Fin 311 Weighted Average Cost of Capital

Principles of Managerial Finance
Sixteenth Edition, Global Edition
Chapter 9
The Cost of Capital
Copyright © 2022 Pearson Education, Ltd.

Learning Goals
• Understand the concept of the cost of capital.
• List the primary sources of capital available to firms.
• Determine the cost of long-term debt, and explain why the after-
tax cost of debt is the relevant cost of debt.
• Determine the cost of preferred stock.
• Calculate the required return on a company’s common stock, and
explain how it relates to the cost of retained earnings and the
cost of new issues of common stock.
• Calculate the weighted average cost of capital (WACC), and
discuss alternative weighting schemes.

Overview of the Cost of Capital
• Cost of Capital
– Represents the firm’s cost of financing and is the minimum rate of return
that a project must earn to increase the firm’s value
– Managers use the cost of capital

 To discount an investment’s future cash flows to decide if an
investment is worth undertaking
 As a benchmark against which they can judge their performance
 To value entire companies, when a firm engages in mergers and
acquisitions

Overview of the Cost of Capital:
The Basic Concept
– Capital
 Refers to a firm’s long-term sources of financing, which include debt
and equity
 Firms raise capital by selling securities such as common stock,
preferred stock, and bonds to investors and reinvesting profits back
into the firm
– Capital Structure
 The mix of debt and equity financing that a firm employs
– Weighted Average Cost of Capital (WACC)
 A weighted average of a firm’s cost of debt and equity financing,
where the weights reflect the percentage of each type of financing
used by the firm (reflects overall cost of financing not just the cost
of one financing source)

Table 1 Capital Structures of Well-
Known Companies in 2020
Value of Value of
Outstanding Outstanding Total Capital
Company Debt ($ billions) % Debt Equity ($ billions) % Equity ($ billions)
Alphabet $ 1 0% $ 911 100% $ 912
Johnson & Johnson 29 7 386 93 415
Procter & Gamble 31 10 282 90 313
Facebook 6 1 580 99 586
General Electric 99 66 51 34 150
General Motors 105 77 31 23 136

Example 1
• A firm is currently considering two investment opportunities. Two financial
analysts, working independently of each other, are evaluating these
opportunities. The following information is for investment A:
Cost $100,000
Life 20 years
Expected Return 7%
The analyst studying this investment recalls that the company recently issued
bonds paying a 6% rate of return. He reasons that because the investment
project earns 7% while the firm can issue debt at 6%, it must be worth doing, so
he recommends that the company undertake investment A.

Example 1 (Cont.)
Investment B
Cost $100,000
Life 20 years
Expected Return 12%
• The analyst assigned to investment B knows that the firm has common stock
outstanding and that investors who hold the company’s stock expect a 14%
return on equity. The analyst decides that the firm should not undertake this
investment because it produces only a 12% return while the company’s
shareholders expect a 14% return.

Example 1 (Cont)
• In this example, each analyst is making a mistake by focusing on one source

of financing rather than on the overall financing mix. What if, instead, the
analysts used a combined cost of financing?
– By weighting the cost of each source of financing by its relative

proportion in the firm’s capital structure, the firm can obtain a weighted
average cost of capital (WACC).
– Assuming this firm desires a 50–50 mix of debt and equity (and ignoring
taxes for the moment), the WACC is 10% [(0.50 × 6% debt) + (0.50 ×
14% equity)].
– With this average cost of financing, the firm should
 reject the first opportunity (7% expected return < 10% WACC) and
 accept the second (12% expected return > 10% WACC).

Overview of the Cost of Capital:
Sources of Long-Term Capital
– Long-term capital for firms derives from four basic sources: long-term
debt, preferred stock, common stock, and retained earnings
– Not every firm will use all of these financing sources

Cost of Long-Term Debt
• Before-Tax Cost of Long-Term Debt

– The before-tax financing cost associated with new funds raised
through long-term borrowing
• Net Proceeds
– Funds actually received by the firm from the sale of a security
• Flotation Costs
– The total costs of issuing and selling a security
– Two components
 Underwriting costs (compensation earned by investment banker for selling the
security)
 Administrative costs (legal and accounting costs)

Example 2
• Duchess Corporation, a major hardware manufacturer, plans to sell $10

million worth of 20-year, 6% coupon bonds, each with a par value of $1,000.
Because bonds with similar risk earn returns equal to 6%, Duchess’s bonds
will sell in the market at par value, and they will have a yield to maturity
(YTM) equal to the coupon rate, 6%. However, Duchess will incur flotation
costs equal to 2% of the par value of the bond.
• What is the net proceeds to the firm from the sale of each bond?
– Duchess will incur flotation costs equal to 2% of the par value of the
bond (0.02 × $1,000), or $20.
– The net proceeds to the firm from the sale of each bond are therefore
$980.

