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Principles of Managerial Finance

Fifteenth Edition, Global Edition

Chapter 9
The Cost of Capital
9.1 Overview of the Cost of Capital (2 of 3)

• The Basic Concept

– 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
Table 9.1 Capital Structures of Well-Known
Companies in 2017
Value of Value of
Outstanding Debt Outstanding Total Capital
Company ($ billions) % Debt Equity ($ billions) % Equity ($ billions)
Alphabet $ 3.9 1% $ 643.5 99% $ 647.40
Johnson & Johnson 23.5 6 341.6 94 365.10
Procter & Gamble 30.5 12 220.4 88 250.90
Dow Chemical 19.3 20 75.0 80 94.30
General Electric 250.2 51 244.3 49 494.50
General Motors 55.0 53 49.6 47 104.60
 Example 9.1 (1 of 3)
A firm is currently considering two investment opportunities. Two financial
analysts, working independently of each other, are evaluating these opportunities.
Assume the following information about investments A and B.

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%, the project must be worth doing, so he recommends that the
company undertake this investment.
 Example 9.1 (2 of 3)

Investment B
Cost $100,000
Life 20 years
Expected Return 12%

The analyst assigned to this project knows that the firm has common stock
outstanding and that investors who hold the company’s stock expect a 14%
return on their investment. 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 9.1 (3 of 3)

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, 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).
9.1 Overview of the Cost of Capital (3 of 3)

• 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
9.2 Cost of Long-Term Debt (1 of 4)
• Cost of Long-Term Debt
– The financing cost associated with new funds raised through long-term
borrowing
• Net Proceeds
– Net Proceeds
 The funds actually received by the firm from the sale of a security
– Flotation Costs
 The total costs of issuing and selling a security
 Example 9.2
• Duchess Corporation, a major hardware manufacturer, is contemplating selling
$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 (0.02 × $1,000), or $20. The net proceeds to the firm from the sale of
each bond are therefore $980.
9.2 Cost of Long-Term Debt (2 of 4)
• 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 relatively quick method for finding the before-tax cost of debt is to observe
the yield to maturity (YTM) on the firm’s existing bonds or bonds of similar risk
issued by other companies
– Calculating the Cost
 Managers can calculate the cost of debt associated with a particular bond
issue by calculating the bond’s YTM
 Example 9.3 (1 of 4)
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. The cash flows associated with Duchess
Corporation’s bond issue are as follows:
 Example 9.3 (2 of 4)

End of year(s) Cash flow

0 $980
1–20 −60
20 −1,000

Duchess can determine the before-tax cost of debt by finding the

YTM, which is the discount rate that equates the present value of
the bond outflows to the initial inflow.
 Example 9.3 (3 of 4)

Spreadsheet use The before-tax cost of debt on the Duchess

Corporation bond can be calculated using an Excel spreadsheet. The
following Excel spreadsheet shows that by referencing the cells
containing the bond’s net proceeds, coupon payment, years to maturity,
and par value as part of Excel’s RATE function, you can quickly
determine that the appropriate before-tax cost of debt for Duchess
Corporation’s bond is 6.177%.
Example 9.3 (4 of 4)
9.2 Cost of Long-Term Debt (3 of 4)
• Before-Tax Cost of Debt
– Approximating the Cost
 The before-tax cost of debt, rd, for a bond with a $1,000 par value can be
approximated by:

$1, 000  N d
I
rd  n (9.1)
N d  $1, 000
2
 Where:
– I = Annual interest in dollars
– Nd = Net proceeds from the sale of debt (bond)
– n = Number of years to the bond’s maturity
 Example 9.4
Substituting the appropriate values from the Duchess Corporation
example into the approximation formula given in Equation 9.1, we get

$1, 000  $980

$60 
20 $60  $1
rd  
$980  $1, 000 $990
2
$61
  0.06162 or 6.162%
$990

This approximate value of before-tax cost of debt is close to 6.177%, but it lacks
the precision of the value derived using the calculator or spreadsheet.
9.2 Cost of Long-Term Debt (4 of 4)
• After-Tax Cost of Debt
– The interest payments paid to bondholders are tax deductible for
the firm, so the interest expense on debt reduces the firm's
taxable income
After-Tax Cost of Debt = rd × (1-T) (9.2)
– where T = The tax rate
– With the passage of the Tax Cuts and Jobs Act of 2017, the top
marginal corporate tax rate is 21%
 Example 9.5
Duchess Corporation has a 21% tax rate. Using the 6.177% before-tax debt cost
calculated above and applying Equation 9.2, we find an after-tax cost of debt of 4.88%
[6.177% × (1 – 0.21)].
Recall that when bondholders purchase a Duchess bond at par value, they expect to earn
a 6% YTM. Incorporating the issuance costs and the tax benefit of debt, the firm’s after-tax
cost of debt is just 4.88%, quite a bit less than the 6% return offered to bondholders.

