Chapter 10

The Cost of Capital

Learning Goals

1. Understand the key assumptions, the basic

concept, and the specific sources of capital
associated with the cost of capital.
2. Determine the following:
– cost of long-term debt
– cost of preferred stock
– cost of common stock equity
– cost of retained earnings
– weighted average cost of capital (WACC) 10-2
Learning Goals (cont.)

3. Calculate the following:

– economic value added (EVA)
– break points
– weighted marginal cost of capital (WMCC)
4. Explain the weighted marginal cost of capital
(WMCC) and its use with the investment
opportunities schedule (IOS) to make financing
and investment decisions.

10-3
An Overview of the Cost of Capital
True or False
• The cost of capital acts as a link between the firm’s long-term
investment decisions and the wealth of the owners as determined
by investors in the marketplace.
• T
• It is the “magic number” that is used to decide whether a proposed
investment will increase or decrease the firm’s stock price.
• T
• Formally, the cost of capital is the rate of return that a firm must
earn on the projects in which it invests to maintain the market value
of its stock.
• T

10-4
The Firm’s Capital Structure

10-5
Some Key Assumptions

• Business Risk—the risk to the firm of being unable to

cover operating costs—is assumed to be unchanged.
This means that the acceptance of a given project does
not affect the firm’s ability to meet operating costs.
• Financial Risk—the risk to the firm of being unable to
cover required financial obligations—is assumed to be
unchanged. This means that the projects are financed
in such a way that the firm’s ability to meet financing
costs is unchanged.
• After-tax costs are considered relevant—the cost of
capital is measured on an after-tax basis.

10-6
The Basic Concept

• Why do we need to determine a company’s

overall “weighted average cost of capital?”
Assume the ABC company has the following investment
opportunity:
- Initial Investment = P100,000
- Useful Life = 20 years
- IRR = 7%
- Least cost source of financing, Debt = 6%
Given the above information, a firm’s financial manger
would be inclined to accept and undertake the investment.
10-7
The Basic Concept (cont.)

• Why do we need to determine a company’s

overall “weighted average cost of capital?”
Imagine now that only one week later, the firm has another
available investment opportunity
- Initial Investment = P100,000
- Useful Life = 20 years
- IRR = 12%
- Least cost source of financing, Equity = 14%
Given the above information, the firm would reject this
second, yet clearly more desirable investment opportunity.
10-8
The Basic Concept (cont.)

• Why do we need to determine a company’s overall

“weighted average cost of capital?”
• As the above simple example clearly illustrates, using
this piecemeal approach to evaluate investment
opportunities is clearly not in the best interest of the
firm’s shareholders.
• Over the long haul, the firm must undertake investments
that maximize firm value.
• This can only be achieved if it undertakes projects that
provide returns in excess of the firm’s overall weighted
average cost of financing (or WACC).

10-9
Specific Sources of Capital:
The Cost of Long-Term Debt
• The pretax cost of debt is equal to the the yield-to-
maturity on the firm’s debt adjusted for flotation costs.
• Recall that a bond’s yield-to-maturity depends upon a
number of factors including the bond’s coupon rate,
maturity date, par value, current market conditions, and
selling price.
• After obtaining the bond’s yield, a simple adjustment
must be made to account for the fact that interest is a
tax-deductible expense.
• This will have the effect of reducing the cost of debt.

10-10
 Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

Net Proceeds

Duchess 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% or P20. The net proceeds to
the firm for each bond is therefore P960 (P980 - P20).

10-11
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
• Before-Tax Cost of Debt
• The before-tax cost of debt can be
calculated in any one of three ways:
– Using cost quotations
– Calculating the cost
– Approximating the cost

10-12
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
• Before-Tax Cost of Debt
– Using Cost Quotations
– When the net proceeds from the sale of a
bond equal its par value, the before-tax cost
equals the coupon interest rate.
– A second quotation that is sometimes used is
the yield-to-maturity (YTM) on a similar
risk bond.

10-13
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
• Before-Tax Cost of Debt
– Calculating the Cost
– This approach finds the before-tax cost of
debt by calculating the internal rate of
return (IRR).
– YTM can be calculated using: (a) trial and
error, (b) a financial calculator, or (c) a
spreadsheet.

