Corporate Finance Dr.

Ridha ESGHAIER

CHAPTER 3
The Cost of Capital

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Fall 2020
 Dr. Ridha ESGHAIER

Chapter PLAN

1- Sources of capital
A- Cost of Debt (rd)
B- Cost of Preferred Stock (rp)
C- Cost of Common Equity
• Cost of retained earnings (rs)
• Cost of New common stock (re)
2- Estimating Weights for the Capital Structure
3- Adjusting for flotation costs
4- Calculating the WACC
5- WACC and Project’s risk

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Dr. Ridha ESGHAIER Introduction
• A company grows by making investments that are expected to
increase revenues and profits. The company acquires the capital
or funds necessary to make such investments by borrowing or
using funds from owners. By applying this capital to investments
with long- term benefits, the company is producing value today.
• The Value produced depends not only on the investments’
expected future cash flows but also on the cost of the funds.
Borrowing is not costless. Neither is using owners’ funds.
• The cost of this capital is an important ingredient in both
investment decision making by the company’s management and
the valuation of the company by investors.
– If a company invests in projects that produce a return in excess of the cost
of capital, the company has created value;
– in contrast, if the company invests in projects whose returns are less than
the cost of capital, the company has actually destroyed value.
Therefore, an accurate estimation of the company’s cost of
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capital is a central issue in corporate financial management.
 The weighted average cost of capital
(WACC) Dr. Ridha ESGHAIER

• The cost of capital is the rate of return that the suppliers of capital —
bondholders and owners—require as compensation for their contribution of
capital. Another way of looking at the cost of capital is that it is the
opportunity cost of funds for the suppliers of capital.
• If a firm’s only investors were common stockholders, then its cost of capital
would be the required rate of return on its equity.
• Most firms employ different types of capital, including issuing equity, debt, and
instruments that share characteristics of debt and equity. And because of their
differences in risk, the different sources selected have different required rates
of return (different cots).
• The required rate of return on each capital component is called its component
cost.
• The cost of capital used to determine the firm’s intrinsic value or to analyze
capital budgeting decisions is found as a weighted average of the various
components’ costs, called the weighted average cost of capital, or WACC.
• Cost of capital estimation is a challenging task. the cost of capital is not
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observable but, rather, must be estimated.
 Dr. Ridha ESGHAIER

Uses of the Cost of Capital

• In the introductive chapter, we said that managers should strive
to make their firms more valuable. The value of a firm is
determined by the size, timing, and risk of its free cash flows
(FCF). Indeed, a firm’s intrinsic value is found as the present value
of its FCFs, discounted at the weighted average cost of capital
(WACC).
• In addition, the cost of capital (WACC) is used primarily to make
investment decisions, and these decisions depend on projects’
NPVs computed using the cost of capital that will be used to
finance those projects.
• In previous chapters, we examined the major sources of
financing (stocks, bonds, and preferred stock) and the costs of
those instruments (the required rates of return by investors).
• In this chapter, we put those pieces together and estimate the
weighted average cost of capital (WACC). 5
 Dr. Ridha ESGHAIER

Valuation & the Cost of Capital

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 What sources of long-term
capital do firms use?
• Capital components are sources of funding that come from
investors. They include: Long-Term
Capital

– Long-term debt Long-Term Preferred Common

– Preferred stock Debt Stock Stock

– Common equity (retained earnings and/or New common stock) Retained

Earnings
New Common
Stock

• Accounts payable, accruals, and deferred taxes are not sources

of funding that come from investors. Instead, they arise from
operating relationships with suppliers and employees so they
are not included in the calculation of the cost of capital. Such
funds are not included when calculating free cash flows, and
they are not included when we calculate the amount of capital
needed in a capital budgeting analysis. Therefore, they should
not be included when we calculate the WACC.
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Dr. Ridha ESGHAIER
 Dr. Ridha ESGHAIER

Calculating the weighted

average cost of capital
WACC = wdrd(1-T) + wprp + wsrs + were

• wd , wp ,ws and we refer, respectively, to the

proportion of debt, preferred stock, retained earnings
and new common stock the firm plans to use in its
capital structure (weights).
• The r ’s refer to the cost of each component.
– rd: the cost of LT debt
– rp: the cost of Preferred stock
– rs: the cost of retained earnings
– re: the cost of new common stock issued (external equity)
• T is the firm’s marginal Tax rate
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 Dr. Ridha ESGHAIER

Should our analysis focus on before-

tax or after-tax capital costs?

– Tax effects associated with financing can be

incorporated either in capital budgeting cash flows
or in cost of capital.
• Stockholders focus on A-T cash flows. Therefore,
we should focus on A-T capital costs, i.e. use A-T
costs of capital in WACC.
• Only cost of debt is affected. rd needs
adjustment, because interest is tax deductible.