In most cases, debt is the least expensive form of financing available to a firm. Debt is a
relatively inexpensive form of financing for two main reasons.
--First, debt is less risky than preferred or common stock. That alone makes debt a low-
cost form of financing because investors accept lower returns on bonds than on stock.
--Second, the firm enjoys a tax benefit from issuing debt that it does not receive when it
uses equity capital.
9.3 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

Dp
rp  (9.3)
Np
 where:
– Dp = Annual dollar dividend
– Np = Net proceeds from the sale of the stock
 Example 9.7

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.

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 9.3 gives the cost of preferred stock, 8.258% ($6.4 ÷ $77.50).
9.4 Cost of Common Stock (1 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 The costs associated with using common stock equity financing
 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
9.4 Cost of Common Stock (2 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 Constant-Growth Valuation (Gordon Growth) Model

D1
P0  (9.4)
rs  g
 where:
– P0 = Current value of common stock
– D1 = Dividend expected in 1 year
– rs = Required return on common stock
– g = Constant rate of growth in dividends
9.4 Cost of Common Stock (3 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 Constant-Growth Valuation (Gordon Growth) Model
– Solving for rs results in the following expression for the required
return on common stock:

D1
rs  g (9.5)
P0
 Example 9.8 (1 of 3)

Duchess Corporation wishes to determine the required return on its

common stock, rs. The market price, P0, of its common stock is $50 per
share. Duchess recently paid a $3.80 dividend. The company has
increased its dividend for several consecutive years. Just 5 years ago,
Duchess paid a dividend of $2.98 on its common stock.
 Example 9.8 (2 of 3)
Using a financial calculator or electronic spreadsheet, in conjunction with the
technique described earlier in this text for finding growth rates, we can calculate
the average annual dividend growth rate, g, over the past 5 years.

The average dividend growth rate is about 5%. 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 $3.99. Substituting D1 = $3.99, P0 = $50, and g = 5%
into Equation 9.5 yields the cost of common stock equity:

$3.99
rs   0.05  0.0798  0.05  0.1298  12.98%
$50
 Example 9.8 (3 of 3)

Because this estimate depends on a somewhat imprecise

forecast of the company’s long-run dividend growth rate, a
kind of false precision arises in concluding that the required
return on equity is 12.98%, so we will just round up to 13%.
9.4 Cost of Common Stock (4 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 Using the Capital Asset Pricing Model (CAPM)
– Capital Asset Pricing Model (CAPM)
• Describes the relationship between the required return, rs,
and the nondiversifiable risk of the firm as measured by the
beta coefficient, βj

rj  RF    j   rm  RF  (9.6)
9.4 Cost of Common Stock (5 of 9)
• Finding the Cost of Common Stock Equity
 where
– rj = Expected return or required return on asset j
– RF = Risk-free rate of return
– βj = Beta coefficient for asset j
– Rm = Market return; expected return on the market portfolio of
assets
 Example 9.9 (1 of 2)

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 9.6, the company estimates that
the required return on its common stock, rs, is 12%:

rs = 3.0% + [1.5 × (9.0% – 3.0%)] = 3.0% + 9% = 12.0%

 Example 9.9 (2 of 2)

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.
9.4 Cost of Common Stock (7 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 Flotation Costs and the Cost of Common Equity
– Flotation costs increase the cost of common equity
 Cost of a New Issue of Common Stock, rn
– The cost of common stock, net of underpricing and associated flotation
costs

D1
rn  g (9.7)
Nn
9.4 Cost of Common Stock (8 of 9)

• Finding the Cost of Common Stock Equity

 where
– Nn = Net proceeds from the sale of the stock
– D1 = Dividend expected in 1 year
– g = Constant rate of growth in dividends
 Example 9.10 (1 of 2)
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 $3.99; 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 has estimated that
on average, new shares can be sold 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. The total underpricing and flotation costs
per share are therefore $3.50.
 Example 9.10 (2 of 2)

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 = $3.99, Nn = $46.50, and g = 5% into Equation
9.7 results in a cost of new common stock, rn:

$3.99
rn   0.05  0.0858  0.05  0.1358  13.58%
$46.50

Duchess Corporation’s cost of new common stock is therefore between

13% and 14%.
9.4 Cost of Common Stock (9 of 9)
• Cost of Retained Earnings
– 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 (9.8)
 Example 9.11

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 12.0% to 13.0%.

