CHAPTER

11
Cost of Capital

PowerPoint Presentation Prepared by Michel Paquet, SAIT

© 2018 McGraw-Hill Education Limited 11-1

 Chapter 11 - Outline

• What is the Cost of Capital?

• Components and Calculation of Cost of Capital
• Optimal Capital Structure
• Use of Cost of Capital
• Capital Asset Pricing Model (CAPM)
• Summary and Conclusions

© 2018 McGraw-Hill Education Limited 11-2

 Learning Objectives

1. Explain that the cost of capital represents the

overall cost of financing to the firm. (LO1)
2. Define the cost of capital as the discount rate
normally used to analyze an investment. It is
an evaluation tool. (LO2)
3. Construct the cost of capital based on the
various valuation techniques from Chapter 10
as applied to bonds, preferred stocks and
common shares. (LO3)

© 2018 McGraw-Hill Education Limited 11-3

 Learning Objectives

4. Examine how a firm attempts to find a

minimum cost of capital by varying the mix of
its sources of financing. (LO4)
5. Apply the marginal cost of capital concept.
(LO5)

© 2018 McGraw-Hill Education Limited 11-4

 The Overall Concept

• Decisions made by the firm are aimed at

increasing shareholder value
• A composite of the firm various financing cost
• Discount rate used to evaluate investments
based on future cash flows
• Minimal acceptable rate of return for an
investment of the same risk as the firm
• Cost of capital to analyze investment decisions
eliminates inconsistency

LO1 © 2018 McGraw-Hill Education Limited 11-5

 Determination of the Cost of Capital

• Each element in the capital structure (Long-

Term debt, Preferred Stock and Common
Equity) has an explicit or opportunity cost
associated with it
• The firm assumes that the value of each
capital structure component of the firm will be
the same
• Symbol “K” represents the cost in percent (or
opportunity cost) for each component of the
capital structure

LO2 © 2018 McGraw-Hill Education Limited 11-6

 Table 11-1
Cost of capital–Baker Corporation

LO2 © 2018 McGraw-Hill Education Limited 11-7

 Cost of Debt
The cost of debt is measured by the yield to
maturity, that would have to be paid to bondholders
for the given price of the corporate debt.

For Baker Corporation:

N = 20; I/Y =?; PV = -940; PMT =100; FV =1,000;

CPT I/Y = 10.74% Cost of debt = 10.74%

LO3 © 2018 McGraw-Hill Education Limited 11-8

 Cost of Debt Part 2

•  Cost of Debt: (Kd)

o The cost of debt to the firm is the effective yield to
maturity (or interest rate) paid to its bondholders
o Two adjustments must be made to the yield:
• Tax and flotation costs

The after tax cost of debt:

Where F = Flotation or selling cost (after tax)

LO3 © 2018 McGraw-Hill Education Limited 11-9

 Cost of Debt for Baker Corporation

•  
• Cost of Debt for Baker Corporation: (Kd)

= 6.75%

Where Y = Yield to maturity = 10.74%

T = Corporate Tax rate = 39%
F = Flotation costs of 3%

LO3 © 2018 McGraw-Hill Education Limited 11-10

 Cost of Preferred Stock

•  Cost of Preferred Stock: (Kp)

o Preferred stock:
• Has a fixed dividend (similar to debt)
• Has no maturity date
• Dividends are not tax deductible and are
expected to be perpetual

The cost of preferred stock:

or

LO3 © 2018 McGraw-Hill Education Limited 11-11

 Cost of Preferred Stock Part 2

Cost of Preferred Stock: (Kp)

LO3 © 2018 McGraw-Hill Education Limited 11-12

 Cost of Preferred Stock for Baker
Corporation

• Cost
  of Preferred Stock for Baker Corporation:
(Kp)

= = 0.1094 = 10.94%
Or
= = 0.1094 = 10.94%

LO3 © 2018 McGraw-Hill Education Limited 11-13

 Cost of Common Equity – Dividend
Valuation Model
•  
• Cost of Common Equity: (Ke)
o The cost of common equity is a function of the
common share market price (Po), the dividend paid
(D1) and a constant growth rate (g) of the dividends

The cost of common equity:

LO3 © 2018 McGraw-Hill Education Limited 11-14

 Cost of Common Equity for Baker
Corporation

•  
• Cost of Common Equity Baker Corporation: (Ke)

LO3 © 2018 McGraw-Hill Education Limited 11-15

 Cost of Retained Earnings

••   Retained earnings belong to common

shareholders and represent a source of equity
capital supplied by current shareholders

