FINA 3330 - Chapter 12 (Cost of Capital)

I. Introduction
II. Component Costs
III. Calculating the WACC
IV. Special Situations
V. Flotation Costs

I. Overview of WACC
Most firms use several types of capital, capital components. The most frequent types used
by firms are: common stock, preferred stock, and debt. All capital components have one feature
in common: the investors who provided the funds expect to receive a return on their investment.
The required return on each capital component is called component cost. The cost of
capital used to analyze capital budgeting decisions is the weighted average of the various
component costs, called the weighted average cost of capital (WACC). In other words, WACC is
the overall cost of the firm, the overall required rate of return.
Most firms set target percentages for the different financing sources. For example, say the
National Computer Corporation (NCC) plans to raise 30 percent of its required capital as debt,
10 percent as preferred stock, and 60 percent as common equity. This is called target capital
structure, and these percentages are called capital structure weights.
However, firms frequently deviate from their target capital structure in the short-run for
various reasons, such as market conditions, or because of flotation costs (costs that a firm must
incur when issuing new securities).

II. Component Costs

At the basic level, the capital structure of any corporation consists of debt and/or equity
(preferred and common). Therefore, a basic corporation will have at most three component costs:

(1) component cost of debt = kd (1-t),

where kd is the YTM (or YTC) on the firm’s existing bonds;
(2) component cost of preferred stock = kps,
where kps the required return on the firm’s preferred stock;
(3) component cost of common stock = ke,
where ke is the cost of common equity raised through retained earnings.

III. Calculating the WACC

A. Capital Structure Weights

Since the firm is financed through debt and/or equity, then

V = D + P + E,

where V is the value of the company; D is the market value of the debt used by the company; P is
the market value of the preferred stock; and E is the market value of the common equity
 Thus, the capital structure weight of debt will be (D/V), the capital structure weight of
preferred stock will be (P/V), and the capital structure weight of common equity will be (E/V),
with (D/V) + (P/V) + (E/V) =1.

B. WACC
Given V = D + P + E, then:

WACC = (D/V) [kd(1-t)] + (P/V) kps + (E/V) ke

IV. Special Situations

In the following three situations, the WACC will be calculated differently than above:
(i) In the case of a company with various divisions, the divisional cost of capital
(i.e., the cost of capital calculated along divisions of the company) will be used. For example,
Microsoft has a division for manufacturing computers, while another division is an Internet
provider. The manufacturing part will have one cost of capital, and the Internet provider will
have another cost of capital.
(ii) The pure play approach will be used when dealing with unique projects. In this
case, the WACC specific to the particular project is calculated based on companies in similar
lines of business.
(iii) The subjective approach (i.e., making subjective adjustments to the overall
WACC) is used when difficulties exist in objectively establishing discount rates for individual
projects of the company.

V. Flotation Costs

A. Weighted Average Flotation Cost (fA)

fA= (D/V) fd + (P/V) fps + (E/V) fe

where fd are the flotation costs of debt; fps are the flotation costs of preferred stock; and fe are the
flotation costs of common equity.
Given flotation costs, the actual amount the company must raise when needing capital is:

Amount Raised = (Amount Needed) / (1 – Flotation Costs)

B. Flotation Costs and NPV

Given flotation costs, the actual NPV of any project will be:

NPV* = NPV – Flotation Costs.