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CHAPTER 6
The Cost of Capital
Long-term debt
Preferred stock
Common equity
6-3
Cost of Debt
0 1 2 30
i=? ...
-1,153.72 60 60 60 + 1,000
D ps 0.1 $100
rps
Pn $113.10 $2.00
$10
0.090 9.0% .
$111.10
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Picture of Preferred
0
rps = ?
1 2
...
-111.1 2.50 2.50 2.50
DQ $2.50
$111.10 .
rPer rPer
$2.50
rPer 2.25%; rps( Nom) 2.25%( 4) 9%.
$111.10
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Note:
More
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D1 D0 1 g
rs g g
P0 P0
$4.19105
.
0.05
$50
0.088 0.05
13.8%.
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g = ROE(Retention rate)
g = 0.35(15%) = 5.25%.
rs = rd + RP
= 10.0% + 4.0% = 14.0%
Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%
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WACC
WACCH H
A Rejection Region
WACCA
B
WACCL L
Risk
0 RiskL RiskA RiskH
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Stand-alone risk
Corporate risk
Market risk
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3. Dont use book weights to estimate
the weights for the capital structure.
Use the target capital structure to determine
the weights.
If you dont know the target weights, then
use the current market value of equity, and
never the book value of equity.
If you dont know the market value of debt,
then the book value of debt often is a
reasonable approximation, especially for
short-term debt.
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