Chapter 10

Introduction to Capital
Structure
• Weighted average cost of capital (WACC) and weighted average
flotation cost (WAFC)
• NPV without flotation cost and NPV with flotation cost
• Practical Approach: Pure play approach, Subjective approach

Note: Use four (4) decimal places for working solutions.

Why Cost of Capital Is Important
• We know that the return earned on assets depends on the risk
of those assets
• The return to an investor is the same as the cost to the
company
• The cost of capital tells the corporation how the market
(investors) perceives the risk of the assets.
• Knowing the cost of capital can also help company determine
the required return for capital budgeting projects
Required Return
• The required return is the same as the appropriate discount rate and
is based on the risk of the cash flows
• Firms/corporation need to know the required return for an
investment before they can compute the Net Present Value (NPV) and
make a decision about whether or not to take the investment
• Firms/corporation need to earn at least the required return to
compensate the investors for the financing they have provided
What is Weighted Average Cost of Capital?
• WACC can be explained as
i. a firm's average cost of capital from all sources (c/s, p/s &
bond)
ii. overall required return on the firm as a whole (appropriate
discount rate to use for cash flows similar in risk to the
overall firm)
iii. common way to determine required rate of return (as it
expresses, in a single number)
iv. the return that both bondholders and shareholders (p/s &
c/s holders) demand in order to provide the company with
capital
What is Weighted Average Cost of Capital?
• WACC use the individual costs of capital (Chapter 9)
that we have computed to get the “average” cost of
capital for the firm.
• This “average” is the required rate of return on the
firm’s assets, based on the market’s perception of
the risk of those assets
• The weights are determined by how much of each
type of financing is used
 WACC Formula
WACC = WcKcs + WpsKps + [WdKd x (1 – T)]
Where,
Wc = weighted of common stock (% financed with shares) =
Kcs = cost of common stock
Wps = weighted of p/stock (% financed with p/stock) =
Kps = cost of preferred stock
Wd = weighted of debt (% financed with debt) =
Kd = cost of debt (before tax)
T = tax rate

• 1 = # of outstanding shares x share price

• 2 = # of outstanding p/shares x p/s price
• 3 = # of outstanding bonds x bond price
 Example: How to determine the Wc & Wd?
• Suppose you have a market value of equity equal to RM500 million and a
market value of debt equal to RM475 million.
• What are the capital structure weights? (Weighted of c/stock and
Weighted of debt)
• Total value of capital = 500 million + 475 million
= 975 million
Weighted Of Common Stock Weighted Of Debt
Wc = / Wd = /
= 500 / 975 = 475 / 975
= .5128 = .4872
= 51.28% = 48.72%

14-7
How to determine the Wc & Wd from DER?
• How to convert from debt equity ratio (DER) to WACC?
• https://www.youtube.com/watch?v=BAipMtb6N9k

• Let say DER = 0.6

• Wc =

• Wd =
Example of WACC?
• Mullineaux Corporation has a target capital structure of 70 percent
common stock and 30 percent debt. Its cost of equity is 15 percent,
and the cost of debt is 8 percent. The relevant tax rate is 35 percent.
What is Mullineaux’s WACC?
WACC = WcKcs + [WdKd x (1 – T)]
= 0.7(15) + 0.3 (8) (1-0.35)
= 10.5 + 1.56
= 12.06%
Flotation Costs
• The required return depends on the risk, not how the money is
raised
• However, the cost of issuing new securities (flotation cost)
should not just be ignored either
• Basic Approach
1. Compute the weighted average flotation cost (WAFC)
2. Use the target weights because the firm will issue securities in these
percentages over the long term
 WAFC Formula
WAFC = WcFc + WpsFc + [WdFc x (1 – T)]
Where,
Wc = weighted of common stock (% financed with shares)
Fc = Flotation cost of equity
Wps = weighted of p/stock (% financed with p/stock)
Fc = Flotation cost of p/stock
Wd = weighted of debt (% financed with debt)
Fc = Flotation cost of debt
T = tax rate
Amount of Flotation Cost
= Actual Cost (True cost) – Project Cost

Where,
Actual cost =
 What is NPV?

Net present value, or NPV, is used to calculate today’s value of a

future stream of payments.
is a method used to determine the current value of all future cash
flows generated by a project, including the initial capital investment.

If the NPV of a project or investment is positive, it means that the

discounted present value of all future cash flows related to that
project will be positive, and therefore attractive.
Net Present Value (NPV)
A. NPV With Floatation Cost B. NPV Without Floatation
Cost
I. NPV FOR PERPETUITY (INDEFINITELY) CASH NPV = - Project Cost
INFLOW
NPV = - Actual Cost
Where,
CF = Annual Cash Inflow
II. NPV FOR NON-PERPETUITY CASH INFLOW
NPV = CF (PVIFA r,n) – Initial Outlay
Where,
CF = Annual Cash Inflow
r = WACC
NPV with Flotation Costs (Non – Perpetuity
C/F) - Example
• Your company is considering a project that will cost RM1 million. The
project will generate after-tax cash flows of RM250,000 per year for 7
years. The WACC is 15%, and the firm’s target D/E ratio is .6. The flotation
cost for equity is 5%, and the flotation cost for debt is 3%. What is the
NPV for the project after adjusting for flotation costs?
NPV for Non-Perpetuity Cash Inflow
NPV = CF (PVIFA r,n) – Initial Outlay
= 250,000 (PVIFA 15%, 7) – 1,000,000
= 250,000 (4.1604) – 1,000,000
= 1,040,100 – 1,000,000
= RM40,100
Pure Play Approach vs Subjective Approach
• Multidivisional firms that have divisions characterized by differing
risks may calculate separate divisional costs of capital
• Two approaches are:
i. Pure Play Approach
ii. Subjective Approach
The Pure Play Approach
i. Find one or more companies that specialize in the product
or service that the companies are considering
ii. Compute the beta for each company
iii. Take an average
iv. Use that beta along with the CAPM to find the appropriate
return (cost of capital) for a project of that risk
v. Often difficult to find pure play companies
The Subjective Approach
i. Firms can categorize the projects /divisions into: low risk, moderate
risk, and high risk and adjust the WACC by some percentage
ii. If the project has more risk than the firm, use a discount rate
greater than the WACC
iii. If the project has less risk than the firm, use a discount rate less
than the WACC
iv. This approach is better than using the overall firm’s WACC for all
projects. All it can do is that it can reduce the chances or risk of
selecting a bad project.
Subjective Approach - Example
Risk level Discount Rate
Very low risk WACC – 8%
Low Risk WACC – 3%
Same Risk as the firm WACC
High Risk WACC + 5%
Very High Risk WACC + 10%
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