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 Dr. Ridha ESGHAIER
Should we focus on historical (embedded) costs
or new (marginal) costs?
• Because we are using the cost of capital in the evaluation of
investment opportunities, we are dealing with a marginal
cost—what it would cost to raise additional funds for the
potential investment project. Therefore, the cost of capital that
the investment analyst is concerned with is a marginal cost.
• In financial management the cost of capital (WACC) is used
primarily to make investment decisions, and these decisions
depend on projects’ expected future returns versus the cost of
the new, or marginal, capital that will be used to finance those
projects
So, we should focus on marginal costs.
• The WACC is also referred to as the Marginal Cost of Capital
(MCC) because it is the cost that a company incurs for
additional capital. 10
 Dr. Ridha ESGHAIER

A- Component cost of debt,

rd(1-T)
WACC = wdrd(1-T) + wprp + wsrs + were

• The first step in estimating the cost of

debt is to determine the rate of return
debtholders require, or rd
• rd is the marginal cost of debt capital.
• The yield to maturity on new L-T debt is
often used as a measure of rd.
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 Dr. Ridha ESGHAIER

Why tax-adjust?
why rd (1-T)?
• The required return to debtholders, rd, is not equal to the
company’s cost of debt for the company because interest
payments are deductible, which means the government in
effect pays part of the total cost.
• The marginal cost of debt financing is the cost of debt
after considering the allowable deduction for interest on
debt based on the country’s tax law.
• As a result, the weighted average cost of capital is calculated
using the after-tax cost of debt, rd(1 −T), which is the interest
rate on debt, rd, less the tax savings that result because interest
is deductible. Here T is the firm’s marginal tax rate

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 Dr. Ridha ESGHAIER
Component Cost of Debt
After-tax component cost of debt = Before tax Interest rate (1− Tax rate)

A-T rd = B-T rd (1-T)

Example 1:
• Suppose a company pays $1 million in interest on its $10 million
of debt. The cost of this debt for the company is not $1 million
because this interest expense reduces taxable income by
$1 million, resulting in a lower tax (since EBT = EBIT – Interest
charges).
• If the company has a marginal tax rate of 40% percent, this
$1 million of interest costs the company ($1 million)(1 - 0.4) =
$0.6 million because the interest reduces the company’s tax bill
by $0.4 million (= interest x T). In this case,
o the before-tax cost of debt is: $1million)/(€10 million) = 10%,
o whereas the after- tax cost of debt is ($0.6 million)/(€10 million)
= 6%, which can also be calculated as 10%(1 – 0.4).
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 Dr. Ridha ESGHAIER
Application 1: A company issues a bond to finance a new
project. It offers a 15-year, $1,000 face vale, 12% semiannual
coupon bond. Upon issue, the bond sells for $1,153.72. Tax=40%.
1. What is the cost of debt (rd)?
2. Calculate the After-Tax cost of debt.
Solution:
1. Cost of bond is rd solving:
INT  1 - (1 + rd /2) -2N  Par Value
PV B =   +
2  rd /2  (1 + rd /2) 2N

INT/2 = 12%x1,000 /2 =60 ; 2N = 2x15 = 30 ; PVB= $1,153.72 ; par value = 1,000

 1 - (1 + rd /2) -30  1, 000
$ 1,153 . 72 = 60   +
 r d / 2  (1 + r d /2 ) 30

rd/2 = 5% The bond’s annual Cost= 2x5% = 10%.

2. interest is tax deductible, so:
A-T rd = B-T rd (1-T)
= 10% (1 - 0.40) = 6% 14
 Dr. Ridha ESGHAIER

B- Component cost of
preferred stock rP

WACC = wdrd(1-T) + wprp + wsrs + were

• rp is the marginal cost of preferred stock,

which is the Nominal return investors
require on a firm’s preferred stock.
• Preferred dividends are not tax-deductible,
so no tax adjustments necessary. Just use
nominal rp.

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 Dr. Ridha ESGHAIER

Comments about
Preferred Stocks

• Preferred stock trades the same way as common stock, usually

through a brokerage firm and with the same transaction costs.
Because the properties generally associated with these stocks will
affect the way investors value them, the prices of common and
preferred stocks offered by the same company will differ.
Preferred stocks tend to be more stable because of the regular
income stream, while common stock can be more volatile.
• Because the dividends received by preferred stockholders are
fixed at the outset, the value of preferred stock is affected more
by interest rate fluctuations than by the company’s performance.

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 Dr. Ridha ESGHAIER

What is the cost of preferred stock?

