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Chapter 9

The Cost of Capital

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 What types of long-term capital do firms
use?
Capital components are sources of funding that come from
investors categorized into three types.
 Common equity (Stocks)
 Preferred stock
 Long-term debt (Bonds)

 What is the weighted average cost of


capital (WACC)?
The weighted average cost of capital (WACC) is the
average rate of return required by all of the
company’s investors (stockholders and creditors). VERY
IMPORT
ANT
WACC= Wd Rd (1 - t) + WPS RPS + WCE
Rs

Where:
Wd: Weight of Long-term debt

Rd: Interest Rate of Debt

t: Tax Rate

WPS: Weight of Preferred stock

RPS: Interest Rate of Preferred stock

WCE: Weight of Common Equity

RS: Required rate of return for equity investor

Rs = RFR + MRP X βs
OR
Rs = RFR + (MRR -RFR) X βs
2
OR
Rs = (D1 / P0 ) + g

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 How do you Determine the Weights for
the WACC?
• The weights are the percentages of the firm that will be
financed by each component.
Example:
Suppose the stock price is $50, there are 3 million shares of stock;
the firm has $25 million of preferred stock, and $75 million of
debt.
• Common Equity Value (VCE) = $ 50 (3 million) = $ 150 million.
• Preferred stock Value (VPS) = $ 25 million.
• Long-term debt Value (Vd) = $ 75 million.
• Total value = $ 150 + $ 25 + $ 75 = $ 250 million.
• Common Equity Weight (WCE) = $ 150/$ 250 = 0.6 = % 60
• Preferred stock Weight (WPS) = $ 25/$ 250 = 0.1 = % 10
• Long-term debt Weight (Wd) = $ 75/$ 250 = 0.3 = % 30
Example (1): Given that:
Wd % 40
Rd % 10 VERY
t % 40 IMPORT
WPS % 30 ANT
RPS % 12
WCE % 30
RFR %8
MRR % 18
β 2

Rs = RFR + (MRR -RFR) X βs


= % 8 + (% 18 - % 8) X 2
= % 28
WACC = Wd Rd (1 - t) + WPS RPS + WCE Rs
= 0.4 X 0.1 X 0.6 + 0.3 X 0.12 + 0.3 X 0.28
= 0.144 = % 14.4

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Example (2): Given that:
Wd % 30
Rd % 15 VERY
t % 35 IMPORT
WPS %0 ANT
WCE % 70
P0 $ 110
g % 10
D0 10 $ / share

Rs = (D1 / P0 ) + g
Rs = (D0 ( 1 + g ) / P0 ) + g
= (10 ( 1 + 0.1 ) / 110 ) + 0.1
= % 20 = 0.2
WACC = Wd Rd (1 - t) + WPS RPS + WCE Rs
= 0.3 X 0.15 X 0.65 + 0 + 0.7 X 0.2
= 0.169 = % 16.9

Note:
• The necessary condition for any project
acceptance :
The project’s rate of return is greater than its cost-- some return is left
over to boost stockholders’ returns.
OR
Project Internal Rate of Return (IRR) > Firm's weighted average cost of
capital (WACC)
This was discussed it in details in Chapter 10 "The Basics of Capital
Budgeting: Evaluating Cash Flows"
• In previous Example:
WACC = % 16.9%, if we have a project with IRR = %20.  Decision:
Accept the project
( Profitable Project)