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Chapter 16 – Cost of Capital Capital definition : Mix of long-term financing sources, primarily debt and equity, used by the company Opportunity Cost Concept Cost of capital is an opportunity cost

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chapter 16 cost of capital
Chapter 16 – Cost of Capital
  • Capital definition:Mix of long-term financing sources, primarily debt and equity, used by the company
opportunity cost concept
Opportunity Cost Concept
  • Cost of capital is an opportunity cost
  • The opportunity cost is the return investors could have expected by investing somewhere else at equal risk
weighted average concept
Weighted Average Concept
  • The cost of capital is an average of the opportunity costs of stockholders and creditors
  • The average is weighted by the proportion of funds provided by each source
marginal cost concept
Marginal Cost Concept
  • The marginal cost of capital is the rate of return that must be earned on new capital to satisfy investors
  • The marginal cost of capital is the weighted average cost of capital that must be earned on new investments
  • The marginal cost of capital is the change in the amount needed to satisfy investors, divided by the amount of new capital raised
cost of debt
Cost of Debt
  • Cost of debt is the interest rate the company would be required to pay on new debt, adjusted upward for flotation costs
  • Yield to maturity on bonds frequently measures the marginal cost of debt
    • To sell new bonds, you must pay at least the yield to maturity for new bonds
    • To justify reinvesting existing funds, your internal investments must be better than the return earned by buying back your existing debt in the marketplace
after tax cost of debt
After-tax Cost of Debt
  • Payment of interest results in a tax savings
  • After-tax cost of debt:Kd = before-tax cost of debt X (1 – Tax rate)
cost of preferred stock
Cost of Preferred Stock
  • Most preferred stock is perpetual; it has no maturity date
  • Cost of preferred stock:Kp = Dividend per share  Market price per share
  • The cost of new preferred stock requires the use of a net price, the amount that the company will net after paying flotation costs
cost of common stock
Cost of Common Stock
  • No direct way to observe the return required by common stockholders; must estimate
  • Use
    • Dividend growth model
    • Earnings yield
    • CAPM
dividend growth model
Dividend Growth Model
  • Ke = (D1/P) + gWhereD1 = Expected dividend at the end of the next year P = Current price of the stock g = Anticipated growth rate of dividends
  • Applies when dividend growth is stable
earnings yield model
Earnings Yield Model
  • Ke = Earnings per share  Price
  • Sometimes used, but
    • Ignores growth
    • Not based on cash flow
mean variance capm
Mean-variance CAPM
  • Ke = Rf + s,m[E(Rm) - Rf]


Rf = Risk-free rate

s,m = Beta of the company’s stock with regard to the market portfolio

E(Rm) = Expected return on the market portfolio

  • Widely used
  • E(Rm) is still widely debated
  • Can use similar company betas for a stock that is not publicly traded
cost of existing equity
Cost of Existing Equity
  • Also called the cost of retained earnings
  • Some authors argue that the cost of retained earnings is Ke(1 – stockholders’ tax rate on dividends)
  • Much stock is held by pension funds and charitable endowments that do not pay taxes on dividends
cost of new equity
Cost of new Equity
  • No dividend growth anticipated:Kne = Ke/(1 – f)where f is flotation cost as a percent of market price
  • With dividend growth anticipated:Kne = D1/[P/(1 – f)] + g
weight for weighted average cost
Weight for Weighted Average Cost
  • Market value weights are recommended
  • Target capital structure is typically used if the the company is moving toward that target
additional issues
Additional Issues
  • Deferred taxes: typically not considered a source of funds because deferred tax reconciles difference between accounting records and cash flows
  • Accounts payable and accrued expenses: typically not considered a source of funds because they reconcile the difference between accounting and cash flow
  • Short-term debt is included if it is used as permanent capital
additional issues16
Additional Issues
  • Leases: often used as a direct substitute for debt, and therefore the implied amount and cost of debt is included in the WACC calculation (covered in Ch. 21)
  • Convertibles: treat as a straight bond and an option
  • Depreciation-generated funds: It makes sense to talk about internally generated funds, which have the cost of existing capital, but not to look separately at depreciation
risk differences and wacc
Risk Differences and WACC
  • The WACC calculations typically assume that projects for a company are all of similar risk
  • When risks are different, they often vary by division
  • Companies often use division cost of capital, estimating the betas and cost of equity for each division if it were a stand-alone company
  • Large individual projects are sometimes evaluated as if they were funded as a stand-alone company
international investments
International Investments
  • Cost of capital should reflect the risk of the project
  • Cost of capital should be denominated in the same currency used to denominate cash flows for capital investment analysis
  • Equity residual method, discussed in Chapter 20, is sometimes used to evaluate international investments with multi-country financing.