A preferred stock pays a fixed dividend in perpetuity.
That’s why we use the constant dividend model to
valuate it. P =D /r
p p p

• The cost of preferred stock can be solved

by using this formula:
r p = D p / Pp

Application 2 : What’s the cost of a preferred

stock if its current price PP = $111.10 and it
pays quarterly dividend DQ of $2.5?
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 Dr. Ridha ESGHAIER

Solution 2
0
rp = ?
1/4 1/2 3/4 1year
∞
...
PP=$111.1 2.50 2.50 2.50 2.50 2.50

DQ $ 2 .50
PP = ⇒ $ 111 .10 =
rP rP
$ 2 . 50
Quartely rP = = 2 . 25 %
$ 111 . 10

⇒ Annual rp = 4 × 2.25% = 9%
annual Div 4 × $2.50
or annual rP = = = 9%
PP $111.10 18
 Dr. Ridha ESGHAIER
Example 2:
You have been asked by a company to calculate its cost of
preferred equity and have recently obtained the following
information:
• The issue price of preferred stock was $3.5 million and the
preferred dividend is 5%.
• If the company issued new preferred stock today, the preferred
coupon rate would be 6.5%.
• The company’s marginal tax rate is 40%.
What is the cost of preferred equity?
Solution:
If the company were to issue new preferred stock today, the
coupon rate would be close to 6.5%. The current terms thus
prevail over the past terms when evaluating the actual cost of
preferred stock. The cost of preferred stock is, therefore, 6.5%.
Because preferred dividends offer no tax shield, there is no
adjustment made based upon the marginal tax rate. 19
 Dr. Ridha ESGHAIER

C- Component cost of
Common equity
Companies can raise common equity in two ways:
(1) Indirectly, by reinvesting earnings that are not
paid out as dividends (retaining earnings).
(2) Directly, by issuing and selling new shares of
common stock to the public.

We use the symbol rs to designate the cost of retained

earnings and re to designate the cost of new common stock
issued (e for external equity)
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 Cost of new Common stock re
and retained earnings rS
WACC = wdrd(1-T) + wprp + wsrs + were

• re is the rate of return investors require on the

firm’s common equity using new common
stocks.
• rs is the marginal cost of common equity using
retained earnings.

As we will see, re is equal to rs plus a factor that

reflects the cost of issuing new stock
Dr. Ridha ESGHAIER 21
 Dr. Ridha ESGHAIER

Why is there a cost for

retained earnings?
Some have argued that retained earnings should be “free” because
they represent money that is “left over” after dividends are paid.
While it is true that no direct costs are associated with retained
earnings, this capital still has a cost, an opportunity cost.
The firm’s after-tax earnings belong to its stockholders. Bondholders
are compensated by interest payments; preferred stockholders, by
preferred dividends.
But the net earnings remaining after interest and preferred dividends
belong to the common stockholders, and these earnings serve to
compensate them for the use of their capital. The managers, who
work for the stockholders, can either pay out earnings in the form of
dividends or retain earnings for reinvestment in the business.
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 Dr. Ridha ESGHAIER

When managers make decision, they should recognize that

there is an opportunity cost involved. Stockholders could
have received the earnings as dividends and invested this money
in other stocks, in bonds, in real estate, or in anything else.
Therefore, the firm needs to earn at least as much on any
earnings retained as the stockholders could earn on alternative
investments of equivalent risk.
Therefore, if the firm cannot invest retained earnings to earn at
least the required rate of return on an equivalent risk stock, it
should pay those funds to its stockholders and let them invest
directly in stocks or other assets that will provide that return.

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 Dr. Ridha ESGHAIER

Remember…

• Earnings can be reinvested or paid out as dividends.

• Investors could buy other securities and earn a
return.
• Thus, if earnings are retained, there is an
opportunity cost
• The opportunity cost is the return that stockholders
could earn on alternative investments of equal risk.

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 Dr. Ridha ESGHAIER

What is the opportunity cost?

• The answer is the required rate of return on the company’s
common stocks, because stockholders could presumably earn
that return by simply buying the stock of the firm in question or
that of a similar firm. Therefore, the cost of common equity
raised internally as reinvested earnings rs is approximated by
the required return on the company’s common stocks.
• The firm needs to earn on its retained earnings at least as much
as stockholders could earn on alternative investments of
comparable risk.
• If a company can’t earn at least rs on reinvested earnings, then
it should pass those earnings on to its stockholders and let
them invest the money themselves in assets that do yield rs
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 Dr. Ridha ESGHAIER

