CHAPTER 13

The Cost of Capital

 Sources of capital
 Component costs
 WACC
 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 a weighted average of the
various sources, including debt, preferred stock, and
common equity:
WACC = Weighted Average Cost of Capital
WACC = After-tax costs x weights
 What sources of long-term
capital do firms use?
Long-Term
Capital

Long-Term Preferred Common

Debt Stock Stock

Retained New Common

Earnings Stock
 Calculating the weighted
average cost of capital
WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs

• The x’s refer to the firm’s capital structure

weights.
• The k’s refer to the cost of each component.
 Should our analysis focus on historical
costs or new (marginal) costs?
• The cost of capital is used primarily to make
decisions that involve raising new capital. So,
focus on today’s marginal costs (for WACC).
 Weighting example
Bonds 40
Pref. Stock 100
Common 100
Ret. Earn. 160
Total L & E 400
What is weight of each component?
 Weighting example
Bonds 40
Pref. Stock 100
Common 100
Ret. Earn. 160
Total L & E 400

Bonds = 40/400 = 10%

Pref. Stock = 100/400 = 25%
 Component cost of
preferred stock
• Preferred dividends are not tax-
deductible, so no tax adjustments necessary.
 Why is there 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).
 Calculate WACC
• If 40% of your financing is from debt at an
after tax cost of 8% and 60% is from pref.
stock at 10%, what is the WACC?
• 40% (.08) + 60% (.10)
• .032 + .06 = .092
• 9.2%
 WACC
• You are analyzing the cost of capital for a firm
that is financed with 60 percent equity and 40
percent debt. The after-tax cost of debt
capital is 10 percent, while the cost of equity
capital is 20 percent for the firm. What is the
overall cost of capital for the firm?
• (.6 x .2) + (.4 x .1) = 16%
Equity + Debt