1. Copyright © 1999 Addison Wesley Longman
CHAPTER
CHAPTER 12
The Cost of Capital
Copyright © 1999 Addison Wesley Longman 1

2. Objectives 1. Compute the cost of debt
2. Compute the cost of preferred stock
3. Compute the cost of equity
4. Compute the weighted average cost of capital.

3. Why Compute an Average Cost of Capital?
Because it will let you make better project selection decisions.

4. For example
Suppose a project is identified that will return 12%. You learn you can borrow the funds to start the project for 10%.
You might reasonably accept the project.

5. Now suppose
A project becomes available that will return 16%, but you find out that you can no longer borrow, instead you must issue equity with a cost of 20%.
You might reasonably reject this project.

6. Table 12.1 Choosing Investment Projects
Business Expected Cost of Cost of Average Cost
Opportunity Return Borrowing Equity of Money
Sun Glass Hut % % %
Custom Shoe % % %

7. You have accepted a 12% project and rejected a 16% project, simply because the 12% project became available first.

8. Average Cost of Funds
If you had used the average cost of funds (15%) you would have rejected the 12% and accepted the 16%

9. After Tax Cost of Debt Review the equation for the price of a bond:
Kd = cost of debt

10. In Chapter 8 we called Kd the yield to maturity
The after-tax cost of debt: Kd (1 – T) = cost of debt
Kd is multiplied by (1 – T) because interest is tax deductible for the firm.

11. Cost of Preferred Stock:
Ppreferred = Div / Kp
Kp = Div / Ppreferred

12. Example
If a firm pays a $2.00 dividend on preferred stock selling for $20.00, what is the cost of preferred?
Kp = $2/$20 = 10%

13. Cost of Equity
The cost of equity is more difficult to accurately estimate since the inputs are less certain.

14. We estimate Ke three ways:
1. CAPM
2. Gordon growth model
3. Bond yield plus premium

15. Ke : CAPM Ke = Rf +  (Rm – Rf )
The Ke on the left side of the equality is the return required by shareholders.

16. Gordon Growth Model
Po = Div Ke – g
Ke – g = Div Po
Ke = Div1 + g Po

17. Bond Yield Plus Premium
Kd represents the risk of the firm’s debt
 is the equity risk premium, or the additional risk that stock has over stock (from 3% to 5%)
Ke = Kd + 

18. Cost of Equity Summary CAPM Ke = Rf +  (Rm – Rf ) Gordon Growth Model
Ke = Div1 + g Po
Bond Yield Plus Premium
Ke = Kd + O

19. To find the cost of equity
Compute using all three methods.
Reconcile the methods.
Weight any method you feel has better inputs more heavily than a method with questionable inputs.

20. Weighted average cost of capital after tax
WACCAT = Wd Kd (1 – T) + Wp Kp + We Ke
Wd , Wp , and We are the proportions of debt, preferred, and equity in the firm’s target capital structure.

21. Example Compute the WACCAT given that:
Kd = 10%, Kp = 12%, and Ke = 14%
The firm has 30% debt, 10% preferred and 60% equity.
The tax rate is 40%.

22. Example
You are buying a $100K. You plan to borrow $80K at 8% and cash in mutual funds that have been yielding 12% to cover the rest. You are in the 28% mtr. What is your WACCAT?

23. Solution WACCAT = .30(10%)(1 – .4) + .1(12%) + .6(14%)

24. Marginal Cost of Capital Schedule
As additional funds are raised the cost of those funds often increases. The graph showing the cost of each additional dollar is the marginal cost of capital schedule.

25. Investment Opportunity Schedule
The Investment Opportunity Schedule can be combined with the marginal cost of capital schedule
Select those projects that return more than they cost

26. FIGURE 12.1 Marginal Cost of Capital and Investment Opportunity Schedules

27. To Prepare a Marginal Cost of Capital Schedule
1. Compute the points where the cost of funds increase—called break points
2. Compute the new weighted cost of funds at each break point

28. Computing Break Points
Divide the amount of funds that are limited by the percentage they make up of the capital structure.

29. Computing Break Points
BPi = TCi Wi
BPi = break point for a particular type of capital, I

30. TCi = amount of funds of a particular type of capital available at a particular cost

31. Example
A firm can raise $5 million in retained earnings with a cost of 12%. New equity will cost 13%. Debt costs 7%. The firm capital structure is 19.42% debt and 80.58% equity.

32. Prepare the cost of capital schedule assuming T = 40%

33. Solution BPi = $5 million = $6,205,013.65 .8058
Between $0 and $6,205, the funds will cost the same. After $6,205, the cost of funds will rise.

34. FIGURE 12.2 Finding the Break Point=
FIGURE Finding the Break Point 3

35. Solution, cont.
Next, compute the cost of capital above and below the break point:
WACCAT = Wd Kd (1 – T) + Wp Kp + We Ke
WACCATo – BP1 = (.07)(1 – .4) + (.8058)(.12)
WACCATo – BP1 = = 10.49%

36. Solution, cont. WACCATABOVE BP1 = .1942(.07)(1 – .4) + (.8058)(.13)

37. FIGURE 12.3 WMCCAT for Harley-Davidson4