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CHAPTER 10The Cost of Capital

Sources of capital

Component costs

WACC

Adjusting for flotation costs

Adjusting for risk

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What sources of long-term

capital do firms use?Long-Term

Capital

Long-TermDebt

PreferredStock

CommonEquity

RetainedEarnings

New CommonStock

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Weighted Average Cost of

Capital (WACC) The weighted average of the

component costs of debt, preferredstock and common equity.

The ws are all weights of different components. The rs are allthe rate of return to be paid to the investors. T is the tax rate.

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Should our analysis focus onhistorical (embedded) costs or new

(marginal) costs?

The cost of capital is used primarily tomake decisions that involve raising new

capital. So, focus on todays marginalcosts (for WACC).

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Cost of debt, rd The quoted interest rate the firm must pay on

new debt.

After tax cost of debt is used, rd(1-T). As interest is tax-deductible, the firm is

getting a tax advantage by taking on debt.Thus the tax advantage is taken into accountwhile calculating the cost of debt.

In effect the government is paying part of thecost.

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Cost of Preferred Stock, rp The rate of return investors require on

firms preferred stocks.

rp = Dp/Pp Preferred dividends are not tax-

deductible, so no tax adjustments

necessary.

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Cost of Equity, rs Equity has two components: Retained

earnings & common stocks

Cost of retained earnings = opportunitycost of investing in more stocks i.e.required rate of return

Cost of common stocks = required rate ofreturn and floating cost of the firmsshares.

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Methods of calculating rs CAPM approach, r = rRF + (rM + rRF)b

Bond yield plus risk premium of 3% to

5%. This approach is very subjective based on

empirical studies

Dividend yield plus expected growthrate, r = (D1/P0) + g

Final estimate of rs is the average of all

the alternative estimates

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Flotation costs The percentage cost of issuing new common stock

given to investment bankers or brokers.

It is usually adjusted with the required rate of returnto find the cost of equity.

Flotation costs depend on the risk of the firm and thetype of capital being raised.

The flotation costs are highest for common equity.However, since most firms issue equity infrequently,the per-project cost is fairly small.

We will frequently ignore flotation costs when

calculating the WACC.

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Floatation Cost Adjustment The amount that must be added to

estimated rs to account for floatation

cost.

F = Floatation cost per share

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Factors affecting WACC Factors firm cannot control

Interest rates in the economy

General level of stock prices

Tax rates

Factors that firm controls

Capital Structure

Dividend payout ratio

Capital Budgeting decisions