The Cost of Capital

CHAPTER 10
Target Capital Structure: The mix of debt, preferred stock and
common equity the firm plans to raise to fund its future projects
The investor supplied items – debt, preferred stock and common
equity are called capital components. Increases in assets must be
financed by increases in these capital components. The cost of each
component is called its component cost
WACC: A weighted average of the component costs of debt,
preferred stock, and common equity
WACC
Cost of Debt
Cost of Preferred Stock
Cost of Retained Earnings
New common equity is raised in two ways:
◦ By retaining some of the current year's earnings
◦ By issuing new common stock

Although it is true that no direct costs are associated with retained earnings, this capital still has a cost, an
opportunity cost. The firm’s after-tax earnings belong to its stockholders. Stockholders could have
received the earnings as dividends and invested this money in other stocks, in bonds or in anything else.
Therefore, the firm needs to earn at least as much on any retained earnings as the stockholders could
earn on alternative investments of comparable risk.
Cost of Retained Earnings
1. CAPM Approach
2. Bond yield plus risk premium
approach
3. Dividend yield plus growth rate
or discounted cash flow
approach
4. Averaging the alternative
estimates
Cost of New Common Stock
When must external equity be used ?
Weighted Average Cost of Capital (WACC)
Factors that affect the WACC
Factors the firm cannot control
1. Interest rates in the economy
2. The general level of stock prices
3. Tax rates
Factors the firm can control
1. Capital structure
2. Dividend payout ratio
3. Capital budgeting decision rules