires $3.54 million (60%) of
common equity and $2.36 million (40%) of debt.
In this scenario, the firm would exhaust its $2
million of retained earnings and be forced to
raise new stock at a cost of 15%. Needing $2.36
million in debt, the firm could get by raising debt
at only 10%. Therefore, its weighted average
cost of capital is: WACC = 0.4(10%)(1 – 0.4) +
0.6(15%) = 11.4%.

81
 WACC Practice
 Kahn Inc. has a target capital structure of 60%
common equity and 40% debt to fund its $10
billion in operating assets. Furthermore, Kahn Inc.
has a WACC of 13%, a before-tax cost of debt of
10%, and a tax rate of 40%. The company’s
retained earnings are adequate to provide the
common equity portion of its capital budget. Its
expected dividend next year (D1) is $3, and the
current stock price is $35.
 a. What is the company’s expected growth rate?
 b. If the firm’s net income is expected to be $1.1
billion, what portion of its net income is the firm
expected to pay out as dividends? 82
 WACC Practice
 Step 1: Determine WACC

WACC = wd(rd)(1 – T) + wc(rs)

13.0% = 0.4(10%)(1 – 0.4) + 0.6(rs)
10.6% = 0.6rs
rs = 0.17667 or 17.67%.

83
 WACC Practice
 Step 2: Determine Growth rate

rs = D1/P0 + g
0.17667 = $3/$35 + g
g = 0.090952  9.10%.

84
 WACC Practice
b. From the formula for the long-run growth
rate:
g = (1 – Div. payout ratio)  ROE
= (1 – Div. payout ratio)  (NI/Equity)
0.090952 = (1 – Div. payout ratio) 
($1,100
million/$6,000 million)
0.090952 = (1 – Div. payout ratio) 

0.1833333
0.496104 = (1 – Div. payout ratio) 85
What factors influence a
company’s WACC?
 Uncontrollable factors:
 Market conditions, especially interest rates.
 The market risk premium.
 Tax rates.
 Controllable factors:
 Capital structure policy.
 Dividend policy.
 Investment policy. Firms with riskier projects
generally have higher financing costs.

86
Should firm-wide WACC be
used for each of its divisions?
 NO! Composite WACC reflects risk of
an average project undertaken by the
firm.
 Different divisions may have different
risks. Division’s WACC should be
adjusted to reflect division’s risk and
cap structure.

87
The Risk-Adjusted Divisional
Cost of Capital
 Estimate cost of capital division
would have if it were a stand-alone
firm.
 This requires estimating division’s
beta, cost of debt, and capital
structure.

88
Pure Play Method for Estimating
Beta for a Division or a Project
 Find several publicly traded companies
exclusively in project’s business.
 Use average of their betas as proxy for
project’s beta.
 Hard to find such companies.

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Accounting Beta Method for
Estimating Beta
 Run regression between project’s
ROA and S&P Index ROA.
 Accounting betas correlated (0.5 –
0.6) with market betas.
 But normally can’t get data on new
projects’ ROAs before capital
budgeting decision made.

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Divisional Cost of Capital
Using CAPM
 Target debt ratio = 10%.
 rd = 12%.
 rRF = 5.6%.
 Tax rate = 40%.
 betaDivision = 1.7.
 Market risk premium = 6%.

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Divisional Cost of Capital
Using CAPM (Continued)

Division’s required return on equity:

rs = rRF + (rM – rRF)bDiv.
rs = 5.6% + (6%)1.7 = 15.8%.
WACCDiv. = wd rd(1 – T) + wsrs
= 0.1(12%)(0.6) + 0.9(15.8%)
= 14.94% ≈ 14.9%

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Division’s WACC vs. Firm’s Overall
WACC?

 Division WACC = 14.9% versus

company WACC = 10.4%.
 “Typical” projects within this division
would be accepted if its returns above
14.9%.

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What are the three types of
project risk?
 Stand-alone risk
 Corporate risk
 Market risk

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How is each type of risk used?
 Stand-alone risk easiest to calculate.
 Market risk theoretically best in most
situations.
 However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
 Therefore, corporate risk is also
relevant.

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A Project-Specific, Risk-Adjusted
Cost of Capital
 Start by calculating a divisional cost of
capital.
 Use judgment to scale up or down the
cost of capital for an individual project
relative to the divisional cost of capital.

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Finding a divisional cost of capital:
Using similar stand-alone firms to
estimate a project’s cost of capital
 Comparison firms have the following
characteristics:
 Target capital structure consists of 40%
debt and 60% equity.
 kd = 12%
 kRF = 7%
 RPM = 6%
 βDIV = 1.7
 Tax rate = 40%
 Calculating a divisional cost of capital

 Division’s required return on equity

 ks = kRF + (kM – kRF)β
= 7% + (6%)1.7 = 17.2%
 Division’s weighted average cost of capital
 WACC = wd kd ( 1 – T ) + wc ks
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
 Typical projects in this division are
acceptable if their returns exceed 13.2%.
Costs of Issuing New Common
Stock
 When a company issues new common
stock they also have to pay flotation
costs to the underwriter.
 Issuing new common stock may send a
negative signal to the capital markets,
which may depress stock price.

