1. 11 Chapter Cost of Capital Based on: Terry Fegarty Carol Edwards,
Lawrence J. Gitman
April 18, 2005
McGraw-Hill Ryerson
©2003 McGraw-Hill Ryerson Limited

2. Chapter 11 - Outline Cost of Capital Weighted Average Cost of capital
PPT 11-2
Chapter 11 - Outline
Cost of Capital
Cost of Debt
Cost of Preferred Stock
Cost of Common Equity:
Common Stock
Retained Earnings
Weighted Average Cost of capital
Optimum Capital Structure
Marginal Cost of Capital
Summary and Conclusions

3. Cost of Capital
For Investors/Creditors, the rate of return on a security is a benefit of investing/lending.
For the Firms, that same rate of return is a cost of raising funds that are needed to operate the firm or finance a project.
In other words, the cost of raising funds is the firm’s cost of capital.

4. Cost of Capital
The cost of capital is an extremely important financial concept. Why?
It acts as the major link between the firm’s long-term investment (Capital Budgeting) decisions and the wealth of the owners as determined by investors/lenders in the marketplace.
It is in effect the “magic number” that is used to decide whether a proposed corporate investment will increase or decrease the firm’s stock price.
Clearly, only those investment projects whose expected returns greater than the cost of funds used to acquire the projects would be recommended.

5. How does a firm raise capital?
A firm raises capital through issuance of :
Bonds
Preferred Stock
Common Stock
Each of these offers a rate of return to investors/creditors.
This return is a cost to the firm.
“Cost of capital” actually refers to the overall cost of capital - a weighted average after-tax cost of financing sources.
WACC = Weighted Average Cost of Capital

6. Cost of Debt For the issuing firm, the cost of debt is:
the rate of return required by lenders,
adjusted for flotation costs (any costs associated with issuing new bonds), and
adjusted for taxes.

7. Cost of Debt This after-tax cost of debt is calculated as: Where:
kd = cost of debt
Y = the yield to maturity on new debt sold
t = the firm’s tax rate
F = flotation or selling cost, % of funds raised

8. Example: Cost of Debt
Prescott Corporation issues a $1,000 par, 20-year bond paying the market rate of 10%. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond (5% of par). Tax rate is 34%.
What is the after-tax cost of debt for Prescott Corporation?

9. Example: Cost of Debt After-tax cost of debt: kd = kd (1 - T)/1-0.05

10. Cost Preferred Stock We already know about preferred stock that:
it has a fixed dividend (similar to debt)
it has no maturity date
its dividends are not tax deductible and are expected to be perpetual or infinite
Finding the cost of preferred stock is similar to finding the rate of return, (from Chapter 10) except that we have to consider the flotation costs associated with issuing preferred stock.

11. Cost Preferred Stock
To find the cost of issuing preferred stock, we use the following formula:
Where:
kP = cost of preferred stock
PP = price per share of the proposed preferred stock issue
DP = annual dividend on preferred stock
F = flotation or selling cost

12. Example: Cost of Preferred
If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?
Solution:

13. Cost of Common Stock There are two forms of common equity financing:
1. Reinvested profits (retained earnings); and
2. New issues of common shares.
The Cost of Common Equity, ke, is the required rate of return on common stock and, as such, represents the minimum acceptable rate of return on the equity-financed portion of new projects.

14. Cost of Common Stock
By retaining earnings, the company is using common shareholders’ funds.
The Cost of Retained Earnings (Reinvested Profits), kr, is equal to the cost of common equity, ke, as follows:
kr = ke
Therefore, Cost of Retained Earnings is equivalent to the Cost of Common Stock. These two are popularly measured using the following methods:
1. Constant-Growth Dividend Valuation Model (DVM) or Gordon Model
2. The Capital Asset Pricing Model (CAPM)

15. Cost of Common Stock
Unlike Cost of New Common Stock, it is not necessary to adjust the Cost of reinvested profits for flotation costs, because these costs are not incurred.
Cost of New Common Stock also uses the DVM Model but takes into account Flotation Costs and other selling costs.
Since dividends are paid from after-tax income, no tax adjustment is required.

