Calculating the Cost of Capital • Cost of Internal Common Stock Equity Capital

Asset Pricing Model

Factors Affecting the Cost of Capital kS = kRF + b(kM – kRF)
 General Economic Conditions Example:
-Affect interest rates The estimated Beta of a stock is 1.2. The
 Market Conditions risk-free rate is 5% and the expected market return
-Affect risk premiums is 13%.
 Operating Decisions kS = 5% + 1.2(13% – 5%) = 14.6%
-Affect business risk
• Cost of New Common Stock
 Financial Decisions
– Must adjust the Dividend Growth Model
-Affect financial risk
equation for floatation costs of the new
 Amount of Financing
common shares.
-Affect flotation costs and market price of
kn = D1 +g
security
P0 - F
Example:
Weighted Cost of Capital Model
If additional shares are issued floatation costs will
• Compute the cost of each source of capital
be 12%. D0 = $3.00 and estimated growth is 10%, Price is
• Determine percentage of each source of capital in
$60 as before
the optimal capital structure
kn = 3(1+0.10) + .10 = .1625 = 16.25%
• Calculate Weighted Average Cost of Capital
52.80
(WACC)

1. Compute Cost of Debt

Weighted Average Cost of Capital
• Required rate of return for creditors
• e.g. Suppose that a company issues bonds with a
Example: Gallagher Corporation estimates the following
before tax cost of 10%.
costs for each component in its capital structure:
• Since interest payments are tax deductible, the
Source of Capital Cost
true cost of the debt is the after tax cost.
Bonds kd = 10%
• If the company’s tax rate (state and federal
Preferred Stock kp = 11.9%
combined) is 40%, the after tax cost of debt
Common Stock
• AT kd = 10%(1-.4) = 6%.
Retained Earnings ks = 15%
New Shares kn = 16.25%
2. Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock.
Gallagher’s tax rate is 40%
Required rate kp = Dividend (Dp)
 If using retained earnings to finance the
Market Price (PP) - F
common stock portion the capital structure:
Example: You can issue preferred stock for a net
price of $42 and the preferred stock pays a
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
$5 dividend.
 The cost of preferred stock:
 Assume that Gallagher’s desired capital
kp = $5.00 = 11.90%
structure is 40% debt, 10% preferred and
$42.00
50% common equity.
3. Compute Cost of Common Equity WACC = .40 x 10% (1-.4) + .10 x 11.9% + .50 x 15% = 11.09%
• Two Types of Common Equity Financing
– Retained Earnings (internal common
equity)  If using a new equity issue to finance the common
– Issuing new shares of common stock stock portion the capital structure:
(external common equity)
– Management should retain earnings only WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
if they earn as much as stockholder’s
next best investment opportunity of the WACC =.40 x 10% (1-.4) + .10 x 11.9% + .50 x 16.25% = 11.72%
same risk.
– Cost of Internal Equity = opportunity
cost of common stockholders’ funds. Marginal Cost of Capital
– Two methods to determine • Gallagher’s weighted average cost will change if
• Dividend Growth Model one component cost of capital changes.
• Capital Asset Pricing Model • This may occur when a firm raises a particularly
• Cost of Internal Common Stock Equity large amount of capital such that investors think
– Dividend Growth Model that the firm is riskier.
kS = D1 + g • The WACC of the next dollar of capital raised in
P0 called the marginal cost of capital (MCC).
Example:
The market price of a share of common stock is Graphing the MCC curve
$60. The dividend just paid is $3, and the expected growth
rate is 10%.
kS = 3(1+0.10) + .10 =.155 = 15.5%
60