COST OF

CAPITAL
WEEK14_FINMNN1
Chapter Outline
• Cost of capital and its importance
• Discount rates used to analyze investments
• Valuation and application to bonds, preferred stock,
and common stock
• Minimum cost of capital
• Increase in cost of capital with increase in utilization
of finances

11-2
Cost of Capital
• In
corporate finance, an investment made is for an
anticipated return in future
• Knowing the appropriate discount rate is vital
• Cost of acquiring the funds
• Earning at least a return equaling the costs
incurred to acquire it – the minimum acceptable
return

11-3
The Overall Concept
• An investment:
• Should not be judged against the specific means of financing
used to implement it
• This would make investment selection decisions inconsistent
• With a low-cost debt must be chosen carefully
• May result in increase of the overall risk
• May make all eventual forms of financing more expensive

11-4
 Determination of Cost of Capital
• Best understood by capital structure of a firm
• The after-tax costs of the individual sources of financing are
multiplied by the weights assigned to them
• Sum of all these gives the weighted average cost

11-5
Cost of Debt
• Measured by interest rate, or yield, paid to bondholders
• Example: $1,000 bond paying $100 annual interest – 10% yield
• Calculation is complex if a bond is priced at discount or premium from
par value
• To determine the cost of a new debt in the marketplace:
• The firm will compute the yield on its currently outstanding debt

11-6
Approximate Yield to Maturity (Y')

11-7
Adjusting Yield for Tax Considerations
• Yield to maturity indicates how much the firm has to
pay on a before-tax basis
• Interest payment on a debt is a tax-deductible
expense
• Due to this, the true cost is less than the stated cost

11-8
Adjusting Yield for Tax Considerations (cont’d)
• The after-tax cost of debt is calculated as shown below:
Kd (Cost of debt) = Y(1 – T)

• Assuming: Yield = 10.84% and Tax rate = 35%

Kd (Cost of debt) = Y(1 – T)
Kd (Cost of debt) = 10.84% (1 – 0.35)
= 10.84% × 0.65
= 7.05%

11-9
Cost of Preferred Stock
•A constant annual payment with no maturity date for the
principal payment
• Computed by dividing dividend payment by net price or proceeds
received
• Represents the rate of return to preferred stockholders and annual cost to
corporation for issue
• Preferred stock dividend is not a tax-deductible expense, with no
downward tax adjustment
• Theproceeds to the firm equals selling price in the market
minus flotation cost

11-10
Cost of Preferred Stock (cont’d)

11-11
11-12
Cost of Preferred Stock (cont’d)

11-13
Cost of Common Equity – Valuation Approach
• In determining the cost of common stock, the firm must be sensitive to pricing
and performance demands of current and future stockholders
• Dividend valuation model:

11-14
Alternate Calculation of the Required Return on Common Stock
• Capital asset pricing model (CAPM)

11-15
Cost of Retained Earnings
• Sources of capital for common stock equity:
• Purchaser of the new shares – external source
• Retained earnings – internal source
• Represent the present and past earnings of the firm minus previously
distributed dividends
• Belong to the current stockholders – may be paid in the form of dividends or
reinvested in the firm
• Reinvestments represent a source of equity capital supplied by the current
stockholders
• An opportunity cost is involved

11-16
Cost of Retained Earnings

11-17
Cost of Retained Earnings

11-18
Cost of New Common Stock

11-19
Cost of New Common Stock (cont’d)

11-20
Optimal Capital Structure – Weighting Costs
• The desire to achieve a minimum overall cost of capital
• Calculated decisions are required on the appropriate weights for:
• Debt
• Preferred stock
• Common stock financing
• Capital mix is determined by:
• Considering the present capital structure
• Ascertaining if the current position is optimal

11-21
Optimal Capital Structure – Weighting Costs (cont’d)
• Assessment of different plans:
• Firm is able to initially reduce weighted average cost of
capital with debt financing
• Beyond Plan B, continued use of debt becomes
unattractive and greatly increases costs of sources of
financing

11-22
Optimal Capital Structure – Weighting Costs (cont’d)

11-23
Cost of
Capital
Curve

11-24
Debt as a Percentage of Total Assets (2010)

11-25
Capital Acquisition and Investment Decision Making
• Financial
capital consists of bonds, preferred stock, and
common equity
• Money raised by sale of these securities and retained earnings is
invested in:
• The real capital of the firm, the long-term productive assets of plant and equipment
• To minimize cost of equity, a firm may sell common stock when prices
are relatively high
• A balance between debt and equity is required to achieve minimum cost
of capital

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Cost of
Capital Over
Time

11-27
Cost of Capital in the Capital Budgeting Decision

• Current
cost of capital for each source of funds is
important for capital budgeting decision
• The required rate of return will be the weighted average
cost of capital
• The common stock value of the firm will be maintained or
will increase, as long as the firm earns its cost of capital

11-28
Investment
Projects
Available
to the Baker
Corporation

11-29
Cost of Capital and
Investment Projects
for the Baker
Corporation

11-30
The Marginal Cost of Capital
• Themarket may demand a higher cost of capital for
each amount of fund required if a large amount of
financing is required
• Equity (ownership) capital is represented by retained earnings
• Retained earnings cannot grow indefinitely as the firm’s capital needs
to expand
• Retained earnings is limited to the amount of past and present
earnings that can be redeployed into investments

11-31
The Marginal Cost of Capital (cont’d)
• Assumptions:
• 60% is the amount of equity capital a firm must maintain to keep a balance
between fixed income securities and ownership interest
• The firm has $23.40 million of retained earning available for investment
• There is adequate retained earning to support the capital structure as shown
below:
• Assuming: X = Retained earnings ;
Percent of retained earnings in the capital structure
• Where X represents the size of the capital structure that retained earnings will
support
X = $23.40 million = $39 million
.60

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Costs of Capital for
Different Amounts of Financing

Kmc , in the bottom right-hand portion of the table, represents the marginal
cost of capital

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 Increasing Marginal Cost of Capital
• Both and represent the cost of capital
• The mc subscript after K indicates the increase in marginal cost of capital
• The increase is because common equity is now in the form of new
common stock rather than retained earnings
• The after-tax cost of the new common stock is more expensive than
retained earnings because of flotation costs

11-34
Increasing Marginal Cost of Capital (cont’d)
• Equation for the cost of new common stock:
= $2 + 7% = $2 + 7% = 5.6% + 7% = 12.6%
$40 - $4 $36
• The $50 million figure can be derived thus:
Z = Amount of lower-cost debt ;
Percent of debt in the capital structure
Z = $15 million = $50 million
.30
• Where Z represents the size of the capital structure in which lower-
cost debt can be used

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Cost of Capital for Increasing Amounts of
Financing

11-36
Changes in the Marginal Costs of Capital

11-37
Marginal Cost
of Capital
and Baker
Corporation
Projects

11-38
Cost of Components in the Capital Structure

11-39