Cost of Capital

Dr. M. Shamim Uddin Khan

Introduction
The cost of capital is the minimum rate of return that a firm must earn on the projects in which it invests
to maintain the market value of its stock. It can also be thought of as the rate of return required by the
market suppliers of capital to attract their funds to the firm. If risk is held constant, projects with a rate
of return above the cost of capital will increase the value of the firm, and projects with a rate of return
below the cost of capital will decrease the value of the firm. The cost of capital acts as a major link
between the firm’s long-term investment decision and the wealth of the owners as determined by
investors in the marketplace. It is, in effect, the magic number that is used to decide whether a proposed
corporate investment will increase or decrease the firm’s stock price.
It is observed that the cost of capital is a topic of serious controversy. The cost of capital
interacts with hypothesis about risk, capital structure, and market valuation. The conceptual difficulty in
the determination of cost of capital arises from the existence of uncertainty and the variety of financial
instruments employed in the market.
Significance of Cost of Capital
The cost of capital is significant in the financial decision making areas as a standard for:
1. Evaluating investment decision where cost of capital is considered as the minimum rate of
returns on an investment project
2. Designing debt-equity policy.
3. Appraising financial performance
4. Formulating dividend policy
5. Determining investment in current assets.
Factors Influencing Cost of Capital Determination
The factors influencing the determination of cost of capital are discussed as follows
1. Business Risk: Business risk is that which occurs from operating business of a firm. It is
influenced among others, largely by fixed costs incurred. The higher the fixed costs, the greater
will be the business risk and vice-versa. It is one of the important factors that influence the
determination of cost of capital. The more the business risk, the higher will be the cost of capital.
2. Financial Risk: Financial risk is one that an enterprise will be unable to satisfy its financial
obligations. The risk that will reduce the financial resources of a firm is known as financial risk.
The more the financial risk the higher will be the cost of capital.
3. Source of Finance: There are various sources of finances namely internal sources and external
sources. Cost of capital is largely dependent on these sources of finance. There are some sources
which are relatively costly, and again, there are some sources which are relatively cheaper from
the view point of cost of capital.
4. Tax Aspect: Tax aspect, income tax as well as VAT also influence the determination of cost of
capital of a firm.
5. Relative Return: Relative return of a firm from its investment also influences the determination
of cost of capital of that firm.
6. Capital Structure Composition: Capital structure composition i.e. debt-equity mix also affects
the determination of cost of capital of a firm.
7. Dividend Policy: Dividend policy and dividend payout and profit retention policies of a firm
also influence the determination of cost of capital.
Methods for Cost of Capital Determination
(A) Methods of Determination of Cost of Debt Capital
Debt is of two types namely long-term and short-term. Both of these debts have their respective cost.
The specific rate of interest of these two types of debt is known as cost of debt. However, the important
methods of determination of cost of debt are as follows:
 (a) Actual rate of interest
(b) Effective rate of interest i.e. actual rate plus some premium
(c) Absolute sum like 9%, 10%, 12% and so on.
Computation of Cost of Debt Capital:
1. Debt capital cost = Before-tax cost of debt = Rate of interest = Kd
2. After-tax cost of debt, K dt  K d (1  T ) ; where T is tax rate.
(B) Methods of Determination of Cost of Equity Capital
Equity capital has its cost in the form of stock/share transactions and dividend payments to the
shareholders. The important methods used in determination of cost of equity are:
(a) Primary rate of returns to investors by ICB, Mutual Fund, NSC etc.
(b) Primary rate of returns plus risk premium
(c) Absolute like 10%, 12%, 14% and so on
(d) As calculated by dividend valuation model
Computation of Cost of Equity Capital:
The cost of common stock is the return required on the stock by investors in the marketplace. There are
two forms of common stock financing (a) retained earnings and (b) new issues of common stock.
Cost of Common Stock Equity (Using constant-growth valuation models)
D1 Dividend on Equity
Ks  g  Growth in dividend
P0 Selling price per stock
Cost of Common Stock Equity (Using CAPM)
K s  R f  [   ( Rm  R f )]  Riskfree rate of return  b(market return - riskfree rate of return)
Cost of New Issues of Common Stock (Equity)
D Dividend on Equity
Kn  1  g   Growth in dividend
Nn Net proceeds
(C) Methods of Determination of Cost of Retained Earnings Capital
Retained earnings, although, an internal source of capital has also its cost in the form of its opportunity
cost. The important methods of determination of cost of retained earnings are
1. By equity capital with its cost
2. By equity capital with its opportunity cost of using the fund by equity-holders
3. By equity capital with dividend payment
4. Absolute sum say 10%, 12%, 14% and so on
Computation of Cost of Retained Earnings: K r  K s
(D) Cost of Preferred Stock Capital
The cost of preferred stock, Kp, is the ratio of the preferred stock dividend to the firm’s net proceeds
from the sale of the preferred stock. The net proceeds represents the amount of money to be received
minus any floatation costs.