Methods to estimate the cost of equity

from retained earnings rs
As we have mentioned previously, the cost of retained
earnings is linked to the required rate of return on the
company’s common stocks rs. Three ways to determine
the cost of common equity from retained earnings, rs.
• (1) CAPM: rs = RRF + β(RM – RRF)
• (2) DCF: rs = (D1 / P0) + g
• (3) Own-Bond-Yield Plus Risk-Premium:
rs = rd + RP

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 (1) Capital Asset Pricing Model Approach
In the capital asset pricing model (CAPM) approach, we use the basic relationship from
the capital asset pricing model theory that the expected return on a stock, E(Ri), is the
sum of the risk- free rate of interest, RRF, and a premium for bearing the stock’s market
risk, βi(E(RM) – RRF).
E(Ri)= RRF + βi(E(RM) – RRF )
• βi = the return sensitivity of stock i to changes in the market return
• E(RM) = the expected return on the market
Dr. Ridha ESGHAIER
• E(RM) – RRF = the expected market risk premium
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk
The time value of money is represented by the risk-free rate (RRF) in the formula and
compensates the investors for placing money in a riskless investment over a period
of time. RRF usually refers to an asset that has no default risk (the Treasury bonds
yield)
The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking an additional risk. This is calculated by
taking a risk measure (beta) based on how the returns of the stock co-move with
the overall market over a period of time, multiplied by the market premium (RM –
RRF).
In general, the selection of the appropriate risk- free rate should be guided by the
duration of projected cash flows. If we are evaluating a project with an estimated useful 27
life of 10 years, we may want to use the rate on the 10- year Treasury bond.
 Dr. Ridha ESGHAIER

The CAPM Approach

Application 3: If the treasury bond yield as
estimation of the risk free rate rRF is 7%, the
market risk premium RPM = (RM – RRF) is 6%,
and the firm’s beta is 1.2, what’s the cost of
its common equity based upon the CAPM?

Solution:
rs = RRF + β(RM – RRF)

rS = 7.0% + 1.2x (6.0%) = 14.2%

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 Dr. Ridha ESGHAIER

(2) The Discounted CF approach

• In the previous chapter, we saw that if the marginal investor expects
dividends to grow at a constant rate “g” and if the company makes all
payouts in the form of dividends, then the price of a stock, P0, can be
found as follows: D1
P0 =
r̂ s - g
• Assuming the stock is in equilibrium, we can solve for rs to obtain the
required rate of return on common equity, which for the marginal
investor is also equal to the expected rate of return:
D1
⇒ r̂s = rs = + expected g
P0
Could DCF methodology be applied if g is not constant?
YES, non-constant g stocks are expected to have constant g at some
point, generally in 5 to 10 years. (use the multistage technique)

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 Dr. Ridha ESGHAIER
Application 4: If D0 =$4.19, P0=$50, and g=5%,
what’s the cost of common equity based upon the
DCF approach?
Solution:
D1 = D0 (1 + g) =$4.19 (1 + 5%)
D1 = $4.3995

rs = (D1 / P0) + g
= ($4.3995 / $50) + 0.05
= 13.8%
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 Dr. Ridha ESGHAIER

Estimating the expected sustainable growth

rate “g”

The expected sustainable growth rate is difficult to

estimate, this can be done using:
• The historical growth rate if you believe the
future will be like the past.
• The analysts’ estimates and forecasts (forecasted
growth rate from a published source or vendor)
• The earnings retention model, illustrated on next
slide.

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 The expected sustainable growth rate using the
Earning Retention Model
• Most firms pay out some of their net income as dividends and
reinvest, or retain, the rest. The more they retain, and the
higher the earned rate of return on those retained earnings,
the larger their growth rate.
• the earnings growth rate depends on the amount of income
the firm retains and the rate of return it earns on those
retained earnings, and the retention growth equation can be
expressed as follows:
g = ROE x Retention ratio
= ROE x ( 1 – Payout ratio)
= ROE x ( 1 – D/EPS)
where D/EPS represents the assumed stable dividend payout
ratio (dividend/earnings per share) and ROE is the historical
return on equity.
Dr. Ridha ESGHAIER 32
 Dr. Ridha ESGHAIER

Application 5:
The firm has been earning 15% on equity (ROE = 15%)
and retaining 35% of its earnings (dividend payout =
65%). This situation is expected to continue.
Calculate the earnings (and Dividend) growth rate
Solution:
g = ROE x ( 1 – Payout )
= 15% x (0.35)
= 5.25%
Very close to the g that was given before.

