Block, Hirt, and Danielsen

Foundations of Financial Management

17th edition

Chapter 11

Cost of Capital

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 Learning Objectives
The cost of capital represents the weighted average cost of
the source of financing to the firm.
The cost of capital is normally the discount rate to use in
analyzing an investment.
The cost of capital is based on the valuation techniques
from the previous chapter and is applied to bonds,
preferred stock, and common stock.
A firm attempts to find a minimum cost of capital through
varying the mix of its sources of financing.
The cost of capital may eventually increase as larger
amounts of financing are utilized.
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 Chapter Opening
Cost of capital in the corporate finance setting
• Investment is made for anticipated future return
• Vital to know appropriate discount rate
Cost of acquiring funds
• Earning return equal to acquisition costs represents
the minimum acceptable return

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 The Overall Concept
Investment
• Should not be judged against specific means of
financing used to implement
• Makes investment selection decisions inconsistent
• Low-cost debt must be chosen carefully
• May increase overall risk of the firm
• May eventually make all forms of financing more
expensive

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 Table 11-1 Cost of Capital—
Baker Corporation
Best understood through firm’s capital structure
Aftertax costs of the individual sources of financing are
shown, then weights are assigned to each, and finally a
weighted average cost is determined.

(1) (3)
Cost (2) Weighted
(aftertax) Weights Cost
Debt ............................................................................ Kd 7.05% 30% 2.12%
..
Preferred Kp 10.94 10 1.09
stock .............................................................
Common equity (retained Ke 12.00 60 7.20
earnings) ............................
Weighted average cost of Ka 10.41%
capital .................................

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 Cost of Debt 1

Measured by interest rate at which company

raises new capital
• Example: $1,000 bond paying $100 annual interest
thus provides 10 percent yield
• Calculation is more complex if bond is priced at
discount or premium from par value
To determine cost of new debt in marketplace
• Firm computes yield on currently outstanding debt
• Not the rate old debt was issued but the rate
investors are demanding today
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 Table 11-2 Yield to Maturity

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 Cost of Debt 2

Adjusting yield for tax considerations

• Yield to maturity indicates what firm must pay on
before-tax basis
• Interest payment on debt is tax-deductible
• True cost less than stated cost
• Aftertax cost of debt
Kd (Cost of debt) = Y(1−T)

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 Cost of Debt 3

Yield is interchangeable with yield to maturity or

approximate yield to maturity
Yield = 10.84%; Tax rate = 35%
Kd (Cost of debt) = Y(1 − T)
Kd (Cost of debt) = 10.84% (1 − 0.35)
= 10.84% × 0.65
= 7.05%

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 Table 11-3 Excerpt from S&P Capital
IQ Net Advantage
Maturity Security Offer Amt. Outstdg. Current Current S&P
Date Issue Type Seniority Coupon Date ($mm) Price YTM Rating
Nov-15-2030 Corporate Corporate Senior 8.000 Nov-15-2000 250.00 131.285 4.710 BBB+
Debentures Debentures Unsecured
Apr-01-2033 KeySpan Corporate Senior 5.875 Apr-01-2003 150.00 117.973 4.250 BBB+
Corporation Debentures Unsecured
Apr-01-2035 KeySpan Corporate Senior 5.803 Mar-29-2005 307.20 117.973 4.021 BBB+
Corporation Debentures Unsecured

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 Cost of Preferred Stock 1

Constant annual payment with no maturity date

for principal payment
• Divide annual dividend by current price
• Represents rate of return to preferred stockholders
and annual cost to corporation for preferred stock
issue
Proceeds to firm are equal to selling price in
market minus flotation cost

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 Cost of Preferred Stock 2

The cost of preferred stock is as follows

Kp (Cost of preferred stock) = Dp / (Pp − F)
Kp = Cost of preferred stock; Dp = Annual dividend on
preferred stock; Pp = Price of preferred stock;
F = Flotation, or selling cost
Assume annual dividend $10.50; preferred stock
$100; flotation or selling cost $4
Kp = Dp / (Pp − F) = $10.50 / ($100 − 4) = $10.50 / $96
= $10.94%
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 Cost of Common Equity—
Valuation Approach
To determine cost of common stock, the firm must be
sensitive to pricing and performance demands of current
and future stockholders
Dividend valuation model:
• P0 = D1 / (Ke – g)
• P0 = Price of the stock today
• D1 = Dividend at the end of the year (or period)
• Ke = Required rate of return
• g = Constant growth rate in dividends
Assuming D1 = $2, P0 = $40, and g = 7%, Ke = 12%
Ke = (D1 / P0) + g = ($2 / $40) + 7% = 5% + 7% = 12% 13
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 Required Return on Common Stock
Using the Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM)
Kj = Rf + β(Km − Rf)
• Kj = Required return on common stock
• Rf = Risk-free rate of return, usually the current rate on Treasury bill
securities
• β = Beta coefficient (measures the historical volatility of an
individual stock’s return relative to a stock market index)
• Km = Return expected in the market as measured by an
approximate index
Assuming Rf = 5.5%, Km = 12%, and β = 1.0, Kj would be:
Kj = 5.5% + 1.0 (12% – 5.5%) = 5.5% + 1.0 (6.5%)
Kj = 5.5% + 6.5% = 12%
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 Cost of Retained Earnings 1

