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1

Cost of Capital Chapter 12


3
Required Rates on Projects
 An important part of capital budgeting is setting the
required rate for the individual project
4
Required Rates on Projects
 An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project

0 1

-1,000 +1,100
5
Required Rates on Projects
 An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project

0 1

-1,000 +1,100

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17


(1+ .09 )
6
Required Rates on Projects
 An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project

0 1

-1,000 +1,100

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17


(1+ .09 )
Accept Project since NPV > 0
7
Required Rates on Projects
 An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project

0 1

-1,000 +1,100

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17


(1+ .09 )
Accept Project since NPV > 0

If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01


(1+ .11 )
8
Required Rates on Projects
 An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project

0 1

-1,000 +1,100

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17


(1+ .09 )
Accept Project since NPV > 0

If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01


(1+ .11 )
Reject Project since NPV < 0
9
Required Rates on Projects
 An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project

0 1

-1,000 +1,100

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17


(1+ .09 )
Accept Project since NPV > 0

If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01


(1+ .11 )
In
Inorder
orderto
toestimate
estimatecorrect
correct required
required rate,
rate,companies
companies
must
mustfind
findtheir
theirown
ownunique
uniquecost
costofofraising
raisingcapital
capital
10
Factors Affecting Cost of Capital
General Economic Conditions--inflation, investment opportunities
Affect interest rates
The Following Factors affect risk premium
Market Conditions
Operating and Financing Decisions
Affect business risk
Affect financial risk
Amount of Financing
Affect flotation costs and market price of security
11
Model Assumptions
Weighted Average Cost of Capital Model
Here, we determine the average cost of capital of a
firm by assuming that the firm continues with its
business, financing and dividend policies.
12
Computing Weighted Cost of Capital
Weighted Average Cost of Capital (WACC)

Average cost of capital of the firm.

To find WACC

1. Compute the cost of each source of capital


2. Determine percentage of each source of capital
3. Calculate Weighted Average Cost of Capital
13
Computing Cost of Each Source
1. Compute Cost of Debt
Required rate of return for creditors
Same cost found in Chapter 7 as “required rate for
debtholders (kd) = YTM”
14
Computing Cost of Each Source
1. Compute Cost of Debt
Required rate of return for creditors
Same cost found in Chapter 7 as “required rate for
debtholders (kd)”
n
It
P0 =  (1  k ) n +
$M
t 1 d (1+kd)n
where:
It = Dollar Interest Payment
Po = Market Price of Debt
M = Maturity Value of Debt
15
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
16
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
n
It
P0 =  (1  k ) n +
$M
t 1 d (1+kd)n
17
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
n
It
P0 =  (1  k ) n +
$M
t 1 d (1+kd)n

12
$90 $1,000
938.55 =  (1  k ) 12
+
(1+kd)10
t 1 d
18
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?

The before tax cost of debt is 10%


Interest
Interestisistax
taxdeductible
deductible
19
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?

The before tax cost of debt is 10%


Interest
Interestisistax
taxdeductible
deductible
Marginal Tax Rate = 40%
After tax cost of bonds = kd(1 - T)
20
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?

The before tax cost of debt is 10%


Interest
Interestisistax
taxdeductible
deductible
Marginal Tax Rate = 40%
After tax cost of bonds = kd(1 - T)
= 10.0%(1– 0.40) = 6 %
21
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
22
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.

From Chapter 8:
Dividend (D)
Required rate kps =
Market Price (P0)
23
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.

From Chapter 8:
Dividend (D)
Required rate kps =
Market Price (P0)

However,
However,there
thereare
arefloatation
floatationcosts
costs of
ofissuing
issuingpreferred
preferredstock:
stock:
24
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.

From Chapter 8:
Dividend (D)
Required rate kps =
Market Price (P0)

However,
However,there
thereare
arefloatation
floatationcosts
costs of
ofissuing
issuingpreferred
preferredstock:
stock:
Cost of Preferred Stock with floatation costs

kps = Dividend (D)


