The Cost

of Capital

1
 Learning Goals
• Sources of capital
• Cost of each type of funding
• Calculation of the weighted average cost of capital
(WACC)
• Construction and use of the marginal cost of capital
schedule (MCC)

2
Factors Affecting the Cost of Capital
• General Economic Conditions
– Affect interest rates
• Market Conditions
– Affect risk premiums
• Operating Decisions
– Affect business risk
• Financial Decisions
– Affect financial risk
• Amount of Financing
– Affect flotation costs and market price of security

3
 Weighted Cost of Capital Model
• Compute the cost of each source of capital
• Determine percentage of each source of
capital in the optimal capital structure
• Calculate Weighted Average Cost of Capital
(WACC)

4
1. Compute Cost of Debt
• Required rate of return for creditors
• Same cost found in Chapter 12 as yield to maturity
on bonds (kd).
• e.g. Suppose that a company issues bonds with a
before tax cost of 10%.
• Since interest payments are tax deductible, the true
cost of the debt is the after tax cost.
• If the company’s tax rate (state and federal
combined) is 40%, the after tax cost of debt
• AT kd = 10%(1-.4) = 6%.

5
 2. Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock.
Dividend (Dp)
Required rate kp =
Market Price (PP) - F

Example: You can issue preferred stock for a net

price of $42 and the preferred stock pays a
$5 dividend.
 The cost of preferred stock:

$5.00
kp =
$42.00
= 11.90%
6
 3. Compute Cost of Common
Equity
• Two Types of Common Equity Financing
– Retained Earnings (internal common
equity)
– Issuing new shares of common stock
(external common equity)

7
3. Compute Cost of Common Equity
• Cost of Internal Common Equity
– Management should retain earnings only
if they earn as much as stockholder’s
next best investment opportunity of the
same risk.
– Cost of Internal Equity = opportunity
cost of common stockholders’ funds.
– Two methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model
8
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Dividend Growth Model

D1
kS = + g
P0

9
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Dividend Growth Model

D1
kS = + g
P0

Example:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%.

10
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Dividend Growth Model

D1
kS = + g
P0
Example:
The market price of a share of common stock is $60.
The dividend just paid is $3, and the expected growth
rate is 10%.

kS = 3(1+0.10) + .10 =.155 = 15.5%

60
11
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM – kRF)

12
3. Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

– Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

13
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

kS = 5% + 1.2(13% – 5%) = 14.6%

14
3. Compute Cost of Common Equity

• Cost of New Common Stock

– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
kn = + g
P0 - F

15
3. Compute Cost of Common Equity
• Cost of New Common Stock
– Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
16
 3. Compute Cost of Common Equity
• Cost of New Common Stock
– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs will
be 12%. D0 = $3.00 and estimated growth is 10%,
Price is $60 as before.

kn = 3(1+0.10) + .10 = .1625 = 16.25%

52.80 17
Weighted Average Cost of Capital
Gallagher Corporation estimates the following
costs for each component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%

Gallagher’s tax rate is 40% 18

Weighted Average Cost of Capital
 If using retained earnings to finance the
common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

19
Weighted Average Cost of Capital

If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

 Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.

20
Weighted Average Cost of Capital

If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

 Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09%
21
Weighted Average Cost of Capital

If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

22
Weighted Average Cost of Capital

If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%

23
 Interest Rate Risk

• Bond Prices fluctuate over Time

– As interest rates in the economy change,
required rates on bonds will also change
resulting in changing market prices.

Interest
Rates
VB
Interest
Rates VB

24
 Valuing Preferred Stock
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
s 42½ 29 QuakerOats OAT 1.14 3.3 24 5067 35 34¼ 34¼ -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾
2377//8820 RJR
20 Nab
RJRpfB
Nab pfB 2.312.31
9.7 9.7
... 966
... 24
966 23
245/8 23¾
235/8 ...
23¾ ...
7¼ 5½RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -
1/8
0 1 2 3 

P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31

P0 = Value of Preferred Stock

= PV of ALL dividends discounted at investor’s

Required Rate of Return
25
 Valuing Preferred Stock
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
s 42½ 29 QuakerOats OAT 1.14 3.3 24 5067 35 34¼ 34¼ -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾
2377//8820 RJR
20 Nab
RJRpfB
Nab pfB 2.312.31
9.7 9.7
... 966
... 24
966 23
245/8 23¾
235/8 ...
23¾ ...
7¼ 5½RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -
1/8
0 1 2 3 