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 (3) The own-bond-yield plus risk-premium
method Dr. Ridha ESGHAIER

In situations where reliable inputs for the CAPM and the dividend
discount model approach are not available (as would be true for a
closely held company), some analysts use a subjective, ad hoc
procedure to estimate a firm’s cost of common equity based on the
fundamental tenet in financial theory that the cost of capital of riskier
cash flows is higher than that of less risky cash flows. They simply add
to the before-tax cost of debt, rd, a judgmental risk premium of 3% to
5% that captures the additional yield on a company’s stock relative to
its bonds.
rs = Company’s own + Judgmental risk
bond yield premium

• This Risk Premium is not the same as the CAPM RPM.

• This method produces a ballpark estimate of rs, and can
serve as a useful check. 34
 Application 6:

If rd = 10% and Risk Premium is 4%, what is rs using

the own-bond-yield plus risk-premium method?

Solution:

rs = Company’s own + Judgmental risk

bond yield premium
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%

Dr. Ridha ESGHAIER

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 Dr. Ridha ESGHAIER

What is a reasonable final

estimate of rs?
Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average rs 14.0%
These results are unusually close, so it would make little difference which
one we used. However, if the methods produced widely varied estimates, then a
financial analyst would have to use his own best judgment regarding the relative
merits of each estimate and then choose one that seemed reasonable under
the circumstances.
Recent surveys indicate that the CAPM is by far the most widely used
method. 36
 Dr. Ridha ESGHAIER

Flotation costs
• When a company raises new capital, it generally seeks
the assistance of investment bankers. Investment
bankers charge the company a fee based on the size
and type of offering. This fee is referred to as the
flotation cost. It includes expenses such as
underwriting fees, legal fees and registration fees.
• In the case of debt and preferred stock, we do not
usually incorporate flotation costs in the estimated cost
of capital because the amount of these costs is quite
small, often less than 1%.
• However, with equity issuance, the flotation costs may
be substantial, so we should consider these when
estimating the cost of external equity capital
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 Dr. Ridha ESGHAIER

Why is the cost of retained earnings rs cheaper

than the cost of issuing new common stock re?

• When a company issues new common stock they

also have to pay flotation costs.
• Flotation costs are paid by the company that issues
the new securities.
• Also, issuing new common stock may send a
negative signal to the capital markets, which may
depress the stock price.

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 Dr. Ridha ESGHAIER

- Because no flotation costs are involved, retained

earnings cost less than new stock. Therefore, firms
should utilize retained earnings to the greatest extent
possible.
- However, if a firm has more good investment
opportunities than can be financed with retained
earnings plus the debt and preferred stock supported by
those retained earnings, it may need to issue new
common stock.

The total cost of the new stocks issued is the

investor’s required return plus the flotation cost
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 Flotation-adjusted cost of Equity
Example 3: Dr. Ridha ESGHAIER

Suppose that the required rate of return on the company’s stock (= cost of
retained earnings rs from the CAPM) is 13.6%. Based on this information, and
given an estimated growth rate of dividend g= 8.3% and a D1 = $1.25, the intrinsic
value of the stock P0 = D1/(rs-g) = 1.25/(13.6% - 8.3%) = $23.58
So, the approximated issuing value P0 of new shares = $23.58
Suppose that the flotation costs F represent 10% of the stock price P0.
Therefore, the firm actually keeps only 90% of the amount that investors supplied.
amount received per issued stock = P0 x(1-F) = $21.222
The question is, given the flotation cost, the firm must earn how much on the
available funds (90% of P0) in order to provide investors with a 13.6% return on
their investment?
• Investor side : rs = D1/P0 + g = 13.6% (= required return from the CAPM);
• Company side : since amount received is only P0 x(1- F)
re = D1/[P0 (1- F)] + g = 1.25/ [23.58(1-0.1)] + 8.3% = 14.19%

In that case, the firm must earn about 14.19% on the available funds in order to
provide investors with a 13.6% return on their investment. This higher rate of
return is the flotation-adjusted cost of equity. 40
 Dr. Ridha ESGHAIER

Example 4:
A company sells its new shares for $50 each and its flotation costs
F=15%. If D0=$4.19, g=5%, Estimate the capital raised by the company
for each new issued share and the cost of new common equity.

Solution:
For each new share the company sells it will
actually raise P0 x (1-F) = 50 x 0.85 = $42.50

The cost of New common equity re will be:

D 0 (1 + g ) $ 4 .19 (1 .05 )
re = +g= + 5 .0 %
P0 (1 − F ) $ 50 (1 − 0 .15 )
$ 4 .40
= + 5 . 0 % = 15 . 4 % > rs (13.8%) in application 4,
$ 42 . 50 because of the flotation costs 41
 Dr. Ridha ESGHAIER
flotation costs for Preferred Stocks
and Debt
• For preferred stock, with F is the flotation cost as a percentage of proceeds,
if Dp is the preferred dividend, Pp is the preferred stock price, the cost of
preferred stock is:
rP = DP / PP (1 - F)
• For Bonds with Flotation cost F, Cost of bond= rd solving:
 1 - [1 + rd ] -N  Par Value
PV B (1 − F) = INT   +
 r d  [1 + r d ] N
The A-T cost of debt = rd (1-T)