D p Dividend on preferred stock Dividend on preferred stock
Kp   
Np Net proceeds Selling price per share - floating cost
Overall Cost of Capital
In theory, there are two methods of determination of the overall cost of capital namely, weighted
average cost of capital (WACC) and marginal cost of capital (MCC).
Weighted Average Cost of Capital (WACC)
Multiply the specific cost of each form of financing by its proportion in the firm’s capital structure and
sum the weighted values. This can be written as:
WACC  (Wi  Ki )  (W p  K p )  (Ws  K r or n )
Wi = proportion of long-term debt in capital structure
Wp = proportion of preferred stock in capital structure
Ws = proportion of common stock in capital structure
Wi + Wp + Ws = 1
The firm’s common stock equity weight Ws is multiplied by either the cost of retained earnings Kr, or
the cost of new common stock Kn. Which cost is used depends on whether the firm’s common stock
equity will be financed using retained earnings Kr or new common stock Kn.
Marginal Cost of Capital (MCC)
MCC is defined as the cost of the last dollar of new capital that the firm raises. The MCC increases as
the firm raises more and more capital during a given period. A graph of the MCC plotted against dollars
raised is the MCC schedule.
D1
MCC  K e  g
P0 (1  F )
Problem 1: The following tabulation gives earning per share figures for the X Company during the
preceding 10 years. The firm’s common stock, 78,00,000 shares outstanding, is now January (2000)
selling for Tk.65 per share, and the expected dividend at the end of the current year (2000) is 55% of the
1999 EPS. Because investors expect past trends to continue, g can be based on the earnings growth rate
(Note that nine years of growth are reflected in the data)
Year EPS Year EPS
1990 Tk.3.90 1995 Tk.5.73
1991 Tk.4.21 1996 Tk.6.19
1992 Tk.4.55 1997 Tk.6.68
1993 Tk.4.91 1998 Tk.7.22
1994 Tk.5.31 1999 Tk.7.80
The current interest rate on new debt is 9%. The firm’s marginal tax rate is 40%. Its capital structure,
considered to be optimal, is as follows:
Debt (long-term only) Tk.104,000,000
Common equity 156,000,000
Total liabilities and equity Tk.260,000,000
Required:
(i) Calculate X Company’s after tax cost of new debt and common equity, assuming that new
equity comes only from retained earnings.
(ii) Calculate the cost of equity.
(iii) Find X Company’s weighted average cost of capital, again assuming that no new common
stock is sold and that all debt costs 9%.
Solution:
(i) After-tax cost of debt, K dt  K d (1  T ) = 0.09 (1-0.40) = 0.054 = 5.4%
D Dividend on Equity
(ii) We know that cost of equity, K S  1  g   Growth in dividend
P0 Selling price per share
4.29
  0.078  0.067  0.078  0.145  14.5%
65
104 156
(iii) WACC  (Wi  K i )  (Ws  K s )   (0.054)   (0.145)  0.1086  10.86%
260 260
Problem 2: Ross Corporation wishes to explore the effect on its cost of capital of the rate at which the
company pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock,
and 60% common stock. The cost of financing with retained earnings is 14%, the cost of preferred stock
financing is 9%, and the before tax cost of debt financing is 11%. Calculate the weighted average cost of
capital (WACC) given the tax rate assumptions in pactrs (i) to (iii).
(i)Tax rate = 40% (ii) Tax rate = 35% (iii) Tax rate = 25
(iv) Describe the relationship between changes in the rate of taxation and the weighted average cost
of capital.
Solution: We are given that,
 Wd  30%, K d  11%
W p  10%, K p  9%
Ws  60%, K s  14%

WACC  (Wd  K d )(1  t )  (W p  K p )  (Ws  K s )

When, tax rate = 40% then WACC  (0.3  0.11)(1  0.4)  (0.1 0.09)  (0.6  0.14)  0.1128

WACC =11.28%
Similarly, when, tax rate = 35%, then WACC = 11.45%
when, tax rate = 25% then WACC = 11.78%
Hence, there is opposite relationship between tax rate and weighted average cost of capital (WACC).
Problem 3: It is expected that Chittagong Cement Clinkers Ltd will declare dividend Tk.50 per share in
next year which will be growing at 5% per year perpetually. What is the cost of equity capital if current
market price of the share is Tk.750 per share? What will be the price after 1st, 2nd and 3rd year?