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.
9.5 Weighted Average Cost of Capital
(1 of 3)

• Calculating the Weighted Average Cost of Capital (WACC)

rwacc  ( wd  rd )(1  T )  ( wp  rp )  ( ws  rs or n ) (9.9)

– 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
9.5 Weighted Average Cost of Capital
(2 of 3)

• Calculating the Weighted Average Cost of Capital (WACC)

– Important Points:
 The weights must be nonnegative and sum to 1.0
 The weights are based on the market value of each capital source as a
percentage of the market value of the firm’s total capital
 We multiply the firm’s common stock equity weight, ws, by either the required
return on the firm’s stock, rs, or the cost of new common stock, rn
 We multiply the firm’s cost of debt by (1 − T) to capture the tax deduction tied
to interest payments
 Example 9.12 (1 of 3)

In earlier examples, we found the costs of the various types of capital for
Duchess Corporation to be as follows:

rd (1 – T ) = 4.880% = 4.88%
rp = 8.258% = 8.26%
rs = 13.00%
Duchess has total capital with a market value of $1 billion. The market value of the firm’s
outstanding long-term debt is $400 million, the value of its preferred stock is $100 million, and
the market value of its common stock is $500 million. Thus, the weights for the weighted
average cost of capital (WACC) calculation are as follows:
 Example 9.12 (2 of 3)

Source of capital Weight

Long-term debt 40%

Preferred stock 10

Common stock equity 50

Total 100%
 Example 9.12 (3 of 3)
 Because the firm expects to have a sizable amount of retained earnings
available, it plans to use the required return on equity, rs (or, equivalently, the
cost of retained earnings, rr), as the cost of common stock equity.

 The calculation for Duchess Corporation’s WACC appears in Table 9.2. The
resulting WACC for Duchess is 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 9.2 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%
9.5 Weighted Average Cost of Capital
(3 of 3)
• Capital Structure Weights
– Market Value Weights
 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
– Target Capital Structure
 The mix of debt and equity financing that a firm desires over the long term
 The target capital structure should reflect the optimal mix of debt and equity for
a particular firm
Review of Learning Goals (1 of 6)

• LG 1
– Understand the basic concept of the cost of capital.
 The cost of capital is the minimum rate of return that a firm must earn
on its investments to increase the firm’s value
 The weighted average cost of capital is a number that blends the
costs of each type of capital that a firm uses and establishes a
minimum rate of return that the firm’s investment should earn
Review of Learning Goals (2 of 6)
• LG 2
– List the primary sources of capital available to firms.
 The primary sources of capital for most firms include debt,
preferred stock, common stock, and retained earnings
Review of Learning Goals (3 of 6)
• LG 3
– Determine the cost of long-term debt, and explain why the after-tax cost
of debt is the relevant cost of debt.
 Managers can find the before-tax cost of long-term debt by using cost
quotations, calculations (either by calculator or spreadsheet), or an
approximation
 The after-tax cost of debt is the product of the before-tax cost of debt and 1
minus the tax rate
 The after-tax cost of debt is the relevant cost of debt because it is the lowest
possible cost of debt for the firm due to the deductibility of interest expenses
Review of Learning Goals (4 of 6)
• LG 4
– Determine the cost of preferred stock.
 The cost of preferred stock is the ratio of the preferred stock
dividend to the firm’s net proceeds from the sale of preferred
stock
Review of Learning Goals (5 of 6)
• LG 5
– 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.
 The required return on the firm’s stock can be calculated by using the
constant-growth valuation (Gordon growth) model or the CAPM
 The cost of retained earnings is equal to the required return on common stock
equity
 An adjustment to the required return on common stock equity to reflect
underpricing and flotation costs is necessary to find the cost of new issues of
common stock
Review of Learning Goals (6 of 6)
• LG 6
– Calculate the weighted average cost of capital (WACC), and
discuss alternative weighting schemes.
 The firm’s WACC is a weighted average of the firm’s cost of
debt and equity capital, where the weights are based on the
market values of each type of financing relative to the total
market value of all financing used by the firm