1. 1 Cost of Capital Chapter 12

2. 2 Learning Objectives Learning Objectives  Explain the concept and purpose of determining a firm’s cost of capital.  Identify the factors that determine a company’s cost of capital.  Describe the assumptions made in computing a firm’s weighted average cost of capital.  Calculate a corporation’s weighted cost of capital.  Explain how PepsiCo calculates its cost of capital.  Compute the cost of capital for an individual project when the firm’s weighted cost of capital is not appropriate as the discount rate.

3. 3 Required Rates on Projects  An important part of capital budgeting is setting the required rate for the individual project

4. 4 Required Rates on Projects  An important part of capital budgeting is setting the required rate for the individual project 0 1 Example: Consider the following project +1,100-1,000

5. 5 Required Rates on Projects  An important part of capital budgeting is setting the required rate for the individual project 0 1 Example: Consider the following project +1,100-1,000 If Required Rate = 9%: NPV = -1,000 + 1,100 (1+.09 ) = $9.17

6. 6 Required Rates on Projects  An important part of capital budgeting is setting the required rate for the individual project 0 1 Example: Consider the following project +1,100-1,000 If Required Rate = 9%: NPV = -1,000 + 1,100 (1+.09 ) = $9.17 Accept Project since NPV > 0

7. 7 Required Rates on Projects  An important part of capital budgeting is setting the required rate for the individual project 0 1 Example: Consider the following project +1,100-1,000 If Required Rate = 9%: NPV = -1,000 + 1,100 (1+.09 ) = $9.17 Accept Project since NPV > 0 If Required Rate = 11%: NPV = -1,000 + 1,100 (1+.11 ) = –$9.01

8. 8 Required Rates on Projects  An important part of capital budgeting is setting the required rate for the individual project 0 1 Example: Consider the following project +1,100-1,000 If Required Rate = 9%: NPV = -1,000 + 1,100 (1+.09 ) = $9.17 Accept Project since NPV > 0 If Required Rate = 11%: NPV = -1,000 + 1,100 (1+.11 ) = –$9.01 Reject Project since NPV < 0

9. 9 Required Rates on Projects  An important part of capital budgeting is setting the required rate for the individual project 0 1 Example: Consider the following project +1,100-1,000 If Required Rate = 9%: NPV = -1,000 + 1,100 (1+.09 ) = $9.17 Accept Project since NPV > 0 If Required Rate = 11%: NPV = -1,000 + 1,100 (1+.11 ) = –$9.01 In order to estimate correct required rate, companies must find their own unique cost of raising capital

10. 10 Factors Affecting Cost of Capital General Economic Conditions--inflation, investment opportunities  Affect interest rates The Following Factors affect risk premium Market Conditions Operating and Financing Decisions  Affect business risk  Affect financial risk Amount of Financing  Affect flotation costs and market price of security

11. 11 Model Assumptions Here, we determine the average cost of capital of a firm by assuming that the firm continues with its business, financing and dividend policies. Weighted Average Cost of Capital Model

12. 12 Computing Weighted Cost of Capital Average cost of capital of the firm. To find WACC 1. Compute the cost of each source of capital 2. Determine percentage of each source of capital 3. Calculate Weighted Average Cost of Capital Weighted Average Cost of Capital (WACC)

13. 13 Computing Cost of Each Source Required rate of return for creditors Same cost found in Chapter 7 as “required rate for debtholders (k d ) = YTM” 1. Compute Cost of Debt

14. 14 Computing Cost of Each Source Required rate of return for creditors Same cost found in Chapter 7 as “required rate for debtholders (k d )” 1. Compute Cost of Debt P 0 = + $M (1+k d ) nwhere: I t =Dollar Interest Payment P o =Market Price of Debt M =Maturity Value of Debt

15. 15 Computing Cost of Each Source Example Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP 0 ) down to $938.55. What is the before tax cost of debt? 1. Compute Cost of Debt

