Chapter 14

The Cost
of Capital

Learning Objectives
1. Understand the concepts underlying the firms
overall cost of capital and the purpose for its
calculation.
2. Calculate the after-tax cost of debt, preferred stock,
and common equity.
3. Calculate a firms weighted average cost of capital.
4. Describe the divisional cost of capital as a viable
alternative for firms with multiple divisions.

Learning Objectives
5. Explain what is meant by the marginal cost of
capital.
6. Describe the rationale for and procedures used to
determine breaking points and the weighted
marginal cost of capital (WMCC).
7. Explain how the weighted marginal cost of capital
(WMCC) can be used with the investment
opportunities schedule (IOS) to make the firms
financing/investment decisions.

THE COST OF CAPITAL: AN

OVERVIEW

The Cost of Capital: An Overview

A firms Weighted Average Cost of Capital,
or WACC is the weighted average of the
required returns of the securities that are
used to finance the firm.
WACC incorporates the required rates of
return of the firms lenders and investors and
also accounts for the particular mix of
financing.
Most firms raise capital with a combination of
debt, equity, and hybrid securities.

The Cost of Capital: An Overview

(cont.)
For Investors, the rate of return on a
security is a benefit of investing.
For Financial Managers, that same
rate of return is a cost of raising
funds that are needed to operate the
firm.
In other words, the cost of raising
funds is the firms cost of capital.

The Cost of Capital: An Overview

(cont.)
The riskiness of a firm affects its WACC as:
required rate of return on securities will be
higher if the firm is riskier, and
risk will influence how the firm chooses to
finance i.e. proportion of debt and equity.

The Cost of Capital: An Overview

(cont.)
WACC is useful in a number of settings:
to value the entire firm.
for determining the discount rate for
investment projects
when evaluating firm performance

The Cost of Capital: An Overview

(cont.)
The cost of capital is the magic number
used to decide whether a proposed
investment will increase or decrease the
firms stock price.
Formally, the cost of capital is the rate of
return that a firm must earn on the projects
in which it invests in order to maintain the
market value of its stock.

Three Step Procedure for Estimating

Firm WACC
1. Define the firms capital structure by determining
the weight of each source of capital.
2. Estimate the cost of each source of financing. We
will use the current market value of each source of
capital based on its current (not historical) costs.
3. Calculate a weighted average of the costs of each
source of financing.

DETERMINING THE FIRMS

CAPITAL STRUCTURE
WEIGHTS

Determining the Firms Capital

Structure Weights
The weights are based on the
following sources of capital:
debt (discretionary short-term
and long-term), preferred stock
and common equity.
Liabilities such as accounts
payable and accrued expenses
(spontaneous liabilities) are not
included in capital structure.

Determining the Firms Capital

Structure Weights (cont.)
Ideally, the weights should be based on
observed market values. However, if not all
market values are available, we can use
book values.

Problem
In the spring of 2014, Templeton was considering the
acquisition of a chain of extended care facilities and
wanted to estimate its own WACC as a guide to the cost
of capital for the acquisition. Templetons capital
structure consists of the following:

Problem
Templeton contacted the firms investment banker to get
estimates of the firms current cost of financing and was told
that if the firm were to borrow the same amount of money
today, it would have to pay lenders 8%; however, given the
firms 25% tax rate, the after-tax cost of borrowing would
only be 6% or 8%(1 - 0.25). Preferred stockholders currently
demand a 10% rate of return, and common stockholders
demand 15%. Templetons CFO knew that the WACC would
be somewhere between 6% and 15% since the firms capital
structure is a blend of the three sources of capital whose
costs are bounded by this range.

Problem

Problem
After completing her estimate of Templetons WACC, the
CFO decided to explore the possibility of adding more lowcost debt to the capital structure. With the help of the firms
investment banker, the CFO learned that Templeton could
probably push its use of debt to 37.5% of the firms capital
structure by issuing more debt and retiring (purchasing)
the firms preferred shares. This could be done without
increasing the firms costs of borrowing or the required rate
of return demanded by the firms common stockholders.
What is your estimate of the WACC for Templeton under
this new capital structure proposal?

 The WACC is equal to 11.625% as

calculated below.

