NHO B&H CH 10 Cost of Capital

The Cost of Capital
Napoleon Overton
The Cost of Capital
 There are two basic sources of capital for a firm:

 Debt and Equity.
 The cost of capital reflects the expected average
cost of funds from these sources over the LONG-
RUN.
 Equity can be subdivided into three categories:
 Preferred Stock
 Common Stock
 Retained earnings
WACC
 The weighted average cost of capital is a simple
weighted average of the cost of debt, preferred equity
and common equity in a company’s capital structure,
with one minor adjustment made to account for the
favorable tax consequences of interest expense.
WACC = wdrd(1-T) + wprp + wcrs

Good News!

Pre-tax cost of debt (rd)
 Co. X has one issue of bonds outstanding that are 7%
coupon bonds with semi-annual payments, 8 years
remaining until maturity, and a market price of $1,150.
What is the firm’s pretax cost of debt?
N I/YR PV PMT FV
16 2.36 -1150 35 1000
rd = 2.36 x 2 = 4.72% pretax cost of debt
Note: If a company had multiple bond issues

outstanding, a weighted average of the yield to maturity
on all of the issues would be used to find r d
Cost of Preferred Stock
 Co. X has one issue of preferred stock outstanding
with a $50 par value and a 5.5% dividend. The
current market price is $42.50/share. What is the
company’s cost of preferred stock (r p)?
 The annual dividend is .055 x $50 = $2.75
 rp = Dp/P0 = 2.75/42.50 = 6.47%
Cost of Common Stock

Cost of Common Stock
 Assume the required rate of return on the market is
10%, the risk-free rate is 2%, and Co. X’s beta is 1.25.
What is Co. X’s cost of common equity?
rs = rRF + b (rM- rRF)
rs = .02 + 1.25(.10 - .02)
= .02 + .10
= .12 = 12%
Estimating rs using Bond Yields
 In some cases, reliable inputs are not available for the
CAPM approach or the discounted cash flow approach
 A closely-held private corporation.
 In these cases, a more subjective approach of adding
an equity risk premium to the company’s cost of long-
term debt may be used.
 Some studies suggest that the cost of equity is
usually 3%-5% over the pretax cost of L-T Debt.
 So, using the Bond Yield + Risk Premium approach,
an estimate of the cost of equity could be made:
 Rs = bond yield + risk premium
 Rs
Retained Earnings vs. External Equity
 A company can obtain common equity capital in two
ways:
 By selling (issuing) shares to investors
 By retaining some of the company’s earnings
 The cost of external equity is higher than the cost of

retained earnings because companies incur floatation
costs (investment bankers’ underwriting fees) when
they issue new shares to the public.
Adjusting for Floatation Costs

Adjusting for taxes
 Interest expense on debt is a tax-deductible expense.
 Dividends are NOT tax-deductible expenses! (Neither
dividends on common or preferred stocks.)
 Financial managers & investors are interested in net
cash flows, and taxes are a real cash cost.
 Therefore, the pretax cost of debt is adjusted for taxes
by calculating an after-tax cost of debt:
After-Tax cost of debt = rd(1-T)
 No adjustment for taxes is necessary for the cost of

either common or preferred equity.
After-tax cost of debt (ri)
 Co. X’s pre-tax cost of debt was calculated to be
4.72%. If the firm’s marginal tax rate is 35%, then
what is Co. X’s after-tax cost of debt?
rd(1-T) = .0472(1-.35) = .0307

= 3.07%

Weighted average cost of capital
 We have used weighted average calculations to
compute:
 The expected return on an investment in a scenario
analysis, where probabilities are weights.
 The expected return on portfolio of assets, where
the weights are the proportion of total portfolio
investment represented by each asset in the
portfolio.

WACC
 The weighted average cost of capital is simply the weighted
average of the costs of debt, preferred stock, and common
stock, weighted by the percentage of total capitalization
represented by each source.
Notation: w = weight in the capital structure based on market

value (not book value). wd = wt. of debt, wp = wt. of pfd., wc = wt.
of common.
Market value (Market Capitalization) of Debt

+ MV (Mkt. Cap.) Preferred
+ MV (Mkt. Cap.) Common
Market Value vs. Book Value
 One of the basic accounting principles underlying GAAP
financial statements is that items are recorded at their
historical cost.
 Book value refers to the value in financial statements.
 Market values may differ substantially from book values.
 The MV of debt is typically close to its book value
 The MV of preferred is often close to BV
 The MV of common is frequently very different from
BV
 Current market value approximates the actual dollars to
be received from the sale of securities, so market value
weights are clearly preferred over book value weights in
calculating WACC.
Co. X Capital Structure
 Assume the Co. X has 10 million common shares
outstanding, 1 million shares of preferred stock
outstanding, and $200 million of long-term debt.
Calculate the weights of debt, common equity and
preferred equity for use in computing Co. X’s WACC.
Amount Percent
47.6%
Common Eq: 10MM x $22 = $220.0 9.2%
Preferred Eq: 1MM x $42.50 = 42.5 43.2%
Debt: = $200.0 100.0%
Calculating Co. X’s WACC
= (.432)(.0307)+(.092)(.0647)+(.476)(.12)
= .0133 + .0059 + .0571
= .0763
= 7.6% (if retained earnings is the source
of new common equity)
= (.432)(.0307)+(.092)(.0647)+(.476)(.124)
= 7.8%
Factors Affecting WACC
 External Factors (Firm cannot control)
 General level of interest rates
 General level of stock prices
 Tax rates
 Internal Factors (Within the firm’s control)

 Capital structure
 Dividend Payout Ratio

Adjusting WACC for Risk
 WACC is a key element in capital budgeting
 Firms should only pursue projects with returns that
exceed WACC, so it is a “hurdle” rate.
 Hurdle rates can be adjusted internally (within a
corporation) for projects with different risk
characteristics.
 The need for such adjustments is apparent for
conglomerates with multiple lines of business.
 Less apparent for other firms, but appropriate
nonetheless.
Remember:
 This is a simple weighted average calculation.
 If you have to calculate weights, they should always
add up to 100%.

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The Cost of Capital

 There are two basic sources of capital for a firm:

WACC = wdrd(1-T) + wprp + wcrs

Note: If a company had multiple bond issues

 The cost of external equity is higher than the cost of

After-Tax cost of debt = rd(1-T)

 No adjustment for taxes is necessary for the cost of

rd(1-T) = .0472(1-.35) = .0307

WACC = wdrd(1-T) + wprp + wcrs

Notation: w = weight in the capital structure based on market

Market value (Market Capitalization) of Debt

WACC = wdrd(1-T) + wprp + wcrs

 Internal Factors (Within the firm’s control)

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