16. 16 Computing Cost of Each Source Example Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP 0 ) down to $938.55. What is the before tax cost of debt? 1. Compute Cost of Debt P 0 = + $M (1+k d ) n

17. 17 Computing Cost of Each Source Example Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP 0 ) down to $938.55. What is the before tax cost of debt? 1. Compute Cost of Debt 938.55 = + $1,000 (1+k d ) 10 P 0 = + $M (1+k d ) n

18. 18 Computing Cost of Each Source Example Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP 0 ) down to $938.55. What is the before tax cost of debt? 1. Compute Cost of Debt The before tax cost of debt is 10% Interest is tax deductible

19. 19 Computing Cost of Each Source Example Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP 0 ) down to $938.55. What is the before tax cost of debt? 1. Compute Cost of Debt The before tax cost of debt is 10% Interest is tax deductible After tax cost of bonds = k d (1 - T) Marginal Tax Rate = 40%

20. 20 Computing Cost of Each Source Example Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP 0 ) down to $938.55. What is the before tax cost of debt? 1. Compute Cost of Debt The before tax cost of debt is 10% Interest is tax deductible After tax cost of bonds = k d (1 - T) = 10.0%(1– 0.40) = 6 % Marginal Tax Rate = 40%

21. 21 Computing Cost of Each Source Cost to raise a dollar of preferred stock. 2. Compute Cost Preferred Stock

22. 22 Computing Cost of Each Source Cost to raise a dollar of preferred stock. 2. Compute Cost Preferred Stock From Chapter 8: Dividend (D) Market Price (P 0 ) Required rate k ps =

23. 23 Computing Cost of Each Source Cost to raise a dollar of preferred stock. 2. Compute Cost Preferred Stock From Chapter 8: Dividend (D) Market Price (P 0 ) Required rate k ps = However, there are floatation costs of issuing preferred stock:

24. 24 Computing Cost of Each Source Cost to raise a dollar of preferred stock. 2. Compute Cost Preferred Stock Cost of Preferred Stock with floatation costs Dividend (D) Net Price (NP 0 ) From Chapter 8: Dividend (D) Market Price (P 0 ) Required rate k ps = However, there are floatation costs of issuing preferred stock: k ps =

25. 25 Computing Cost of Each Source Example Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend. 2. Compute Cost Preferred Stock

26. 26 Computing Cost of Each Source Example Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend. 2. Compute Cost Preferred Stock Cost of Preferred Stock $5.00 $42.00 k ps =

27. 27 Computing Cost of Each Source Example Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend. 2. Compute Cost Preferred Stock Cost of Preferred Stock $5.00 $42.00 = 11.90% k ps =

28. 28 Computing Cost of Each Source Example Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend. 2. Compute Cost Preferred Stock Cost of Preferred Stock $5.00 $42.00 = 11.90% k ps = No adjustment is made for taxes as dividends are not tax deductible.

29. 29 Computing Cost of Each Source Two kinds of Common Equity  Retained Earnings (internal common equity)  Issuing new shares of common stock 3. Compute Cost of Common Equity

30. 30 Computing Cost of Each Source Cost of Internal Common Equity  Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity. 3. Compute Cost of Common Equity

31. 31 Computing Cost of Each Source Cost of Internal Common Equity  Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity.  Cost of Internal Equity = opportunity cost of common stockholders’ funds. 3. Compute Cost of Common Equity

32. 32 Computing Cost of Each Source Cost of Internal Common Equity  Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity.  Cost of Internal Equity = opportunity cost of common stockholders’ funds.  Cost of internal equity must equal common stockholders’ required rate of return. 3. Compute Cost of Common Equity

33. 33 Computing Cost of Each Source Cost of Internal Common Equity  Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity.  Cost of Internal Equity = opportunity cost of common stockholders’ funds.  Cost of internal equity must equal common stockholders’ required rate of return.  Three methods to determine  Dividend Growth Model  Capital Asset Pricing Model  Risk Premium Model 3. Compute Cost of Common Equity

