Cost of Capital

Chapter 9
Definition
• Cost of capital is the rate return the firm requires from investment in
order to increase the value of the firm in the market place.
• The sources of capital of a firm must be in the form of preference
shares, equity shares, debt and retained earnings.
• In simple cost of capital of a firm is the weighted average cost of their
different sources of financing.
Components of cost of capital
• Debt
• Preferred stock
• Common equity
• Retained earnings
What types of long-term capital do
firms use?
• Long-term debt
• Preferred stock
• Common equity
Cost of capital
• Capital components are sources of funding that come from investors.
• Accounts payable, accruals, and deferred taxes are not sources of
funding that come from investors, so they are not included in the
calculation of the cost of capital. These arises from operational
decisions.
• We do adjust for these items when calculating the cash flows of a
project, but not when calculating the cost of capital.
Should we focus on before-tax or after-
tax capital costs?
• Tax effects associated with financing can be incorporated
either in capital budgeting cash flows or in cost of capital.
• Most firms incorporate tax effects in the cost of capital.
Therefore, focus on after-tax costs
Tax effect in profit
A B
• Net income before interest 110 110
• Less: Interest 10 0
• N.P after Interest 100 110
• Less:Tax (40%) 40 44
• Net profit 60 66
Should we focus on historical (embedded)
costs or new (marginal) costs?
• The cost of capital is used primarily to make decisions which
involve raising and investing new capital.
• So, we should focus on marginal costs.
• The target proportions of debt (wd), preferred stock (wps), and
common equity (ws)—along with the costs of those components—are
used to calculate the firm’s weighted average cost of capital, WACC:

WACC = the firm’s weighted average, or overall, cost of capital.

Definition
• w = wd, wps, ws, we = target weights of debt, preferred stock, internal equity
(retained earnings) and external equity (new issues of common stock).
• rd = Interest rate on the firm’s new debt = before-tax component cost of
debt. (calculate YTM)
• rd(1 − T) = After-tax component cost of debt, where T is the firm’s marginal
tax rate. rd(1 − T) is the debt cost used to calculate the weighted average cost
of capital.
• rps = Component cost of preferred stock, found as the yield investors expect
to earn on the preferred stock. Preferred dividends are not tax deductible, so
the before-tax and after-tax costs of preferred are equal.
• To illustrate, we first note that NCC has a target capital structure
calling for 30% debt, 10% preferred stock, and 60% common equity.
Its before-tax cost of debt, rd, is 9%; its cost of preferred stock, rps, is
8.2%; its cost of common equity, rs, is 11.6%;its marginal tax rate is
40%; and all of its new equity will come from reinvested earnings.
• We can now calculate NCC’s weighted average cost of capital as
follows:
Point to note here:
• First, the WACC is the cost the company would incur to raise each
new, or marginal, dollar of capital—it is not the average cost of dollars
raised in the past.
• Second, the percentages of each capital component, called weights,
should be based on management’s target capital structure, not on the
particular sources of financing in any single year.
9-1
• Calculate the after-tax cost of debt under each of the following
conditions:
a. Interest rate of 13%, tax rate of 0%
b. Interest rate of 13%, tax rate of 20%
c. Interest rate of 13%, tax rate of 35%
Factors Affecting the Cost of Capital
• General Economic Conditions
• Affect interest rates
• Market Conditions
• Affect risk premiums
• Operating Decisions
• Affect business risk
• Financial Decisions
• Affect financial risk
• Amount of Financing
• Affect flotation costs and market price of security

14
 Weighted Cost of Capital Model
• Compute the cost of each source of capital
• Determine percentage of each source of capital in
the optimal capital structure
• Calculate Weighted Average Cost of Capital (WACC)

15
1. Compute Cost of Debt
• Required rate of return for creditors
• Same cost found in Chapter 5 as yield to maturity on bonds
(Rd).
• e.g. Suppose that a company issues bonds with a before tax
cost of 10%.
• Since interest payments are tax deductible, the true cost of
the debt is the after tax cost.
• If the company’s tax rate (state and federal combined) is 40%,
the after tax cost of debt : Rd (1- T)
• AT Rd = 10%(1-0.4) = 6%.
16
 2. Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock.

