10 - 1

Capital components: debt, preferred stock,

and common stock.
Any increase in total assets must be financed
by an increase in one or more of these capital
components
Kd: the interest rate on the firms new debt
Kps: the cost of preferred stock
Ks: the cost of retained earnings
Ke:the cost of common equity (equity obtained
by issuing new common stock as apposed to
retaining eanings
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10 - 2

1. The cost of debt

Kd(1-T) is the after tax cost of debt. The
relevant cost of new debt, taking into
account the tax deductibility of interest.
In effect, the government pays part of the
cost of debt because interest is
deductible.

Note that the cost of debt is the interest rate

on new debt, not the interest rate paid on
existing or old debt.
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10 - 3

A 15-year, 12% semiannual bond sells

for $1,153.72. Whats kd?
0

i=?

60

30
N

OUTPUT

30

...

-1,153.72

INPUTS

2
60

-1153.72 60
I/YR

PV

PMT

60 + 1,000

1000
FV

5.0% x 2 = kd = 10%

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10 - 4

Component Cost of Debt

Interest is tax deductible, so

kd AT

= kd BT(1 T)
= 10%(1 0.40) = 6%.

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10 - 5

2. The cost of preferred stock (Kp)

The rate of return investors require on the
firms preferred stock.
Preferred stock is a perpetuity that pays a
fixed dividend (Dp) forever.
Kp = Preferred dividend / the current price
of the preferred stock

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10 - 6

Whats the cost of preferred stock?

Pp = $111.10; $10 dividend/share
Use this formula:
Dp
$10
kp

0.090 9.0%.
Pp $111 .10

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10 - 7

Note:
Preferred dividends are not tax
deductible, so no tax adjustment.
Just kp.
Nominal kp is used.
Our calculation ignores flotation
costs.

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10 - 8

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.
Thus, there is an opportunity cost if
earnings are retained.
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10 - 9

Opportunity cost: The return

stockholders could earn on
alternative investments of equal risk.
They could buy similar stocks and
earn ks. So, ks is the cost of retained
earnings. The rate of return required by
stockholders on a firms common stock

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10 - 10

Three ways to determine cost of

common equity, ks:
1. CAPM: ks = kRF + (kM kRF)b.
2. The bond-yield plus risk-premium approach:
Ks= bond yield + firms risk premium
firms with risky, low-rated, and consequently
high-interest-rate debt will also have risky, highcost equity. The risk premium over a firms own
bond yield has generally ranged from 3 to 5
percentage.
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10 - 11

3. Discount Cash Flow model

(Constant dividend growth model)
Ks = (D1/Po) + g
How to estimate g?
g = (1- dividend pay out ratio)*ROE

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10 - 12

Whats the cost of common equity

based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.

ks = kRF + (kM kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

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10 - 13

Whats the DCF cost of common

equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
ks = D1 + g = D0(1 + g) + g
P0
P0
= $4.19(1.05) + 0.05
$50
= 0.088 + 0.05
= 13.8%.
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10 - 14

Suppose the company has been

earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout =
65%), and this situation is expected to
continue.
Whats the expected future g?

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10 - 15

Retention growth rate:

g = (1 Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 Payout) = Fraction retained.

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10 - 16

Find ks using the own-bond-yield-plusrisk-premium method.

(kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%
This RP CAPM RP.
Produces ballpark estimate of ks.
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10 - 17

Whats a reasonable final estimate of k s?

Method

Estimate

CAPM

14.2%

DCF

13.8%

kd + RP

14.0%

Average
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14.0%
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10 - 18

Why is the cost of retained earnings

(ks) cheaper than the cost of issuing
new common stock (ke)?
1. When a company issues new common
stock they also have to pay flotation costs
to the underwriter.
2. Issuing new common stock may send a
negative signal to the capital markets,
which may depress stock price.