34. 34 Computing Cost of Each Source Cost of Internal Common Equity  Dividend Growth Model  Assume constant growth in dividends (Chap. 8) 3. Compute Cost of Common Equity

35. 35 Computing Cost of Each Source Cost of Internal Common Equity  Dividend Growth Model  Assume constant growth in dividends (Chap. 8) 3. Compute Cost of Common Equity Cost of internal equity--dividend growth model D 1 P 0 k cs =+ g

36. 36 Computing Cost of Each Source Cost of Internal Common Equity  Dividend Growth Model  Assume constant growth in dividends (Chap. 8) 3. Compute Cost of Common Equity Cost of internal equity--dividend growth model D 1 P 0 k cs =+ g 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%.

37. 37 Computing Cost of Each Source Cost of Internal Common Equity  Dividend Growth Model  Assume constant growth in dividends (Chap. 8) 3. Compute Cost of Common Equity Cost of internal equity--dividend growth model D 1 P 0 k cs =+ g 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%. 3(1+0.10) 60 k cs =+.10

38. 38 Computing Cost of Each Source Cost of Internal Common Equity  Dividend Growth Model  Assume constant growth in dividends (Chap. 8) 3. Compute Cost of Common Equity Cost of internal equity--dividend growth model D 1 P 0 k cs =+ g 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%. 3(1+0.10) 60 k cs =+.10=.155 = 15.5%

39. 39 Computing Cost of Each Source Cost of Internal Common Equity  Dividend Growth Model  Assume constant growth in dividends (Chap. 8) 3. Compute Cost of Common Equity Cost of internal equity--dividend growth model D 1 P 0 k cs =+ g 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%. 3(1+0.10) 60 k cs =+.10=.155 = 15.5% The main limitation in this method is estimating growth accurately.

40. 40 Computing Cost of Each Source Cost of Internal Common Equity  Capital Asset Pricing Model  Estimate the cost of equity from the CAPM (Chap. 6) 3. Compute Cost of Common Equity

41. 41 Computing Cost of Each Source Cost of Internal Common Equity  Capital Asset Pricing Model  Estimate the cost of equity from the CAPM (Chap. 6) 3. Compute Cost of Common Equity k cs = k rf +  (k m – k rf ) Cost of internal equity--CAPM

42. 42 Computing Cost of Each Source Cost of Internal Common Equity  Capital Asset Pricing Model  Estimate the cost of equity from the CAPM (Chap. 6) 3. Compute Cost of Common Equity Example The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. k cs = k rf +  (k m – k rf ) Cost of internal equity--CAPM

43. 43 Computing Cost of Each Source Cost of Internal Common Equity  Capital Asset Pricing Model  Estimate the cost of equity from the CAPM (Chap. 6) 3. Compute Cost of Common Equity Example The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. k cs = k rf +  (k m – k rf ) Cost of internal equity--CAPM k cs = 5% + 1.2(13% – 5%)

44. 44 Computing Cost of Each Source Cost of Internal Common Equity  Capital Asset Pricing Model  Estimate the cost of equity from the CAPM (Chap. 6) 3. Compute Cost of Common Equity Example The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. k cs = k rf +  (k m – k rf ) Cost of internal equity--CAPM k cs = 5% + 1.2(13% – 5%) = 14.6%

45. 45 Computing Cost of Each Source Cost of Internal Common Equity  Risk Premium Approach  Adds a risk premium to the bondholder’s required rate of return. 3. Compute Cost of Common Equity

46. 46 Computing Cost of Each Source Cost of Internal Common Equity  Risk Premium Approach  Adds a risk premium to the bondholder’s required rate of return. 3. Compute Cost of Common Equity k cs = k d + RP c Cost of internal equity--Risk Premium Where: RP c = Common stock risk premium