• NOTE: instead of finding the pre-tax yield based upon pre-tax cash flows and
then adjusting it to reflect taxes, as we did before, we can find the after-tax,
flotation-adjusted cost of Debt rd(1-T) by using this formula:
 1 - [1 + rd (1 - T)] -N  Par Value
PVB (1 − F) = INT(1 - T)   +
 rd (1 - T)  [1 + rd (1 - T)] N

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 Dr. Ridha ESGHAIER

Comments about flotation costs

• Flotation costs depend on the risk of the firm and

the type of capital being raised.
• Most debt offerings have very low flotation costs,
most analysts ignore them when estimating the
after-tax cost of debt
• The flotation costs are highest for common equity.
However, since most firms issue equity
infrequently, We frequently ignore flotation costs
when calculating the WACC.

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 Dr. Ridha ESGHAIER
Determining the Weights for
the WACC
• The weights are the percentages of the firm
that will be financed by each component.
• Ideally, we want to use the proportion of each
source of capital that the company would use
in the project or company. If we assume that a
company has a target capital structure and
raises capital consistent with this target, we
should use this target capital structure (the
one that a company is striving to obtain).

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 Dr. Ridha ESGHAIER

Estimating Weights for the

Capital Structure
If we know the company’s target capital structure, then, of
course, we should use this in our analysis. Someone outside the
company, however, such as an analyst, typically does not know
the target capital structure and must estimate it using one of
several approaches:
1. Assume the company’s current capital structure, at market
value weights for the components, represents the company’s
target capital structure.
2. Examine trends in the company’s capital structure or
statements by management regarding capital structure policy to
infer the target capital structure.
3. Use averages of comparable companies’ capital structures as
the target capital structure 45
 Dr. Ridha ESGHAIER

Estimating Weights for the

Capital Structure
• If available, always use the target weights for the
percentages of the firm that will be financed with
the various types of capital.
• If you don’t know the targets, it is better to
estimate the weights using current market values
than current book values.
• If you don’t know the market value of debt, then
it is usually reasonable to use the book values of
debt, especially if the debt is short-term.
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 Dr. Ridha ESGHAIER
Example 5:
if a company has the following market values for its capital
• Bonds outstanding $5 million
• Preferred stock 1 million
• Common stock 14 million
Calculate each of the capital component weight based on the
information available

Solution
Total capital = $5M + $1M + $14M = $20 million
The weights that we apply would be
• Wd = Bonds value /Total Capital = 0.25
• Wp = Preferred stock /Total Capital = 0.05
• We = Common stock /Total Capital = = 0.70
47
 Dr. Ridha ESGHAIER
Example 6:
Suppose a firm plans to retain $66 million of earnings for the year. It
wants to finance using its current target capital structure of 45% debt, 2%
preferred, and 53% common equity. How large could its capital budget be
before it must issue new common stock?

Solution :
• Common equity = 0.53 x Total capital budget
If Common equity is totally composed by retained earnings, we can write:
Retained earnings = 0.53 x Total capital budget
Total capital budget = Retained earnings / 0.53
= 66/0.53 = 124.5 million
• If the firm has more good investment opportunities (more than that
can be financed with 124.5 million) it will need to issue new common
stock.
Note:
• Debt target amount = 124.5 x 0.45 = 56.025 million
• Preferred stocks target amount = 124.5 x 0.02 = 2.49 million 48
Dr. Ridha ESGHAIER
Application 7:
A financial analyst is in the process estimating the cost of capital of the
company Alpha. The following information is provided concerning
Alpha:
• Market value of debt €50 million
• Market value of equity €60 million
Primary competitors and their capital structures:
Competitor Market Value of Debt Market Value of Equity
A $25M $50M
B €101M €190M
C $40M $60M

What are Alpha Company’s proportions of debt and equity that the analyst
would use if estimating these proportions using the company’s:
1. current capital structure?
2. competitors’ capital structure?
3. Suppose Alpha announces that a debt-to-equity ratio of 0.7 reflects its
target capital structure. What weights should the analyst use in the cost of
capital calculations? 49
 SOLUTION 7: Dr. Ridha ESGHAIER
1. Current capital structure
wd= 50 / (50+60) = 0.4545
we= 60 / (50+60) = 0.5454
2. Competitors’ capital structure: These weights represent the arithmetic
average of the three companies’ debt proportion and equity proportion,
respectively.
$25 + €101 + ( $40 )
$25+$50 €101+€190 $40+$60 = 0.3601
wd=
3
$50 + €190 + ( $60 )
€101+€190
we= $25+$50 $40+$60 = 0.6399
3
3. Note that a simple way of transforming a debt/equity ratio D/E into a
weight—that is, D/(D + E)—is to divide D/E by 1 + D/E.
A debt/equity ratio of 0.7 represents a weight on debt of 0.7/1.7 = 0.4118
so that :
• wd = 0.4118 and
• we = 1 - 0.4118 = 0.5882. 50
 Dr. Ridha ESGHAIER

