The Cost

of Capital

1
Need & Source of Capital
• Need for capital
• Sources of capital (Debt, PS, Equity)
• What do the debt, PS, equity holders want? Return
• Their return is Firms cost – called Cost of capital

2
Factors Affecting the Cost of Capital
• Business Risk—the risk to the firm of being unable to
cover operating costs—is assumed to be unchanged. This
means that the acceptance of a given project does not
affect the firm’s ability to meet operating costs.
• Financial Risk—the risk to the firm of being unable to
cover required financial obligations—is assumed to be
unchanged. This means that the projects are financed in
such a way that the firm’s ability to meet financing costs is
unchanged.
• After-tax costs are considered relevant—the cost of
capital is measured on an after-tax basis.

3
Compute Cost of Debt

• Required rate of return for creditors

• Same cost found in as yield to maturity on bonds
(kd).
• e.g. Suppose that a company issues bonds with a
before tax cost of 10%.
• Since interest payments are tax deductible, the true
cost of the debt is the after tax cost.
• If the company’s tax rate (state and federal
combined) is 40%, the after tax cost of debt
• AT kd = 10%(1-.4) = 6%.

4
Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock.
Dividend (Dp)
Required rate kp =
Market Price (PP)-F

Example: You can issue preferred stock for a

price of $45 and a transaction cost of $3 and the
preferred stock pays a $5 dividend.
 The cost of preferred stock:

$5.00
kp =
$42.00
= 11.90%
5
Compute Cost of Common Equity

• Cost of Equity is the return that the investors

holding shares in a firm require.
• If it is a return for investors, it is cost for the
firm
• Two Types of Common Equity Financing
– Retained Earnings (internal common equity)
– Issuing new shares of common stock
(external common equity)

6
Compute Cost of Common Equity
• Cost of Internal Common Equity
– Management should retain earnings only
if they earn as much as stockholder’s
next best investment opportunity of the
same risk.
– Cost of Internal Equity = opportunity
cost of common stockholders’ funds.
– Two methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model
7
Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Dividend Growth Model

D1
P0=
ke - g

Or

D1
ke = + g
P0

8
Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Dividend Growth Model

D1
ke = + g
P0

Example:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%.

9
Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

– Dividend Growth Model

D1
ke = + g
P0
Example:
The market price of a share of common stock is $60.
The dividend just paid is $3, and the expected growth
rate is 10%.

ke = 3(1+0.10) + .10 =.155 = 15.5%

60
10
Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

– Capital Asset Pricing Model

ke = kRF + (kM – kRF)

11
Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

– Capital Asset Pricing Model (Chapter 7)

ke = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

12
Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

– Capital Asset Pricing Model

ke = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

ke = 5% + 1.2(13% – 5%) = 14.6%

13
Compute Cost of Common Equity

• Cost of New Common Stock

– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
Kne = + g
P0 - F

14
Compute Cost of Common Equity
• Cost of New Common Stock
– Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
kne = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
15
 Compute Cost of Common Equity
• Cost of New Common Stock
– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
kne = +g
P0 - F
Example:
If additional shares are issued floatation costs will
be 12%. D0 = $3.00 and estimated growth is 10%,
Price is $60 as before.

kne = 3(1+0.10) + .10 = .1625 = 16.25%

52.80 16
 Weighted Cost of Capital Model
• Compute the cost of each source of capital
• Determine percentage of each source of
capital in the optimal capital structure
• Calculate Weighted Average Cost of Capital
(WACC)

17
 Weighted Average Cost of Capital

WACC= (Wd x kd) + (Wp x kp) + (Wre x kre) + (Wne x kne)

18
Weighting Example
$ Million
Bonds 40
Pref. Stock 100
Common shares 100
Retained earnings 160
Total 400

What is weight of each component?

19
Weighting Example
$ Million Weight
Bonds 40 0.10
Pref. Stock 100 0.25
Common shares 100 0.25
Retained earnings 160 0.40
Total 400 1.00

20
Calculating the WACC for Templeton Extended Care Facilities,
Inc.
In the spring of 2010, Templeton was considering the acquisition
of a chain of extended care facilities and wanted to estimate its
own WACC as a guide to the cost of capital for the acquisition.
Templeton’s capital structure consists of the following:

21
Templeton contacted the firm’s investment banker to get
estimates of the firm’s current cost of financing and was
told that if the firm were to borrow the same amount of
money today, it would have to pay lenders 8%; the firm’s
current tax rate 25%, the after-tax cost of borrowing would
only be 6% = 8%(1-.25). Preferred stockholders currently
demand a 10% rate of return, and common stockholders
demand 15%. Templeton’s CFO knew that the WACC would
be somewhere between 6% and 15% since the firm’s
capital structure is a blend of the three sources of capital
whose costs are bounded by this range.

