CHAPTER 7

Cost of Capital
The Short Story of WACC
Purposes/Use
The weighted average cost of capital (WACC)
serves three primary purposes:
1. To evaluate capital project proposals before-the-fact.
2. To set performance targets in order for management
to sustain or grow market values, and
3. to measure management performance after-the-fact.
20 - 2
The Short Story of WACC
What Costs are Measured?
Costs associated with financing the firms
invested capital including:
Debt Costs:
Bank loans
Long-term debt bonds
Equity Costs:
Preferred equity costs
Common equity costs
20 - 3
The Short Story of WACC
Why the Marginal Cost?
What capital cost the firm 5 months, 5 years
or 5 decades ago is irrelevant.
What is relevant is what the next dollar of
capital will cost in todays economic
environment for this particular firm.
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The Short Story of WACC
Steps in Solving for the WACC
1. Identify the relevant sources of capital (debt and
equity).
2. Estimate the market values for the sources of
capital and determine the market value weights.
3. Estimate the marginal, after-tax, and after-
floatation cost for each source of capital.
4. Calculate the weighted average.
CHAPTER 20 Cost of Capital 20 - 5
The Short Story of WACC
The Formula
CHAPTER 20 Cost of Capital 20 - 6
Once you have the specific marginal costs of capital (after accounting for taxes
and floatation costs) and you have found the appropriate weights to use, the
actual calculation of a WACC is a simple matter.
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V
D
T K
V
S
K K WACC
d e a
The cost of equity
times the market
value weight of
equity
The cost of debt
after tax times the
market value weight
of debt
The Short Story of WACC
The Spreadsheet Approach
(1) (2) (3) (4) = (2)*(3)
Type of
Capital
Specific
Marginal Cost
after tax and
floatation
costs
Market
Value
Weights
Weighted
Specific
Marginal
Cost
Long-Term Debt 5.5% 43.0% 0.02365
Preferred Stock 11.4% 11.0% 0.01254
Common Stock 12.9% 46.0% 0.05934
WACC = 9.55%
CHAPTER 20 Cost of Capital 20 - 7
WACC is the sum of the weighted
specific marginal costs of each source of
capital.
Important Terms
Financial Structure
Includes both short-term and long-term sources of financing (debt and
equity)
Capital Structure
How the firm finances its invested capital
Includes long-term sources of financing
Includes:
Bank Loans
Long-term debt
Common stock and retained earnings
20 - 8
Financing Sources
Capital Structure
$50 Accruals $100
200 Accounts payable 200
250 Short-term debt 50
0 Total current liabilities 350
Total current assets 500 Long-term debt 650
1,500 Shareholders' equity 1,000
Total assets $2,000 Total liabilities and shareholders' equity $2,000
Prepaid expenses
Net fixed assets
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
CHAPTER 20 Cost of Capital 20 - 9
Financial Structure = $2,000 Capital Structure = $1,700
Financing Sources
Interpreting Balance Sheets
Balance sheets are prepared in accordance with GAAP:
Represent historical costs which may not be relevant for current
decision-making purposes.
Analysis of reported data should include ratios such as:
Debt to Equity:
Interest bearing debt to shareholders equity plus minority interest
Convert book values to market values
This is done by multiplying the market-to-book ratio times the book value.
Interpret the ratios again.


(Table 20 2 will be used to illustrate the adjustment process from book values to
market values)
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