The Weighted Cost of Capital

Objectives
 Define the concept of cost of capital.
 Use the concept of cost of capital to link
the investment decisions with financing
decisions.
 Examine the key factors that affect a firm’s
weighted cost of capital.
 Consider the assumptions of the weighted
cost of capital model.
 Study the procedure to estimate a firm’s
weighted average cost of capital.
Concept of Cost of Capital
 The cost of capital is the rate that the
firm must earn on its investment in order
to satisfy the required rate of return of
the firm’s investors.
 The weighted cost of capital (WCC) for a
firm is equal to the cost of each source
of financing (debt, preferred stock,
common stock) multiplied by the
percentage of the financing provided by
that source.
Linkage
Financing Decisions

affects

affects
Cost of Capital

affects

Investment Decisions
Using WCC for Investment
Decisions
IRR
Weighted Cost of Capital
IRR

IRR

IRR
Percent

A Optimal decision: Invest a total of

B 17 million in projects A, B, and C.
C
D

5 12 17 20
Financing (millions)
Factors Determining WCC
 General Economic Conditions
 An increase in riskless rate increases the WCC. The riskless rate
is determined by:
○ the demand and supply of capital within the economy.
○ the expected level of inflation.

 Market Conditions
 The WCC increases due to an increase in the market risk as
investors demand a higher risk premium.
 The market risk could increase due to decrease in the liquidity of
the security.
Factors Determining WCC
 Firm’s Operating and Financing Decisions
 Risk also results from the decisions made within the company.
The risk can be divided into two classes:
○ Business Risk: Refers to the variability in returns on assets
and is affected by the company’s investment decisions.
○ Financial Risk: Refers to the increased variability in returns
to the common stockholders as a result of using debt and
preferred stock.
 Amount of Financing
 An increase in the amount of financing increases the WCC as
a result of increase in flotation costs.
 The risk premium may be a non-linear function of amount of
funds.
Assumptions of WCC Model
 Constant Business Risk: The model assumes
that any investment being considered will not
significantly change the firm’s business risk.
 Constant Financial Risk: Management is
assumed to use the same financial mix as it
used in the past.
 Constant Dividend Policy: The model
assumes that the firm’s dividends are
growing at a constant rate and that the
dividend payout ratio is constant.
Computing the WCC
 Determine the cost of capital for
individual source of financing (debt,
preferred stock, and common stock).
 Determine the percentage of debt,
preferred stock, and common stock to
be used for financing future investment.
 Use the individual costs and the capital
structure percentage in the first two
steps to compute the WCC.
Level of Financing and WCC
 Effect of additional financing on the cost
of capital
 Issuing new common stock will increase the firm’s
weighted cost of capital because external equity capital
has a higher cost than internally generated common
equity.
 As we use additional debt and preferred stock, their cost
may increase, which will result in an increase in WCC.