Application 8:
A firm has a target capital structure of 43% debt, 5% preferred
stocks and 52% common equity (retained earnings 30% ; new
shares 70%).
rd=10%, tax rate =40%,
Net price of preferred stock = $48, preferred dividend = $6.
the risk free rate RRF = 3%, the expected return of the market
E(RM)= 13.5% and the company’s beta =1.3.
The price of new issued shares is approximated by the constant
dividend growth model with a P0 based on the CAPM, g =3%
and D1=$2.8. flotation costs on new issued stocks are 8% of P0.

Calculate each of the component cost and the company WACC

51
 SOLUTION 8: Dr. Ridha ESGHAIER

• Debt:
– wd = 0.43
– rd (1-t) = 0.1 (1- 0.4) = 0.06
• Preferred stock:
– wp = 0.05
– rp = pref. D/ price of pref. stock = 6/48 = 0.125
• Retained earnings:
– ws = 0.52 (0.3) = 0.156
– rs = rRF + ß [E(rM) – rRF] = 0.03 + 1.3 [0.135 – 0.03] = 0.1665
• External equity:
– we= 0.52 (0.7) = 0.364
P0 = D1/(rs –g) = 2.8/(0.1665 – 0.03) = $20.51
– re = (D1/[P0(1-F)]) + g = 2.8/[20.51 (1-0.08)] +0.03= 0.1784
WACC= wdrd(1-T) + wprp + wsrs + were = 12.3%
This is the weighted average cost of the hole capital used by the firm and, thus,
could be used as the required return on the total assets of a firm or the
required return for all new projects with similar risk to that of the existing
firm 52
 Dr. Ridha ESGHAIER

What factors influence a company’s

composite WACC?

• Factors the firm cannot control:

– Market conditions (stock and bond prices, interest rates,
investors aversion to risk, tax rates)
• Factors the firm can control:
– The firm’s capital structure (mix between debt and
Equity) and dividend policy (payout ratio).
– The firm’s investment policy. Firms with riskier projects
generally have a higher WACC.

53
 Dr. Ridha ESGHAIER

WACC and project risk

Should the company use the composite WACC as the
hurdle rate for each of its projects?

NO! The composite WACC reflects the risk of an average project

undertaken by the firm. Therefore, the WACC only represents the
“hurdle rate” for a typical project with average risk.
• If the new project is belonging in the same risk category than the
hole company, its NPV should be computed by using the company’s
cost of capital.
• If the risk of the new project is different from the risk of the whole
company, the investors will require a different rate of return. Thus,
The discounting rate used to compute NPV will be different from the
company cost of capital. This discounting rate should reflect the
project risk. That’s why we need to adjust the WACC
Since different projects have different risks, the project’s WACC
should be adjusted to reflect the project’s risk.
54
 The true cost of capital depends on project risk, not on the
company undertaking the project. So why is so much time spent
estimating the company cost of capital?
There are two reasons:

• First, many (maybe most) projects can be treated as average risk, that
is, neither more nor less risky than the average of the company’s
other assets. For these projects the company cost of capital is the
right discount rate.
• Second, the company cost of capital is a useful starting point for
setting discount rates for unusually risky or safe projects. It is easier
to add to, or subtract from, the company cost of capital than to
estimate each project’s cost of capital from scratch.

Therefore, the WACC is used to evaluate most projects; but if a

project has an especially high or low risk, the WACC will be
adjusted up or down to account for the risk differential.

Dr. Ridha ESGHAIER 55

 Dr. Ridha ESGHAIER
Projects are generally classified into several categories. Then with
the firm’s overall WACC as a starting point, a risk-adjusted cost of
capital is assigned to each category.
For example, a firm might establish three risk classes, assign the
corporate WACC to average-risk projects, add a 5% risk premium
for higher-risk projects, and subtract 2% for low-risk projects.
Under this setup, if the company’s overall WACC was 10%, 10%
• would be used to evaluate average-risk projects, 15% for high-risk
projects, and 8% for low-risk projects. While this approach is
probably better than not making any risk adjustments, these
adjustments are highly subjective and difficult to justify.

