Vicentiu Covrig FIN303

Cost of Capital
(chapter 10)

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What sources of capital do firms use?

Capital

Preferred Common
Debt
Stock Equity

Notes Long-Term Retained New Common

Payable Debt Earnings Stock

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Should our analysis focus on before-tax or after-
tax capital costs?
Stockholders focus on A-T CFs.
Therefore, we should focus on A-T capital
costs, i.e. use A-T costs of capital in
WACC. Only rd needs adjustment,
because interest is tax deductible.

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How are the weights determined?

WACC = wdrd(1 T) + wprp + wsrs
d is for debt;
s is for common equity and
p is for the preferred stock

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Overview of Coleman Technologies

Firm calculating cost of capital for major expansion
program.
- Tax rate = 40%.
- 15-year, 12% coupon, semiannual payment noncallable
bonds sell for $1,153.72. New bonds will be privately
placed with no flotation cost.
- 10%, $100 par value, quarterly dividend, perpetual
preferred stock sells for $111.10.
- Common stock sells for $50. D0 = $4.19 and g = 5%.
- b = 1.2; rRF = 7%; RPM = 6%.
- Bond-Yield Risk Premium = 4%.
- Target capital structure: 30% debt, 10% preferred, 60%
common equity.
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Component Cost of Debt

WACC = wdrd(1 T) + wprp + wcrs
rd is the marginal cost of debt capital.
The yield to maturity on outstanding L-T debt is
often used as a measure of rd.
Why tax-adjust; i.e., why rd(1 T)?

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A 15-year, 12% semiannual coupon bond
sells for $1,153.72. What is the cost of
debt (rd)?
Remember, the bond pays a semiannual
coupon, so rd = 5.0% x 2 = 10%.
INPUTS 30 -1153.72 60 1000
N I/YR PV PMT FV
OUTPUT 5

Interest is tax deductible, so

A-T rd = B-T rd(1 T)
= 10%(1 0.40) = 6%

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Component Cost of Preferred Stock

WACC = wdrd(1 T) + wprp + wcrs

rp is the marginal cost of preferred stock, which is

the return investors require on a firms preferred
stock.
Preferred dividends are not tax-deductible, so no
tax adjustments necessary. Just use nominal rp.

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What is the cost of preferred stock?

The cost of preferred stock can be solved
by using this formula:

rp = Dp/Pp
= $10/$111.10
= 9%

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Is preferred stock more or less risky to
investors than debt?
More risky; company not required to pay
preferred dividend.
However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred stockholders
may gain control of firm.

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Component Cost of Equity

WACC = wdrd(1 T) + wprp + wcrs
rs is the marginal cost of common equity
The rate of return investors require on the firms
common equity using new equity is re.

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Component cost of equity
WACC = wdrd(1-T) + wc rs
rs is the cost of common equity

CAPM: ks = kRF + (kM kRF)

If the kRF = 7%, RPM = 6%, and the firms beta is 1.2, whats the
cost of common equity based upon the CAPM? 14.2%

DCF: ks = D1 / P0 + g section 10-5c in the text

^ D1
[ This formula above is a rearrangement of P 0 ]
ks - g
If D0 = $4.19, P0 = $50, and g = 5%, whats the cost of common
equity based upon the DCF approach? 13.8%

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What factors influence a companys
composite WACC?
Market conditions.
The firms capital structure and dividend
policy.
The firms investment policy. Firms with
riskier projects generally have a higher
WACC.

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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.

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Exam type question

Wyden Brothers has no retained earnings. The company uses the CAPM to
calculate the cost of equity capital. The companys capital structure consists
of common stock and debt. Which of the following events will reduce the
companys WACC?
a. A reduction in the market risk premium. *
b. An increase in the companys credit risk.
c. An increase in the companys beta.
d. An increase in expected inflation.

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Exam type question

Billick Brothers is estimating its WACC. The company has collected the following
information:
Its capital structure consists of 40 percent debt and 60 percent common equity.
The company has 20-year bonds outstanding with a 9 percent annual coupon that
are trading at par.
The companys tax rate is 40 percent.
The risk-free rate is 5.5 percent.
The market risk premium is 5 percent.
The stocks beta is 1.4.
What is the companys WACC?
a. 9.71%
b. 9.66% *
c. 8.31%
d. 11.18%

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Learning objectives
Know how to calculate the WACC based on the equity and debt components
Discuss several factors that can affect the composite cost of capital (see slide 8)
Floatation costs and sections 10-5b and 10.6 will NOT be on the exam
Recommended end-of-chapter problems: 10-1,10-3, 10-4 (without floatation),
10-8

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