Cost of Capital

INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK
Chapter 10
The Cost of Capital
Sources of Capital
Component Costs
Adjusting for Flotation Costs
WACC
Adjusting for Risk
10-1
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What sources of capital do firms use?
Capital
Preferred Common
Debt
Stock Equity
New
Notes Long-Term Retained
Common
Payable Debt Earnings
Stock
10-2
Calculating the Weighted Average Cost of Capital
WACC = wdrd(1 – T) + wprp + wcrs
• The w’s refer to the firm’s capital

structure weights.
• The r’s refer to the cost of each
component.
10-3
Should our analysis focus on before-tax or

after-tax capital costs?
• Stockholders focus on after-tax

CFs. Therefore, we should focus
on after-tax capital costs; i.e., use
after-tax costs of capital in WACC.
Only rd needs adjustment,
because interest is tax deductible.
10-4
Should our analysis focus on historical (embedded) costs or

new (marginal) costs?
• The cost of capital is used

primarily to make decisions that
involve raising new capital. So,
focus on today’s marginal costs
(for WACC).
10-5
Component Cost of Debt
• rd is the marginal cost of debt capital.

• The yield to maturity on outstanding L-T debt is
often used as a measure of rd.
• Why tax-adjust; i.e., why rd(1 – T)?
10-6
Component Cost of Debt
• Interest is tax deductible, so

A-T rd = B-T rd(1 – T)
= 10%(1 – 0.40) = 6%
• Use nominal rate.
10-7
Component Cost of Preferred Stock
• rp is the marginal cost of preferred stock, which

is the return investors require on a firm’s
preferred stock.
• Preferred dividends are not tax-deductible, so
no tax adjustments necessary. Just use
nominal rp.
• Our calculation ignores possible flotation costs.
10-8
What is the cost of preferred stock?
• The cost of preferred stock can be

solved by using this formula:
rp = Dp/Pp
= P10/P111.10
= 9%
10-9
Component Cost of Equity
• rs 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 re.
10-10
Why is there a cost for retained earnings?
• Earnings can be reinvested or paid out as

dividends.
• Investors could buy other securities, earn a
return.
• If earnings are retained, there is an opportunity
cost (the return that stockholders could earn on
alternative investments of equal risk).
– Investors could buy similar stocks and earn r . s
– Firm could repurchase its own stock and earn

rs. 10-11
Three Ways to Determine the Cost of Common Equity, r s
• CAPM: rs = rRF + (rM – rRF)b
• DCF: rs = (D1/P0) + g
• Bond-Yield-Plus-Risk-Premium:
rs = rd + RP
10-12
Can DCF methodology be applied

if growth is not constant?
• Yes, nonconstant growth stocks are

expected to attain constant growth at
some point, generally in 5 to 10 years.
• May be complicated to calculate.
10-13
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.
10-14
Approaches for Flotation Adjustment
• Include costs as part of the project’s

upfront cost.
–This reduces the project’s estimated
return.
• Adjust cost of capital to include
flotation in DCF model.
–Commonly done by incorporating
flotation in DCF model.
10-15
If new common stock issue incurs a flotation cost of 15% of the

proceeds, what is re?
D 0 (1  g)
re  g
P0 (1  F)
$4.19(1.05)
  5. 0 %
$50(1  0.15)
$4.3995
  5 .0 %
$42.50
 15.4%
10-16
Flotation Costs
• Flotation costs depend on the firm’s

risk and the type of capital raised.
• 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.
10-17
What is the firm’s WACC

(ignoring flotation costs)?

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
10-18
PRACTICE
Your company’s stock sells for P50 per

share, its last dividend (D0) was P2.00,
its growth rate is a constant 5 percent,
and the company will incur a flotation
cost of 15 percent if it sells new common
stock.
What is the firm’s cost of new equity, ke?
10-19
PRACTICE
Flaherty Electric has a capital structure that consists of
70 percent equity and 30 percent debt. The
company’s long-term bonds have a before-tax yield to
maturity of 8.4 percent. Flaherty’s common stock
currently trades at P45 per share. The year-end
dividend (D1) is expected to be P2.50 per share, and
the dividend is expected to grow forever at a constant
rate of 7 percent a year.
The company estimates that it will have to issue new
common stock to help fund this year’s projects. The
flotation cost on new common stock issued is 10
percent, and the tax rate is 40 percent. What is the
10-20
company’s weighted average cost of capital, WACC?
PRACTICE
The following information applies to the Coetzer
Company:
• Coetzer has a target capital structure of 40 percent
debt and 60 percent common equity.
• Coetzer has P1,000 par value bonds outstanding
with a 15-year maturity, a 12 percent annual coupon,
and a current price of P1,150.
• The risk-free rate is 5 percent. The market risk
premium (kM – kRF) is also 5 percent.
• Coetzer’s common stock has a beta of 1.4.
10-21
• Coetzer’s tax rate is 40 percent.
What factors influence a company’s

composite WACC?
Factors the firm cannot control:

• Market conditions such as interest rates and
tax rates.
Factors the firm can control:

• Firm’s capital structure.
• Firm’s dividend policy.
• The firm’s investment policy. Firms with riskier
projects generally have a higher WACC.
10-22

Cost of Capital

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INTRO SOURCES COMP COSTS ADJ/FLOTATION WACC ADJ/RISK

The Cost of Capital

What sources of capital do firms use?

Calculating the Weighted Average Cost of Capital

WACC = wdrd(1 – T) + wprp + wcrs

• The w’s refer to the firm’s capital

Should our analysis focus on before-tax or

• Stockholders focus on after-tax

Should our analysis focus on historical (embedded) costs or

• The cost of capital is used

Component Cost of Debt

WACC = wdrd(1 – T) + wprp + wcrs

• rd is the marginal cost of debt capital.

Component Cost of Debt

• Interest is tax deductible, so

Component Cost of Preferred Stock

WACC = wdrd(1 – T) + wprp + wcrs

• rp is the marginal cost of preferred stock, which

What is the cost of preferred stock?

• The cost of preferred stock can be

Component Cost of Equity

WACC = wdrd(1 – T) + wprp + wcrs

• rs is the marginal cost of common

Why is there a cost for retained earnings?

• Earnings can be reinvested or paid out as

– Firm could repurchase its own stock and earn

Three Ways to Determine the Cost of Common Equity, r s

• CAPM: rs = rRF + (rM – rRF)b

Can DCF methodology be applied

• Yes, nonconstant growth stocks are

Why is the cost of retained earnings cheaper than the cost of

• When a company issues new

Approaches for Flotation Adjustment

• Include costs as part of the project’s

If new common stock issue incurs a flotation cost of 15% of the

• Flotation costs depend on the firm’s

What is the firm’s WACC

WACC = wdrd(1 – T) + wprp + wcrs

Your company’s stock sells for P50 per

What factors influence a company’s

Factors the firm cannot control:

Factors the firm can control:

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