Solution:
D Dividend on Equity
Ks  1  g   Growth in dividend
P0 Selling price per share
50
Ks   0.05  0.6667  0.05  0.11667 i.e. 11.76%
750
The price of the share at the end of year 1, 2, and 3 can be estimated as follows:
D2 50(1.05) 52.5
P1     Tk .787
K s  g 0.1167 - 0.05 0.0667
D3 52.5(1.05) 55.125
P2     Tk.826
K s  g 0.1167 - 0.05 0.0667
D4 55.125(1.05) 57.88
P3     Tk.868
K s  g 0.1167 - 0.05 0.0667
Problem 4: The following tabulation gives earning per share figures for the Badrul Company during the
preceding ten years. The firm’s common stock, 78,00,000 shares outstanding, is now (January 1, 2000)
selling for Tk.65 per share, and the expected dividend at the end of the current year (2000) is 55 percent
of the 1999 EPS. Because investors expect past trends to continue, g can be based on the earnings
growth rate (Note that nine years of growth are reflected in the data.)
Year EPS Year EPS
1990 Tk.3.90 1995 Tk.5.73
1991 4.21 1996 6.19
1992 4.55 1997 6.68
1993 4.91 1998 7.22
1994 5.31 1999 7.80
The current interest rate on new debt is nine percent. The firm’s marginal tax rate is 40 percent. Its
capital structure, considered to be optimal, is as follows:
Debt (long-term only) Tk.104,000,000
Common equity Tk.156,000,000
Total liabilities and equity Tk.260,000,000
Requirements:
(a) Calculate Badrul’s after-tax cost of new debt and common equity, assuming that new equity comes
only from retained earnings.
(b) Calculate the cost of equity as k e = D1/P0 + g.
(c) Find Badrul’s weighted average cost of capital, again assuming that no new common stock is sold
and that all debt costs nine percent.
Solution:
(a) Proportion of debt and common equity is as follows:
104,000,000 156,000,000
Wd   0.40 We   0.60
260,000,000 260,000,000
Growth rate, g  E0 (1  g ) n
7.8  3.9(1  g ) 9
g  8%
We know that, K dt  K d (1  T )  0.09(1  0.40)  0.054  5.4%
D 55% on 7.8
(b) We know that, K e  1  g   8%  14.6%
P0 65
(c) We know that,WACC  Wd K dt  We K e  0.40  0.054  0.60  0.146  0.1086  10.86%
Problem 5: Burger Paints Corporation has a target capital structure of 40% debt and 60% common
equity. The company expects to have Tk. 600 of after-tax income during the coming year and it plans to
retain 40% of its earnings. The current stock price is Tk. 30 and the last dividend was Tk. 2 and dividend
is expected to grow at a constant rate of 7%. New stock can be sold at a floatation cost of 25%> What
will be the marginal cost of equity capital if the company raises a total of Tk. 500 new capital.
D1 2.00
Solution: MCC  K e  g  0.07  0.159  15.9%
P0 (1  F ) 30(1  0.25)
Problem 6: Lancaster Engineering Inc. has the following capital structure, which it considers to be
optimal:
Debt 25%
Preferred stock 15%
Common equity 60%
Total 100%
LEI’s expected net income this year is $34285.72, its established dividend payout ratio is 30%, its
federal plus state tax rate is 40%; and investors expect future earnings and dividends to grow at a
constant rate of 9%. LEI paid a dividend of $3.60 per share last year, and its stock currently sells for
$54.00 per share.
LEI can obtain new capital in the following ways:
Preferred: New preferred stock with a dividend of $11.00 can be sold to the public at a price of $95.00
per share.
Debt: Debt can be sold at an interest rate of 12%.
Requirements:
(a) Determine the cost of each capital component.
(b) Calculate the WACC.
(c) LEI has the following investment opportunities that are average-risk projects:
Project Cost at t=0 Rate of Return
A 10,000 17.4%
B 20,000 16.0
C 10,000 14.2
D 20,000 13.7
E 10,000 12.0
Which projects should LEI accept? Why?