Sources of capital for common stock equity

• Purchaser of new shares—external source
• Retained earnings—internal source
• Represent present and past earnings of firm minus
previously distributed dividends
• Belong to current stockholders—paid as dividends or
reinvested in firm
• Reinvestments represent source of equity capital supplied
by current stockholders
• Opportunity cost involved
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 Cost of Retained Earnings 2

The cost of retained earnings is equivalent to the rate

of return on the firm’s common cost, representing the
opportunity cost
Ke represents both the required rate of return on
common stock and the cost of equity in the form of
retained earnings
Ke = (D1 / P0) + g
• Ke = Cost of common equity in the form of retained earnings
• D1 = Dividend at the end of the first year, $2
• P0 = Price of stock today, $40
• g = Constant growth rate in dividends, 7%
Ke = (D1 / P0) + g = ($2 / $40) + 7% = 5% + 7% = 12%
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 Cost of New Common Stock 1

Slightly higher return than Ke expected

• Represents required rate of return of present
stockholders
• Needed to cover distribution costs of new securities
Common Stock
K e  ( D1 / P0 )  g

New common stock

K n  [ D1 / ( P0 – F )]  g
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 Cost of New Common Stock 2

Assuming
• D1 = $2
• P0 = $40
• F (Flotation or selling costs) = $4
• g = 7%
Kn = [$2 / ($40 +4)] + 7%
= ($2 / $36) + 7%
= 5.6% + 7%
= 12.6%
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 Optimum Capital Structure—
Weighting Costs 1

Desire to achieve minimum overall cost of

capital
• Calculated decisions required on appropriate
weights for
• Debt
• Preferred stock
• Common stock financing
• Capital mix determined by
• Considering present capital structure
• Ascertaining if current position optimal
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 Optimum Capital Structure—
Weighting Costs 2

Assessment of different plans:

• Firm able to initially reduce weighted average cost of capital
with debt financing
• Beyond Plan B, continued use of debt becomes unattractive
and greatly increases costs of sources of financing
Cost (aftertax) Weights Weighted Cost
Financial Plan A:
Debt ........................................................ 6.5% 20% 1.3%
Equity ..................................................... 12.0 80 9.6
10.9%
Financial Plan B:
Debt ....................................................... 7.0% 40% 2.8%
Equity .................................................... 12.5 60 7.5
10.3%
Financial Plan C:
Debt ....................................................... 9.0% 60% 5.4%
Equity .................................................... 15.0 40 6.0
11.4%

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 Figure 11-1 Cost of Capital Curve

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 Table 11-4 2015 and 2018 Long-Term Debt
as a Percentage of Debt + Equity (MV)
2015 2018
Selected Companies with Industry Designations Percent Percent
Microsoft 9% 10%
(computers) ...........................................................................
Intel 11 8
(semiconductors) ...........................................................................
Home Depot (home repair 11 8
products) ....................................................
Merck & Co. 16 13
(pharmaceuticals) ..............................................................
PepsiCo (soft drinks and 19 15
snacks) ............................................................
ExxonMobil (integrated 22 8
oil).....................................................................
Hyatt Hotels 22 13
(lodging) ............................................................................
Pfizer 25 13
(pharmaceuticals) .........................................................................
Delta Air Lines (air 42 14
travel) .......................................................................
Gannett (newspapers and 43 23
publishing) ................................................... 22
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 Capital Acquisition and
Investment Decision Making
Financial capital consists of bonds, preferred
stock, common equity
• Money raised by sale is invested in
• Real capital of firm, long-term productive assets of plant
and equipment
• To minimize equity cost, firm may sell common stock
when prices are relatively high
• Balance between debt and equity required to
achieve minimum cost of capital

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 Figure 11-2 Cost of Capital Over Time

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 Cost of Capital in the Capital
Budgeting Decision
Current cost of capital for each source of funds
important for capital budgeting decision
• Required rate of return, or discount rate, will be
weighted average cost of capital
• Common stock value of firm will stay same or
increase as long as firm earns cost of capital
• Stockholders’ expectations being met

