1. THE COST OF CAPITAL © 2000 South-Western College Publishing
Chapter 11
THE COST OF CAPITAL
© 2000 South-Western College Publishing

2. COST OF CAPITAL
The return an investor receives on debt, preferred stock, or common equity is a cost to the company
Costs are returns adjusted for taxes and transactions cost
Overall cost is a weighted average of these
Component Costs
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3. The mix of capital components in use The Target Capital Structure
Debt $30, %
Preferred Stock $10, %
Equity $60, %
Total Capital $100, %.
RELATED CONCEPTS
The Target Capital Structure
Raising Money in the Proportions of the Capital Structure
TM Slide 2 of 2

4. THE WEIGHTED AVERAGE CALCULATION - THE WACC
A firm's overall cost of capital is the average of the costs of its separate sources weighted by the proportion of each source used
Example of Calculation
Capital
Component Value Weight Cost
Debt $60, x 9% = 2.70%
Preferred Stock $50, x 11% = 2.75%
Common Stock $90, x 14% = 6.30%
$200, WACC = 11.75%
TM 11-2

5. CAPITAL STRUCTURE AND COST - BOOK VS MARKET VALUES
A Source of Confusion:
Both capital structure and component costs can be viewed in terms of either the book or market values of the underlying capital
1. CAPITAL STRUCTURE
Initial Capital Structure - Book and Market Values Equal
$ %
Equity 10,000 shrs x $10 = $100, %
Debt bonds x $1,000 = $100, %
Total $200, %
Now imagine that stock price increases to $12, while interest rates climb driving
the price of the bonds down to $850
-Book Values Don't Change-
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6. Market-Value-Based Capital Structure
$ %
Equity 10,000 shrs x $12 = $120, %
Debt 100 bonds x $850 = $ 85, %
Total $205, %
(From Tables 11-1 and 2)
2. COMPONENT RETURNS
Every security has a return on the money initially invested to buy it and a current return that's available to new investors in the secondary market.
For example, a bond pays its coupon rate on the original investment of its face value and the market yield to a new buyer.
TM Slide 2 of 3

7. Structure: Maintain the existing structure based on market prices, or
3. THE APPROPRIATE PERSPECTIVE FOR THE WACC CALCULATION
Book Values - Existing Capital - Already Committed
Market Values - New Capital - Next Year's Projects
IRR and NPV Evaluate Newly Proposed Projects
Therefore, Market Values Are Appropriate
4. THE CUSTOMARY APPROACH
Structure: Maintain the existing structure based on market prices, or
strive for a target structure based on market prices.
Component Costs: Based on market prices
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8. CALCULATING THE WACC Three Steps
1. Develop a market value based capital structure.
2. Adjust market returns to reflect
component costs of capital.
3. Calculate WACC.
TM 11-4

9. STEP ONE: DEVELOPING MARKET VALUE BASED CAPITAL STRUCTURES
EXAMPLE 11-2
Debt: Two thousand bonds were issued five years ago at a coupon rate of 12%. They had thirty year terms and $1,000 face values. They are now selling to yield 10%.
Preferred Stock: Four thousand shares of preferred are outstanding each of which pays an annual dividend of $ They originally sold to yield 15% of their $50 face value. They're now selling to yield 13%.
Equity: 200,000 shares of common stock are outstanding currently selling at $15 per share.
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10. Debt: Preferred Stock: SOLUTION: Pb = PMT[PVFAk,n] + FV[PVFk,n]
= $60[PVFA5,50] + $1,000[PVF5,50]
= $60( ) + $1,000(.0872)
= $1,182.55
Market Value = $1, x 2,000 = $2,365,100
Preferred Stock:
Market Value = $57.69 x 4, = $230,760
TM 11-5 Slide 2 of 3

11. Market Value Based Weights:
Common Equity:
Market Value = $15.00 x 200, = $3,000,000
Market Value Based Weights:
$ %
Debt $2,365, %
Preferred , %
Equity ,000, %
$5,595, %
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12. STEP TWO: CALCULATING COMPONENT COSTS OF CAPITAL
Adjustments To Investor's Returns Reflect The Effect
Of Financial Markets and Taxes
Taxes Reduce the Effective Cost of Debt
kd(1-T)
Flotation Costs Increase the Effective Cost of a Component
Component
cost of
capital
TM 11-6

13. DEBT: Cost of debt = kd (1 - T)
ILLUSTRATIONS
DEBT: Cost of debt = kd (1 - T)
EXAMPLE 11-3
Blackstone Inc. has bonds outstanding which yield 8% to investors buying them now. The marginal tax rate is 37%
SOLUTION: Cost of debt = kd (1 - T)
= .08 (1-.37)
= 5.4%
PREFERRED STOCK: Cost of
Preferred
Stock
EXAMPLE 11-4
Francis Corporation's preferred stock yields new investors 9%. Flotation costs are 11%.
SOLUTION: Cost of
TM 11-7

14. COMMON EQUITY - RETAINED EARNINGS:
No Adjustments:
Internally Generated and Not Tax Deductible
The CAPM Approach - The Required Rate of Return
kX = kRF + (kM - kRF)bX
The Dividend Growth Approach - The Expected Rate of Return
The Risk Premium Approach
ke = kd + rpe
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15. COMMON EQUITY - NEW STOCK:
Cost of New Equity
EXAMPLE 11-8
Periwinkle Inc.'s last annual dividend was $1.65, its stock sells for $33.60, and it is expected to grow at 7.5%.
SOLUTION:
Cost of
new
Equity
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16. THE MARGINAL COST OF CAPITAL (MCC)
A graph showing how the WACC changes as a firm raises more capital during a planning period, usually a year
A Typical MCC Schedule
WACC
Total
Capital
Raised
The MCC breaks upward when the cost of a capital component increases. The first break usually occurs when retained earnings runs out and outside equity is raised at higher cost.
TM 11-9

17. ILLUSTRATION OF MCC CONSTRUCTION
Capital Capital
Structure Component
Weights Cost
With equity from RE
Debt x % = %
Equity x % = %
WACC = %
With equity from new stock
Debt x % = %
Equity x % = %
WACC = 10.4%
If expected RE = $3M and the capital structure is 60% equity, the first break in the WACC occurs at $3M / .60 = $5M
Table 11-4 (modified)
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18. The Marginal Cost of Capital (MCC) Schedule
WACC
$5M $10M
Figure The Brighton Company
The Marginal Cost of Capital (MCC) Schedule
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10.4%
9.2%

19. COMBINING THE MCC AND THE INVESTMENT OPPORTUNITY SCHEDULE (IOS)
WACC
Project
IOS IRRs
MCC
WACC=10.4%
9.2%
$5M $10M
Figure The Marginal Cost of Capital (MCC) Schedule and
The Investment Opportunity Schedule (IOS)
TM 11-11 A B C D E