Solution:
(a) Given that, Dividend payout ratio = 30%, Tax, T = 40%, Growth rate, g = 9%,
Dividend paid per share =$3.60, Stock price, P = 54
 D1 D (1  g ) 3.60(1  0.09)
We know that, K S  g 0 g  0.09  16.27%
P0 P0 54
D 11
We know that, K P  1   11.58%
P0 95
11
We know that, K dt  K d (1  T )  12%(1  0.4)   7.27%
95
(b) Given that,
Wd  25%, Wp  15%, We  60% , K dt  K d (1  T )  7.27%, K P  11.58%, K e  16.27%,
We know that,WACC  Wd K dt  W p K P  We K e  0.25  0.0727  0.15  0.1158  0.6  0.1627  0.1330  13.30%
(d) LEI should accept Projects A, B, C, and D. It should reject Project E because its rate of return
does not exceed the WACC of funds needed to finance it.
Problem 7: Percy Motors has a target capital structure of 40% debt and 60% common equity, with no
preferred stock. The yield to maturity on the company’s outstanding bonds is 9% and its tax rate is 40%.
Percy’s CFO estimates that the company’s WACC is 9.96%. What is Percy’s cost of common equity?
Solution:
We are given that, Debt, Wd = 40%, Equity, We = 60%, Kd = 9%, Tax rate = 40%, WACC = 9.96, Ke =?
We know that,WACC  Wd K d (1  T )  We K e
0.996  0.40  0.09  (1  0.40)  0.0727  0.60  K e
K e  13%
Problem 8: Hook Industries capital structure consists solely of debt and common equity. It can issue
debt at rd = 11%, and its common stock currently pays a $2.00 dividend per share (D0 = $2.00). The
stock’s price is currently $24.75, its dividend is expected to grow at a constant rate of 7% per year, its
tax rate is 35%, and its WACC is 13.95%. What percentage of the Company’s capital structure consists
of debt?
Solution: We are given that, Cost of debt, Kd = 11%, Dividend per share, D0 = $2, Current stock price,
P0 = $24.75 Tax rate, T = 35%, WACC = 13.95%, Wd =?
D D (1  g ) 2(1  0.07)
We know that, K S  1  g  0 g  0.07  15.64%
P0 P0 24.75
Again, we know that, WACC  Wd K d (1  T )  WS K S
0.1395  Wd  0.11  (1  0.35)  (1  Wd )  0.1564
Wd  20%
WS  (1  0.20)  80%
Problem 9: Midwest Electric Company (MEC) uses only debt and common equity. It can borrow
unlimited amounts at an interest rate of rd = 10%, as long as it finances at its target capital structure,
which calls for 45% debt and 55% common equity. Its last dividend was $2, its expected constant
growth rate is 4%, and its common stock sells for $20. MEC’s tax rate is 40%. Two projects are
available: Project A has a rate of return of 13%, while Project B’s return is 10%. These two projects are
equally risky as the firm’s existing assets.
Requirements:
(a) What is the cost of common equity?
(b) What is the WACC?
(c) Which project should Midwest accept?
Solution:
D1 D (1  g ) 2(1  0.04)
(a) We know that, cost of common equity, K e  g 0 g  0.04  14.4%
P0 P0 20
(b) We know that, WACC  Wd K d (1  T )  WS K S  0.45  0.10  (1  0.40)  0.55  0.144  10.62%
(c) MEC should accept Project A.
Problem 9: The Evanec Company’s next expected dividend D1 is $3.18; its growth rate is 6% and its
common stock now sells for $36.00. New stock (external equity) can be sold to net $32.40 per share.
Requirements:
(a) What is the Evanec’s cost of retained earnings?
(b) What is the Evanec’s percentage flotation cost, F?
(c) What is the Evanec’s cost of new common stock re?
Solution:
We are given that, Dividend per share, D1 = 3.18, Growth rate, g = 6%, Current stock price, P0 = $36.00
Price of external equity = $32.40.
D1 3.18
(a) We know that, cost of retained earnings, K r   g   0.06  14.83%
P0 36
(b) Flotation cost, FC = (36.00 – 32.40) = 3.6
3.6
Percentage of flotation cost =  100  10%
36
D1 3.18
(c) We know that, cost of new common stock, K n   g   0.06  15.81%
P0  FC 32.40
Problem 10: What will be the yield to maturity on a debt that has par value of $1000, a coupon interest
rate of 5%, time to maturity of 10 years and is currently trading at $900? What will be the cost of debt if
the tax rate is 30%?
Solution: Given that, Interest amount, C = 1000 x 5% = 50; Face value, F = $1000, Market price,
P = $900, Number of years, n = 10, Tax rate, T = 30%.
F P 1000  900
C 50 
n  10 50  10
We know that, K d    6.32%
FP 1000  900 950
2 2
After tax cost of debt Kdt= Kd(1-T)=6.32(1-0.3) = 4.424%.
Problem 11: Prescott Corporation issues a $1000 par, 20 year bond paying the market rate of 10%.
