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Chapter 9: The Cost of Capital. The Cost of Capital:. Chapter Outline:. The Purpose of the Cost of Capital Capital Components Calculating Component Costs of Capital Calculating the WACC Factors that affect the cost of capital Problem areas in cost of capital.

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## Chapter 9: The Cost of Capital

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**Chapter Outline:**• The Purpose of the Cost of Capital • Capital Components • Calculating Component Costs of Capital • Calculating the WACC • Factors that affect the cost of capital • Problem areas in cost of capital**The Purpose of the Cost of Capital:**• The cost of capital—the average rate paid for the use of capital. • Primarily used in capital budgeting • Used as the ‘hurdle rate,’ or benchmark for projects • Compare IRR to this rate • Discount cash flows at this rate to find NPV • If a project cannot earn above this return, it is not worthwhile**The Purpose of the Cost of Capital:**• It is important to estimate the cost of capital as accurately as possible in order to effectively manage the firm • Firm’s cost of capital can be viewed as its required rate of return on projects of average risk**Required Rate of Return(Opportunity Cost Rate):**• The return that must be raised on invested funds to cover the cost of financing such investments**Capital Components:**• Components of firm’s capital are: • Debt: • Borrowed money, either loans or bonds • Common equity: • From sale of common shares or from retained earnings • Preferred shares: • Cross between debt and common equity**Capital Components:**• Capital structure is mix of three capital components • Target Capital Structure • Mix of capital components that management considers optimal and strives to maintain**Basic Definitions:**• Capital Component: • Types of capital used by firms to raise money • kd = before tax interest cost • kdT = kd(1-T) = after tax cost of debt • kps = cost of preferred stock • ke = cost of retained earnings • ks = cost of issuing new stocks**Basic Definitions:**• WACC:Weighted Average Cost of Capital • Capital Structure:A combination of different types of capital(debt and equity) used by a firm**After-Tax Cost of Debt:**• The relevant cost of new debt • Taking into account the tax deductibility of interest • Used to calculate the WACCkdT = bondholders’ required rate of return minus tax savingskdT = kd(1-T).**Cost of Debt:**• Interest is tax deductible, so kdT = kd (1-T) = 10% (1 - 0.40) = 6% • Use nominal rate. • Flotation costs are small, so ignore them.**Cost of Preferred Stock:**• Rate of return investors require on the firm’s preferred stock • The preferred dividend divided by the net issuing price**Cost of Preferred Stock:**• The cost of preferred stock can be solved by using this formula: kp = Dp / Pp = $10 / $111.10 = 9%**Cost of Retained Earnings:**• Rate of return investors require on the firm’s common stock**Why there is a cost for retained earnings?**• Earnings can be reinvested or paid out as dividends. • Investors could buy other securities, earn a return. • If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). • Investors could buy similar stocks and earn ks. • Firm could repurchase its own stock and earn ks. • Therefore, ks is the cost of retained earnings.**Three ways to determine the cost of common equity:**• The CAPM Approach. • The Discounted Cash Flow Approach. • The Bond-Yield-Plus-Premium Approach.**(**) k k k - k b = + M RF s RF s The CAPM Approach: ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2%**The Discounted Cash Flow Approach:**• Price and expected rate of return on a share of common stock depend on the dividends expected on the stock.**The Discounted Cash Flow Approach:**ks = D1 / P0 + g = $4.3995 / $50 + 0.05 = 13.8%**The Bond-Yield-Plus-Premium Approach:**• Estimating a risk premium above the bond interest rate • Judgmental estimate for premium • “Ballpark” figure only**The Bond-Yield-Plus-Premium Approach:**ks = kd + RP ks = 10.0% + 4.0% = 14.0%**Cost of Newly Issued Common Stock:**• External equity, ke • Based on the cost of retained earnings • Adjusted for flotation costs (the expenses of selling new issues)**Flotation costs:**• Flotation costs depend on the risk of the firm and the type of capital being raised. • The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. • We will frequently ignore flotation costs when calculating the WACC.**The Weighted Average Cost of Capital—The WACC:**• A firm’s WACC is the average of the costs of the separate sources weighted by the proportion of each source used To compute a WACC, we need two things: the mix of the capital components in use and the cost of each component**Weighted Average Cost of Capital, WACC:**• A weighted average of the component costs of debt, preferred stock, and common equity**Q: Calculate the WACC given the following capital**structure. A: First calculate the capital structure weights. For debt this weight is $60,000 $200,000 = 30%. Next, multiply each component’s cost by its weight. Capital Component Value Cost Debt $60,000 6% Preferred shares 50,000 4 Common shares 90,000 10 $200,000 Example Capital Component Value Weight Cost Debt $60,000 30% 6% 1.8% Preferred shares 50,000 25% 4 1.0% Common shares 90,000 45% 10 4.5% $200,000 100% WACC = 7.3% Example 15.1: Computing the WACC:

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