Chapter 9

The Cost of Capital

Financial management
Chienlin Lu
 2

Learning Objectives
9.1 Understand the concepts underlying the firm’s cost of
capital.
9.2 Evaluate the costs of the individual sources of capital
9.3 Calculate a firm’s weighted average cost of capital.
9.4 Estimate divisional costs of capital.
 3

Capital Structure
Capital
• Capital represents the funds used to finance a firm’s
assets and operations. Capital constitutes all items on the
right hand side of balance sheet, i.e., liabilities and
common equity.
• Main sources: Debt, preferred stock, retained earnings,
and common stock.

Capital
 4

Figure 9.1 Capital Structures for a

Retail Chain and Oil and Gas
Producer

The ratio of financing sources will be the weight of their corresponding

costs.
 5

Debt

TSMC ( 台積
電)

Equity

Total assets

Equity
 6

Debt

YANGMING ( 陽
明)

Equity

Total assets

Equity
 7

Opportunity Cost of Capital

• Cost of Capital
– The firm’s cost of capital is also referred to as the
firm’s opportunity cost of capital.

– Because a firm chooses to use investor’s money,

investor’s opportunity cost for these money becomes
the key.
 8

Investor’s Required Rate of Return

• Investor’s Required Rate of Return—the minimum rate

of return necessary to attract an investor to purchase or
hold a security.
• Investor’s required rate of return is not the same as cost of
capital due to taxes and transaction costs.
– Impact of taxes () : For example, a firm may pay 8
percent interest on debt but due to tax benefit on
interest expense, the net cost to the firm will be lower
than 8 percent.
 9

Investor’s Required Rate of Return

• Impact of transaction costs on cost of capital () : For

example, if a firm sells new stock for $50 a share and
incurs $5 in flotation costs, and the investors have a
required rate of return of 15 percent, what is the cost of
capital?
• The firm has only $45 to invest after transaction cost.

×$50.00 = $7.5
0.15×
$7.5
k= = 0.1667 or16.67%  rather than 15% 
$45.00 
Or P.317
10
 11

Financial Policy
• A firm’s financial policy indicates the desired sources of
financing and the particular mix in which it will be used.
• For example, a firm may choose to raise capital by issuing
stocks and bonds in the ratio of 6:4 (60 percent stocks
and 40 percent bonds). The choice of mix will impact the
cost of capital.
Weight

𝑊𝐴𝐶𝐶 =𝑤𝑏 ×𝑘𝑏 ×(1− 𝑇 𝑐 )+𝑤 𝑐𝑠 ×𝑘𝑐𝑠 +𝑤𝑝𝑠 ×𝑘𝑝𝑠

Costs of capital

Weighted Average Cost of Capital

 12

Example of WACC
• Case 1
• Suppose you collect $100 from bonds.
• Weight of bonds: 100% (or 1).
• Costs of bonds: 4% (or 0.04).
• Then your WACC will be . $4 per year.
• Case 2
• Suppose you collect $50 from bonds and $50 from stocks.
• Weight of bonds: 50%; Weight of stocks: 50%.
• Costs of bonds: 4%; Costs of stocks: 6%.
• Then your WACC will be .
 13

The Cost of Debt

• The bondholder’s required rate of return on debt is the
return that bondholders demand. As seen in Chapter 7,
this can be estimated using the bond price equation:

Bond market price =

interest paid in year 1 interest paid in year 2
+
1 + bondholder's required rate of return  rb  1 + bondholder's required rate of return rb 
1 2

interest paid in year 3 principal

+ +
1 + bondholder's required rate of return  r  1 + bondholder's required rate of return  r 
3 3
b b

• → Yield to maturity (YTM)

 14

The Cost of Debt

• Because firms must pay flotation costs when they sell
bonds, the net proceeds per bond received by firm is less
than the market price of the bond. Hence, the cost of debt
capital (Kd) will be higher than the bondholder’s required
rate of return. It can be calculated using the following
equation:
Bond market price minus flotation costs
interest paid in year 1 interest paid in year 2
Net proceeds per bond = +
1 + cost of debt capital or kb  1 + cost of debt capital or kb 
1 2

interest paid in year 3 principal

= +
1 + cost of debt capital or kb  1 + cost of debt capital or kb 
3 3
 15

The Cost of Debt

See Example 9.1
• Investor’s required rate of return on a 8 percent 20-year
bond trading for $908.32 = 9 percent and 21 percent tax
bracket.