Coupons are annual. The bond will sell for par since it pays the market rate, but flotation costs amount
to $50 per bond. Assume tax rate is 34%. What is the pre-tax and after tax cost of debt for Prescott
Corporation?
Solution: Given that, Interest amount, C = 1000 x 10% = 100; Face value, F = $1000, Market price,
P = 1000 – 50 = $950, Number of years, n = 20, Tax rate, T = 34%.
F P 1000  950
C 100 
n  20 100  2.5
We know that, K d    10.5%
FP 1000  950 975
2 2
After tax cost of debt Kdt= Kd(1-T)=10.51(1-0.34) = 6.94%
Problem-12 (ST. 9.1: Specific costs, WACC, WMCC, and IOS): Humble Manufacturing is interested
in measuring its overall cost of capital. The firm is in the 40% tax bracket. Current investigation has
gathered the following data:
Debt: The firm can raise an unlimited amount of debt by selling $1,000-parvalue, 10% coupon interest
rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average
discount of $30 per bond must be given. The firm must also pay flotation costs of $20 per bond.
Preferred stock: The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par
value. The cost of issuing and selling the preferred stock is expected to be $4 per share. An unlimited
amount of preferred stock can be sold under these terms.
Common stock: The firm’s common stock is currently selling for $80 per share. The firm expects to pay cash
dividends of $6 per share next year. The firm’s dividends have been growing at an annual rate of 6%, and this rate
is expected to continue in the future. The stock will have to be underpriced by $4 per share, and flotation costs are
expected to amount to $4 per share. The firm can sell an unlimited amount of new common stock under these
terms.
Retained earnings: The firm expects to have $225,000 of retained earnings available in the coming
year. Once these retained earnings are exhausted, the firm will use new common stock as the form of
common stock equity financing.
a. Calculate the specific cost of each source of financing. (Round to the nearest 0.1%.)
b. The firm uses the weights shown in the following table, which are based on target capital structure
proportions, to calculate its weighted average cost of capital. (Round to the nearest 0.1%.)
Source of capital Weight
Long-term debt 40%
Preferred stock 15
Common stock equity 45
Total 100%
(1) Calculate the single break point associated with the firm’s financial situation.
(Hint: This point results from the exhaustion of the firm’s retained earnings.)
(2) Calculate the weighted average cost of capital associated with total new financing below the break
point calculated in part (1).
(3) Calculate the weighted average cost of capital associated with total new financing above the break
point calculated in part (1).
c. Using the results of part b along with the information shown in the following table on the available
investment opportunities, draw the firm’s weighted marginal cost of capital (WMCC) schedule and
investment opportunities schedule (IOS) on the same set of axes (total new financing or investment on
the x axis and weighted average cost of capital and IRR on the y axis).
Investment Internal rate of Initial
opportunity return (IRR) investment
A 11.2% $100,000
B 9.7 500,000
C 12.9 150,000
D 16.5 200,000
E 11.8 450,000
F 10.1 600,000
G 10.5 300,000
d. Which, if any, of the available investments do you recommend that the firm accept? Explain your
answer. How much total new financing is required?
Solution:
RV - NSV 1000 - 950
I 100 
(a ) We know that cost of debt, Kd (YTM)  N  5  10.8%
RV  NSV 1000  950
2 2
where RV = Redeemable Value = $1000
NSV =Net Sales Value = 1000 – 30 - 20 = $950
N = Number of years to the bond maturity = 10
I = Annual Interest Amount = $100
K dt  K d (1  T )  10.8%(1  0.40)  6.5%
D1 0.11 100 11
We know that, cost of preferred stock, K p     11.5%
P0  FC 100 - 4 96
D 6
We know that, cost of retained earnings, K r  1  g   0.06  13.5%
P0 80
D1 6 6
We know that, cos t of new common stock, K n   g   0.06   0.06  14.3%
P0  FC 80 - (4  4) 72
(b) (1) Break Point, BP
AFCommon equity 225,000
BPCommon equity    $500,000
WCommonequity 0.45
(2) WACC for total new financing < $500,000
Source of Capital Weight Cost Weighted Cost
Long-term debt 0.40 6.5% 2.6%
Preferred stock 0.15 11.5% 1.7%
Common stock equity 0.45 13.5% 6.1%
Total 1.00 10.4%
Weighted average cost of capital is 10.4%
(3) WACC for total new financing > $500,000
Source of Capital Weight Cost Weighted Cost
Long-term debt 0.40 6.5% 2.6%
Preferred stock 0.15 11.5% 1.7%
Common stock equity 0.45 14.3% 6.4%
Total 1.00 10.7%
Weighted average cost of capital is 10.7%
(c) Investment Opportunity Schedule (IOS) data for graph
Investment Internal rate of Initial Cumulative
opportunity return (IRR) investment investment
D 16.5% $200,000 $200,000
C 12.9 150,000 350,000
E 11.8 450,000 800,000
A 11.2 $100,000 900,000
G 10.5 300,000 1200,000
F 10.1 600,000 1800,000
B 9.7 500,000 2300,000
(d) Projects D, C, E, and A, should be accepted because their respective IRRs exceed the WMCC. They
will require $900,000 of total new financing.
