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The Cost of

Sources of capital

Capital

Component costs

WACC

Cost of Capital

cost of financing to the firm

The cost of capital is normally the relevant

discount rate to use in analyzing an

investment

The overall cost of capital is a weighted

average of the various sources, including

debt, preferred stock, and common equity:

WACC = Weighted Average Cost of Capital

WACC = After-tax costs x weights

What sources of long-term

capital do firms use?

Long-Term Capital

Long-Term Capital

Long-Term Debt

Long-Term Debt Preferred

Preferred Stock

Stock Common

Common Stock

Stock

Retained Earnings

Retained Earnings New Common

New Common Stock

Stock

Calculating the weighted

average cost of capital

WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs

weights.

The ks refer to the cost of each component.

Should our analysis focus on

before-tax or after-tax costs?

Stockholders focus on After-Tax CFs.

Therefore, we should focus on A-Tax

capital costs.

Only cost of debt needs adjustment,

because interest is tax deductible.

Should our analysis focus on

historical costs or new (marginal)

costs?

Thecost of capital is used primarily to

make decisions that involve raising new

capital. So, focus on todays marginal

costs (for WACC).

How are the weights

determined?

WACC = xd(pretax kd)(1-Tax rate) + xpkp + xcskcs

Weighting example

Bonds 40

Pref. Stock 100

Common 100

Ret. Earn. 160

Total L & E 400

What is weight of each component?

Weighting example

Bonds 40

Pref. Stock 100

Common 100

Ret. Earn. 160

Total L & E 400

Pref. Stock = 100/400 = 25%

Component cost of debt

WACC = xd(pretax kd)(1-T) + xpkp + xcskcs

Theyield to maturity on outstanding L-T debt is

often used as a measure of kd.

Why tax-adjust, i.e. why kd(1-Tax rate)?

If tax rate is 40% then

10% before tax = 6% after tax

Interest 100* 0

Tax 40% 360 400

EAT 540 600 60

difference

Component cost of debt

Interestis tax deductible, so

aftertax kd = pretax kd (1-T)

= 10% (1 - 0.40) = 6%

T = tax rate =

40%

Cost of debt

What is the current cost of debt for a

firm that has a 9% coupon bond with 5

years to maturity and a current price of

$962?

What is the after tax cost if it is in the

40% tax bracket?

Component cost of

preferred stock

WACC = xdkd(1-T) + xpkp + xcskcs

The rate of return investors require on the

firms preferred stock.

What is the cost of

preferred stock?

Thecost of preferred stock can be

solved by using this formula:

kp = Dp / Pp

= $8 / $111

= 7.2%

Component cost of

preferred stock

Preferred

dividends are not

tax-deductible, so no tax adjustments

necessary.

Component cost of equity

WACC = xd(pretax kd)(1-T) + xpkp + xcskcs

Why is there a cost for

retained earnings?

Earnings can be reinvested or paid out as

dividends.

Investors could buy other securities, earn a

return.

If earnings are retained, there is an

opportunity cost (the return that

stockholders could earn on alternative

investments of equal risk).

Investors could buy similar stocks and earn k cs.

Firm could repurchase its own stock and earn k cs.

Therefore, kcs is the cost of retained earnings.

Two ways to determine the

cost of common equity, kcs

1. CAPM: kcs = RRF + x (Mkt. risk premium [E(RM)

RRF])

RM = Return on the market

= Beta - the relation of its returns with that of

the stock market e.g.

0 not correlated

1 - moves with the market

2 twice as volatile

Two ways to determine

the cost of common

equity,

2. DCF: P = k

0 (D / r - g)

1

cs

r = kcs

If the market premium is 6%, risk-free

rate is 2.7% and the firms beta is 1.48,

whats the cost of common equity based

upon the CAPM?

kcs = RRF + (mkt premium)

= 2.7% + 1.48(6.0%) = 11.58%

If D0 = $1.72, P0 = $43, and g = 5%,

whats the cost of common equity based

upon the DCF approach?

D1 = D0 (1+g)

D1 = $1.72 (1 + .05)

D1 = $1.81

= ($1.81 / $43) + 0.05

= 9.2%

What is a reasonable final

estimate of kcs?

Method Estimate

CAPM 11.58%

DCF 9.2%

Average 10.4%

Calculate WACC

If 40% of your financing is from debt at

an after tax cost of 8% and 60% is from

pref. stock at 10%, what is the WACC?

It will be between what two numbers?

40% (.08) + 60% (.10)

.032 + .06 = .092

9.2%

Balance Sheet

use costs that were just calculated

Market values

Stock 6,000

Ignoring issuance costs, what

is the firms WACC?

WACC = xd(pretax kd)(1-Tax) + xpkp + xcskcs

= 8.7%

WACC

You are analyzing the cost of capital for

a firm that is financed with 60 percent

equity and 40 percent debt. The after-

tax cost of debt capital is 10 percent,

while the cost of equity capital is 20

percent for the firm. What is the overall

cost of capital for the firm?

(.6 x .2) + (.4 x .1) = 16%

Equity + Debt

Cardinal Health has bonds outstanding

with 15 years to maturity and are

currently priced at $800. If the bonds

have a coupon rate of 8.5 percent, then

what is the after-tax cost of debt for

Beckham if its marginal tax rate is 30%?

7.9%

Should the company use the

composite WACC as the hurdle rate

for each of its projects?

NO! The composite WACC reflects the

risk of an average project undertaken

by the firm. Therefore, the WACC only

represents the hurdle rate for a

typical project with average risk.

Different projects have different risks.

The projects WACC should be adjusted

to reflect the projects risk.

Optimum Capital Structure

Theoptimal (best) situation is associated with the

minimum overall cost of capital:

Optimum capital structure means the lowest WACC

Usually occurs with 30-50% debt in a firms capital

structure

WACC is also referred to as the required rate of

return or the discount rate

Optimal Capital Structure

Cost (After-tax) 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%

Cost of capital curve

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