Chapter 8The Cost of Capital

Fin 320Dr. B. Asiri

© 2005 Thomson/South-Western

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Cost of Capital

Firm’s average cost of funds, which is the average return required by firm’s investors

What must be paid to attract funds

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Required Rate of Return(Opportunity Cost Rate)

The return that must be raised on invested funds to cover the cost of financing such investments

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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.

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Basic Definitions

Capital ComponentTypes of capital used by firms to raise

moneykd = before tax interest costkdT = kd(1-T) = after tax cost of debtkps = cost of preferred stockks = cost of retained earningske = cost of external equity (new

stock)

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Basic Definitions

WACC Weighted Average Cost of Capital

Capital StructureA combination of different types of capital(debt and equity) used by a firm

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After-Tax Cost of Debt

The relevant cost of new debtTaking into account the tax deductibility of

interestUsed to calculate the WACC

kdT = bondholders’ RRR minus tax savings

kdT = kd - (kd x T) = kd(1-T)

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Cost of Preferred Stock

Rate of return investors require on the firm’s preferred stock

The preferred dividend divided by the net issuing price

)F1(P

D

costs FlotationP

D

NP

Dk

0

ps

0

pspsps

9

s0

1RFs k̂ g

P

D̂ RP kk

Cost of Retained Earnings

Rate of return investors require on the firm’s common stock

1. The CAPM Approach

s

RFk-

Mk

RFk

sk ( )

2. The Discounted CF Approach

Price and E(k) on a share of common stock depend on the dividends expected on the stock.

gP

D̂k̂k

0

1ss

14% 4% 10%

premiumRisk yield Bond ks

3. The Bond-Yield-Plus-Premium Approach

Estimating a risk premium above the bond interest rate

Judgmental estimate for premium

gF1P

D̂g

NP

D̂k

0

11s

Cost of Newly Issued Common Stock

External equity, ke

Based on the cost of retained earnings

Adjusted for flotation costs (the expenses of selling new issues)

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Target Capital Structure

Optimal Capital StructurePercentage of debt, preferred stock,

and common equity in the capital structure that will maximize the price of the firm’s stock

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sspspsdTd k

w

k

w

k

w

equity

common

of Cost

equity

common

of %

stock

preferred

of Cost

stock

preferred

of %

debt

of cost

tax-After

debt

of %

Weighted Average Cost of Capital, WACC

A weighted average of the component costs of debt, preferred stock, and common equity

Marginal Cost of Capital

MCCCost of obtaining another dollar of new

capitalWeighted average cost of the last dollar

of new capital raised

Marginal Cost of Capital ScheduleA graph that relates the firm’s weighted

average of each dollar of capital to the total amount of new capital raised

Reflects changing costs, depending on amounts of capital raised

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Point structure capital in the capital of type thisof Proportion

given type a of capitalcost lower ofamount TotalBreak

Break Point

BPThe dollar value of new capital that

can be raised before an increase in the firm’s weighted average cost of capital occurs

MCC Schedule

Weighted Average Cost of Capital (WACC) (%)

New Capital Raised (millions of dollars)

100 150

11.5 -

11.0 -

10.5 -WACC1=10.5%

WACC2=11.0%

WACC3=11.5%

BPRE BPDebt

Schedule and break points depend on capital structure used.

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0 -Dollars of New Capital Raised

WACC

Smooth, or Continuous, Marginal Cost of Capital Schedule

MCC Schedule

Weighted Average Cost of Capital (WACC) (%)

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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 firm’s investment

opportunities ranked in order of the projects’ internal rate of return

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Optimal Capital Budget - $115

Combining the MCC and Investment Opportunity Schedules

New Capital Raised and invested (millions of dollars)

IRRC = 12.1%

IRRB = 11.7%IRRD = 11.5%

IRRE = 11.3%

IRRA = 10.2%

Percent

20 40 60 80 100 120 140 160

12.0 -

11.0 -

10.0 -

MCC

IOSWACC1=10.0%

WACC3=11.0%

WACC2=10.5%