Problem- 13 (ST. 9.9: Cost of common stock equity): J&M Corporation common stock has a beta, b,
of 1.2. The risk-free rate is 6%, and the market return is 11%.
a. Determine the risk premium on J&M common stock.
b. Determine the required return that J&M common stock should provide.
c. Determine J&M’s cost of common stock equity using the CAPM.
Solution: Given that Rf  6%, Rm  11%,   1.2
(a) Risk premium = R m - R f  11% - 6%  5%
(b) R  R f  [   ( Rm  R f )]  6  1.2(11 - 6)  12%
(c) After-tax cost of common equity using the CAPM is 12%
Problem-14 (ST. 9.10: Cost of common stock equity): Ross Textiles wishes to measure its cost of
common stock equity. The firm’s stock is currently selling for $57.50. The firm expects to pay a $3.40
dividend at the end of the year (2016). The dividends for the past 5 years are shown in the following
table.
Year Dividend
2015 3.10
2014 2.92
2013 2.60
2012 2.30
2011 2.12
After underpricing and flotation costs, the firm expects to net $52 per share on a new issue.
a. Determine the growth rate of dividends.
b. Determine the net proceeds, Nn, that the firm actually receives.
c. Using the constant-growth valuation model, determine the cost of retained earnings, kr.
d. Using the constant-growth valuation model, determine the cost of new common stock, kn.
Solution:
(a) Growth rate, S  P(1  g ) n
2.12  3.1(1  g )5
g = 10%
(b) Net proceeds, Nn=$52
D1 3.40
(c) We know that, cost of retaied earnings, K r   g   0.10  15.91%
P0 57.50
D 3.40
(d) We know that, cost of new common stock, K n  1  g   0.10  16.54%
Nn 52
Problem- 15 (ST. 9.14: WACC—Book weights and market weights): Webster Company has
compiled the information shown in the following table.
Source of capital Book value Market value After tax cost
Long-term debt $4000,000 3,840,000 6.0%
Preferred stock 40,000 60,000 13.0
Common stock equity 1,060,000 3,000,000 17.0
Total 5,100,000 6,900,000
a. Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value weights.
c. Compare the answers obtained in parts a and b. Explain the differences.
Solution: (a) Book Value Weights:
Type of Capital Book Value Weight Cost Weighted Cost
Long-term debt $4000,000 0.784 6.0% 4.704%
Preferred stock 40,000 0.008 13.0% 0.104%
Common stock equity 1,060,000 0.208 17.0% 3.536%
Total 5,100,000 8.344%
(b) Market Value Weights:
Type of Capital Market Value Weight Cost Weighted Cost
Long-term debt 3,840,000 0.557 6.0% 3.342%
Preferred stock 60,000 0.009 13.0% 0.117%
Common stock equity 3,000,000 0.435 17.0% 7.395%
Total 6,900,000 10.854%
(c) The difference lies in the two different value bases. The market value approach yields the better
value since the costs of the components of the capital structure are calculated using the prevailing
market prices. Since the common stock is selling at a higher value than its book value, the cost of capital
is much higher when using the market value weights. Notice that the book value weights give the firm a
much greater leverage position than when the market value weights are used.
Problem-16 (ST. 9.15: WACC and target weights): After careful analysis, Dexter Brothers has
determined that its optimal capital structure is composed of the sources and target market value weights
shown in the following table.
Source of capital Target market
value weight
Long-term debt 30%
Preferred stock 15
Common stock equity 55
Total 100%
 The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to be 13.5%; the cost of
retained earnings is estimated to be 16.0%; and the cost of new common stock is estimated to be 18.0%.
All of these are after-tax rates. The company’s debt represents 25%, the preferred stock represents 10%,
and the common stock equity represents 65% of total capital on the basis of the market values of the
three components. The company expects to have a significant amount of retained earnings available and
does not expect to sell any new common stock.
a. Calculate the weighted average cost of capital on the basis of historical market value weights.
b. Calculate the weighted average cost of capital on the basis of target market value weights.
c. Compare the answers obtained in parts a and b. Explain the differences.
