Contemporary Financial Management. Chapter 8: The Cost of Capital. Introduction. This chapter discusses: The cost of capital What is it How is it measured What is the Weighted Average Cost of Capital (WACC) Risk vs. required return trade-off. Cost of Capital.
The Cost of Capital
ka = Weighted Average Cost of Capital
D = Market value of the firm’s Debt
Pf = Market value of the firm’s Preferred Shares
E = Market value of the firm’s Common Equity
ke = Marginal Cost of Common Share Capital
kd = Marginal Pre-Tax Cost of Debt
kp = Marginal Cost of Preferred Share Capital
T = Corporate Tax Rate
Example: A firm’s capital structure includes $3 Million in bonds, $6 Million in equity, and $1 Million in preferred stock (market values). The firm’s cost of equity is 15%, the cost of debt is 8% and the cost of preferreds is 10%. If the firm’s marginal tax rate is 50%, what is its WACC?
Common Shares X
Low QualityCorporate X
XHigh QualityPreferred Shares
XHigh QualityCorporate Debt
XLong-term Government Debt
XShort-term Government Debt
The firm can raise a total of $12.5 Million of new financing (including $5 Million of 9% debt) before it has to begin issuing new debt at 10%.
The firm can raise a total of $20 Million of new financing before it needs to issue new common stock.