The Cost of Capital

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Topics Covered

Geothermal’s Cost of Capital

Weighted Average Cost of Capital (WACC)
Capital Structure
Required Rates of Return
Big Oil’s WACC
Interpreting WACC
Flotation Costs

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Cost of Capital

Cost of Capital - The return the firm’s

investors could expect to earn if they
invested in securities with comparable
degrees of risk.

Capital Structure - The firm’s mix of long

term financing and equity financing.

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?

Market Value Debt $194 30%

Market Value Equity $453 70%
Market Value Assets $647 100%

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?

Portfolio Return = (.3x8%) + (.7x14%) = 12.2%

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital? Portfolio Return = (.3x8%) + (.7x14%) = 12.2%

Interest is tax deductible. Given a 35% tax rate, debt only

costs us 5.2% (i.e. 8 % x .65).

WACC = (.3x5.2%) + (.7x14%) = 11.4%

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WACC

Weighted Average Cost of Capital (WACC)

- The expected rate of return on a portfolio of
all the firm’s securities.

Company cost of capital = Weighted average of debt

and equity returns.

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WACC

Three Steps to Calculating Cost of Capital

1. Calculate the value of each security as a
proportion of the firm’s market value.
2. Determine the required rate of return on
each security.
3. Calculate a weighted average of these
required returns.

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WACC
Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.

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WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market
value of these securities are
$4mil, $2mil, and $6mil,
respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.

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WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3

WACC = [ 4
12 x(1-.35).06 + ] ( 2
12 x.12 + ) ( 6
12 x.18 )
=.123 or 12.3%

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Measuring Capital Structure

In estimating WACC, do not use the Book

Value of securities.
In estimating WACC, use the Market Value
of the securities.
Book Values often do not represent the true
market value of a firm’s securities.

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Measuring Capital Structure

Market Value of Bonds - PV of all coupons

and par value discounted at the current
interest rate.

Market Value of Equity - Market price per

share multiplied by the number of
outstanding shares.

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Required Rates of Return

Bonds
rd = YTM

Common Stock
re = CAPM
= rf + B(rm - rf )

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Required Rates of Return

Dividend Discount Model Cost of Equity

Perpetuity Growth Model =
Div1
P0 =
re - g

solve for re
Div1
re = + g
P0

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Required Rates of Return

Expected Return on Preferred Stock

Price of Preferred Stock =
Div1
P0 =
rpreferred

solve for preferred

Div1
rpreferred =
P0

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Flotation Costs

The cost of implementing any financing

decision must be incorporated into the cash
flows of the project being evaluated.
Only the incremental costs of financing
should be included.
This is sometimes called Adjusted Present
Value.

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Problems

Q1) Cost of Debt. Micro Spinoffs, Inc., issued 20-

year debt a year ago at par value with a coupon
rate of 8 percent, paid annually. Today, the debt is
selling at $1,050. If the firm’s tax bracket is 35
percent, what is its after-tax cost of debt?
Q2) Cost of Preferred Stock. Micro Spinoffs also
has preferred stock outstanding. The stock pays a
dividend of $4 per share, and the stock sells for
$40. What is the cost of preferred stock?

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Problems

 Q3) Calculating WACC. Suppose Micro Spinoffs’s cost of

equity is 12 percent. What is its WACC if equity is 50 percent,
preferred stock is 20 percent, and debt is 30 percent of total
capital?
 Q4) Calculating WACC. Reactive Industries has the following
capital structure. Its corporate tax rate is 35 percent. What is its
WACC?

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Problems

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Problems
Q5 Calculating WACC. Find the WACC of
William Tell Computers. The total book value of
the firm’s equity is $10 million; book value per
share is $20. The stock sells for a price of $30 per
share, and the cost of equity is 15 percent. The
firm’s bonds have a par value of $5 million and
sell at a price of 110 percent of par. The yield to
maturity on the bonds is 9 percent, and the firm’s
tax rate is 40 percent.

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Problems
 Long street communications Inc (LCI) has the following capital
structure, which it considers to be optimal:
Debt = 25%
Preferred Stocks = 15%
Common stocks = 60%
LCI’s net income expected this year is $ 17,142.86, its established
dividend payout ratio is 30 percent, its tax rate is 40 percent and
investors expect earning and dividends to grow at a constant rate of
9 percent in the future. LCI paid a dividend of $ 3.60 per share last
year and its stock currently sells at a price of $ 60 per share.
Treasury bonds yield 11 percent and average stock beta has a 14
percent expected rate of return and LCI’s beta is 1.51. These terms
will apply to new offerings:
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Problems
Common: New common stock would have a
floating cost of 10 percent.
Preferred: New preferred could be sold to the
public at a price of $ 100 per share with the
dividend of $11, Floating cost of $ 5 would be
incurred.
Debt: New debt could be sold at an interest rate of
12 percent.
Find the component cost debt, preferred stock,
retained earnings and new common stocks?
What is the WACC?

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