Chapter 12

The Cost of Capital

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 Introduction

 Cost of Capital
 The rate of return required by investors
in the firm’s securities

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What goes into calculating a firm’s
cost of capital?

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 Summary of Notation (slide 1 of 5)

 rf
 Risk-free rate of return
 rm
 Expected return on the “market”
portfolio
 β
 The beta of a company’s stock

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Summary of Notation (slide 2 of 5)

 kd
 Pretax cost of debt
 ki
 After-tax cost of debt
 kp
 Cost of preferred stock

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Summary of Notation (slide 3 of 5)

 ke
 Cost of internal common equity
 k'e
 Cost of external common equity
 ka
 Weighted (marginal) cost of capital

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Summary of Notation (slide 4 of 5)

 P0
 The current market price of a security
 Pnet
 The net proceeds to the firm from the
sale of a security

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 Summary of Notation (slide 5 of 5)

 Pf
 Market value of a firm’s preferred stock
 E
 Market value of a firm’s common equity
 B
 Market value of a firm’s debt in its
capital structure

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Weighted Cost of Capital (slide 1 of 4)

 The discount rate used when

computing the NPV of a project of
average risk
 The hurdle rate used in conjunction with
the IRR approach to project evaluation

E B Pf
ka =
B + E + Pf
k e  +
B + E + Pf
 k d  (1-T) +
B + E + Pf
 kp

which is…
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Weighted Cost of Capital (slide 2 of 4)

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Weighted Cost of Capital (slide 3 of 4)

 Market Value Versus Book Value Weights

 The preferred weighting to use is the market
value weight
 The Problem of “Lumpy” Capital
 Although firms may raise only one type of
capital at a time, it is generally incorrect to
associate any particular source of financing
with a particular project
 The investment and the financing decisions
should be separate

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Weighted Cost of Capital (slide 4 of 4)

 Example

 ka = 0.47×10.4% + 0.51×8.0%×(1 – 0.4) + 0.02×8.1%

 ka = 7.5%
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Relative Costs of Capital (slide 1 of 2)

 The cost of capital to the firm is equal to

the equilibrium rate of return demanded
by investors in the capital markets for
securities with that degree of risk

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Relative Costs of Capital (slide 2 of 2)

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing the Component Costs of
Capital (slide 1 of 9)
 Marginal Costs
 Cost of Debt
 Pretax cost of debt is based on net
proceeds of issuing new bonds
P = net
n
I t+ M n
1+kd 1+kd
   
t=1    
   
   
 After-tax cost of debt is the relevant
cost
k i = k d (1-T)

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing the Component Costs of
Capital (slide 2 of 9)
 Cost of Debt
 Pretax cost of debt can be estimated
using:
 The yield-to-maturity of outstanding bonds
 The pretax cost of debt recently sold by
similar-risk firms

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing the Component Costs of
Capital (slide 3 of 9)
 Cost of Preferred Stock

kp = D p
Pnet

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing the Component Costs of
Capital (slide 4 of 9)
 Cost of Internal Equity Capital
 Firms raise equity capital in two primary
ways:
 Internally, through retained earnings
 Externally, through the sale of new common
stock
 The cost of internal equity to the firm is
less than the cost of new common stock
because of issuance costs

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing the Component Costs of
Capital (slide 5 of 9)
 Dividend Valuation Model Approach
D1
k e = +g
P0

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Computing the Component Costs of
Capital (slide 6 of 9)
 Nonconstant Dividend Growth and the
Cost of Common Equity
 Solve for ke
D1 D2 Dn Pn
P0    ... 
1  ke (1  ke ) 2
(1  ke ) (1  k e ) n
n

 Issues in Implementation
 Expectations about future growth rates
 Investors
Analysts
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© 2018
Computing the Component Costs of
Capital (slide 7 of 9)
 Capital Asset Pricing Model Approach
 SML

k j = rf + β j (rm - rf )
 Expected values
 Risk-free rate
 Expected market return
 Firm’s beta

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing the Component Costs of
Capital (slide 8 of 9)

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing the Component Costs of
Capital (slide 9 of 9)
 Risk Premium over Debt
 Stocks That Do Not Pay Dividends
Pt
P0 = t
(1 + k e )
 Cost of External Equity

D1
'
k = e +g
Pnet

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Divisional Costs of Capital (slide 1 of 2)

 Some divisions of a company may have

higher or lower systematic risk
 Discount rates for divisions should be
higher or lower than the discount rate
for the firm as a whole
 Each division could have its own beta
and discount rate
 Should reflect both the differential risks
and the differential normal debt ratios
for each division

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Divisional Costs of Capital (slide 2 of 2)

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Determining the Weighted (Marginal)
Cost of Capital Schedule (slide 1 of 2)
 Step 1
 Calculate the cost of capital for each
individual component
 Step 2
 Compute the weighted (marginal) cost of
capital for each increment of capital raised
 Break points can be determined by dividing
the amount of funds available from each
financing source at a fixed cost by the target
capital structure proportion for that financing
source

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Determining the Weighted (Marginal)
Cost of Capital Schedule (slide 2 of 2)

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Questions?

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.