10-14
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
• Before-Tax Cost of Debt
– Calculating the Cost

10-15
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
• Before-Tax Cost of Debt
– Calculating the Cost

10-16
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
• Before-Tax Cost of Debt
– Approximating the Cost (YTM 60:40)

10-17
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)

Find the after-tax cost of debt for Duchess

assuming it has a 40% tax rate:
ki = 9.45% (1-.40) = 5.67%

This suggests that the after-tax cost of raising

debt capital for Duchess is 5.6%.

10-18
Pop Quiz
The before-tax cost of debt for a firm which has a 40 percent marginal tax
rate is 12 percent. The after-tax cost of debt is
(a) 4.8 percent.
(b) 6.0 percent.
(c) 7.2 percent.
(d) 12 percent.

19
Pop Quiz
When determining the after-tax cost of a bond, the face value of the issue
must be adjusted to the net proceeds amounts by considering
(a) the risk.
(b) the flotation costs.
(c) the approximate returns.
(d) the taxes.

20
Pop Quiz
The approximate before-tax cost of debt for a 10-year, 8 percent, P1,000
par value bond selling at P1,150 is
(a) 6 percent.
(b) 8.3 percent.
(c) 8.8 percent.
(d) 9 percent.

21
Specific Sources of Capital:
The Cost of Preferred Stock

Duchess Corporation is contemplating the issuance of a

7.89% preferred stock that is expected to sell for its P100-
per share value. The cost of issuing and selling the stock
is expected to be P18 per share.

KP = DP/Np = P7.89/P82 = 9.62%

10-22
Pop Quiz
What is the dividend on an 8 percent preferred stock that currently sells
for P45 and has a face value of P50 per share?
(a) P3.33
(b) P3.60
(c) P4.00
(d) P5.00

23
Pop Quiz
A firm has issued 10 percent preferred stock, which sold for P100 per
share par value. The cost of issuing and selling the stock was P2 per
share. The firm’s marginal tax rate is 40 percent. The cost of the preferred
stock is
(a) 3.9 percent.
(b) 6.1 percent.
(c) 9.8 percent.
(d) 10.2 percent.

24
Pop Quiz
Tangshan Mining is considering issuing preferred stock. The preferred
stock would have a par value of P75, and a 5.50 percent dividend. What
is the cost of preferred stock for Tangshan if flotation costs would amount
to 5.5 percent of par value?
(a) 5.50%.
(b) 5.27%.
(c) 7.73%.
(d) 5.82%.

25
Specific Sources of Capital:
The Cost of Common Stock
• There are two forms of common stock financing: (1)
retained earnings and (2) new issues of common
stock.
• In addition, there are two different ways to estimate the
cost of common equity: (1) any form of the dividend
valuation model, and (2) the capital asset pricing
model (CAPM).
• The dividend valuation models are based on the
premise that the value of a share of stock is based on
the present value of all future dividends.

10-26
Specific Sources of Capital:
The Cost of Common Stock (cont.)
• Using the constant growth model, we have:

kS = (D1/P0) + g

• We can also estimate the cost of common

equity using the CAPM:

kE = rF + b(kM - RF).

10-27
Specific Sources of Capital:
The Cost of Common Stock (cont.)
• The CAPM differs from dividend valuation
models in that it explicitly considers the firm’s
risk as reflected in beta.
• On the other hand, the dividend valuation model
does not explicitly consider risk.
• Dividend valuation models use the market price
(P0) as a reflection of the expected risk-return
preference of investors in the marketplace.

10-28
Specific Sources of Capital:
The Cost of Common Stock (cont.)
• Dividend valuation models (unlike the CAPM)
are often preferred because the data required
are more readily available.
• The two methods also differ in that the dividend
valuation models can easily be adjusted for
flotation costs when estimating the cost of new
equity.
• This will be demonstrated in the examples
that follow.

10-29
Specific Sources of Capital:
The Cost of Common Stock (cont.)
• Cost of Retained Earnings (kE)
– Constant Dividend Growth Model
ks = D1/P0 + g

For example, assume a firm has just paid a dividend of

P2.50 per share, expects dividends to grow at 10%
indefinitely, and is currently selling for P50.00 per share.