Cost of Long-Term Debt (Cont)
• Before-Tax Cost of Debt
– The before-tax cost of debt, rd, is simply the rate of return the firm must
pay on new borrowing
– Using Market Quotations

 A simple way to estimate a firm’s before-tax cost of debt is to go to a
financial web site and look up the yield to maturity (YTM) on the firm’s
existing bonds or on bonds of similar risk issued by other companies.
– Calculating the Cost Directly

 Rather than using the YTMs on other bonds to estimate the costs
associated with a new bond issue, it is possible to do a YTM
calculation to calculate the costs of a new bond issue directly.

Example 3
• In the preceding example, Duchess receives proceeds of $980 by

issuing a 20-year bond with a $1,000 par value and 6% coupon
interest rate.
• To calculate the before-tax cost of debt, begin by writing down
the cash flows associated with this bond issue.
– The cash flow pattern consists of an initial inflow (the net proceeds)
followed by a series of annual outflows (the interest payments).
– In the final year, when the debt is retired, an outflow representing the
repayment of the principal also occurs.

Example 3 (Cont)
The cash flows associated with Duchess Corporation’s bond issue are as
follows:
End of year(s) Cash flow
0 $ 980
1–20 −60
20 −1,000
The before-tax cost of debt associated with this bond issue is the YTM, which is
the discount rate that equates the present value of the bond’s coupon and
principal payments to the initial net proceeds.

• After-Tax Cost of Debt

– Unlike dividends on stock, interest payments on bonds are tax deductible,
so the interest expense on debt reduces taxable income and, therefore, the
firm’s tax liability
After-Tax Cost of Debt = rd × (1 - T) Eq. (9.1)

Where:
• T is the tax rate
• rd is the before-tax cost of debt

Example 4
• Duchess Corporation pays a 21% tax rate. Using the 6.18%
before-tax debt cost calculated above and applying Equation 9.1,
after-tax cost of debt is……. 4.88% [6.18 × (1 - 0.21)]

– For two main reasons, debt is usually the least expensive
form of financing available to a firm
 Debt is less risky than preferred or common stock

– Investors accept lower returns on bonds than on stock
 The firm enjoys a tax benefit from issuing debt that it does not
receive when it uses equity capital


– This does not imply that firms should always finance their
investments with debt
 Financing with debt puts the firm’s existing shareholders in a riskier
position because the firm must repay lenders regardless of whether it
is profitable
 Existing shareholders will then demand a higher return, thus raising
the firm’s cost of equity
 The increase in the cost of equity could partially or fully offset the
benefit of using low-cost debt as a financing source
 Firms must carefully weigh the tradeoffs when using different
sources of capital

Cost of Preferred Stock
• Preferred Stock Dividends
– When companies issue preferred shares, the shares usually pay a
fixed dividend and have a fixed par value
• Calculating the Cost of Preferred Stock
– Cost of Preferred Stock, rp
 The ratio of the preferred stock dividend to the firm’s net
proceeds from the sale of preferred stock
where:
– Dp = Annual dollar dividend
– Np = Net proceeds from the sale of the stock
Example 5
• Duchess Corporation is contemplating issuance of an 8%
preferred stock they expect to sell at par value for $80 per share.
The cost of issuing and selling the stock will be $2.50 per share.
• What is the cost of preferred stock for Duchess corporatin?
– The first step in finding the cost of the stock is to calculate the
dollar amount of the annual preferred dividend, which is $6.40
(0.08 × $80).
– The net proceeds per share from the proposed sale of stock equals
the sale price minus the flotation costs ($80 − $2.50 = $77.50).
– Substituting the annual dividend, Dp, of $6.40 and the net
proceeds, Np, of $77.50 into Equation 9.2 gives the cost of
preferred stock, 8.26% ($6.4 ÷ $77.50).

