CHAPTER 10 The 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-Term Debt

Preferred Stock

Common Equity

Retained Earnings

New Common Stock

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Weighted Average Cost of Capital (WACC)

The weighted average of the component costs of debt, preferred stock and common equity.

The ws are all weights of different components. The rs are all the rate of return to be paid to the investors. T is the tax rate.
9-3

Should our analysis focus on historical (embedded) costs or new (marginal) costs?

The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on todays marginal costs (for WACC).

9-4

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 account while calculating the cost of debt.

In effect the government is paying part of the cost.

9-5

Cost of Preferred Stock, rp

The rate of return investors require on firms preferred stocks. rp = Dp/Pp Preferred dividends are not taxdeductible, so no tax adjustments necessary.

9-6

Cost of Equity, rs

Equity has two components: Retained earnings & common stocks

Cost of retained earnings = opportunity cost of investing in more stocks i.e. required rate of return Cost of common stocks = required rate of return and floating cost of the firms shares.
9-7

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 growth rate, r = (D1/P0) + g Final estimate of rs is the average of all the alternative estimates 9-8

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 return to find the cost of equity. Flotation costs depend on the risk of the firm and the type 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.
9-9

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 Capital Structure Dividend payout ratio Capital Budgeting decisions
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Factors that firm controls