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10 - 19

Two approaches that can be used to

account for flotation costs:
Include the flotation costs as part of the
projects up-front cost. This reduces the
projects estimated return.
Adjust the cost of capital to include
flotation costs. This is most commonly
done by incorporating flotation costs in
the DCF model.
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10 - 20

Ke = [D1/Po(1-F) ] + g
F is the percentage flotation cost incurred in
selling the new stock.
So, Po (1-F) is the net price per share
received by the company.

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10 - 21

New common, F = 15%:

D0 (1 g)
ke
g
P0 (1 F)
$4.19 1.05

5 .0 %
$50 1 0.15
$4.40

5.0% 15.4%.
$42.50
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10 - 22

Because of flotation costs, dollars raised by

selling new stock must work harder than
dollars raised by retaining earnings.
Moreover, since no flotation costs are
involved, retained earnings have a lower cost
than new stock.
Therefore, the firms should utilize retained
earnings to the extent possible to avoid the
costs of new common stock.
However, if a firm has more good investment
opportunities, issuing new common stock is
necessary.
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10 - 23

The retained earnings breakpoint

represents the total amount of financing
that can be raised before the firm is forced
to sell new common stock.
Retained earnings breakpoint
= addition to retained earnings/equity fraction

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10 - 24

E.g) Suppose a firm estimates its

earnings to be $100M next year and
has a payout ratio of 40%. Its capital
structure consists of 45% debt, 2%
preferred, and 53% equity.
The break point will be $60M/0.53 =
$113.2M; After the firm has raised total
capital of $113.2M, the firm will be
forced to issue new common stock.
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10 - 25

Comments about 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 perproject cost is fairly small.
We will frequently ignore flotation
costs when calculating the WACC.
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10 - 26

5. Weighted Average Cost of Capital (WACC)

If all new equity will come from retained earnings:
WACC = Wd [Kd(1-t)] + Wp(Kps) + Wc(Ks)
Wd, Ws, Wc are the weights used for debt, preferred
stock, and common equity.
Assume that the firm has established such a target
and will finance all new investments so as to
maintain a constant target capital structure.
Weights should be based on the market value.

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10 - 27

Whats the firms WACC (ignoring

flotation costs)?

WACC = wdkd(1 T) + wpkp + wcks

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

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10 - 28

The company has a target capital structure

of 40 percent debt and 60 percent equity
Bonds pay 10% coupon (semiannual),
mature in 20 years and sell for $849.54
the company stock beta is 1.2
rf = 10%, market risk premium = 5%
the company is a constant growth firm
that just paid a dividend of $2, sells for $27
per share, and a growth rate of 8%
marginal tax rate is 40%.
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10 - 29

What factors influence a companys

composite WACC?
Market conditions. (the level of interest
rates, tax rates)
The firms capital structure and dividend
policy.
The firms investment policy. Firms with
riskier projects generally have a higher
WACC.
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10 - 30

WACC Estimates for Some Large

U. S. Corporations, Nov. 1999
Company
Intel
General Electric
Motorola
Coca-Cola
Walt Disney
AT&T
Wal-Mart
Exxon
H. J. Heinz
BellSouth
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WACC
12.9%
11.9
11.3
11.2
10.0
9.8
9.8
8.8
8.5
8.2
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10 - 31

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.
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10 - 32

What procedures are used to determine

the risk-adjusted cost of capital for a
particular project or division?
Subjective adjustments to the
firms composite WACC.
Attempt to estimate what the cost
of capital would be if the
project/division were a standalone firm. This requires
estimating the projects beta.
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10 - 33

Find the divisions market risk and cost

of capital based on the CAPM, given
these inputs:
Target debt ratio = 40%.
kd = 12%.
kRF = 7%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.
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10 - 34

Beta = 1.7, so division has more market risk

than average.
Divisions required return on equity:
ks = kRF + (kM kRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdkd(1 T) + wcks
= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.

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10 - 35

How does the divisions market risk

compare with the firms overall market
risk?
Division WACC = 13.2% versus company
WACC = 11.1%.
Indicates that the divisions market risk is
greater than firms average project.
Typical projects within this division
would be accepted if their returns are
above 13.2%.
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