Cost of Common Stock
• Cost of Common Stock Equity

– The cost of common stock equity is equal to the required
return on the firm’s common stock in the absence of flotation
costs
– Thus, the cost of common stock equity is the same as the

cost of retained earnings, but the cost of issuing new
common equity is higher

Cost of Common Stock (Cont)
• Finding the Cost of Common Stock Equity

 Using the Constant-Growth Valuation (Gordon Growth) Model
 where:
– P0 = Current value of common stock
– D1 = Dividend expected in one year
– rs = Required return on common stock
– g = Constant rate of growth in dividends

• Solving Equation 9.3 for rs results in the following expression
for the required return on common stock:
• The first term captures the return that shareholders expect to earn
from dividends
• The second term captures the return they expect to earn from
capital gains

Example 6
• Duchess Corporation wishes to determine the required return, rs,

on its common stock. The market price, P0, is $50 per share.
Duchess recently paid a $3.80 dividend. The company has
increased its dividend for several consecutive years. Just five
years ago, Duchess paid a dividend of $2.98 on its common
stock.
• If Duchess continues to increase the dividend at this rate, find
the cost of common stock equity?

Example 6 (Cont.)
• If Duchess continues to increase the dividend at this rate, then
next year’s dividend will be 5% more than the $3.80 dividend
that it just paid, or $4. Substituting D1 = $4, P0 = $50, and g =
5% into Equation 9.4 yields the cost of common stock equity:
rs =4/50 +0.05 =0.13 =13%

• Capital Asset Pricing Model (CAPM)
– Describes the relationship between the required or expected return on
some asset j, rj, and the nondiversifiable risk of the firm as measured by
the beta coefficient, βj . The CAPM says that
– where
 rj = Expected return or required return on asset j
 RF = Risk-free rate of return
 βj = Beta coefficient for asset j
 rm = expected market return; expected return on the market portfolio

Example 7
• Duchess Corporation now wishes to calculate the required return
on its common stock, rs, by using the CAPM. The firm’s
investment advisors and its own analysts indicate that the risk-
free rate, RF, equals 3%; the firm’s beta, β, equals 1.5; and the
market return, rm, equals 9%.
• Substituting these values into Equation 9.5, the company
estimates that the required return on its common stock, rs, is….
rs = 3.0% + [1.5 × (9.0% − 3.0%)] = 3.0% + 9% = 12%

Example 7 (Cont)
• Notice that this estimate of the required return on Duchess stock
does not line up exactly with the estimate obtained from the
constant-growth model.
• That is to be expected because the two models rely on different

assumptions.
• In practice, analysts at Duchess might average the two figures to

arrive at a final estimate for the required return on common
stock.

Comparing Constant-Growth and
CAPM Techniques
• The CAPM technique differs from the constant-growth valuation

model in that it directly considers the firm’s risk, as reflected by
beta, in determining the required return on common stock equity.
• The constant-growth model does not look at risk directly; it uses

an indirect approach to infer what return shareholders expect
based upon the price they are willing to pay for the stock today,
P0, given estimates of the firm’s future dividends

• Cost of a New Issue of Common Stock, rn
– The cost of common stock, net of underpricing and

associated flotation costs
– where
 Nn = net proceeds per share from sale of new common stock after subtracting
underpricing and flotation costs
 D1 = Dividend expected in one year
 g = Constant rate of growth in dividends

Example 8
• In the constant-growth valuation example, we found that Duchess
Corporation’s required return on common stock, rs, was 13%, using the
following values: an expected dividend, D1, of $4; a current market price, P0,
of $50; and an expected growth rate of dividends, g, of 5%.
• To determine its cost of new common stock, rn, Duchess Corporation estimates
that new shares will sell for $48. Thus, Duchess’s shares will be underpriced
by $2 per share. A second cost associated with a new issue is flotation costs of
$1.50 per share that would be paid to issue and sell the new shares.
• Subtracting the $3.50-per-share underpricing and flotation cost from the
current $50 share price results in expected net proceeds of $46.50 per share.
Substituting D1 = $4, Nn = $46.50, and g = 5% into Equation 9.6 results in a
cost of new common stock,
rn= 4/46.5 +0.05 =0.136 =13.6%