22
23
24
After completing her estimate of Templeton’s WACC, the
CFO decided to explore the possibility of adding more low-
cost debt to the capital structure. With the help of the
firm’s investment banker, the CFO learned that Templeton
could probably push its use of debt to 37.5% of the firm’s
capital structure by issuing more debt and retiring
(purchasing) the firm’s preferred shares. This could be
done without increasing the firm’s costs of borrowing or the
required rate of return demanded by the firm’s common
stockholders. What is your estimate of the WACC for
Templeton under this new capital structure proposal?
WACC=wd * kd (1-T) + we * ke
0.375x6% +0.625x15%=11.625%.

25
 Optimum Capital Structure
• The optimal (best) situation is associated with
the minimum overall cost of capital:
• Optimum capital structure means the lowest
WACC
• Usually occurs with 30-50% debt in a firm’s
capital structure
• WACC is also referred to as the required rate
of return or the discount rate

26
 Optimum Capital Structure
Cost (After-tax) Weights Weighted
Cost
Financial Plan A:
Debt………………………… 6.5% 0.20 1.3%
Equity………………………. 12.0 0.80 9.6
10.9%
Financial Plan B:
Debt………………………… 7.0% 0.40 2.8%
Equity………………………. 12.5 0.60 7.5
10.3%
Financial Plan C:
Debt………………………… 9.0% 0.60 5.4%
Equity………………………. 15.0 0.40 6.0
11.4%

27
28
 The Marginal Cost
& Investment Decisions
• The Weighted Marginal Cost of Capital (WMCC)
– The WACC typically increases as the volume of new capital
raised within a given period increases.
– This is true because companies need to raise the return to
investors in order to entice them to invest to compensate
them for the increased risk introduced by larger volumes
of capital raised.
– In addition, the cost will eventually increase when the firm
runs out of cheaper retained equity and is forced to raise
new, more expensive equity capital.
 The Marginal Cost
& Investment Decisions (cont.)

• The Weighted Marginal Cost of Capital (WMCC)

– Finding Break Points
Finding the break points in the WMCC schedule will allow us to
determine at what level of new financing the WACC will increase
due to the factors listed above.

BEP = Funds available at given cost / Target capital structure

weight for source

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 The Marginal Cost
& Investment Decisions (cont.)
• The Weighted Marginal Cost of Capital (WMCC)
– Finding Break Points

Assume that in the example we have been using that the firm
has $2 million of retained earnings available. When it is
exhausted, the firm must issue new (more expensive) equity.
Furthermore, the company believes it can raise $1 million of
cheap debt after which it will cost 7% (after-tax) to raise
additional debt.

Given this information, the firm can determine its break points as
follows:
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 The Marginal Cost
& Investment Decisions (cont.)
• The Weighted Marginal Cost of Capital (WMCC)
– Finding Break Points

BPequity = $2,000,000/.50 = $4,000,000

BPdebt = $1,000,000/.40 = $2,500,000

This implies that the firm can fund up to $4 million of new investment
before it is forced to issue new equity and $2.5 million of new investment
before it is forced to raise more expensive debt.
Given this information, we may calculate the WMCC as follows:

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 The Marginal Cost
& Investment Decisions (cont.)
WACC for Ranges of Total New Financing
Range of total Source of Weighted
New Financing Capital Weight Cost Cost
$0 to $2.5 million Debt 40% 5.67% 2.268%
Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.130%

$2.5 to $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.662%

over $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 16.00% 8.000%
WACC 11.762%
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 The Marginal Cost
& Investment Decisions (cont.)

11.76 WMCC
%
11.75
%
11.66
%
11.50
%

11.25
%
11.13
%

$2.5 $4.0 Total Financing (millions)

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 The Marginal Cost
& Investment Decisions (cont.)
• Investment Opportunities Schedule (IOS)
• Now assume the firm has the following investment
opportunities available:

Initial Cumulative
Project IRR Ivestment Investment
A 13.0% $ 1,000,000 $ 1,000,000
B 12.0% $ 1,000,000 $ 2,000,000
C 11.5% $ 1,000,000 $ 3,000,000
D 11.0% $ 1,000,000 $ 4,000,000
E
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 The Marginal Cost
& Investment Decisions (cont.)
13.0 A WMCC
%
12.0 B
%
11.66
% This indicates
11.5%
that the firm can
C
accept only
Projects A & B.

11.13 D
%
11.0%

$1. $2. $2.5 $3. $4.0 Total Financing (millions)

0
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 Table 11.4 Summary of Key Definitions and
Formulas for Cost of Capital

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