16. Cost of Common Stock and Retained Earnings – DVM Model
The cost of Retained Earnings or Common Stock is measured by the following formula:
Where:
ke = the cost of equity in the form of retained earnings
D1 = expected dividend at the end of year 1
P0 = current stock price
g = the expected compound annual dividend growth rate

17. Cost of Common Stock and Retained Earnings – Example using the DVM Model
Du Pont’s dividends grew at a 14.5% compound annual rate from The company paid dividends of $1.23 a share in 2004, and the stock price was $60.06 a share at year end.
Solution:

18. Cost of Common Stock and Retained Earnings – Limitations of the DVM Model
Inappropriate for those firms that either pay no dividends or have erratic dividend payments.
Past dividend growth rates may not be a good predictor of future dividends.

19. Cost of Common Stock and Retained Earnings - CAPM
Where:
kj = the cost of equity
rf = the risk free rate
j = measure of a firm’s common stock performance versus the market performance
rm - rf = the market risk premium

20. Cost of Common Stock and Retained Earnings – Example Using CAPM
Dupont Common Stock rate of return is 6.0%. Its beta is 1.10, and the market risk premium is 7.4%.
Solution:
kj = Rf + b j  (km - Rf)
= 6.00% + 1.1(7.4)
= 14.14%

21. Cost of Common Stock and Retained Earnings- Comparing CAPM and DVM
CAPM directly considers risk, as reflected by beta, in determining the cost of capital.
DVM does not look at risk directly, but uses the market price, P0, as a reflection of the expected risk-return preference of investors.
DVM approach more often used as required data is more readily available.

22. Cost of New Common Stock
The cost of New Common Shares, kn, is determined by calculating the cost of common shares, net of discounts and associated flotation costs.
Where:
kn = the cost of new common stock
D1 = expected dividend at the end of year 1
P0 = current stock price
Pn = net proceeds received on a new share issue after floatation costs
g = the expected compound annual dividend growth rate

23. Cost of New Common Stock – Example Using DVM
Murray Motor Company wants you to calculate its cost of new common stock. During the next 12 months, the company expects to pay dividends (D1) of $2.50 per share. The current price of its common stock is $50.00 per share. The expected growth rate is 8% and flotation cost is $3.00 per share.
Solution:

24. Weighted Average Cost of Capital
The Weighted Average Cost of Capital (WACC), ka, reflects the expected average future cost of funds.
Regardless of the particular source of funds for a project, a firm must use WACC as its required rate or discount rate.
WACC is computed using the following formula:
where
wd = proportion of long-term debt in capital structure
wp = proportion of preferred equity in capital structure
we = proportion of common equity in capital structure
wd + wp + we = 1.0

25. Weighted Average Cost of Capital
A firm’s Weighted Average Cost of Capital (WACC) is determined by a firm’s target capital structure.
Assets Liabilities & Equity
Current assets Current Liabilities
Long-term debt
Preferred Stock
Common Equity }
Capital Structure

26. Weighted Average Cost of Capital
Capital structure is the firm’s mix of debt and equity financing.
We measure the cost of capital using the market value of the financing, not the book value.

27. Weighted Average Cost of Capital
Baker Corporation’s WACC
(1) (2) (3)
Cost Weighted
(after tax) Weights Cost
Debt Kd 6.55% % 1.97%
Preferred stock Kp
Common equity
(retained earnings) Ke
Weighted average
cost of capital Ka %

28. Optimum Capital Structure
PPT 11-8
Optimum Capital Structure
The optimum (best) capital structure is associated with the minimum overall cost of capital:
Optimum capital structure means the lowest WACC
Usually occurs with 40-70% debt in a firm’s capital structure
WACC (or the required rate of return or the discount rate) based on optimum capital structure is the rate where value of shareholder’s wealth is maximized.
Based upon the market value rather than the book value of the firm’s debt and equity

29. Optimum Capital Structure
Cost Weights Weighted Cost
(after-tax)
Financial Plan A:
Debt % % %
Equity
10.9%
Financial Plan B:
Debt % % %
Equity
10.3%
Financial Plan C:
Debt % % %
Equity
11.4%

30. Figure 11-1 Cost of capital curve
PPT 11-9
Figure 11-1 Cost of capital curve
Cost of capital (percent)
Cost of equity
Weighted average cost of capital
U-shaped
Cost of debt
Minimum point for cost of capital 40 80
Debt-equity mix (percent)

31. Investment Opportunities Schedule (IOS)
The Investment Opportunities Schedule (IOS) is a ranking of investment possibilities from best (highest return) to worst (lowest return).
Investment projects available to the Baker Corporation
Expected Cost
Projects Returns ($ millions)
A % $10 B C D E F G H
$95