• There is an opportunity cost as the funds could

be paid out as dividends
o Common equity in the form retained earnings is
equal to the rate of return on the firm’s common
stock
The cost of common equity as retained earnings:

LO3 © 2018 McGraw-Hill Education Limited 11-16

 Cost of New Common Stock

• Cost
  of new common stock: (Kn)
o The cost of new common stock is higher than retained
earnings because of flotation costs
• The cost of new common stock is a function of the
common share market price (Po), the dividend paid (D1), a
constant growth rate (g) of the dividends and the net
market price of the new shares after flotation costs (Pn)
The cost of new common stock:
or

LO3 © 2018 McGraw-Hill Education Limited 11-17

 Cost of New Common Stock for Baker
Corporation
••   Cost of new common stock for Baker
Corporation: (Kn)

Or

LO3 © 2018 McGraw-Hill Education Limited 11-18

 CAPM for the Required Return on
Common Stock
• Cost of Common Stock using CAPM: (Kj)
o An alternative model to calculate the required rate of return on
common stock. The model is based on a risk return relationship.
Required return = Risk free rate + Risk premium

LO3 © 2018 McGraw-Hill Education Limited 11-19

 Cost of New Common Stock using
CAPM
• Cost of New Common Stock using CAPM: (Kjn)

o A flotation cost adjustment can be achieved, for new

equity, by adjusting the formula by

LO3 © 2018 McGraw-Hill Education Limited 11-20

 Cost of Common Stock for Baker
Corporation using CAPM
• Cost
  of Common Stock using CAPM for Baker
Corporation: (Kjn)

o For Baker Corporation, assuming Rf = 9% and Rm =

11% and βj = 1.5

= 9% + 1.5(11% - 9%) = 12%

or

LO3 © 2018 McGraw-Hill Education Limited 11-21

 Optimum Capital Structure – Weighting
Costs
The optimum (best) situation is associated with the
minimum overall cost of capital:
o Costs of individual components of financing weighed
by their proportions (weights) in the firm’s capital
structure produce the Weighted Average Cost of
Capital (WACC)
o Optimum capital structure means the lowest WACC
o Usually occurs with 40-70% debt in a firm’s capital
structure
o Based upon the market value rather than the book
value of the firm’s debt and equity

LO4 © 2018 McGraw-Hill Education Limited 11-22

 Figure 11-1
Cost of capital curve

LO4 © 2018 McGraw-Hill Education Limited 11-23

 Table 11-3
Debt (total) to total assets, early 2017

© 2018 McGraw-Hill Education Limited

LO4 11-24
 Market Value Weightings

• To calculate the cost of capital, we weigh each

component of the capital structure based on how
the corporation will raise funds in the future
• The current capital structure should be based on
market value of debt and equity
• Present value models are employed to revalue
debt, preferred shares and common equity of
the firm

LO4 © 2018 McGraw-Hill Education Limited 11-25

 Calculating Market Value Weightings
for Baker Corporation Part 1
•  Market Value of Debt:

• Market Value of Preferred Shares:

Pp = 7% x $1,000,000 = $700,000
.10

© 2018 McGraw-Hill Education Limited 11-26

 Calculating Market Value Weightings
for Baker Corporation Part 2
• Market Value of Common Stock and Retained
Earnings (Pe ):
o Common stock and retained earnings are combined
into equity
o The market value of the shares at $8 per share
represents both equity account, thus:

Pe = $8.00 per share x 1 million c/s outstanding

= $8,000,000

© 2018 McGraw-Hill Education Limited 11-27

 Calculating Market Value Weightings
for Baker Corporation Part 3

© 2018 McGraw-Hill Education Limited

LO4 11-28
 Capital Acquisition and Investment
Decision Making
• The firm wishes to finance at the lowest possible
cost. Sell debt at low interest rates and issue
common stock when share prices are high
• The task for the firm is to find a balance between
debt and equity that achieves its minimum cost
of capital
• Firms, in reality, operate within a relevant range
of debt to equity before capital increases in
overall cost because of higher risk

LO4 © 2018 McGraw-Hill Education Limited 11-29

 Figure 11-2
Cost of capital over time

LO4 © 2018 McGraw-Hill Education Limited 11-30

 Cost of Capital in the Capital Budgeting
Decision
• The cost of capital (WACC) represents the
overall rate of return required by a firm’s
investors – bondholders, preferred shareholders
and common shareholders
• Investments must be judged against this
benchmark regardless of the particular source of
funds the firm is using for a particular investment
• If investments are matched with their financing,
investments with lower return may be accepted
while those with higher return would be rejected

