Chapter 11

THE COST OF
CAPITAL
© 2000 South-Western College Publishing
 COST OF CAPITAL

The return an investor receives on debt, preferred stock,

or common equity is a cost to the company

Costs are returns adjusted for taxes and transactions cost

Overall cost is a weighted average of these

Component Costs

TM 11-1 Slide 1 of 2
 CAPITAL STRUCTURE
The mix of capital components in use
Component $000 %

Debt $30,000 30%

Preferred Stock $10,000 10%
Equity $60,000 60%
Total Capital $100,000 100%.

RELATED CONCEPTS
The Target Capital Structure
Raising Money in the Proportions of the Capital Structure

TM 11-1 Slide 2 of 2
THE WEIGHTED AVERAGE CALCULATION -
THE WACC
A firm's overall cost of capital is the average of the costs of its
separate sources weighted by the proportion of each source used

Example of Calculation

Capital
Component Value Weight Cost
Debt $60,000 .30 x 9% = 2.70%
Preferred Stock $50,000 .25 x 11% = 2.75%
Common Stock $90,000 .45 x 14% = 6.30%
$200,000 1.00 WACC = 11.75%

TM 11-2
 CAPITAL STRUCTURE AND COST - BOOK
VS MARKET VALUES
A Source of Confusion:
Both capital structure and component costs can be viewed in terms of either the
book or market values of the underlying capital

1. CAPITAL STRUCTURE
Initial Capital Structure - Book and Market Values Equal
$ %
Equity 10,000 shrs x $10 = $100,000 50%
Debt 100 bonds x $1,000 = $100,000 50%
Total $200,000 100%

Now imagine that stock price increases to $12, while interest rates climb driving
the price of the bonds down to $850
-Book Values Don't Change-

TM 11-3 Slide 1 of 3
 Market-Value-Based Capital Structure
$ %
Equity 10,000 shrs x $12 = $120,000 58.5%
Debt 100 bonds x $850 = $ 85,000 41.5%
Total $205,000 100.0%

(From Tables 11-1 and 2)

2. COMPONENT RETURNS
• Every security has a return on the money initially invested to buy it
and a current return that's available to new investors in the
secondary market.
• For example, a bond pays its coupon rate on the original investment
of its face value and the market yield to a new buyer.

TM 11-3 Slide 2 of 3
3. THE APPROPRIATE PERSPECTIVE FOR THE WACC
CALCULATION
Book Values - Existing Capital - Already Committed
Market Values - New Capital - Next Year's Projects
IRR and NPV Evaluate Newly Proposed Projects
Therefore, Market Values Are Appropriate

4. THE CUSTOMARY APPROACH

Structure: Maintain the existing structure based on market prices,
or
strive for a target structure based on market prices.

Component Costs: Based on market prices

TM 11-3 Slide 3 of 3
 CALCULATING THE WACC
Three Steps
1. Develop a market value based capital structure.

2. Adjust market returns to reflect

component costs of capital.

3. Calculate WACC.

TM 11-4
 STEP ONE:
DEVELOPING MARKET VALUE BASED CAPITAL STRUCTURES

EXAMPLE 11-2
Debt: Two thousand bonds were issued five years ago at a coupon rate of
12%. They had thirty year terms and $1,000 face values. They are now
selling to yield 10%.

Preferred Stock: Four thousand shares of preferred are outstanding

each of which pays an annual dividend of $7.50. They originally sold to yield
15% of their $50 face value. They're now selling to yield 13%.

Equity: 200,000 shares of common stock are outstanding currently selling

at $15 per share.