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 Table 11-5 Investment Projects Available to
the Baker Corporation
Expected Cost
Projects Returns ($ millions)
A ..................... 16.00% $10
B ..................... 14.00 5
C ..................... 13.50 4
D ..................... 11.80 20
E ..................... 10.65 11
F .................... 9.50 20
G .................... 8.60 15
H .................... 7.00 10
$95 million

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 Figure 11-3 Cost of Capital and Investment
Projects for the Baker Corporation

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 The Marginal Cost of Capital 1

Market may demand higher cost of capital for

each each amount of funds if large amount of
financing required
• Equity (ownership) capital represented by retained
earnings
• Retained earnings cannot grow indefinitely, as firm’s
capital must expand
• Retained earnings limited to past and present earnings
that can be redeployed into investments

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 The Marginal Cost of Capital 2

Assumptions:
• Firm has $23.40 million of retained earnings available for
investment
• Since retained earnings are 60 percent of the capital
structure, there are adequate retained earnings to support
up to $39 million
Adequate retained earnings to support capital structure
X = Retained earnings / Percent of retained earnings in the
capital structure
• Where X represents size of capital structure that retained earnings will
support
X = $23.40 million / 0.60 = $39 million
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 Table 11-6 Costs of Capital for
Different Amounts of Financing
First $39 Million Next $11 Million
A/T Weighted A/T Weighted
Cost Wts. Cost Cost Wts. Cost
Debt ........................ Kd 7.05% 0.30 2.12% Debt .......................... Kd 7.05% 0.30 2.12%
Preferred ................. Kp 10.94 0.10 1.09 Preferred .................. Kp 10.94 0.10 1.09
Common equity* ..... Ke 12.00 0.60 7.20 Common equity† ..... Kn 12.60 0.60 7.56
Ka = 10.41% Kmc = 10.77%
*Retained earnings. New common stock.

Kmc in bottom right-hand portion of table represents marginal cost of capital

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 Increasing Marginal Cost of Capital
Both Kmc and Ka represent cost of capital
• mc subscript after K indicates increase in marginal
cost of capital
Increase because common equity is now in form
of new common stock rather than retained
earnings
Aftertax cost of new common stock more
expensive than retained earnings because of
flotation costs
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 Marginal Cost of Capital
Equation for cost of new common stock:
Kn = [D1 / (P0 − F) + g + [$2 / ($40 − $4)] + 7%
= ($2 / $36) +7%
= 5.6% +7%
= 12.6%
$50 million figure can be derived thus:
Z = Amount of lower-cost debt / Percent of debt in the capital
structure
Z = $15 million / 0.30 = $50 million
• Where Z represents size of capital structure in which lower-cost debt can
be used
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 Table 11-7 Cost of Capital for
Increasing Amounts of Financing

Over $50 Million

Cost Weighted
(aftertax) Weights Cost
Debt (higher cost) ............................................ Kd 8.60% 0.30 2.58%
Preferred stock ................................................ Kp 10.94 0.10 1.09
Common equity (new common stock)............. Kn 12.60 0.60 7.56
Kmc = 11.23%

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 Marginal Costs of Capital
Changes in the marginal costs of capital

Amount of Financing Marginal Cost of Capital

0–$39 million ........................................ 10.41%
$39–50 million ...................................... 10.77
Over $50 million ................................... 11.23

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 Figure 11-4 Marginal Cost of Capital
and Baker Corporation Projects

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 Table 11-8 Cost of Components
in the Capital Structure

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 Table 11A-1 Performance of
PAI and the Market
Rate of Return Rate of Return
on Stock on Stock
Year PAI Market
1 .................................................. 12.0% 10.0%
.
2 .................................................. 16.0 18.0
.
3 .................................................. 20.0 16.0
.
4 .................................................. 16.0 10.0
.
5 .................................................. 6.0 8.0
.
Mean return ................................ 14.0% 12.4%
Standard deviation ...................... 4.73% 3.87%

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 Figure 11A-1 Linear Regression of
Returns Between PAI and the Market

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 Figure 11A-2 The Security Market
Line (SML)
Under CAPM model, investor expects extra return above that of
riskless asset in order to justify additional risk
Security Market Line (SML) identifies risk-return trade-off of any
common stock (asset) relative to company’s beta

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 Figure 11A-3 The Security Market
Line and Changing Interest Rates

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 Figure 11A-4 The Security Market Line
and Changing Investor Expectations
Pessimistic investors require larger premiums for
assuming risks

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