47. 47 Computing Cost of Each Source Cost of Internal Common Equity  Risk Premium Approach  Adds a risk premium to the bondholder’s required rate of return. 3. Compute Cost of Common Equity Example If the risk premium is 5% and k d is 10% k cs = k d + RP c Cost of internal equity--Risk Premium Where: RP c = Common stock risk premium

48. 48 Computing Cost of Each Source Cost of Internal Common Equity  Risk Premium Approach  Adds a risk premium to the bondholder’s required rate of return. 3. Compute Cost of Common Equity Example If the risk premium is 5% and k d is 10% k cs = k d + RP c Cost of internal equity--Risk Premium k cs = 10% + 5% Where: RP c = Common stock risk premium

49. 49 Computing Cost of Each Source Cost of Internal Common Equity  Risk Premium Approach  Adds a risk premium to the bondholder’s required rate of return. 3. Compute Cost of Common Equity Example If the risk premium is 5% and k d is 10% k cs = k d + RP c Cost of internal equity--Risk Premium k cs = 10% + 5% = 15% Where: RP c = Common stock risk premium

50. 50 Computing Cost of Each Source Cost of New Common Stock  If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock. 3. Compute Cost of Common Equity

51. 51 Computing Cost of Each Source Cost of New Common Stock  If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock.  Dividend Growth Model--Must adjust for floatation costs of the new common shares. 3. Compute Cost of Common Equity

52. 52 Computing Cost of Each Source Cost of New Common Stock  If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock.  Dividend Growth Model--must adjust for floatation costs of the new common shares. 3. Compute Cost of Common Equity Cost of new common stock D 1 NP 0 k cs =+ g

53. 53 Computing Cost of Each Source Cost of New Common Stock 3. Compute Cost of Common Equity Cost of new common stock D 1 NP 0 k nc =+ g

54. 54 Computing Cost of Each Source Cost of New Common Stock 3. Compute Cost of Common Equity Cost of new common stock D 1 NP 0 k nc =+ g Example Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and estimated growth is 10%.

55. 55 Computing Cost of Each Source Cost of New Common Stock 3. Compute Cost of Common Equity Cost of new common stock D 1 NP 0 k nc =+ g Example Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and estimated growth is 10%. NP 0 = $60.00 – (.12x 60) = $52.80 Floatation Costs Floatation Costs

56. 56 Computing Cost of Each Source Cost of New Common Stock 3. Compute Cost of Common Equity Cost of new common stock D 1 NP 0 k nc =+ g Example Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and estimated growth is 10%. NP 0 = $60.00 – (.12x 60) = $52.80 3(1+0.10) 52.80 k cs =+.10

57. 57 Computing Cost of Each Source Cost of New Common Stock 3. Compute Cost of Common Equity Cost of new common stock D 1 NP 0 k nc =+ g Example Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and estimated growth is 10%. NP 0 = $60.00 – (.12x 60) = $52.80 3(1+0.10) 52.80 k cs =+.10=.1625 = 16.25%

58. 58 Capital Structure Weights Long Term Liabilities and Equity Weights of each source should reflect expected financing mix Assume a stable financial mix–so use Balance Sheet percentages to calculate the weighted average cost of capital.

59. 59 Capital Structure Weights Long Term Liabilities and Equity Balance Sheet Green Apple Company Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds4,000 Total Assets$12,000Preferred Stock1,000 Common Stock5,000 Total Liabilities and Owners Equity$12,000 Assets Liabilities Firm Raises $10,000 of capital from long term sources

60. 60 Capital Structure Weights Long Term Liabilities and Equity Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds4,000 Total Assets$12,000Preferred Stock1,000 Common Stock5,000 Total Liabilities and Owners Equity$12,000 Assets Liabilities Compute Firm’s Capital Structure (% of each source) Bonds: 4,000 10,000 = 40% Amount of Bonds Total Capital Sources Balance Sheet Green Apple Company

