FM- II Chapter 4: Cost of Capital

Chapter Outline
• Cost of capital and its importance.
Chapter Cost of Capital • Discount rates used to analyze

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investments.
• Valuation and application to bonds,
preferred stock, and common stock.
• Minimum cost of capital.
• Increase in cost of capital with increase in
utilization of finances.

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 1-2

What sources of long-term

capital do firms use? • Capital Components is one of the types of
capital used by firms to raise funds.
Long-Term
– Debt
Capital
– preferred stock and
– common equity
Long-Term Preferred Common
Debt Stock Stock • The cost of each component is called its
Cost of Capital or component cost
Retained New Common
Earnings Stock
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 FM- II Chapter 4: Cost of Capital

The following symbols identify the cost and Calculating the weighted
weight of each average cost of capital
• rd= interest rate on the firm’s new debt • Weighted Average Cost of Capital (WACC) A weighted
• rd (1 - T)= after-tax component cost of debt, average of the component costs of debt, preferred stock,
• rp= component cost of preferred stock and common equity.
• rs= component cost of common equity raised by retaining WACC = wdrd(1-T) + wprp + wcrs
earnings, or internal equity
• re = component cost of external equity, or common equity • The w’s refer to the firm’s capital structure
raised by issuing new stock. weights.
• wd, wp, wc = target weights of debt, preferred stock, and • The r’s refer to the cost of each component.
common equity
• WACC = the firm’s weighted average, or overall, cost of
capital.

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Should our analysis focus on before-tax Should our analysis focus on historical
or after-tax capital costs? (embedded) costs or new (marginal) costs?

• Stockholders focus on After tax CFs.

Therefore, we should focus on After tax • The cost of capital is used primarily to make
capital costs, i.e. use After tax costs of capital decisions that involve raising new capital.
in WACC. Only rd needs adjustment, So, focus on today’s marginal costs (for
because interest is tax deductible. WACC).

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 FM- II Chapter 4: Cost of Capital

How are the weights determined? Component cost of debt

• A firm can borrow at an interest rate of
WACC = wdrd(1-T) + wprp + wcrs 10%, and its marginal federal-plus-state tax
rate is 40%. Interest is tax deductible, so
• Use accounting numbers or market A-T rd = rd (1-T)
value (book vs. market weights)? = 10% (1 - 0.40) = 6%
• Use actual numbers or target capital • Use nominal rate.
structure? • Flotation costs are small, so ignore them.

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Component cost of preferred stock What is the cost of preferred stock?

• The cost of preferred stock can be solved

WACC = wdrd(1-T) + wprp + wcrs by using this formula:
rp = Dp / Pp
• rp is the marginal cost of preferred stock,
which is the return investors require on a • would sell its stock and the stock would
firm’s preferred stock. have a $10.00 dividend per share, and it
• Preferred dividends are not tax-deductible, would be priced at $97.50 a share.
so no tax adjustments necessary. Just use
nominal rp. = $10 / $97.50
• Our calculation ignores possible flotation = 10.30%
costs.

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 FM- II Chapter 4: Cost of Capital

Is preferred stock more or less risky to

investors than debt?
Component cost of equity
• More risky; company not required to pay
preferred dividend. WACC = wdrd(1-T) + wprp + wcrs
• However, firms try to pay preferred dividend. • rs is the marginal cost of common equity
Otherwise, using retained earnings.
(1) cannot pay common dividend,
• The rate of return investors require on the
(2) difficult to raise additional funds, firm’s common equity using new equity is re.
(3) preferred stockholders may gain control of firm.

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Three ways to determine the cost of

Why is there a cost for retained earnings?
common equity, rs
• CAPM: rs = rRF + (rM – rRF) b
• Earnings can be reinvested or paid out as
dividends.
• Investors could buy other securities, earn a
• DCF: rs = (D1 / P0) + g
return.
• If earnings are retained, there is an opportunity • Own-Bond-Yield-Plus-Risk-Premium:
cost (the return that stockholders could earn on
alternative investments of equal risk). rs = rd + RP
– Investors could buy similar stocks and earn rs.
– Firm could repurchase its own stock and earn rs.

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 FM- II Chapter 4: Cost of Capital

CAPM APPROACH

• The most widely used method for estimating the If the rRF = 5.6%, RPM = 5.0%, and the firm’s
cost of common equity is the capital asset pricing beta is 14.8, what’s the cost of common equity
model (CAPM)
based upon the CAPM?
• Step 1: Estimate the risk-free rate, rRF. We
generally use the 10-year Treasury bond rate as
the measure of the risk-free rate, rs = rRF + (rM – rRF) b
• Step 2: Estimate the stock’s beta coefficient, bi,
and use it as an index of the stock’s risk. rs= 5.6% + (5.0%)(1.48)
• Step 3: Estimate the market risk premium the • = 13.0%
difference between the return that investors require
on an average stock and the risk-free rate.
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Can DCF methodology be applied if growth

is not constant?
• Yes, nonconstant growth stocks are
If D0 = $5.4, P0 = $23.06, and g = 8.3%, what’s expected to attain constant growth at some
the cost of common equity based upon the DCF point, generally in 5 to 10 years.
approach? • May be complicated to compute.

rs= (D1/ P0) + g

= ($5.4 / $23.06) + 0.83
= 13.7%

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 FM- II Chapter 4: Cost of Capital

If rd = 10% and RP = 4%, what is rs using the What is a reasonable final estimate of rs?
own-bond-yield-plus-risk-premium method?

• This RP is not the same as the CAPM RPM. Method Estimate

• This method produces a ballpark estimate CAPM 13.0%
of rs, and can serve as a useful check. DCF 13.7%
rd + RP 14.0%
rs = rd + RP Average 13.56%
rs = 10.0% + 4.0% = 14.0%

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What is the firm’s WACC?

• assumes that common equity comes
Allied’s target capital structure calls for 45% debt, exclusively from retained earnings. If,
2% preferred stock, and 53% common equity instead, Allied had to issue new common
stock, its WACC would be slightly higher
because of the additional flotation costs:
WACC= wdrd(1-T) + wprp + wcrs
= 0.45(10%)(0.6) + 0.02(10.30%) + 0.53(13.5%)
= 2.7% + 0.206% + 7.155%
= 10.1%
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 FM- II Chapter 4: Cost of Capital

What factors influence a company’s

composite WACC?

WACC= wdrd(1-T) + wprp + wcre • Market conditions.

= 0.45(10%)(0.6) + 0.02(10.30%) + • The firm’s capital structure and
0.53(14.1%) dividend policy.
= 2.7% + 0.206% + 7.473% • The firm’s investment policy. Firms
= 10.4% with riskier projects generally have a
higher WACC.

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Should the company use the composite WACC as

the hurdle rate for each of its projects?

• NO! The composite WACC reflects

the risk of an average project
undertaken by the firm. Therefore, the
WACC only represents the “hurdle
rate” for a typical project with average
risk.
The End
• Different projects have different risks.
The project’s WACC should be
adjusted to reflect the project’s risk.
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