Cost of Capital

Cost of Capital - The return the firm’s

investors could expect to earn if they invested
in securities with comparable degrees of risk.

Capital Structure - The firm’s mix of long term

financing and equity financing.
What sources of long-term capital do
firms use?

Long-Term
Capital

Long-Term Preferred Common

Debt Stock Stock

Retained New Common

Earnings Stock

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Cost of Capital
Example
Geothermal Inc.
has the following
structure. Given
that geothermal
pays 8% for debt
and 14% for
equity, what is the
Company Cost of
Capital?
Cost of Capital

Example - Geothermal Inc. has the following

structure. Given that geothermal pays 8% for
debt and 14% for equity, what is the Company
Cost of Capital?

Market Value Debt $194 30%

Market Value Equity $453 70%
Market Value Assets $647 100%
Cost of Capital

Example - Geothermal Inc. has the following

structure. Given that geothermal pays 8% for
debt and 14% for equity, what is the Company
Cost of Capital?

Portfolio Return = (.3x8%) + (.7x14%) = 12.2%

WACC
Weighted Average Cost of Capital (WACC)
- The expected rate of return on a portfolio
of all the firm’s securities.

Company cost of capital = Weighted average of

debt and equity returns.
WACC

rassets   x rdebt
D
V
  E
V x requity 
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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WACC

 Taxes are an important consideration in the

company cost of capital because interest
payments are deducted from income before tax
is calculated.
Cost of Capital

Example - Geothermal Inc. has the following

structure. Given that geothermal pays 8% for
debt and 14% for equity, what is the Company
Cost of Capital?
Portfolio Return = (.3x8%) + (.7x14%) = 12.2%
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2%
(i.e. 8 % x .65).

WACC = (.3x5.2%) + (.7x14%) = 11.4%

WACC

Weighted -average cost of capital=

WACC = [D
V ] [
x (1 - Tc)rdebt + E
V ]
x requity
How are the weights determined?

WACC = wdrd(1 – T) + wprp + wcrs

 Use accounting numbers or market value

(book vs. market weights)?
 Use actual numbers or target capital
structure?

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Calculating the Weighted Average Cost
of Capital
WACC = wdrd(1 – T) + wprp + wcrs

 The w’s refer to the firm’s capital structure

weights.
 The r’s refer to the cost of each component.

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WACC

Three Steps to Calculating Cost of Capital

1. Calculate the value of each security as a
proportion of the firm’s market value.
2. Determine the required rate of return on each
security.
3. Calculate a weighted average of these
required returns.
WACC

Example - Executive Fruit has

issued debt, preferred stock
and common stock. The
market value of these
securities are $4mil, $2mil,
and $6mil, respectively. The
required returns are 6%,
12%, and 18%, respectively.
Q: Determine the WACC for
Executive Fruit, Inc. given a
tax rate of 35%.
WACC

Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3

WACC = [ 4
12 ] (
x(1-.35).06 + 2
12 ) (
x.12 + 6
12 )
x.18
=.123 or 12.3%
Measuring Capital Structure

 In estimating WACC, do not use the Book

Value of securities.
 In estimating WACC, use the Market Value of
the securities.
 Book Values often do not represent the true
market value of a firm’s securities.
Measuring Capital Structure

Market Value of Bonds - PV of all

coupons and par value discounted at
the current interest rate.
Measuring Capital Structure

Market Value of Bonds - PV of all

coupons and par value discounted at
the current interest rate.

Market Value of Equity - Market price

per share multiplied by the number of
outstanding shares.
Required Rates of Return
Bonds
rd = YTM

Common Stock
re = CAPM
= rf + B(rm - rf )
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)?

10-21
Required Rates of Return

Dividend Discount Model Cost of Equity

Perpetuity Growth Model =
Div1
P0 =
re - g

solve for re
Div1
re = + g
P0
Three Ways to Determine the Cost of
Common Equity, rs
 CAPM
 rs = rRF + (rM – rRF)b

 DCF (DDM Constant Growth):

 rs = (D1/P0) + g

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Required Rates of Return

Expected Return on Preferred Stock

Price of Preferred Stock =
Div1
P0 =
rpreferred

solve for preferred

Div1
rpreferred =
P0
Component Cost of Equity

WACC = wdrd(1 – T) + wprp + wcrc

 rc is the cost of common equity.

 The rate of return investors require on the
firm’s common equity rc.

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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

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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 firm’s
preferred stock.
 Preferred dividends are not tax-deductible, so
no tax adjustments necessary. Just use
nominal rp.
 Our calculation ignores possible flotation costs.

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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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What factors influence a company’s
composite WACC?
 Market conditions.
 The firm’s capital structure and dividend
policy.
 The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.

10-29