First, D1 = P2.50(1+.10) = P2.75, and

kS = (P2.75/P50.00) + .10 = 15.5%.

10-30
Specific Sources of Capital:
The Cost of Common Stock (cont.)
• Cost of Retained Earnings (kE)
– Security Market Line Approach

ks = rF + b(kM - RF).

For example, if the 3-month T-bill rate is currently 5.0%,

the market risk premium is 9%, and the firm’s beta is
1.20, the firm’s cost of retained earnings will be:

ks = 5.0% + 1.2 (9.0%) = 15.8%.

10-31
Specific Sources of Capital:
The Cost of Common Stock (cont.)
• Cost of Retained Earnings (kE)

The previous example indicates that our estimate of the

cost of retained earnings is somewhere between 15.5%
and 15.8%. At this point, we could either choose one or
the other estimate or average the two.

Using some managerial judgement and preferring to err

on the high side, we will use 15.8% as our final estimate
of the cost of retained earnings.

10-32
Specific Sources of Capital:
The Cost of Common Stock (cont.)
• Cost of New Equity (kn)
– Constant Dividend Growth Model

kn = D1/Nn + g

Continuing with the previous example, how much would it

cost the firm to raise new equity if flotation costs amount
to P4.00 per share?

kn = [P2.75/(P50.00 - P4.00)] + .10 = 15.98% or 16%.

10-33
Pop Quiz
The cost of common stock equity may be estimated by using the
(a) yield curve.
(b) net present value method.
(c) Gordon model.
(d) DuPont analysis.

34
Pop Quiz
In calculating the cost of common stock equity, the model having the
stronger theoretical foundation is
(a) the constant growth model.
(b) the Gordon model.
(c) the variable growth model.
(d) the capital asset pricing model.

35
Pop Quiz
A firm has common stock with a market price of P25 per share and an
expected dividend of P2 per share at the end of the coming year. The
growth rate in dividends has been 5 percent. The cost of the firm’s
common stock equity is
(a) 5 percent.
(b) 8 percent.
(c) 10 percent.
(d) 13 percent.

36
Pop Quiz
Given that the cost of common stock is 18 percent, end-of-year dividends
are P1.50 per share, and the price of the stock is P12.50 per share, what
is the annual growth rate of dividends?
(a) 4 percent.
(b) 5 percent.
(c) 6 percent.
(d) 8 percent.

37
Pop Quiz
A firm has a beta of 1.2. The market return equals 14 percent and the
risk-free rate of return equals 6 percent. The estimated cost of common
stock equity is
(a) 6 percent.
(b) 7.2 percent.
(c) 14 percent.
(d) 15.6 percent.

38
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

• Capital Structure Weights

The weights in the above equation are intended to
represent a specific financing mix (where w i = % of
debt, wp = % of preferred, and ws= % of common).

Specifically, these weights are the target percentages

of debt and equity that will minimize the firm’s overall
cost of raising funds.
10-39
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

• Capital Structure Weights

One method uses book values from the firm’s balance
sheet. For example, to estimate the weight for debt,
simply divide the book value of the firm’s long-term debt
by the book value of its total assets.

To estimate the weight for equity, simply divide the total

book value of equity by the book value of total assets.
10-40
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

• Capital Structure Weights
A second method uses the market values of the firm’s debt
and equity. To find the market value proportion of debt,
simply multiply the price of the firm’s bonds by the number
outstanding. This is equal to the total market value of the
firm’s debt.

Next, perform the same computation for the firm’s equity

by multiplying the price per share by the total number of
shares outstanding.
10-41
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

• Capital Structure Weights

Finally, add together the total market value of the firm’s
equity to the total market value of the firm’s debt. This
yields the total market value of the firm’s assets.

To estimate the market value weights, simply divide the

market value of either debt or equity by the market value
of the firm’s assets.
10-42
 The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

• Capital Structure Weights

For example, assume the market value of the firm’s debt is P40
million, the market value of the firm’s preferred stock is P10
million, and the market value of the firm’s equity is P50 million.

Dividing each component by the total of P100 million gives us

market value weights of 40% debt, 10% preferred, and 50%
common.