• Unfortunately, there’s no perfect way to specify how high or low

the adjustments should be.
• We should note that the CAPM approach can be used for
projects provided there are specialized publicly traded firms in the
same business as that of the project under consideration.
56
 Dr. Ridha ESGHAIER
Application 9:

A Company is targeting the following capital structure:

- Common equity: 58%
- Preferred stocks: 2%
- Debt : 40%
The marginal cost of each financing source is:
- Cost of Common equity: 14%
- Cost of Preferred stocks: 11%
- Cost of Debt: 9.43%
The company’s marginal tax rate = 30%
1. Compute the company’s WACC
2. The company’s management would like to know if the following
project is profitable. I0 : $68,000; CF1 : $18,000; CF2 : $23,000;
CF3 : $31,000; CF4 : $21,000
Note: The project has a higher risk than the company’s average projects
(a risk premium of 3% should be used) 57
 SOLUTION 9: Dr. Ridha ESGHAIER

1. WACC= wdrd(1-T) + wprp + wsrs + were

WACC = 0.4(9.43%)(1-0.3) + 0.02(11%) + 0.58(14%)

= 10.98%
2. Since the New project is riskier than the company’s avrerage projects, a risk premium of 3%
should be taken into consideration when computing the minimum required return on it.

WACC new project = WACC average + Risk premium

= 10.98% + 3% = 13.98%
To accept the new project, its NPV using the adjusted WACC should be positive, or its
internal rate of return (IRR) should be higher than its required rate of return (the
adjusted WACC)
18000 23000 31000 21000
NPV(13.98% ) = − 68000 + 1
+ 2
+ 3
+ 4
= $ − 1126.24 < 0
(1.1398) (1.1398) (1.1398) (1.1398)

At 13.98%, NPV= -1126.24 IRR − 12.98% 0 − 335.56

IRR? , NPV=0 = = 0.2295
13.98% − 12.98% − 1126.24 - 335.56
At 12.98%, NPV= 335.56
IRR = 12.98% + (1% × 0.2295) = 13.21%
IRR < 13.98% and/or NPV<0 refuse the project 58
Dr. Ridha ESGHAIER
Application 10:
A Corporation is estimating its WACC. Its target capital structure is 30% debt, 10%
preferred stock, and 60% common equity (retained earnings 20% ; new shares 80%).
- Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years,
and sell for $1,000. The firm's marginal tax rate is 40%.
- The firm could sell, at par, $100 preferred stock which pays a 12% annual preferred
dividend. Flotation costs of 5% would be incurred.
- The company’s beta is 1.3, the risk-free rate is 10%, and the market risk premium is
5%. It is a constant-growth firm which just paid a dividend of $2.00 and has a
growth rate of 8%.
- The price of new issued shares is approximated by the constant dividend growth
model with a P0 based on the CAPM, flotation costs on new issued stocks are 5% of
P0.
Calculate the company’s WACC.
1. What is the firm’s component cost of debt?
2. What is its cost of preferred stock?
3. What is its cost of common equity from retained earnings using the CAPM?
4. What is its cost of new common stock knowing that the flotation costs represent 5%
of P0?
5. What is the firm’s WACC?
59
Dr. Ridha ESGHAIER SOLUTION 10:
1. Cost of debt
Since the bond sells at par of $1,000, its YTM and coupon rate (12%) are equal. Thus, the before-tax
cost of debt is 12%. The after-tax cost of debt equals:
rd,After-tax = 12%(1 – 40%) = 7.2%.
Or N = 40; PVB = 1,000; INT/2 = 60; MV = 1,000;
 1 - (1 + rd /2) -40
 1 , 000
$ 1 , 000 = 60  +
 ( 1 + r /2 ) 40
 rd / 2  d

rd/2 = 6% so rd = 12% rd(1 - T) = 12%(1-40%) = 7.2%.

2. Cost of preferred stock
Cost of preferred stock: rp = DP/PP(1-F) = $12/$100(1-5%) =12.6%
3. Cost of common equity from retained earnings:
(CAPM approach): rs = 10% + 1.3x(5%) = 16.5%
The Cost of retained earnings rs = 16.5%
4. Cost of new common stocks :
• P0 = D1/(rs – g) = (2x1.08)/(16.5%-8%) = $25.41
• (DCF approach): re = (2x1.08)/[25.41x(1-5%)] + 8% = 16.95%
5. WACC = wdrd(1 - T) + wprp + wsrs + were
= 0.3(12%)(1-0.4) + 0.1(12.6%) + 0.6x0.2(16.5%) + 0.6x0.8(16.95%)
= 0.0216 + 0.0126 + 0.0198 + 0.08136 = 13.536% 60