• Cost of Retained Earnings, rr

– The cost of retained earnings is equal to the required
return on a firm’s common stock, rs
rr = rs (9.7)

Example 9
• The cost of retained earnings for Duchess Corporation equals the
required return on equity. Recall that we calculated the required
return using two methods.
– With the constant-growth model, we estimated the required return
on equity to be 13% (before accounting for flotation costs and
underpricing), and with the CAPM, the required return on equity
was 12%.
• Thus, the cost for Duchess Corporation to finance investments
through retained earnings, rr, falls somewhere in the range of
12% to 13%. Both estimates are lower than the cost of a new
issue of common stock because by using retained earnings the
firm avoids the additional costs associated with issuing new
equity.

Matter of Fact
Retained Earnings, the Preferred Source of Financing
• In the United States and most other countries, firms rely more
heavily on retained earnings than any other financing source.
• In 2019 the Federal Reserve conducted a survey of 5,514 small

businesses and found that for 77% of companies, the most
important source of financing was retained earnings.

Weighted Average Cost of Capital
• Calculating the Weighted Average Cost of Capital (WACC)
– where
 wd = proportion of long-term debt in capital structure
 wp = proportion of preferred stock in capital structure
 ws = proportion of common stock equity in capital structure
 wd + wp + ws = 1.0

Example 10
In earlier examples, we found that the costs of the various types of

capital for Duchess Corporation were:
rd =4.88%
rp =8.26%
rs =rre =13%
rn =13,6%

Example 10 (Cont)
• Duchess has total capital with a market value of $1 billion. The
market values of the firm’s outstanding long-term debt, preferred
stock, and common stock are $400 million, $100 million, and
$500 million respectively. Thus, the weights for the weighted
average cost of capital (WACC) calculation are as follows:
Source of capital Weight
Long-term debt 40%
Preferred stock 10
Common stock equity 50
Total 100%

Example 10 (Cont)
• Because Duchess has retained earnings available, its cost of
common equity is the required return on equity, rs (or,
equivalently, the cost of retained earnings, rr).
– We assume no additional new issues
• The calculation for Duchess Corporation’s WACC appears in

Table 2.

Table 2 Calculation of the Weighted Average
Cost of Capital for Duchess Corporation
Blank
Weight Cost Weighted cost
Source of capital w r w×r
Long-term debt 0.40 4.88% 1.95%

Preferred stock 0.10 8.26 0.83
Common stock equity 0.50 13.00 6.50
Totals 1.00 WACC = 9.28%
• This establishes a hurdle rate for Duchess, meaning that the company
should accept investment opportunities that promise returns above 9.28%
as long as those investment opportunities are not riskier than the firm’s
current investments.

Table 3 WACC Calculations for Well-Known
Companies
Company % Debt Cost of Debt % Equity Beta Cost of WACC

Equity
Procter & Gamble 10% 3.0% 90% 0.4 4.4% 4.2%
General Electric 66 5.0 34 0.9 7.4 5.1
Johnson & Johnson 7 2.0 93 0.7 6.2 5.9
Target 19 3.5 81 0.9 7.4 6.5
General Motors 77 7.5 23 1.3 9.8 6.8
Alphabet 0 NA 100 1.0 8.0 8.0
Apple 8 2.3 92 1.1 8.6 8.1
Amazon 4 3.3 96 1.3 9.8 9.5
Facebook 0 NA 100 1.3 9.8 9.8

Weighted Average Cost of Capital:
Weighting Schemes
• Book Value versus Market Value:
– Book value weights are weights that use accounting values

to measure the proportion of each type of capital in the
firm’s financial structure.
– Market value weights are weights that use market values to

measure the proportion of each type of capital in the firm’s
financial structure.
 In calculating a firm’s WACC, market value weights should be used

rather than book or par values

Weighted Average Cost of Capital: Weighting
Schemes
• Historical versus Target:
– Historical weights are either book or market value weights

based on actual capital structure proportions.
– Target weights are either book or market value weights

based on desired capital structure proportions.
• From a strictly theoretical point of view, the preferred weighting

scheme is target market value proportions.

