Chapter 11

The Cost of Capital

2007 Thomson/South-Western

Essentialsof
Chapter11
What types of capital do firms use to finance
investments?
What is the cost of capital?
How is the cost of capital used to make
financial decisions?
Why do funds generated through retained
earnings have a cost?
Who determines a firms cost of capital?

Cost of Capital
Firms average cost of funds, which is
the average return required by firms
investors
What must be paid to attract funds

Required Rate of Return

(Opportunity Cost Rate)
The return that must be raised on
invested funds to cover the cost of
financing such investments

The Logic of the Weighted

Average Cost of Capital
The use of debt impacts the ability
to use equity, and vice versa, so
the weighted average cost must be
used to evaluate projects,
regardless of the specific financing
used to fund a particular project.

Basic Definitions
Capital Component
Types of capital used by firms to raise
money
rd

= before tax interest cost

rdT

= rd(1-T) = after tax cost of debt

rps

= cost of preferred stock

rs

= cost of retained earnings

re

= cost of external equity (new stock)

Basic Definitions
WACC
Weighted Average Cost of Capital
Capital Structure
A combination of different types of
capital(debt and equity) used by a
firm

After-Tax Cost of Debt

The relevant cost of new debt
Taking into account the tax deductibility
of interest
Used to calculate the WACC
rdT = bondholders required rate of
return minus tax savings
rdT = rd - (rd x T) = rd(1-T)

Cost of Preferred Stock

Rate of return investors require on
the firms preferred stock
The preferred dividend divided by
the net issuing price

rps

D ps
NP

D ps
P0 Flotation costs

D ps
P0 (1 F)

Cost of Retained Earnings

Rate of return investors require on
the firms common stock

D
1 g r
r r
RP
s RF
s
P
0

10

The CAPM Approach

rs = rRF + (rM - rRF )s

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The Discounted Cash Flow

Approach

Price and expected rate of return on a

share of common stock depends on the
dividends expected on the stock.

P
0

D
1

D
2

1 rs 1 rs
1

D
t

t
t 1 1 r
s

1 rs

12

The Discounted Cash Flow Approach

P
0

D
1

D
2

1 rs 1 rs
1

1 rs

D
D
t
1 if g is constant

t k g
t 1 1 r
s
s

D
1

r r
g
s s P
0

13

The Bond-Yield-Plus-Premium
Approach
Estimating a risk premium above
the bond interest rate
Judgmental estimate for premium
Ballpark figure only

r Bond yield Risk premium

s
10% 4% 14%
14

Cost of Newly Issued Common

Stock
External equity, re
Based on the cost of retained
earnings
Adjusted for flotation costs (the
expenses of selling new issues)

D
D
1
1
r
g
g
s NP
P 1 F
0
15

Target Capital Structure

Optimal Capital Structure
Percentage of debt, preferred stock,
and common equity in the capital
structure that will maximize the price
of the firms stock

16

Weighted Average Cost of

Capital, WACC
A weighted average of the
component costs of debt, preferred
stock, and common equity
Proportion After - tax Proportion Cost of Proportion Cost of








of

cost
of

of
preferred

preferred

of
common

common

stock stock equity equity

debt debt

wd

rdT

w ps

rps

ws

rs

17

Marginal Cost of Capital

Marginal Cost of Capital Schedule
A graph that relates the firms
weighted average of each dollar of
capital to the total amount of new
capital raised
Reflects changing costs, depending
on amounts of capital raised

18

MCC Schedule
Weighted Average Cost of Capital
(WACC) (%)
WACC3=11.5%

11.5 WACC2=11.0%

11.0 10.5 -

WACC1=10.5%

100

150

New Capital
Raised (millions
of dollars)
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Break Point (BP)

The dollar value of new capital that can
be raised before an increase in the
firms weighted average cost of capital
occurs
Total amount of lower cost capital of a given type
Break

Point Proportion of this type of capital in the capital structure

20

MCC Schedule
Weighted Average Cost of Capital
(WACC) (%)
WACC3=11.5%

11.5 11.0 10.5 -

WACC2=11.0%
WACC1=10.5%

New Stock,
Preferred,
Expensive Debt

New Stock,
Preferred,
Cheap Debt

RE,
Preferred,
Cheap Debt

BPRE
100

BPDebt
150

New Capital Raised

(millions of dollars)
21

MCC Schedule
Schedule and break points depend
on capital structure used

22

MCC Schedule
Weighted Average Cost of Capital
(WACC) (%)
Smooth, or Continuous,
Marginal Cost of Capital
Schedule
WACC

0-

Dollars of New Capital Raised

23

Combining the MCC and

Investment Opportunity
Schedules
Use the MCC schedule to find the cost
of capital for determining projects net
present values.
Investment Opportunity Schedule
(IOS)
Graph of the firms investment
opportunities ranked in order of the
projects internal rate of return

24

Combining the MCC and

Investment
Opportunity
Percent
12.0 Schedules
IRRC = 12.1%

IRRB = 11.7%

IRRD = 11.5%
IRRE = 11.3%

WACC3=11.0%

MCC

WACC2=10.5%

10.0 -

IRRA = 10.2% IOS

WACC1=10.0%

Optimal Capital
Budget - $115
20

40

60

80

New Capital Raised and invested

(millions of dollars)

100 120 140

160

25

Chapter 11 Essentials
What types of capital do firms use to finance
investments?
Either debt (bond issues) or equity (preferred stock and
common equity)

What is the cost of capital?

The average price a firm pays for the funds it uses to
purchase assets

How is the cost of capital used to make financial

decisions?
A firm should invest in projects that ae expected to
provide returns greater than its WACC

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Chapter 11 Essentials
Why do funds generated through
retained earnings have a cost?
Firms may retain earnings only as long as it
can reinvest the earnings at a higher rate
than stockholders can earn elsewhere

Who determines a firms cost of capital?

Investors

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