Weights

Cost

Product

Debt

0.375

0.06

0.0225

Common Stock

0.625

0.15

0.09375

0.1

WACC

0.11625

Preferred Stock

ESTIMATING THE COST OF

INDIVIDUAL SOURCES OF
CAPITAL

Flotation Costs
Flotation costs are costs of issuing and selling a security.
They include:
1. Underwriting costspaid to investment bankers for selling the
security.
2. Administrative costsexpenses such as legal, accounting, and
printing.

Because of flotation costs, the firm will have to raise more

than the amount it needs.
Net proceeds are the funds actually received by the firm
from the sale of a security.

Floatation Costs (cont.)

Example
If a firm needs P100 million to
finance its new project and the flotation cost is
expected to be 5.5%, how much should the
firm raise by selling securities?
= P100 million (1-.055) = P105.82 million
Thus the firm will raise P105.82 million,
which includes flotation cost of P5.82 million.

The Cost of Debt

The cost of debt is the rate of
return the firms lenders demand
when they loan money to the firm.
The rate of return is not the same
as coupon rate, which is the rate
contractually set at the time of
issue.
We can estimate the markets
required
rate
of
return
by
examining the yield to maturity on
the firms debt.

The Cost of Debt

For the issuing firm, the cost of
debt is:
the rate of return required by
investors
adjusted for flotation costs,
and
adjusted for taxes by
multiplying the pre-tax cost
by (1 tax rate).

The Cost of Debt

Example: What will be the yield to maturity
on a debt that has par value of P1,000, a
coupon interest rate of 5%, time to maturity
of 10 years and is currently trading at P900?
What will be the cost of debt if the tax rate is
30%?

The Cost of Debt

YTM (pre-tax) = 6.38%
After-tax cost of Debt = YTM
(1-tax rate)
= 6.38 (1-.3)
= 4.47%

The Cost of Debt

Global
Corporation,
a
major
hardware
manufacturer, is contemplating selling P10
million worth of 20-year, 9% coupon bonds
with a par value of P1,000. Because current
market interest rates are greater than 9%,
the firm must sell the bonds at P980.
Flotation costs are 2% of par value and tax
rate is 40%.

The Cost of Debt

Global
Corporation,
a
major
hardware
manufacturer, is contemplating selling P10
million worth of 20-year, 9% coupon bonds
with a par value of P1,000. Because current
market interest rates are greater than 9%, the
firm must sell the bonds at P980. Flotation
costs are 2% of par value and tax rate is 40%.
YTM = 9.45%
After-tax cost of debt=9.45%(1-.40) =5.60%

The Cost of Preferred Equity

The cost of preferred equity is the rate of
return investors require of the firm when
they purchase its preferred stock. The cost
is not adjusted for taxes since dividends
are paid to preferred stockholders out of
after-tax income.
For a new issuance of preferred stock, the
associated
flotation
costs
must
be
considered.

The Cost of Preferred Equity

The Cost of Preferred Equity

Example: Consider the preferred shares of
Relay Company that are trading at P25 per
share. What is the cost of preferred equity if
these stocks have a par value of P35 and pay
annual dividend of 4%?

The Cost of Preferred Equity

kps = P1.40 P25 = .056 or 5.6%

The Cost of Preferred Equity

Example: SME Corporation issues 8% P100
par value preferred stock at P75 per share.
If flotation costs amount to P1 per share,
what is the cost of preferred stock for SME?

The Cost of Preferred Equity

Example: SME Corporation issues 8% P100
par value preferred stock at P75 per share.
If flotation costs amount to P1 per share,
what is the cost of preferred stock for SME?
Kps = 8 (75-1)
= 10.81%

The Cost of Common Equity

Cost of common equity is harder to estimate
since common stockholders do not have a
contractually defined return (similar to
interest on bonds or dividends on preferred
stock).
There are two approaches to estimating the
cost of common equity:
1. Constant growth valuation model/Gordon Model
(introduced in chapter 10)
2. CAPM (introduced in chapter 8)

Cost of Common Equity

1) Constant Growth (Gordon) Model
kce =

D1 + g
Po

2) Capital Asset Pricing Model (CAPM)

kj = krf +

(km - krf )

Constant Growth (Gordon) Model

There are two sources of Common Equity:
1. Internal common equity (retained
earnings)
2. External common equity (new common
stock issue)
Do they have the same cost?

Cost of Internal Common Equity

Dividend Growth Model

knc =

D1 + g
MPo
Market Price

Cost of External Common Equity

Dividend Growth Model

knc =

D1
NPo

+g
Net proceeds to the firm
after flotation costs!