WACC as a Hurdle Rate
• WACC is a kind of hurdle rate that a firm’s investments must clear if they are
to create value for investors
• Using the WACC in this way is appropriate as long as the investment being
held to that standard is about as risky as the average investment that the firm
makes
– If the investment is riskier than typical, a higher rate that reflects the
investment’s greater risk is appropriate
– If the investment is atypically low risk, then the WACC is an

inappropriately high hurdle rate and a lower rate is fitting
– When considering an acquisition, make sure to use a WACC that is

appropriate for the target you are acquiring

Problem 1
• Edna Recording Studios, Inc., reported earnings available to
common stock of $4,200,000 last year.
– From those earnings, the company paid a dividend of $1.26 on each of

its 1,000,000 common shares outstanding.
– The capital structure of the company includes 40% debt, 10% preferred
stock, and 50% common stock.
– It is taxed at a rate of 40%.

Problem 1 (Cont.)
a. If the market price of the common stock is $40 and dividends are expected to
grow at a rate of 6% per year for the foreseeable future, what is the
company’s cost of retained earnings financing?
b. If underpricing and flotation costs on new shares of common stock amount to
$7.00 per share, what is the company’s cost of new common stock financing?
c. The company can issue $2.00 dividend preferred stock for a market price of
$25.00 per share. Flotation costs would amount to $3.00 per share. What is
the cost of preferred stock financing?
d. The company can issue $1,000-par-value, 10% coupon, 5-year bonds that
can be sold for $1,200 each. Flotation costs would amount to $25.00 per
bond. Use the approximate YTM formula to figure the approximate cost of
debt financing.
e. What is the WACC (no additional issue of common stock)?

Problem 2
• American Exploration, Inc., a natural gas producer, is trying to

decide whether to revise its target capital structure. Currently it
targets a 50-50 mix of debt and equity, but it is considering a
target capital structure with 70% debt. American Exploration
currently has 6% after-tax cost of debt and a 12% cost of
common stock. The company does not have any preferred stock
outstanding.

Problem 2 (Cont.)
a. What is American Exploration’s current WACC?

b. Assuming that its cost of debt and equity remain unchanged, what will be
American Axploration’s WACC under the revised target capital structure?
c. Do you think shareholders are affected by the increase in debt to 70%? If so,
how are they affected? Are their common stock claims riskier now?
d. Suppose that in response to the increase in debt, American Exploration’s
shareholders increase their required return so that cost of common equity is
16%. What will its new WACC be in this case?
e. What does your answer in part b suggest about the tradeoff between
financing with debt versus equity?

End of Chapter

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Principles of Managerial Finance

Sixteenth Edition, Global Edition

Copyright © 2022 Pearson Education, Ltd.

Copyright © 2022 Pearson Education, Ltd.

– Managers use the cost of capital

Copyright © 2022 Pearson Education, Ltd.

Copyright © 2022 Pearson Education, Ltd.

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• In this example, each analyst is making a mistake by focusing on one source

– By weighting the cost of each source of financing by its relative

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• Before-Tax Cost of Long-Term Debt

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• Duchess Corporation, a major hardware manufacturer, plans to sell $10

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– Using Market Quotations

– Calculating the Cost Directly

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• In the preceding example, Duchess receives proceeds of $980 by

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• After-Tax Cost of Debt

After-Tax Cost of Debt = rd × (1 - T) Eq. (9.1)

• rd is the before-tax cost of debt

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 Debt is less risky than preferred or common stock

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• After-Tax Cost of Debt

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• Cost of Common Stock Equity

– Thus, the cost of common stock equity is the same as the

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• Finding the Cost of Common Stock Equity

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• Duchess Corporation wishes to determine the required return, rs,

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rs =4/50 +0.05 =0.13 =13%

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rs = 3.0% + [1.5 × (9.0% − 3.0%)] = 3.0% + 9% = 12%

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• That is to be expected because the two models rely on different

• In practice, analysts at Duchess might average the two figures to

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• The CAPM technique differs from the constant-growth valuation

• The constant-growth model does not look at risk directly; it uses

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• Cost of a New Issue of Common Stock, rn

– The cost of common stock, net of underpricing and

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• Cost of Retained Earnings, rr

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