After - tax bondholder's required  tax 

= ×  11 
× 
cost of debt rate of return (kb )  rate 
× (1  0.21) = 0.0711, or 7.11%
= 0.09 ×
 16

Hint: Flotation costs are not priced in bonds.

 17

The Cost of Preferred Stock

• If flotation costs are incurred, preferred stockholder’s
required rate of return will be less than the cost of
preferred capital to the firm.
• Thus, in order to determine the cost of preferred stock, we
adjust the price of preferred stock for flotation cost to give
us the net proceeds.
• Net proceeds = issue price − flotation cost
 18

The Cost of Preferred Stock

Dp
• Cost of Preferred Stock: rps =
Pn
Pn = net proceeds (i.e., issue price − flotation costs)
Dp = preferred stock dividend per share

• Example: Determine the cost for a preferred stock that

pays annual dividend of $4.25, has current stock price
$58.50, and incurs flotation costs of $1.375 per share.

$4.25
Cost = = 0.074 or 7.44%
58.50 -1.375
 19

The Cost of Common Equity

• Cost of equity is more challenging to estimate than the
cost of debt or the cost of preferred stock because
common stockholder’s rate of return is not fixed as there
is no stated coupon rate or dividend.
• Furthermore, the costs will vary for two sources of equity
(i.e., retained earnings and new issue).

• Retained earnings – without issuance costs

• New issues – with issuance costs
 20

Cost Estimation Techniques

• Two commonly used methods for estimating common
stockholder’s required rate of return are
– The Dividend Growth Model – Use dividends
– The Capital Asset Pricing Model – Use stock price
 21

The Dividend Growth Model

• Investors’ required rate of return (for Retained Earnings):
𝐷 0 ( 1+ 𝑔 )
D1
kcs = +g
Pcs
Preferred stocks have dividends with zero growth
• D1 = Dividends expected one year hence

• ​ Pcs = Price of common stock

• g = growth rate (P.296)
(1 – dividend payout ratio)
 22

The Dividend Growth Model

• Investors’ required rate of return (For new issues)
𝐷 0 ( 1+ 𝑔 )
D1
kncs = +g
NPcs
• ​ D1 = Dividends expected one year hence

• ​ Pcs = Net proceeds per share (Price – issuance costs)

• g = growth rate
 23

The Dividend Growth Model

• Dividend growth model is simple to use but suffers from
the following drawbacks:
– It assumes a constant growth rate.
– It is not easy to forecast the growth rate.
 24

The Capital Asset Pricing Model

kc = rf + β  rm  rf 
rf = Risk-free rate

β = Beta

rm − rf = Market Risk Premium or expected rate of return for

“average security” minus the risk-free rate
 25

The Capital Asset Pricing Model

Example: If beta is 1.40, risk-free rate is 2.75 percent and

expected return on market is 10 percent.

Cost of common
= rf + β (rm  rf ) = 0.0275 + 1.4(0.10  0.0275) = 0.129 or 12.9%
stock (kcs )
 26

Capital Asset Pricing Model Variable

Estimates
• CAPM is easy to apply. Also, the estimates for model
variables are generally available from public sources.
• Risk-Free Rate: Wide range of U.S. government
securities can be used as base for risk-free rate.
• Beta: Estimates of beta are available from a wide range of
services or can be estimated using regression analysis of
historical data.
• Market Risk Premium: It can be estimated by looking at
history of stock returns and premium earned over risk-free
rate.
27
 28

The Weighted Average Cost of

Capital (WACC)
Bringing it all together: WACC
• To estimate WACC, we need to know the capital structure
mix and the cost of each of the sources of capital.
• For a firm with only two sources: debt and common equity,

→ Be aware of new issues

𝑊𝐴𝐶𝐶 =𝑤𝑏 ×𝑘𝑏 ×(1− 𝑇 𝑐 )+𝑤 𝑐𝑠 ×𝑘𝑐𝑠 +𝑤𝑝𝑠 ×𝑘𝑝𝑠
→ Be aware of after-tax cost
 29

WACC Example
• A firm borrows money at 6 percent interest after taxes and
pays 10 percent for equity. The company raises capital in
equal proportions, i.e., 50 percent debt and 50 percent
equity.
• WACC = (0.06 × 0.5) + (0.10 × 0.5)
= 0.08 or 8.0%
 30