Problem-Cost of Internal Common Equity

Duchess Corporation wishes to
determine its cost of common stock
equity. The market price of its
common stock is P50 per share. The
firm expects to pay a dividend of P4
at the end of the coming year, 2016.
The
dividends
paid
on
the
outstanding stock over the past 6
years (20102015) were as follows:

Copyright 2015 Pearson Education, Inc. All rights reserved.

9-40

Problem-Cost of Internal Common Equity

Duchess Corporation wishes to
determine its cost of common stock
equity. The market price of its
common stock is P50 per share. The
firm expects to pay a dividend of P4
at the end of the coming year, 2016.
The dividends paid on the
outstanding stock over the past 6
years (20102015) were as follows:
kcs = (P4/P50) + 0.0505 = 0.08 + 0.05 = 0.130, or
13.05%
Copyright 2015 Pearson Education, Inc. All rights reserved.

9-41

Cost of External Common Equity (New

Issues of Common Stock)
The cost of a new issue of common stock is the
cost of common stock, net of underpricing and
associated flotation costs.
New shares are underpriced if the stock is sold at
a price below its current market price.

Copyright 2015 Pearson Education, Inc. All rights reserved.

9-42

Problem: Cost of External Common Equity

(New Issues of Common Stock)
Duchess Corporation common stock is currently selling
at P50 per share. To determine its cost of new common
stock, kn, Duchess Corporation has estimated that on
average, new shares can be sold for P47. The P3-pershare underpricing is due to the competitive nature of
the market. A second cost associated with a new issue
is flotation costs of P2.50 per share that would be paid
to issue and sell the new shares. The total underpricing
and flotation costs per share are therefore P5.50.
kn = (P4.00/P44.50) + 0.0505 = 0.09 + 0.05 =
0.1405, or 14.05%

Copyright 2015 Pearson Education, Inc. All rights reserved.

9-43

Pros and Cons of the Dividend Growth

Model Approach
Pros:
easy to use
data required are more readily available
can easily be adjusted for flotation cost when estimating the
cost of new equity
Cons:
- severely dependent upon the quality of growth rate estimates
- not all firms pay dividends
- does not explicitly consider risk; uses the market price as a
reflection of the expected risk-return preference of investors
in the marketplace.

The Capital Asset Pricing

Model
CAPM was used in chapter 8 to
determine the expected or
required rate of return for risky
investments.

Cost of Common Stock (cont.)

Duchess Corporation now wishes to calculate
its cost of common stock equity by using the
capital asset pricing model. The firms
investment advisors and its own analysts
indicate that the risk-free rate is 8%; the
firms beta equals 1.5; and the market return,
equals 11%.
What is the cost of common stock equity?

Cost of Common Stock (cont.)

Substituting these values into the CAPM, the
company estimates the cost of common stock
equity to be:
kcs = 8.0% + [1.5 (11.0% 8.0%)] = 12.5%

Pros and Cons of the CAPM

Approach

Pros:
- does not depend on dividends or growth rate so it can be
applied to companies that do not currently pay dividends or
are
not expected to experience a constant rate of growth in
dividends
- explicitly considers the firms risk as reflected in beta
Cons:

does not offer any guidance on the appropriate choice for the risk-free rate.
Risk-free rate may vary widely depending on the Treasury security chosen.
Estimates of beta can vary widely depending upon the market index and
time period chosen
Estimates of market risk premium will also vary depending on the time
period and security chosen

CALCULATING THE FIRMS

WACC

Summing Up Calculating the Firms

WACC
The final step is to calculate the firms overall
cost of capital by taking the weighted
average of the firms financing mix that we
evaluated in Steps One and Two.
Determine weights based on market value
rather than book value.

ESTIMATING PROJECT COSTS

OF CAPITAL

Estimating Project Cost of Capital

Should the firms WACC be used to evaluate
all new investments?
In theory, it is appropriate only if the risk of the
new project is equal to the overall risk of the
firm.
However, firms tend to use single, company-wide
discount rate to evaluate all of their investment
proposals.
It may be difficult to trace the source of financing for
individual project since most firms raise money in bulk
for all the projects.

Estimating Divisional WACCs

If
a
firm
undertakes
investment with very different
risk characteristics, it will try
to
estimate
divisional
WACCs.
The divisions are generally
defined
by
geographical
regions (e.g., Asian region
versus European region) or
industry.