Net Price (NP0)
25
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
26
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
Cost of Preferred Stock

kps = $5.00
$42.00
27
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
Cost of Preferred Stock

kps = $5.00
= 11.90%
$42.00
28
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
Cost of Preferred Stock

kps = $5.00
= 11.90%
$42.00

No
Noadjustment
adjustmentisis made
madefor
for taxes
taxes as
as
dividends
dividendsare
arenot
nottaxtaxdeductible.
deductible.
29
Computing Cost of Each Source
3. Compute Cost of Common Equity
Two kinds of Common Equity
Retained Earnings (internal common equity)
Issuing new shares of common stock
30
Computing Cost of Each Source
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.
31
Computing Cost of Each Source
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.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
32
Computing Cost of Each Source
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.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
Cost of internal equity must equal common
stockholders’ required rate of return.
33
Computing Cost of Each Source
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.
Cost of Internal Equity = opportunity cost of common stockholders’
funds.
Cost of internal equity must equal common stockholders’ required rate
of return.
Three methods to determine
Dividend Growth Model
Capital Asset Pricing Model
Risk Premium Model
34
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
35
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model

D1
kcs = + g
P0
36
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model

D1
kcs = + 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% .
37
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model

D1
kcs = + 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% .

kcs = 3(1+0.10) + .10


60
38
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model

D1
kcs = + 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% .

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


60
39
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model

D1
kcs = + 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% .

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


60

The
Themain
mainlimitation
limitationin
inthis
thismethod
methodisisestimating
estimatinggrowth
growthaccurately.
accurately.
40
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
41
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM

kcs = krf + (km – krf)


42
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM

kcs = 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%.
43
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM

kcs = 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%.

kcs = 5% + 1.2(13% – 5%)


44
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
Cost of internal equity--CAPM

kcs = 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%.

kcs = 5% + 1.2(13% – 5%) = 14.6%


45
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
46
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc RPc = Common stock
risk premium
47
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc RPc = Common stock
Example risk premium
If the risk premium is 5% and kd is 10%
48
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc RPc = Common stock
Example risk premium
If the risk premium is 5% and kd is 10%

kcs = 10% + 5%
49
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc RPc = Common stock
Example risk premium
If the risk premium is 5% and kd is 10%

kcs = 10% + 5% = 15%


50
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
51
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
Dividend Growth Model--Must adjust for floatation
costs of the new common shares.
52
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
Dividend Growth Model--must adjust for floatation
costs of the new common shares.
Cost of new common stock

D1
kcs = + g
NP0
53
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock

D1
knc = + g
NP0
54
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock

D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently
$60. If additional shares are issued floatation costs will be 12%.
D0 = $3.00 and estimated growth is 10%.
55
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock

D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently
$60. If additional shares are issued floatation costs will be 12%.
D0 = $3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80
Floatation
Floatation
Costs
Costs
56
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock

D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently
$60. If additional shares are issued floatation costs will be 12%.
D0 = $3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80

kcs = 3(1+0.10) + .10


52.80
57
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock

D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently
$60. If additional shares are issued floatation costs will be 12%.
D0 = $3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80

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


52.80
58
Capital Structure Weights
Long Term Liabilities and Equity

Weights of each source should reflect expected


financing mix
Assume a stable financial mix–so use Balance Sheet
percentages to calculate the weighted average cost
of capital.
59
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000

Firm Raises $10,000 of capital from long term sources


60
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000

Compute Firm’s Capital Structure (% of each source)


Amount of Bonds
4,000
Bonds: = 40%
10,000
Total Capital Sources
61
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000

Compute Firm’s Capital Structure (% of each source)


Amount of Preferred Stock
1,000
Preferred Stock: = 10%
10,000
Total Capital Sources
62
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000

Compute Firm’s Capital Structure (% of each source)


Amount of Common Stock
5,000
Common Stock: = 50%
10,000
Total Capital Sources
63
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000 40%
Total Assets $12,000 Preferred Stock 1,000 10%
Common Stock 5,000 50%
Total Liabilities and
Owners Equity $12,000

When money is raised for capital projects, approximately


40% of the money comes from selling bonds, 10%
comes from selling preferred stock and 50% comes from
retaining earnings or selling common stock
64
Computing WACC
Green Apple Company estimates the following costs
for each component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kps = 11.9%
Common Stock
Retained Earnings kcs = 15%
New Shares knc = 16.25%