32. PPT 11-13
Figure 11-3 Cost of capital and investment projects for the Baker Corporation
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
Percent 50 39
Amount of capital ($ millions)
10.26% 95
Weighted average cost of capital Ka A B C D E F G H

33. Marginal Cost of Capital
PPT 11-14
Marginal Cost of Capital
Baker Corp has $23.4 M in retained earnings.
After $23.4 of RE is exhausted, in order to maintain its capital structure, the firm must resort to new common equity financing, raising cost of equity financing.
This new WACC is known as the Marginal Cost of Capital, kmc.
The Marginal Cost of Capital (MCC) is the firm’s average cost of capital associated with its next dollar of total new financing.
This happens because as the volume of financing increases, the costs of various types of financing will increase, raising the firm’s weighted average cost of capital.

34. Marginal Cost of Capital
PPT 11-14
Marginal Cost of Capital
To calculate MCC, we must calculate the Break Points that reflect the level of new financing at which the cost of one of the financing components rises.
Where: BPj = break point for financing source j
AFj = amount of funds available from financing source j at a given cost
wj = capital structure weight for financing source j
Once the break points have been determined, the next step is to calculate the weighted average cost of capital over the range of total new financing between break points.
First, calculate the WACC for the level of total new financing between zero and the first break point.
Next, calculate the MCC for a level of financing between the first and second break point, and so on.

35. Calculating Marginal Cost of Capital
Baker Corp has $23.4 M in retained earnings. At 60% equity financing, retained earnings of $23.4 M will be exhausted once total investments reach $39.0 M
Furthermore, the cost of debt of 6.55% applies only to the first $15 M of debt the firm raises. After that, the after-tax rate rises to 7.9%

36. Marginal Cost of Capital
PPT 11-14
Marginal Cost of Capital
First $39 Million Next $11 Million
(1 M -39 M) (over $39 M - $50 M)
A/T Weighted A/T Weighted
Cost Wts Cost Cost Wts Cost
Debt Kd 6.55% % Debt Kd % %
Preferred. . Kp Preferred . Kp
Common Common
equity *. . Ke equity † . . Kn
Ka = % Kmc = %
*Retained earnings †New common equity

37. Table 11-6 Cost of capital for increasing amounts of financing
PPT 11-15
Table 11-6 Cost of capital for increasing amounts of financing
Over $50 Million
Cost Weighted
(after tax) Weights Cost
Debt (higher cost) Kd % %
Preferred stock Kp
Common equity
(new common stock) Kn Kmc = 11.46%

38. Using MMC and IOS in Decision-Making
When a project’s expected return (internal rate of return) is greater than the marginal cost of new financing, the project should be accepted.
Firms may accept projects up to the point at which the marginal return on its investment equals its marginal cost of capital.

39. Figure 11-4 Marginal cost of capital and Baker Corporation investment alternatives
PPT 11-16
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
Percent 50 39
Amount of capital ($ millions)
11.46% 95
Marginal cost of capital
Kmc A B C D E F G H
11.06%
10.26%

40. Table 11-7 Cost of components in the capital structure
PPT 11-17
Table 11-7 Cost of components in the capital structure
Yield = 10.74%
T = Corporate tax rate, 39%
Dp = Preferred dividend, $10.50
Pp = Price of preferred stock, $100
F = Flotation costs, $4
D1 = First year common dividend, $2
Pc = price of common stock, $40
g = growth rate, 7%
Same as above, with Pn =$36.00
F = Flotation costs, $4,
1. Cost of debt Kd = Yield (1-T) = 6.55%
2. Cost of preferred stock
3. Cost of common equity
(retained earnings)
4. Cost of new common stock

41. Summary and Conclusions
PPT 11-31
Summary and Conclusions
The cost of debt is the effective interest rate (yield to maturity)
the cost of preferred stock is the dividend rate (yield) that must be paid to investors
The cost of common shares is the current dividend rate (yield) plus the anticipated future rate of growth
The cost of capital from retained earnings is the required rate of return on the common stock
The marginal cost of capital is the cost of the next dollar of financing required
The cost of capital represents the overall cost of future financing to the firm
It is a weighted average of the costs of the various source of funds available
It represents the minimum acceptable return from an investment