CAPITAL
OBJECTIVES:
Understand the need to know the Cost of
Capital
Explain why WACC is used in capital
budgeting
Estimate costs of different capital
components
Determine the firms WACC
COST OF
CAPITAL
Capital Budgeting Decision
Capital Requirement
Optimum Capital Structure
Resource Mobilization
Determination of duration of Project
Capital
Preferred Common
Debt
Stock Equity
Preferred Common
Debt Stock Equity
New
Retained
Common
Notes Long-Term Earnings
Stock
Payable Debt
Component Cost of Preferred
Stock
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.
Our calculation ignores possible flotation costs.
Coleman cost of preferred
stock
The cost of preferred stock can be solved by using this formula:
rp = Dp/Pp
= 0.1 ($100)
$ 111.10
= $10/$111.10
= 0.090
= 9%
Preferred Common
Debt
Stock Equity
DISCOUNTED
CASH FLOW
DCF
DISCOUNTED
CASH FLOW
(Dividend Current stock
price)
DCF
+ DISCOUNTED
Growth rate CASH FLOW
($1. / $23.06 + 8.3%
25
( Dividend / Current )
stock price) + Growth rate
Risk premium
3-5%
BYPR
P
BOND-YIELD-
PLUS-RISK-
PREMIUM
BYPR Bond yield
P +
BOND-YIELD- Risk premium
PLUS-RISK-
PREMIUM
10% + 4%
Bond yield + Risk premium
JUDGMENTAL
13.0 13.7 14.0
% % %
CAPM DCF BYPRP
13.0 14.0
% %
13.5%
Cost of Common Stock
Cost of New Common Stock
Flotation cost
Includes underwriting fees, legal fees, registration fees, etc.
Cost of New Common Stock
Flotation cost
Add to the Increase the
Project Cost of
Cost Capital
Add Flotation Cost to the Project
Cost
10%
90%
100%
100%
DISCOUNTED
DCF CASH FLOW
Dividend
+ Growth
Current stock price
x (1
- F) rate
($1. / $23.06 + 8.3%
25
( Dividend / Current )
stock price) + Growth rate
Dividend
+ Growth
Current stock price x ( 1
F ) rate
$1.25
+ 8.3 %
$23.06 x ( 1 0.10 )
Flotation Cost Adjustment
13.0 14.0
% %
13.5%
Cost of Common Stock
13.5% + 0.6% =
14.1%
Cost of Common Stock
(w/ Flotation cost adjustment)
QUESTIONS?