Solution: (a) Historical Market Weights:
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.25 7.2% 1.80%
Preferred stock 0.10 13.5% 1.35%
Common stock equity 0.65 16.0% 10.40%
Total 13.55%
(b) Target Market Weights:
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.30 7.2% 2.160%
Preferred stock 0.15 13.5% 2.025%
Common stock equity 0.55 16.0% 8.800%
Total 12.985%

Using the historical weights the firm has a higher cost of capital due to the weighing of the more
expensive common stock component (0.65) versus the target weight of (0.55). This over-weighting in
common stock leads to a smaller proportion of financing coming from the significantly less expensive
Long-term debt and the lower costing preferred stock.
Problem- 17 (ST. 9.16: Cost of capital and break point): Edna Recording Studios, Inc., reported
earnings available to common stock of $4,200,000 last year. From those earnings, the company paid a
dividend of $1.26 on each of its 1,000,000 common shares outstanding. The capital structure of the
company includes 40% debt, 10% preferred stock, and 50% common stock. It is taxed at a rate of 40%.
a. If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6% per
year for the foreseeable future, what is the company’s cost of with retained earnings financing?
b. If underpricing and flotation costs on new shares of common stock amount to $7.00 per share, what is
the company’s cost of new common stock financing?
c. The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share.
Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing?
d. The company can issue $1,000 par value, 10% coupon, 5-year bonds that can be sold for $1,200 each.
Flotation costs would amount to $25.00 per bond. Use the estimation formula to figure the approximate
cost of new debt financing.
e. What is the maximum investment that Edna Recording can make in new projects before it must issue
new common stock?
f. What is the WACC for projects with a cost at or below the amount calculated in part e?
g. What is the WMCC for projects with a cost above the amount calculated in part e (assuming that debt
across all ranges remains at the percentage cost calculated in part d)?
Solution:
D1 D (1  g ) 1.26(1  0.06)
(a) We know that, cost of retained earnings, K r  g 0 g  0.06  9.35%
P0 P0 40
D1 D (1  g ) 1.26(1  0.06)
(b) We know that, cost of new common stock, K n  g 0 g  0.06  10.06%
P0  FC P0  FC 40 - 7
D1 2
(c) We know that, cost of preferred stock, K p    9.09%
P0  FC 25 - 3
 RV - NSV 1000 - 1175
I 100 
(d ) We know that cost of debt, Kd (YTM)  N  5  5.98%
RV  NSV 1000  1175
2 2
where RV = Redeemable Value = $1000
NSV =Net Sales Value = 1200 – 25 = 1175
N = Number of years to the bond maturity = 5
I = Annual Interest Amount = $100

K dt  K d (1  T )  5.98%(1  0.40)  3.59%

4200,000  (1.26  1,000,000)

( e) Breakin g Point Common equity   $5,880,000
0.50
(f) We know that, WACC  Wd K d (1  T )  W p K p  WS K S  0.40  5.98%(1  0.4)  0.10  9.09%  0.50  9.35%  7.02%
This WACC applies to projects with a cumulative cost between 0 and $5,880,000.
(g) We know that, WACC  Wd K d (1  T )  W p K p  WS K S  0.40  5.98%(1  0.4)  0.10  9.09%  0.50  10.06%  7.38%
This WACC applies to projects with a cumulative cost over $5,880,000.
Problem- 18 (ST. 9.17: Calculation of specific costs, WACC, and WMCC): Dillon Labs has asked
its financial manager to measure the cost of each specific type of capital as well as the weighted average
cost of capital. The weighted average cost is to be measured by using the following weights: 40% long-
term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock,
or both). The firm’s tax rate is 40%.
Debt: The firm can sell for $980 a 10-year, $1,000-par-value bond paying annual interest at a 10%
coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per
bond.
Preferred stock: Eight percent (annual dividend) preferred stock having a par value of $100 can be sold
for $65. An additional fee of $2 per share must be paid to the underwriters.
Common stock: The firm’s common stock is currently selling for $50 per share. The dividend expected
to be paid at the end of the coming year (2007) is $4. Its dividend payments, which have been
approximately 60% of earnings per share in each of the past 5 years, were as shown in the following
table.
Year Dividend
2006 3.75
2005 3.50
2004 3.30
2003 3.15
2002 2.85
It is expected that in order to sell, new common stock must be underpriced $5 per share, and the firm
must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of
earnings.
a. Calculate the specific cost of each source of financing. (Assume that kr = ks.)
b. If earnings available to common shareholders are expected to be $7 million, what is the break point
associated with the exhaustion of retained earnings?
c. Determine the weighted average cost of capital between zero and the break point calculated in part b.
d. Determine the weighted average cost of capital just beyond the break point calculated in part b.