61. 61 Capital Structure Weights Long Term Liabilities and Equity Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds4,000 Total Assets$12,000Preferred Stock1,000 Common Stock5,000 Total Liabilities and Owners Equity$12,000 Assets Liabilities Compute Firm’s Capital Structure (% of each source) Amount of Preferred Stock Total Capital Sources Preferred Stock: 1,000 10,000 = 10% Balance Sheet Green Apple Company

62. 62 Capital Structure Weights Long Term Liabilities and Equity Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds4,000 Total Assets$12,000Preferred Stock1,000 Common Stock5,000 Total Liabilities and Owners Equity$12,000 Assets Liabilities Compute Firm’s Capital Structure (% of each source) Amount of Common Stock Total Capital Sources Common Stock: 5,000 10,000 = 50% Balance Sheet Green Apple Company

63. 63 Capital Structure Weights Long Term Liabilities and Equity Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds4,000 Total Assets$12,000Preferred Stock1,000 Common Stock5,000 Total Liabilities and Owners Equity$12,000 Assets Liabilities 40% 10% 50% When money is raised for capital projects, approximately 40% of the money comes from selling bonds, 10% comes from selling preferred stock and 50% comes from retaining earnings or selling common stock Balance Sheet Green Apple Company

64. 64 Computing WACC Green Apple Company estimates the following costs for each component in its capital structure: Source of Capital Cost Bondskd = 10% Preferred Stockk ps = 11.9% Common Stock Retained Earningsk cs = 15% New Sharesk nc = 16.25% Green Apple’s tax rate is 40%

65. 65 Computing WACC  If using retained earnings to finance the common stock portion the capital structure WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock

66. 66 Balance Sheet Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds (9%)4,000 Total Assets$12,000Preferred Stock (10%)1,000 Common Stock(13%)5,000 Tax Rate = 40% Total Liabilities and Owners Equity$12,000 Assets Liabilities 40% 10% 50% WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock Computing WACC - using Retained Earnings

67. 67 Balance Sheet Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds (10%)4,000 Total Assets$12,000Preferred Stock (11.9%)1,000 Common Stock(15%)5,000 Tax Rate = 40% Total Liabilities and Owners Equity$12,000 Assets Liabilities 40% 10% 50% WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock Computing WACC - using Retained Earnings WACC =.40 x 10% (1-.4)

68. 68 Balance Sheet Assets Liabilities 40% 10% 50% WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock Computing WACC - using Retained Earnings WACC =.40 x 10% (1-.4) +.10 x 11.9% Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds (10%)4,000 Total Assets$12,000Preferred Stock (11.9%)1,000 Common Stock(15%)5,000 Tax Rate = 40% Total Liabilities and Owners Equity$12,000

69. 69 Balance Sheet Assets Liabilities 40% 10% 50% WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock Computing WACC - using Retained Earnings WACC =.40 x 10% (1-.4) +.10 x 11.9% +.50 x 15% Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds (10%)4,000 Total Assets$12,000Preferred Stock (11.9%)1,000 Common Stock(15%)5,000 Tax Rate = 40% Total Liabilities and Owners Equity$12,000

70. 70 Balance Sheet Assets Liabilities 40% 10% 50% WACC =.40 x 10% (1-.4) +.10 x 11.9% +.50 x 15% = 11.09% WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock Computing WACC - using Retained Earnings Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds (10%)4,000 Total Assets$12,000Preferred Stock (11.9%)1,000 Common Stock(15%)5,000 Tax Rate = 40% Total Liabilities and Owners Equity$12,000

71. 71 Computing WACC  If use newly issued common stock, use k nc rather than k cs for the cost of the equity portion. WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock k nc

