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# Sources of capital

Component costs
WACC

CHAPTER 13
The Cost of
Capital

Cost of Capital
The

## cost of capital represents the overall

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
Capital
Long-Term
Long-Term Debt
Debt Preferred
Preferred Stock
Stock Common
Common Stock
Stock
Long-Term
Retained Earnings
Earnings
Retained

New Common
Common Stock
Stock
New

## Calculating the weighted

average cost of capital
WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
The

## xs refer to the firms capital structure

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?
The

## cost 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

As

## a percentage of total financing

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
Pref. Stock
Common
Ret. Earn.
Total L & E

40
100
100
160
400

## Bonds = 40/400 = 10%

Pref. Stock = 100/400 = 25%

kd

The

## yield to maturity on outstanding L-T debt is

often used as a measure of kd.

Why

## If tax rate is 40% then

10% before tax = 6% after tax
Sales

1,000

1,000

100*

EBT

900

1,000

Tax 40%

360

400

EAT

540

600

Interest

60
difference

## Component cost of debt

Interest

is 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
kp

The

## rate of return investors require on the

firms preferred stock.

preferred stock?
The

## cost 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
kcs

## 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])
RRF =
RM =

## Risk Free Rate (now around 2.7%)

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
2. DCF: P = k
(D / r - g)
equity,
cs
0

r = kcs
kcs = (D1 / P0)+ g

## 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
kcs = (D1 / P0)+ g
= (\$1.81 / \$43) + 0.05
= 9.2%

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

Cash

5,000

LT Debt

3,000

Equipment

5,000

Pref. Stock

1,000

Stock

6,000

10,000

Tot. Assets

10,000

## Ignoring issuance costs, what

is the firms WACC?
WACC = xd(pretax kd)(1-Tax) + xpkp + xcskcs
= .3(10%)(0.6) + .1(7.2%) + .6(10.4%)
= 1.8% + 0.72% + 6.2%
= 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 aftertax 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.

The

## optimal (best) situation is associated with the

minimum overall cost of capital:

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
Financial Plan A:
Debt
Equity.
Financial Plan B:
Debt
Equity.

Cost (After-tax)
6.5%
12.0
7.0%
12.5

Weights

Weighted

20%
80

1.3%
9.6
10.9%

40%
60

2.8%
7.5
10.3%

Financial Plan C:
Debt
Equity.

9.0%
15.0

60%
40

5.4%
6.0
11.4%