10-43
The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n

• Capital Structure Weights

Using the costs previously calculated along with the
market value weights, we may calculate the weighted
average cost of capital as follows:

WACC = .40(5.67%) + .10(9.62%) + .50(15.8%)

= 11.13%

This assumes the firm has sufficient retained earnings to

fund any anticipated investment projects.

10-44
The Marginal Cost
& Investment Decisions
• The Weighted Marginal Cost of Capital (WMCC)
– The WACC typically increases as the volume of new
capital raised within a given period increases.
– This is true because companies need to raise the
return to investors in order to entice them to invest to
compensate them for the increased risk introduced
by larger volumes of capital raised.
– In addition, the cost will eventually increase when the
firm runs out of cheaper retained equity and is forced
to raise new, more expensive equity capital.

10-45
The Marginal Cost
& Investment Decisions (cont.)
• The Weighted Marginal Cost of Capital (WMCC)
– Finding Break Points
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 from financing source j
AFj = amount of funds available at a given cost
wj = target capital structure weight for source j
10-46
The Marginal Cost
& Investment Decisions (cont.)
• The Weighted Marginal Cost of Capital (WMCC)
– Finding Break Points
Assume that in the example we have been using that the firm has
P2 million of retained earnings available. When it is exhausted,
the firm must issue new (more expensive) equity. Furthermore,
the company believes it can raise P1 million of cheap debt after
which it will cost 7% (after-tax) to raise additional debt.

Given this information, the firm can determine its break points as
follows:

10-47
The Marginal Cost
& Investment Decisions (cont.)
• The Weighted Marginal Cost of Capital (WMCC)
– Finding Break Points
BPequity = P2,000,000/.50 = P4,000,000

BPdebt = P1,000,000/.40 = P2,500,000

This implies that the firm can fund up to P4 million of new

investment before it is forced to issue new equity and P2.5 million
of new investment before it is forced to raise more expensive debt.
Given this information, we may calculate the WMCC as follows:

10-48
The Marginal Cost
& Investment Decisions (cont.)
WACC for Ranges of Total New Financing
Range of total Source of Weighted
New Financing Capital Weight Cost Cost
$0 to $2.5 million Debt 40% 5.67% 2.268%
Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.130%

$2.5 to $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 15.80% 7.900%
WACC 11.662%

over $4.0 million Debt 40% 7.00% 2.800%

Preferred 10% 9.62% 0.962%
Common 50% 16.00% 8.000%
WACC 11.762%
10-49
The Marginal Cost
& Investment Decisions (cont.)
11.76% WMCC

11.75%
11.66%

11.50%

11.25%
11.13%

P2.5 P4.0 Total Financing

(millions)
10-50
The Marginal Cost
& Investment Decisions (cont.)
• Investment Opportunities Schedule (IOS)
• Now assume the firm has the following
investment opportunities available:
Initial Cumulative
Project IRR Ivestment Investment
A 13.0% $ 1,000,000 $ 1,000,000
B 12.0% $ 1,000,000 $ 2,000,000
C 11.5% $ 1,000,000 $ 3,000,000
D 11.0% $ 1,000,000 $ 4,000,000
E 10.0% $ 1,000,000 $ 5,000,000
10-51
 The Marginal Cost
& Investment Decisions (cont.)
13.0% A WMCC
12.0% B

11.66%
This indicates
11.5%
C that the firm can
accept only
Projects A & B.

11.13% D
11.0%

P1.0 P2.0P2.5P3.0 P4.0 Total Financing

(millions) 10-52
Pop Quiz

53
Pop Quiz

54
Pop Quiz

55
The Weighted Average Cost of Capital:
Economic Value Added (EVA®)
• EVA is a popular measure used by firms to
determine whether an investment contributes to
owners’ wealth.
• EVA = Net Operating Profits After Taxes
(NOPAT) minus the cost of funds used to
finance the investment.
• The cost of funds = WACC x peso amount of
funds used to finance the investment

10-56
 The Weighted Average Cost of Capital:
Economic Value Added (EVA®)
For Example, the EVA® of an investment of P3.75 million
by a firm with a WACC of 10% in a project expected to
generate NOPAT of P410,000 would be:

EVA® = P410,000 – (10% x P3,750,000) = P35,000

Because the EVA® is positive, the proposed investment is

expected to increase owner wealth and is therefore
acceptable.

10-57