72. 72 Balance Sheet Assets Liabilities WACC =.40 x 10% (1-.4) +.10 x 11.9% +.50 x 16.25% = 11.72% WACC= k 0 =%Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock Computing WACC - using New Common Shares Current Assets$5,000Current Liabilities$2,000 Plant & Equipment 7,000Bonds (10%)4,000 Total Assets$12,000Preferred Stock (11.9%)1,000 Common Stock(16.25%)5,000 Tax Rate = 40% Total Liabilities and Owners Equity$12,000

73. 73 Weighted Marginal Cost of Capital A firm’s cost of capital will change as it is raises more and more capital  Retained earnings will be used up at some level  The cost of other sources may rise beyond a certain amount of money has been raised

74. 74 Weighted Marginal Cost of Capital A firm’s cost of capital will changes as it is raising more and more capital  Retained earnings will be used up at some level  The cost of other sources may rise beyond a certain amount of money raised  Therefore, beyond a point, the WACC will rise. Calculate the point at which the cost of capital increases

75. 75 Weighted Marginal Cost of Capital A firm’s cost of capital will changes as it is raising more and more capital  Retained earnings will be used up at some level  The cost of other sources may rise beyond a certain amount of money raised Calculate the point at which the cost of capital increases Break in cost of capital curve Amt of lower cost capital that can be raised before component cost rises Weight of this kind of capital in the capital structure =

76. 76 Weighted Marginal Cost of Capital Break in cost of capital curve Retained earnings available for reinvesting Percentage of common financing = If Green Apple Company has $100,000 of internally generated common:

77. 77 Weighted Marginal Cost of Capital Break in cost of capital curve Retained earnings available for reinvesting Percentage of common financing = If Green Apple Company has $100,000 of internally generated common: Break in cost of capital curve $100,000.50 =

78. 78 Weighted Marginal Cost of Capital Break in cost of capital curve Retained earnings available for reinvesting Percentage of common financing = If Green Apple Company has $100,000 of internally generated common: Break in cost of capital curve $100,000.50 = = $200,000

79. 79 Weighted Marginal Cost of Capital Break in cost of capital curve Retained earnings available for reinvesting Percentage of common financing = If Green Apple Company has $100,000 of internally generated common: Break in cost of capital curve $100,000.50 = = $200,000 Once $200,000 is raised from all sources, the cost of capital will rise because all the lower cost retained earnings will be used up.

80. 80 Weighted Marginal Cost of Capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 0100,000200,000300,000 400,000 Marginal weighted cost of capital curve: 11.09% Cost of Capital using internal common stock

81. 81 Weighted Marginal Cost of Capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 0100,000200,000300,000 400,000 Marginal weighted cost of capital curve: 11.09% Break-Point for common equity

82. 82 Weighted Marginal Cost of Capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 0100,000200,000300,000 400,000 Marginal weighted cost of capital curve: 11.09% Cost of Capital using internal common stock 11.72% Cost of Capital using new common equity

83. 83 Weighted Marginal Cost of Capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 0100,000200,000300,000 400,000 Marginal weighted cost of capital curve: 11.09% 11.72%

84. 84 Making Decisions Choosing Projects Using Weighted Marginal Cost of Capital  Graph IRR’s of potential projects Weighted Cost of Capital Total Financing 9% 10% 11% 12% 0100,000200,000300,000 400,000 Marginal weighted cost of capital curve: Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR = 11.5%

85. 85 Making Decisions Choosing Projects Using Weighted Marginal Cost of Capital  Graph IRR’s of potential projects  Graph Weighted Marginal Cost of Capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 0100,000200,000300,000 400,000 Marginal weighted cost of capital curve: Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR = 11.5%

86. 86 Making Decisions Choosing Projects Using Weighted Marginal Cost of Capital  Graph IRR’s of potential projects  Graph Weighted Marginal Cost of Capital  Choose projects whose IRR is above the weighted marginal cost of capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 0100,000200,000300,000 400,000 Marginal weighted cost of capital curve: Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR = 11.5% Accept Projects #1 & #2

87. 87