Green Apple’s tax rate is 40%


65
Computing WACC
 If using retained earnings to finance the common
stock portion the capital structure
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
66
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (9%) 4,000 40%
Total Assets $12,000 Preferred Stock (10%) 1,000 10%
Common Stock(13%) 5,000 50%
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
67
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000 40%
Total Assets $12,000 Preferred Stock (11.9%)1,000 10%
Common Stock(15%) 5,000 50%
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
68
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000 40%
Total Assets $12,000 Preferred Stock (11.9%)1,000 10%
Common Stock(15%) 5,000 50%
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
69
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000 40%
Total Assets $12,000 Preferred Stock (11.9%)1,000 10%
Common Stock(15%) 5,000 50%
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15%
70
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000 40%
Total Assets $12,000 Preferred Stock (11.9%)1,000 10%
Common Stock(15%) 5,000 50%
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15% = 11.09%
71
Computing WACC
 If use newly issued common stock, use knc rather
than kcs for the cost of the equity portion.
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock

kkncnc
72
Computing WACC - using New Common Shares
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%)1,000
Common Stock(16.25%)5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 16.25% = 11.72%
73
Weighted Marginal Cost of Capital
A firm’s cost of capital will change as it is raises more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money has been raised
74
Weighted Marginal Cost of Capital
A firm’s cost of capital will changes as it is raising more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money raised
Therefore, beyond a point, the WACC will rise.
Calculate the point at which the cost of capital
increases
75
Weighted Marginal Cost of Capital
A firm’s cost of capital will changes as it is raising more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money raised
Calculate the point at which the cost of capital
increases
Amt of lower cost capital that can
Break in cost be =raised before component cost rises
of capital curve Weight of this kind of capital
in the capital structure
76
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
of capital curve Percentage of
common financing

If Green Apple Company has $100,000 of internally


generated common:
77
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
of capital curve Percentage of
common financing

If Green Apple Company has $100,000 of internally


generated common:

Break in cost = $100,000


of capital curve .50
78
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
of capital curve Percentage of
common financing

If Green Apple Company has $100,000 of internally


generated common:

Break in cost = $100,000


= $200,000
of capital curve .50
79
Weighted Marginal Cost of Capital
Retained earnings
Break in cost = available for reinvesting
of capital curve Percentage of
common financing

If Green Apple Company has $100,000 of internally


generated common:

Break in cost = $100,000


= $200,000
of capital curve .50

Once
Once$200,000
$200,000isisraised
raisedfrom
fromall
allsources,
sources,the
the
cost
costof
ofcapital
capitalwill
willrise
risebecause
becauseallallthe
thelower
lower
cost
costretained
retainedearnings
earningswill
willbe
beused
usedup.up.
80
Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve:
Weighted Cost of Capital

12%

11.09%
11%
Cost
CostofofCapital
Capital
using
usinginternal
internal
10% common
commonstockstock

9%

0 100,000 200,000 300,000 400,000


Total Financing
81
Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve:
Weighted Cost of Capital

12%

11.09%
11%

10%

Break-Point
Break-Pointfor
for
9% common
commonequity
equity

0 100,000 200,000 300,000 400,000


Total Financing
82
Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve:
Cost
CostofofCapital
Capitalusing
using
11.72% new
newcommon
commonequity
Weighted Cost of Capital

12% equity

11.09%
11%
Cost
CostofofCapital
Capital
using
usinginternal
internal
10% common
commonstockstock

9%

0 100,000 200,000 300,000 400,000


Total Financing
83
Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve:

11.72%
Weighted Cost of Capital

12%

11.09%
11%

10%

9%

0 100,000 200,000 300,000 400,000


Total Financing
84
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects

Marginal weighted cost of capital curve:


Weighted Cost of Capital

12%

11% Project 1
IRR = 12.4%
Project 2
10% IRR = 12.1% Project 3
IRR = 11.5%
9%

0 100,000 200,000 300,000 400,000


Total Financing
85
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital

Marginal weighted cost of capital curve:


Weighted Cost of Capital

12%

11% Project 1
IRR = 12.4%
Project 2
10% IRR = 12.1% Project 3
IRR = 11.5%
9%

0 100,000 200,000 300,000 400,000


Total Financing
86
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital
Choose projects whose IRR is above the weighted
marginal cost of capital
Marginal weighted cost of capital curve:
Weighted Cost of Capital

12%
Accept Projects #1 & #2

11% Project 1
IRR = 12.4%
Project 2
10% IRR = 12.1% Project 3
IRR = 11.5%
9%

0 100,000 200,000 300,000 400,000


Total Financing
87