Using Pure Play Firms to Estimate

Divisional WACCs
Here a
identify
division
firms or

firm with multiple divisions may

a comparable firm with only one
(called a pure play comparison
comps).

The estimate of pure play firms cost of

capital can then be used as a proxy for that
particular divisions cost of capital.

MARGINAL COST OF CAPITAL

Marginal Cost and Investment

Decisions
The firms WACC is a key input to
the investment decision-making
process.
The firm should make only those
investments
for
which
the
expected return is greater than
the WACC.

Marginal Cost and Investment

Decisions
However, at any given time, the firms
financing costs and investment returns will
be affected by the volume of financing and
investments undertaken.
The weighted marginal cost of capital
(WMCC)
and
the
investment
opportunities
schedule
(IOS)
are
mechanisms
whereby
financing
and
investments
decisions
can
be
made
simultaneously.

Weighted Marginal Cost of

Capital
Weighted Marginal Cost of Capital (WMCC)
The firms
associated
financing.
The WACC
new capital

weighted average cost of capital

with its next peso of total new
typically increases as the volume of
raised within a given period increases.

Weighted Marginal Cost of

Capital
Why?
companies need to raise the return to investors in
order to entice them to invest and to compensate
them for the increased risk introduced by larger
volumes of capital raised.
the cost will eventually increase when the firm
runs out of cheaper retained equity and is forced
to raise new, more expensive equity capital.

Example: WMCC
Assume the following:
Source of capital
Long-term debt
Preferred stock
Retained earnings
New common stock

Cost Weight
5.6% 40%
10.6
10
13.0
50
14.0

Example: WMCC
Source of capital Weight
Long-term debt
.40
Preferred stock
.10
Common stock equity* .50
WACC

Cost
5.6%
10.6
13.0

Wtd Cost
2.24%
1.06
6.50
9.80%

*Assuming the company has a sizeable amount of

retained earnings available for investments

Example: WMCC
The Weighted Marginal Cost of Capital
(WMCC)
Finding Break Points
Assume in the example that the firm has P300,000 of retained earnings
available.

When it is exhausted, the firm must issue new (more

expensive) equity. Furthermore, the company believes it can only raise

P400,000 of debt at 5.6%, after which it will cost 8.4% (after-tax) to
raise additional debt.
Given this information, the firm can determine its break points.

Example: WMCC
What is a break point?
It is the level of total new financing at
which the cost of one of the financing
components rises, thereby causing an upward
shift in the weighted marginal cost of
capital (WMCC).

Example: WMCC
Finding the break points in the WMCC schedule will allow
us to determine at what level of new financing the WACC
will increase due to the factors listed above.

BPj = AFj/wj
where:
BPj = breaking point form financing source j
AFj = amount of funds available at a given cost
wj

= target capital structure weight for source j

Example: WMCC
The Weighted Marginal Cost of Capital
(WMCC)
Finding Break Points:
BPequity

= P300,000/.50 = P600,000

BPdebt

= P400,000/.40 = P1,000,000

This implies that the firm can fund up to P600,000 of new

investment before it is forced to issue new equity and P1,000,000 of
new investment before it is forced to raise more expensive debt.
Given this information, we may calculate the WMCC as follows:

Example: WMCC
WACC for Ranges of Total New Financing
Range of total

Source of

New Financing

Capital

P0 to P600,000

Weighted
Weight

Cost

Cost

Debt

40%

5.6%

2.24%

Preferred

10%

10.6%

1.06%

Common

50%

13.0%

6.50%

WACC
P600,000 to P1 million

over P1 million

9.80%

Debt

40%

5.6%

2.24%

Preferred

10%

10.6%

1.06%

Common

50%

14.0%

7.00%

WACC

10.30%

Debt

40%

8.4%

3.36%

Preferred

10%

10.6%

1.06%

Common

50%

14.0%

7.00%

WACC

11.42%

Example: WMCC

Investment Opportunities
Schedule
Investment Opportunities Schedule (IOS)
A ranking of investment possibilities from best
(highest return) to worst (lowest return).

WMCC and IOS Graph

Decision
rule:
Accept projects up
the point at which the
marginal return on an
investment equals its
weighted
Marginal
cost
of
capital.
Optimal capital
budget - P1.1m
At P1.1m, IRR equals
the
weighted
average
cost of capital, and
shareholder value will
be