LO4 © 2018 McGraw-Hill Education Limited 11-31

 Table 11-4
Investment projects available to the Baker
Corporation

LO2 and LO4 © 2018 McGraw-Hill Education Limited 11-32

 Figure 11-3
Cost of capital and investment projects for the
Baker Corporation

LO2 and LO4 © 2018 McGraw-Hill Education Limited 11-33

 The Marginal Cost of Capital
• A firm’s cost of debt or preferred stock or
common stock increases as it uses more debt or
preferred stock or common stock
• This will lead to a higher cost of capital even if a
given capital structure is maintained
• The marginal cost of capital measures a firm’s
overall cost of receiving extra dollar from
investors

LO5 © 2018 McGraw-Hill Education Limited 11-34

 Table 11-5
Cost of capital for different amounts of financing

LO5 © 2018 McGraw-Hill Education Limited 11-35

 Table 11-6
Cost of capital for increasing amounts of financing

LO5 © 2018 McGraw-Hill Education Limited 11-36

 Figure 11-4
Marginal cost of capital and Baker Corporation
investment alternatives

LO5 © 2018 McGraw-Hill Education Limited 11-37

 Table 11-7
Cost of components in the capital structure

© 2018 McGraw-Hill Education Limited 11-38

 Capital Asset Pricing Model (CAPM)

• Relates the risk-return trade-offs of individual

assets to market returns.
• Suggests that the expected return of an asset
based on the asset’s risk that cannot be diversified
away.
• Using least square regression analysis, the return
Kj of an individual stock is:
 

APP-11A © 2018 McGraw-Hill Education Limited 11-39

 Table 11A-1
Performance of PAI and the market

© 2018 McGraw-Hill Education Limited

APP-11A 11-40
 Figure 11A-1a
Linear Regression of returns between PAI and the
market

© 2018 McGraw-Hill Education Limited

APP-11A 11-41
 Figure 11A-1b
Linear Regression of returns between PAI and the
market

© 2018 McGraw-Hill Education Limited

APP-11A 11-42
 Figure 11A-2
The security market line

© 2018 McGraw-Hill Education Limited

APP-11A 11-43
 Figure 11A-3
The SML and changing interest rates

© 2018 McGraw-Hill Education Limited

APP-11A 11-44
 Figure 11A-4
The SML and changing investor expectations

© 2018 McGraw-Hill Education Limited

APP-11A 11-45
 Capital Structure Theory and Modigliani
and Miller
• The foundation supporting Cost of Capital
theories was primarily developed by Modigliani
and Miller in the 1950s and mid 1960s
• David Durand was the first to attempt to describe
the effect of financial leverage on the cost of
capital and valuation
• He described three different approaches: the net
income approach, the net operating income
approach and the traditional approach

APP-11B © 2018 McGraw-Hill Education Limited 11-46

 Capital Structure Theory and Modigliani
and Miller
• Net Income (NI) Approach
o Assumes that the firm can raise all the funds it
desires at a constant cost of equity and debt
• Net Operating Income (NOI) Approach
o Assumes the low cost of debt remains constant with
greater debt utilization
• Modigliani and Miller Model
o Assumes that the value of the firm and its cost of
capital are independent of the means of financing that
occurs

APP-11B © 2018 McGraw-Hill Education Limited 11-47

 Figure 11B-1
Net Income (NI) approach

© 2018 McGraw-Hill Education Limited

APP-11B 11-48
 Figure 11B-2
Net Operating Income (NOI) approach

© 2018 McGraw-Hill Education Limited

APP-11B 11-49
 Figure 11B-3
Traditional approach as described by Durand

© 2018 McGraw-Hill Education Limited

APP-11B 11-50
 Figure 11B-4
Modigliani and Miller with corporate taxes

© 2018 McGraw-Hill Education Limited

APP-11B 11-51
 Figure 11B-5
Combined impact of the corporate tax effect and
bankruptcy effect on valuation and cost of capital

© 2018 McGraw-Hill Education Limited

APP-11B 11-52
 Summary and Conclusions

• The cost of capital is calculated as the weighted

average of costs from various sources of
financing (WACC).
• The cost of capital is a critical component of the
valuation of the firm and its future prospects.
• The weightings are based on the market value of
the existing capital structure.
• The weights for each elements of the capital
structure should be chosen with a view to
minimize the overall cost of capital.

© 2018 McGraw-Hill Education Limited 11-53

 Summary and Conclusions

• Firms choose the weights to minimize WACC.

• The cost of capital is used as an evaluation tool
to analyze investment proposals.
• The marginal cost of capital is important in
considering what happens to a firm’s cost of
capital as it tries to finance large requirements
for funds.

© 2018 McGraw-Hill Education Limited 11-54