Dividend (Dp)
Required rate Rp =

Market Price (PP) - F

 Example: You can issue preferred stock for a net

price of $42 and the preferred stock pays a

 $5
Thedividend.
cost of preferred stock:

$5.00
Rp = = 11.90%
$42.00
17
 3. Compute Cost of Common
Equity
• Two Types of Common Equity Financing
1. Retained Earnings (internal common equity)
2. Issuing new shares of common stock (external common
equity)

18
 3. Compute Cost of Common Equity
• Cost of Internal Common Equity
• Management should retain earnings only if they earn as much as
stockholder’s next best investment opportunity of the
same risk.
• Cost of Internal Equity = opportunity cost of common stockholders’
funds.
• Two methods to determine
1. Dividend Growth Model
2. Capital Asset Pricing Model

19
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Dividend Growth Model

D1
RS = + g
P0

20
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Dividend Growth Model

D1
RS = + g
P0

Example:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%.

21
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Dividend Growth Model

D1
rS = + g
P0
Example:
The market price of a share of common stock is $60.
The dividend just paid is $3, and the expected growth
rate is 10%.

rS = 3(1+0.10) + .10 =.155 = 15.5%

60
22
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Capital Asset Pricing Model (CAPM)

rS = rRF + (RM – rRF)

MRP= RM -rRF

23
3. Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

• Capital Asset Pricing Model (Chapter 7)

rS = rRF + (rM – rRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

24
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Capital Asset Pricing Model

rS = rRF + (rM – rRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

rS = 5% + 1.2(13% – 5%) = 14.6%

25
What are Flotation Costs?
• Flotation costs are the costs that are incurred by a company when
issuing new securities. The costs can be various expenses including,
but not limited to, underwriting, legal, registration, and audit fees.
Flotation expenses are expressed as a percentage of the issue price.
3. Compute Cost of Common Equity

• Cost of New Common Stock

• Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
rn = + g
P0 - F

Require rate of return on new stock = rn

27
3. Compute Cost of Common Equity
• Cost of New Common Stock
• Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
rn = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
28
 3. Compute Cost of Common Equity
• Cost of New Common Stock
• Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
rn = +g
P0 - F
Example:
If additional shares are issued floatation costs will
be 12%. D = $3.00 and estimated growth is 10%,
0

Price is $60 as before.

rn = 3(1+0.10) + .10 = .1625 = 16.25%

52.80 29
Weighted Average Cost of Capital
Gallagher Corporation estimates the following
costs for each component in its capital structure:

Source of Capital Cost

Bonds rd = 10%
Preferred Stock rp = 11.9%
Common Stock
Retained Earnings rs = 15%
New Shares rn = 16.25%

Gallagher’s tax rate is 40% 30

Weighted Average Cost of Capital
 If using retained earnings to finance the
common stock portion the capital structure:

31
Weighted Average Cost of Capital
 If using retained earnings to finance the
common stock portion the capital structure:

 Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.

32
Weighted Average Cost of Capital

 If using retained earnings to finance the

common stock portion the capital structure:

 Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09% 33
Weighted Average Cost of Capital

 If using a new equity issue to finance the

common stock portion the capital structure:

34
Weighted Average Cost of Capital

 If using a new equity issue to finance the

common stock portion the capital structure:

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%

35
(ST–1)
• Longstreet Communications Inc. (LCI) has the following capital structure, which it
considers to be optimal: debt = 25%, preferred stock = 15%, and common stock =
60%. LCI’s tax rate is 40%, and investors expect earnings and dividends to grow at a
constant rate of 6% in the future. LCI paid a dividend of $3.70 per share last year
(D0), and its stock currently sells at a price of $60 per share. Ten-year Treasury
bonds yield 6%, the market risk premium is 5%, and LCI’s beta is 1.3. The following
terms would apply to new security offerings.
• Preferred: New preferred could be sold to the public at a price of $100 per share,
with a dividend of $9. Flotation costs of $5 per share would be incurred.
• Debt: Debt could be sold at an interest rate of 9%.
• Common: New common equity will be raised only by retaining earnings.
a. Find the component costs of debt, preferred stock, and common stock.
b. What is the WACC?
ST1 solution:
ST-1 (cont.)
problems to solve:
• 9-2
• 9-3
• 9-4
• 9-5
• 9-6
• 9-7
• 9-8