Table 9.1 Calculating the Weighted

Average Cost of Capital
 31

Table 9.2 Capital Structure and

Capital Costs for Ash Inc

Amount of Percentage After-Tax

Source of
Funds Cost of
Capital
Raised ($) of Total Capital
Bonds 1,750,000 35% 7%
Preferred stock 250,000 5% 13%
Retained 3,000,000 60% 16%
earnings
Total 5,000,000 100% Blank
 32

Table 9.3 The Weighted Average Cost

of Capital for Ash Inc
33
34
 35

Divisional Costs of Capital

• Firms with multiple operating divisions often have unique
risks and different costs of capital for each division.
• Consequently, the WACC used in each division is
potentially unique for each division.
 36

Advantages of Divisional WACC

• Different discount rates reflect differences in the
systematic risk of the projects evaluated by different
divisions.
• It entails calculating one cost of capital for each division
(rather than each project).
• Divisional cost of capital limits managerial latitude and the
attendant influence costs.
 37

Using Pure Play Firms to Estimate

Divisional WACCs
• Divisional cost of capital can be estimated by identifying
“pure play” comparison firms that operate in only one of
the individual business areas.
• For example, Valero Energy Corp. may use the WACC
estimate of firms that operate in the refinery industry to
estimate the WACC of its division engaged in refining
crude oil.
 38

Divisional WACC Example

• Table 9.4 contains hypothetical estimates of the divisional
WACC for the refining and retail (convenience store)
industries.
• Panel A: Cost of debt (tax = 38%)
• Panel B: Cost of equity (betas differ)
• Panels D & E: Divisional WACCs
39
 40

Divisional WACC—Estimation Issues

and Limitations
• Sample chosen may not be a good match for the firm or
one of its divisions due to differences in capital structure
or project risk.
• Good comparison firms for a particular division may be
difficult to find.
 41

Table 9.5 Choosing the Right WACC-

Discount Rates and Project Risk
There are good reasons for using a single, company-wide WACC to evaluate the firm’s
investments even where there are differences in the risks of the projects the firm
undertakes. However, the most common tool used by firms that use a variety of discount
rates to evaluate new investments in an effort to accommodate risk differences is the
divisional WACC. The divisional WACC represents something of a compromise that
minimizes some of the problems encountered when attempting to estimate both the
project-specific costs of capital and the costs that arise when a single discount rate is used
that is equal to the firm’s WACC.
Method Description Advantages Disadvantages When to Use
WACC Estimated • Familiar concept to • Does not adjust • Projects are
WACC for the most business discount rates for similar in risk to
firm as an executives. differences in the firm as a
entity; used as project risk. whole.
the discount • Minimizes estimation
rate on all costs, as there is only • Does not provide • Using multiple
projects. one cost of capital for flexibility in discount rates
calculation for the firm. adjusting for creates
differences in significant
• Reduces the problem project debt in the problems with
of influence cost issues. capital structure. influence costs.
 42

Table 9.5 Choosing the Right WACC-

Discount Rates and Project Risk
Method Description Advantages Disadvantages When to Use
Divisional Estimated • Uses division-level • Does not capture • Individual
WACC WACC for risk to adjust intradivision risk projects within
individual discount rates for differences in projects. each division
business units individual projects. have similar risks
or divisions • Does not account for and debt
within the firm; • Reduces influence differences in project debt capacities.
used as the costs to the capacities within
only discount competition among divisions. • Discount rate
rates within division managers to discretion creates
each division. lower their division’s • Potential influence costs significant
cost of capital. associated with the influence costs
choice of discount rates within divisions
across divisions. but not between
divisions.
•Difficult to find single-
division firms to proxy for
divisions.
 43

Cost of Capital to Evaluate New

Capital Investments
• Cost of capital can serve as the discount rate in evaluating
new investments when the projects offer the same risk as
the firm as a whole.
• If risk differs, it is better to calculate a different cost of
capital for each division. Figure 9.2 illustrates the danger
of not doing so.
 44

Figure 9.2 Global Energy Divisional

Costs of Capital
Using a company-wide cost of capital for a multidivisional
firm results in systematic overinvestment in high-risk
projects and underinvestment in low-risk projects.
 45

Simplify decision with WACC.

 46

Study problems
• 9-3.
• 9-5.
• 9-6.
• 9-11.
• 9-16.