P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31

2.31 2.31 2.31
P0 = (1+ kp) + (1+ kp)2 +(1+ kp)3 +···


26
 Valuing Preferred Stock
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
s 42½ 29 QuakerOats OAT 1.14 3.3 24 5067 35 34¼ 34¼ -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾
2377//8820 RJR
20 Nab
RJRpfB
Nab pfB 2.312.31
9.7 9.7
... 966
... 24
966 23
245/8 23¾
235/8 ...
23¾ ...
7¼ 5½RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -
1/8
0 1 2 3 

P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31

2.31 2.31 2.31
P0 = (1+ kp) + (1+ kp )2 +(1+ kp )3 +···

Dp 2.31
P0 =
kp = .10 = $23.10
27
 Valuing Individual Shares of Common
Stock
P0 = PV of ALL expected dividends discounted at investor’s
Required Rate of Return

0 1 2 3 

P0 D1 D2 D3 D

D1 D2 D3
P0 = (1+ ks ) + (1+ ks )2 +
(1+ ks )3 +···
Not like Preferred Stock since D0 = D1 = D2 = D3 = DN , therefore the cash
flows are no longer an annuity.

28
Valuing Individual Shares of Common
Stock
P0 = PV of ALL expected dividends discounted at investor’s
Required Rate of Return

0 1 2 3 

P0 D1 D2 D3 D
D1 D2 D3
P0 = (1+ ks ) + (1+ ks )2 +
(1+ ks )3 +···
Investors do not know the values of
D1, D2, .... , DN. The future dividends must be
estimated.

29
Constant Growth Dividend Model

Assume that dividends grow at a constant rate (g).

0 1 2 3 

D0 D1=D0 (1+g) D2=D0 (1+g)2D3=D0 (1+g)3 D=D0 (1+g)

30
Constant Growth Dividend Model
Assume that dividends grow at a constant rate (g).

0 1 2 3 

D0 D1=D0 (1+g) D2=D0 (1+g)2D3=D0 (1+g)3 D=D0 (1+g)

D0 (1+ g) D0 (1+ g)2 D0 (1+ g)3

P0 = (1+ ks ) + (1+ ks )2 +(1+ ks )3 
+ ···
+ Reduces to:

D0(1+g) D1
P0 = ks – g =
ks – g Requires ks
>g
31
Constant Growth Dividend Model

What is the value of a share of common stock if the

most recently paid dividend (D0) was $1.14 per share and
dividends are expected to grow at a rate of 7%?
Assume that you require a rate of return of 11%
on this investment.

D0(1+g) D1
P0 = ks – g =
ks – g

1.14(1+.07)
P0 = .11 – .07 = $30.50
32
Valuing Total Stockholders’ Equity

• The Investor’s Cash Flow DCF Model

– Investor’s Cash Flow is the amount that is
“free” to be distributed to debt holders,
preferred stockholders and common
stockholders.
– Cash remaining after accounting for
expenses, taxes, capital expenditures and
new net working capital.

33
Calculating Intrinsic Value
Coca Cola Example

34
 ECP Homework

1. Indicate which of the following bonds seems to be reported incorrectly with respect to discount, premium,
or par and explain why.

Bond Price Coupon Rate Yield to Maturity

A 105 9% 8%
B 100 6% 6%
C 101 5% 4.5%
D 102 0% 5%

2. What is the price of a ten-year $1,000 par-value bond with a 9% annual coupon rate and a 10% annual
yield to maturity assuming semi-annual coupon payments?

3. You have an issue of preferred stock that is paying a $3 annual dividend. A fair rate of return on this
investment is calculated to be 13.5%. What is the value of this preferred stock issue?

4. Total assets of a firm are $1,000,000 and the total liabilities are $400,000. 500,000 shares of common
stock have been issued and 250,000 shares are outstanding. The market price of the stock is $15 and net
income for the past year was $150,000.
a.. Calculate the book value of the firm.
b. Calculate the book value per share.
c. Calculate the P/E ratio.

5. A firm’s common stock is currently selling for $12.50 per share. The required rate of return is 9% and the
company will pay an annual dividend of $.50 per share one year from now which will grow at a constant rate
for the next several years. What is the growth rate?

35