99
Cost of New Common Equity: P0 = $50,
D0 = $3.12, g = 5.8%, and F = 15%

D0(1 + g)
re = +g
P0(1 – F)
$3.12(1.058) + 5.8%
=
$50(1 – 0.15)

= $3.30 + 5.8% = 13.6%

$42.50
100
Cost of New 30-Year Debt: Par = $1,000,
Coupon = 10% paid annually, and F = 2%

 Using a financial calculator:

 N = 30
 PV = 1,000(1 – 0.02) = 980
 PMT = -(0.10)(1,000)(1 – 0.4) = -60
 FV = -1,000
 Solving for I/YR: 6.15%

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 WACC Practice
 Midwest Electric Company (MEC) uses only debt and
common equity. It can borrow unlimited amounts at an
interest rate of Rd = 10% as long as it finances at its
target capital structure, which calls for 45% debt and 55%
common equity. Its last dividend was $2, its expected
constant growth rate is 4%, and its common stock sells
for $20. MEC’s tax rate is 40%. Two projects are available:
Project A has a rate of return of 13%, while Project B’s
return is 10%. These two projects are equally risky and
about as risky as the firm’s existing assets.
 a. What is its cost of common equity?
 b. What is the WACC?
 c. Which projects should Midwest accept? 102
 WACC Practice

a. rd = 10%, rd(1 – T) = 10%(0.6) = 6%.

wd = 45%; D0 = $2; g = 4%; P0 = $20; T =

40%.

Project A: Rate of return = 13%.

Project B: Rate of return = 10%.

rs = $2(1.04)/$20 + 4% = 14.40%.
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 WACC Practice

b. WACC = 0.45(6%) + 0.55(14.40%) =

10.62%.
c. Since the firm’s WACC is 10.62% and each of
the projects is equally risky and as risky as
the firm’s other assets, MEC should accept
Project A. Its rate of return is greater than
the firm’s WACC. Project B should not be
accepted, since its rate of return is less than
MEC’s WACC.
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 WACC Practice
 Hook Industries’ capital structure consists
solely of debt and common equity. It can issue
debt at rd = 11%, and its common stock
currently pays a $2.00 dividend per share (D0
= $2.00). The stock’s price is currently $24.75,
its dividend is expected to grow at a constant
rate of 7% per year, its tax rate is 35%, and
its WACC is 13.95%. What percentage of the
company’s capital structure consists of debt?

105
 WACC Practice

Step1: Determine Cost of Equity

rs = (D1/P0 )+ g
= [$2(1.07)/$24.75] + 7%
= 8.65% + 7%
= 15.65%.

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 WACC Practice

WACC = wd(rd)(1 – T) + wc(rs)

wc = 1 – wd

107
 WACC Practice

WACC = wd(rd)(1 – T) + wc(rs)

wc = 1 – wd

13.95% = wd(11%)(1 – 0.35) + (1 -

wd)(15.65%)
0.1395 = 0.0715wd + 0.1565 – 0.1565wd
-0.017 = -0.085wd
wd = 0.20 or 20%.
108
Comments about flotation
costs:
 Flot costs depend on risk of firm & type of
capital being raised.
 Flot costs highest for common equity.
However, most firms issue equity
infrequently, the per-project cost is fairly
small.
 We will frequently ignore flotation costs when
calculating the WACC.

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Four Mistakes to Avoid
 Current vs. historical cost of debt
 Mixing current and historical measures
to estimate the market risk premium
 Book weights vs. Market Weights
 Incorrect cost of capital components

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110
Current vs. Historical Cost of
Debt
 When estimating the cost of debt, don’t
use the coupon rate on existing debt,
which represents the cost of past debt.
 Use the current interest rate on new
debt.

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Estimating the Market Risk
Premium
 When estimating the risk premium for the
CAPM approach, don’t subtract the current
long-term T-bond rate from the historical
average return on common stocks.
 For example, if the historical rM has been
about 12.2% and inflation drives the current
rRF up to 10%, the current market risk
premium is not 12.2% – 10% = 2.2%!
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Estimating Weights
 Use target cap structure to determine wts.
 If don’t know target wts, use MV of equity.
 If don’t know MV of debt, then use BV of
debt.

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Capital components are sources of
funding that come from investors.
 Accounts payable, accruals, and deferred
taxes are not sources of funding that come
from investors, so they are not included in
the calculation of the WACC.
 We do adjust for these items when
calculating project cash flows, but not when
calculating the WACC.

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