Chapter 9

The Cost of Capital

Sources of Capital Component Costs WACC Adjusting for Flotation Costs Adjusting for Risk

Capital
Capital represents the funds used to finance a firm's assets and operations. Capital constitutes all items on the right hand side of a balance sheet i.e. liabilities and common equity.
Main sources: Debt, Preferred stock, Retained earnings and Common Stock

Cost of Capital
Cost of capital is the return/interest the investors/lenders

require on their capital (for example, a corporation has to pay interest on bonds).
Cost of capital can also be regarded as the hurdle rate that

must be achieved by an investment before it will increase shareholder wealth.

Cost of capital provides the basis for evaluating division or

firm performance.

Cost of Capital
Cost of Capital is also called:
Hurdle rate for new investment Opportunity cost of funds Required rate of return

Cost of Debt, Preferred stock and Common equity

The Cost of Debt

The investors required rate of return on debt is simply the return that creditors demand on new borrowing.

Cost of Debt
After tax cost of debt = kd(1-Tc)

= Before tax cost of capital less the effect of tax savings

Example: Debt at 9.75% and tax rate of 34%

After-tax cost of debt = .0975(1-.34)

= 6.435%

Component Cost of Preferred Stock

kp is the marginal cost of preferred stock, which is

the return investors require on a firms preferred stock. Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal kp. Our calculation ignores possible flotation costs.

What is the cost of preferred stock?

The cost of preferred stock can be solved by using this

formula:
Kp

= Dp/Pp = $10/$111.10 = 9%

Is preferred stock more or less risky to investors than debt?

More risky; company not required to pay preferred

dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds

Common Equity
Sources:
Retained earnings Sale of new shares

There is no flotation cost on retained earnings. Retained earnings are not a free source of

capital.

Cost estimation challenges

Cost of equity is more challenging to estimate than cost of debt or cost of preferred stock because common stockholders rate of return is not fixed. Furthermore, the costs will vary for two sources of equity (i.e. retained earnings and new issue).

Why is there a cost for retained earnings?

Earnings can be reinvested or paid out as dividends.
Investors could buy other securities, earn a return. If earnings are retained, there is an opportunity cost

(the return that stockholders could earn on alternative investments of equal risk).

Cost estimation techniques

Two commonly used methods for estimating common stockholders required rate of return are:
1. 2.

Dividend Growth Model Capital Asset Pricing Model

Three Ways to Determine the Cost of Common Equity, Ks

CAPM:
DCF:

Ks = KRF + (KM KRF)b

Ks = (D1/P0) + g

Own-Bond-Yield-Plus-Risk-Premium:

Ks = Kd + RP

Find the Cost of Common Equity Using the CAPM Approach

The KRF = 7%, RPM = 6%, and the firms beta is 1.2.
Ks = KRF + (KM KRF)b = 7.0% + (6.0%)1.2 = 14.2%

Capital Asset Pricing Model Variable estimates

CAPM is easy to apply. Also, the estimates for model

variables are generally available from public sources.

Risk Free Rate: Wide range of US government securities

on which to base risk-free rate.

Beta: Estimates of beta available from a wide range of

services, or can be estimated using regression analysis of historical data.

Market risk premium: It can be estimated by looking at

history of stock returns and premium earned over riskfree rate.

Find the Cost of Common Equity Using the DCF Approach

D0 = $4.19, P0 = $50, and g = 5.
D1 = D0(1 + g)

= $4.19(1 + 0.05) = $4.3995

Ks = (D1/P0) + g = ($4.3995/$50) + 0.05 = 13.8%

Find Ks Using the Own-Bond-Yield-Plus-RiskPremium Method

Kd = 10% and RP = 4.
This RP is not the same as the CAPM RPM. This method produces a ballpark estimate of Ks, and can

serve as a useful check.

Ks = Kd + RP Ks = 10.0% + 4.0% = 14.0%

What is a reasonable final estimate of ks?

Method CAPM DCF Kd + RP Average Estimate 14.2% 13.8% 14.0% 14.0%

Why is the cost of retained earnings cheaper than the cost of issuing new common stock?
When a company issues new common stock they also

have to pay flotation costs to the underwriter. Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.

If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is Ke?
D 0 (1 g) Ke g P0 (1 F) $4.19(1.05 ) 5.0% $50(1 0.15) $4.3995 5.0% $42.50 15.4%

Flotation Costs
Flotation costs depend on the firms risk and the

type of capital being raised. Flotation costs are highest for common equity.

Bringing it all together: WACC

To estimate WACC, we need to know the capital structure mix and the cost of each of the sources of capital. For a firm with only two sources: debt and equity,

WACC = (After tax cost of debt X proportion of debt financing) + (Cost of equity X proportion of equity financing)

Weighted Average Cost of Capital (WACC)

Combined costs of all the sources of financing used by the firm. The weighted average of the after-tax costs of each of the sources of capital used by a firm to finance a

project where the weights reflect the proportion of total financing from each source.

The calculation of firms WACC?

WACC = wdkd(1 T) + wpkp + wcks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%

WACC Example
A firm borrows money at 7% after taxes and pays 12% for equity. The company raises capital in equal proportions 50/50.
WACC = (.07 X .5) + (.12 X .5) = .095 or 9.5%

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. Different projects have different risks. The projects WACC should be adjusted to reflect the projects risk.

Risk and the Cost of Capital

Rate of Return (%)
Acceptance Region WACC WACCH A WACCA B WACCL L H Rejection Region

RiskL

RiskA

RiskH

Risk

three types of project risk?

Stand-alone risk Corporate risk Market risk

What factors influence a companys composite WACC?

Market conditions.
The firms capital structure and dividend policy. The firms investment policy. Firms with riskier

projects generally have a higher WACC.