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9-1

CHAPTER 9
The Cost of Capital
Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
9-2
What sources of long-term
capital do firms use?
Long-Term Capital
Long-Term Debt Preferred Stock Common Stock
Retained Earnings New Common Stock
9-3
Calculating the weighted
average cost of capital
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


The ws refer to the firms capital
structure weights.
The ks refer to the cost of each
component.
9-4
Should our analysis focus on
before-tax or after-tax capital costs?
Stockholders focus on After Tax CFs.
Therefore, we should focus on After Tax
capital costs, i.e. use After Tax costs of
capital in WACC. Only k
d
needs
adjustment, because interest is tax
deductible.
9-5
Should our analysis focus on
historical (embedded) costs or new
(marginal) costs?
The cost of capital is used primarily to
make decisions that involve raising new
capital. So, focus on todays marginal
costs (for WACC).
9-6
How are the weights determined?
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


Use accounting numbers or market
value (book vs. market weights)?
Use actual numbers or target capital
structure?
9-7
Component cost of debt
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


k
d
is the marginal cost of debt capital.
The yield to maturity on outstanding
L-T debt is often used as a measure
of k
d
.
Why tax-adjust, i.e. why k
d
(1-T)?
9-8
Component cost of debt
Interest is tax deductible, so
A-T k
d
= B-T k
d
(1-T)
= 10% (1 - 0.40) = 6%
Use nominal rate.
Flotation costs are small, so ignore
them.
9-9
Component cost of preferred
stock
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


k
p
is the marginal cost of preferred
stock.
The rate of return investors require on
the firms preferred stock.
9-10
What is the cost of preferred
stock?
The cost of preferred stock can be
solved by using this formula:

k
p
= D
p
/ P
p

= $10 / $111.10
= 9%
9-11
Component cost of preferred
stock
Preferred dividends are not tax-
deductible, so no tax adjustments
necessary. Just use k
p
.
Nominal k
p
is used.
Our calculation ignores possible
flotation costs.
9-12
Is preferred stock more or less
risky to investors than debt?
More risky; company not required to
pay preferred dividend.
However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred
stockholders may gain control of firm.
9-13
Why is the yield on preferred
stock lower than debt?
Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred stock often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to an investor, and the A-T cost
to the issuer, are higher on preferred stock
than on debt. Consistent with higher risk of
preferred stock.
9-14
Illustrating the differences between
A-T costs of debt and preferred stock
Recall, that the firms tax rate is 40%, and its
before-tax costs of debt and preferred stock
are k
d
= 10% and k
p
= 9%, respectively.

A-T k
p
= k
p
k
p
(1 0.7)(T)
= 9% - 9% (0.3)(0.4) = 7.92%
A-T k
d
= 10% - 10% (0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%
9-15
Component cost of equity
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s


k
s
is the marginal cost of common
equity using retained earnings.
The rate of return investors require on
the firms common equity using new
equity is k
e
.
9-16
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).
Investors could buy similar stocks and earn k
s
.
Firm could repurchase its own stock and earn k
s
.
Therefore, k
s
is the cost of retained earnings.
9-17
Why is the cost of retained earnings
cheaper than the cost of issuing new
common stock?
When a company issues new common
stock they also have to pay flotation costs
to the underwriter.
Issuing new common stock may send a
negative signal to the capital markets,
which may depress the stock price.
9-18
If issuing new common stock incurs a
flotation cost of 15% of the proceeds,
what is k
e
?
15.4%
5.0%
$42.50
$4.3995

5.0%
0.15) - $50(1
) $4.19(1.05

g
F) - (1 P
g) (1 D
k
0
0
e

9-19
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.
9-20
Ignoring flotation costs, what is the
firms WACC?
WACC = w
d
k
d
(1-T) + w
p
k
p
+ w
c
k
s

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%

9-21
Flaherty Electric has a capital structure that consists of 70
percent equity and 30 percent debt. The companys long-
term bonds have a before-tax yield to maturity of 8.4 percent.
The company uses the DCF approach to determine the cost of
equity. Flahertys common stock currently trades at $45 per
share. The year-end dividend (D
1
) is expected to be $2.50
per share, and the dividend is expected to grow forever at a
constant rate of 7 percent a year. The company estimates
that it will have to issue new common stock to help fund this
years projects. The flotation cost on new common stock
issued is 10 percent, and the companys tax rate is 40
percent. What is the companys weighted average cost of
capital, WACC?


9-22
What factors influence a
companys composite WACC?
Market conditions.
The firms capital structure and
dividend policy.
The firms investment policy. Firms
with riskier projects generally have a
higher WACC.
9-23
Should the company use the
composite WACC as the hurdle rate
for each of its projects?
NO! The composite WACC reflects the risk
of an average project undertaken by the
firm. Therefore, the WACC only represents
the hurdle rate for a typical project with
average risk.
Different projects have different risks. The
projects WACC should be adjusted to
reflect the projects risk.
9-24
Risk and the Cost of Capital
Rate of Return
(%)
WACC
Rejection Region
Acceptance Region
Risk
L
B
A
H
12.0
8.0
10.0
10.5
9.5
0 Risk
L
Risk
A
Risk
H
9-25
What are the three types of
project risk?
Stand-alone risk
Corporate risk
Market risk
9-26
How is each type of risk used?
Market risk is theoretically best in most
situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
9-27
Problem areas in cost of capital
Depreciation-generated funds
Privately owned firms
Measurement problems
Adjusting costs of capital for
different risk
Capital structure weights
9-28
How are risk-adjusted costs of
capital determined for specific
projects or divisions?
Subjective adjustments to the firms
composite WACC.
Attempt to estimate what the cost of
capital would be if the project/division
were a stand-alone firm. This requires
estimating the projects beta.
9-29
Finding a divisional cost of capital:
Using similar stand-alone firms to
estimate a projects cost of capital
Comparison firms have the following
characteristics:
Target capital structure consists of 40%
debt and 60% equity.
k
d
= 12%
k
RF
= 7%
RP
M
= 6%

DIV
= 1.7
Tax rate = 40%
9-30
Calculating a divisional cost of capital
Divisions required return on equity
k
s
= k
RF
+ (k
M
k
RF
)
= 7% + (6%)1.7 = 17.2%
Divisions weighted average cost of capital
WACC = w
d
k
d
( 1 T ) + w
c
k
s

= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
Typical projects in this division are
acceptable if their returns exceed 13.2%.