TM 11-5 Slide 1 of 3
SOLUTION:
Debt:
Pb = PMT[PVFAk,n] + FV[PVFk,n]
= $60[PVFA5,50] + $1,000[PVF5,50]
= $60(18.2559) + $1,000(.0872)
= $1,182.55
Market Value = $1,182.55 x 2,000 = $2,365,100

Preferred Stock:
Dp $7.50
Pp    $57.69
k .13

Market Value = $57.69 x 4,000 = $230,760

TM 11-5 Slide 2 of 3
Common Equity:
Market Value = $15.00 x 200,000 = $3,000,000

Market Value Based Weights:

$ %
Debt $2,365,100 42.3%
Preferred 230,760 4.1%
Equity 3,000,000 53.6%
$5,595,860 100.0%

TM 11-5 Slide 3 of 3
 STEP TWO:
CALCULATING COMPONENT COSTS OF CAPITAL

Adjustments To Investor's Returns Reflect The Effect

Of Financial Markets and Taxes

Taxes Reduce the Effective Cost of Debt

kd(1-T)

Flotation Costs Increase the Effective Cost of a Component

Component
Investor's return k
cost of = 
capital (1  f ) (1  f )

TM 11-6
 ILLUSTRATIONS
DEBT: Cost of debt = kd (1 - T)

EXAMPLE 11-3
Blackstone Inc. has bonds outstanding which yield 8% to investors buying
them now. The marginal tax rate is 37%
SOLUTION: Cost of debt = kd (1 - T)
= .08 (1-.37)
= 5.4%
PREFERRED STOCK: Cost of Dp kp
Preferred  
Stock (1  f )Pp (1  f )

EXAMPLE 11-4
Francis Corporation's preferred stock yields new investors 9%. Flotation
costs are 11%.
SOLUTION: Cost of kp 9%
Preferred    10.1%
Stock ( 1  f ) 1 .11

TM 11-7
 COMMON EQUITY - RETAINED EARNINGS:
No Adjustments:
Internally Generated and Not Tax Deductible

The CAPM Approach - The Required Rate of Return

kX = kRF + (kM - kRF)bX

The Dividend Growth Approach - The Expected Rate of Return

D0 ( 1  g )
ke  g
P0
The Risk Premium Approach
ke = kd + rpe
 COMMON EQUITY - NEW STOCK:
Cost of New Equity D0 ( 1  g )
ke  g
(1  f )P0

EXAMPLE 11-8
Periwinkle Inc.'s last annual dividend was $1.65, its stock sells for
$33.60, and it is expected to grow at 7.5%.

SOLUTION:
Cost of
$1.65(1.075 )
new   .075  13.5%
(.88 )$33.60
Equity

TM 11-8 Slide 2 of 2
 THE MARGINAL COST OF CAPITAL (MCC)
A graph showing how the WACC changes as a firm raises more capital
during a planning period, usually a year

A Typical MCC Schedule

WACC

WACC

Total
Capital
Raised

The MCC breaks upward when the cost of a capital component increases.
The first break usually occurs when retained earnings runs out and outside
equity is raised at higher cost.

TM 11-9
 ILLUSTRATION OF MCC CONSTRUCTION
Capital Capital
Structure Component
Weights Cost
With equity from RE
Debt .4 x 8% = 3.2%
Equity .6 x 10% = 6.0%
WACC = 9.2%

With equity from new stock

Debt .4 x 8% = 3.2%
Equity .6 x 12% = 7.2%
WACC = 10.4%

If expected RE = $3M and the capital structure is 60% equity, the first break
in the WACC occurs at $3M / .60 = $5M

Table 11-4 (modified)

 WACC
10.4%

WACC
9.2%

$5M $10M

Figure 11-1 The Brighton Company

The Marginal Cost of Capital (MCC) Schedule

TM 11-10 Slide 2 of 2
 COMBINING THE MCC AND THE INVESTMENT
OPPORTUNITY SCHEDULE (IOS)
WACC
Project
IOS IRRs
A
MCC
B
WACC=10.4% C

9.2%
D
E

$5M $10M

Figure 11-2 The Marginal Cost of Capital (MCC) Schedule and

The Investment Opportunity Schedule (IOS)