Cost of Capital

Chapter 11

Chapter 11 - Outline

Cost of capital Cost of Debt Cost of Preferred Stock Cost of Common Equity:- Retained Earnings- New Common Stocks Optimum Capital Structure

Cost of Capital The cost of capital represents the overall

cost of financing to the firm. The cost of capital is normally the relevant

discount rate to use in analyzing an investment.

The overall cost of capital is weighted average of the various sources, including debt, preferred stock, and common equity

- WACC = Weighted Average Cost of Capital- WACC = After-tax cost × weights

Cost of Debt The cost of debt to the firm is the

effective yield to maturity (interest rate) paid to the company’s bondholders

Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity

- After-tax cost of debt= yield × (1- tax rate)

Cost of Preferred Stock Preferred Stock:- Has a fixed dividend (similar to

debt)- Has no maturity date- Dividends are not tax deductible to

the firm and are expected to be perpetual or infiniteCost of Preferred

Stock

Dividend

Price – Flotation Cost=

Cost of Common Equity: Retained Earnings Common stock equity is available

through retained earnings or by issuing new common stock.

Common Equity = R.E + New Common Equity The Cost of common equity in the form

of retained earnings is equal to the required rate of return on the firm’s common stock (this is the opportunity cost).

The cost of new common stock is higher than the cost of retained earnings because of flotation costs

Flotation costs: are selling and administrative costs (such as sales commissions) for the new securities

Cost of Common Equity: New Common Stock

Optimal Capital Structure The optimal (best) situation is

associated with the minimum overall cost of capital:

- Optimal capital structure means the lowest WACC.

Usually occurs with 30-50% debt in the firm’s capital structure.

WACC is also referred to as the required rate of return or discount rate.

Example: Cost of Capital

10.41%KaWACC

7.2%60%12%KeEquity (R.E)

1.09%10%10.94%KPPreferred Stock

2.12%30%7.05%KdDebt

Weighted cost

WeightsCost (After tax)

(3)(2)(1)

40%

Cost of equity

WACC

Cost of debt

%

Debt ratio%

Minimum WACC: lowest cost of

capital

Minimum WACC

Example: Projects and Rates of Return

Projects

Expected Return

Cost (Millions)

A16%$10

B14%5

C13.5%4

D11.8%20

E10.65%11

F9.5%20

G8.6%15

H7%10

Total$ 95

Cost of Capital and Investment Projects: Stable WACC

%

Amount of Capital

WACC

AB

CD E

FG

H

Cost of Capital and Investment Projects: Increasing WACC

%

Amount of Capital

WACCA

BC

D EF

GH

End of Chapter