Solution:
RV - NSV 1000 - 950
I 100 
(a ) We know that cost of debt, Kd (YTM)  N  10  10.77%
RV  NSV 1000  950
2 2
K dt  K d (1  T )  10.77%(1  0.40)  6.46%
Dp 8
We know that, cost of preferred stock, K p    12.70%
Np 63
Growth rate, S  P(1  g ) n
3.75  2.85(1  g ) 5
g = 7%
D1 4
We know that, cos t of common stock equity, K s g  0.07  15%
P0 50
D
We know that, cost of new common stock equity, K n  1  g  424  0.07  16.52%
P0

AFi 7000,000  (1  0.6)

(b) Breaking Point    5,600,000
Wi 0.50
Between $0 and $5600,000 the cost of common stock equity is 15% because all common stock equity
comes from retained earnings. Above $5600,000 the cost of common stock equity is 16.52%. It is higher
due to the floatation costs with a new issue of common stock.
The firm expects to pay 60% of all earnings available to common shareholders as dividends.
(c) WACC ($0 to $5600,000):
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.40 6.46% 2.58%
Preferred stock 0.10 12.7% 1.27%
Common stock equity 0.50 15.0% 7.50%
Total 11.35%
(d) WACC (Above $5600,000):
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.40 6.46% 2.58%
Preferred stock 0.10 12.7% 1.27%
Common stock equity 0.50 16.52% 8.26%
Total 12.11%
Problem- 19 (ST. 9.19: Calculation of specific costs, WACC, and WMCC): Lang Enterprises is
interested in measuring its overall cost of capital. Current investigation has gathered the following data.
The firm is in the 40% tax bracket.
Debt: The firm can raise an unlimited amount of debt by selling $1,000-parvalue, 8% coupon interest
rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average
discount of $30 per bond would have to be given. The firm also must pay flotation costs of $30 per
bond.
Preferred stock: The firm can sell 8% preferred stock at its $95-per-share par value. The cost of issuing
and selling the preferred stock is expected to be $5 per share. An unlimited amount of preferred stock
can be sold under these terms.
Common stock: The firm’s common stock is currently selling for $90 per share. The firm expects to
pay cash dividends of $7 per share next year. The firm’s dividends have been growing at an annual rate
of 6%, and this is expected to continue into the future. The stock must be underpriced by $7 per share,
and flotation costs are expected to amount to $5 per share. The firm can sell an unlimited amount of new
common stock under these terms.
Retained earnings: When measuring this cost, the firm does not concern itself with the tax bracket or
brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year;
once these retained earnings are exhausted, the firm will use new common stock as the form of common
stock equity financing.
a. Calculate the specific cost of each source of financing. (Round answers to the nearest 0.1%.)
Source of capital Weight
Long-term debt 30%
Preferred stock 20
Common stock equity 50
Total 100%
b. The firm’s capital structure weights used in calculating its weighted average cost of capital are shown
in the table above. (Round answer to the nearest 0.1%.)
(1) Calculate the single break point associated with the firm’s financial situation.
(Hint: This point results from exhaustion of the firm’s retained earnings.)
(2) Calculate the weighted average cost of capital associated with total new financing below the break
point calculated in part (1).
(3) Calculate the weighted average cost of capital associated with total new financing above the break
point calculated in part (1).
Solution:
RV - NSV 1000 - 940
I 80 
(a ) We know that cost of debt, Kd (YTM)  N  20  8.56%
RV  NSV 1000  940
2 2
K dt  K d (1  T )  8.56%(1  0.40)  5.14%
Dp 7.60
We know that, cost of preferred stock, K p    8.44%
Np 90
D1 7
We know that, cos t of common stock equity, K s  g  0.06  14.97%
P0 78
D 7
We know that, cost of retained earnings, K n  1  g   0.06  13.78%
P0 90
AFi 100,000
(b) Breaking Point    $200,000
Wi 0.50
WACC (Equal to or below $200,000 BP):
Type of Capital Target capital Cost Weighted Cost
structure (%)
Long-term debt 0.30 5.1% 1.53%
Preferred stock 0.20 8.4% 1.68%
Common stock equity 0.50 13.8% 6.90%
Total 10.11%

WACC (Above $200,000 BP):

Type of Capital Target capital Cost Weighted Cost
structure (%)
Long-term debt 0.30 5.1% 1.53%
Preferred stock 0.20 8.4% 1.68%
Common stock equity 0.50 15.0% 7.50%
Total 10.71%