What Sources of Long-term Capital

Do Firms Use?
CHAPTER 9
The Cost of Capital

Long-Term
Capital
Long-Term
Debt

Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk

Preferred
Stock

Common
Stock

Retained
Earnings

New Common
Stock
9-2

What Is Cost of Capital?

Capital Components

From investors point of view:

The minimum return a firm needs to earn to satisfy

all of its investors

The weighted average of required returns of the
securities used to finance the firm

From firms point of view:

The various types of debt, preferred stock,

and common equity shown on the B/S
The sources of funding that come from
investors
A/P, accruals, and deferred taxes are not the

The cost of capital for the firm as a whole

The cost of capital depends primarily on the use of

sources of funding that come from investors

They are not the components of the cost of capital

the funds, not the source

9-3

Before-tax vs. After-tax Capital

Costs

Calculating the WACC

WACC = wdrd(1-T) + wpsrp + wcsrs

9-4

The ws refer to the firms capital structure

weights.

rd= cost of debt

rp= cost of preferred stock

rs= cost of common stock

T= tax rate

Tax effects associated with financing can be

incorporated either in capital budgeting CFs
or in cost of capital
Most firms incorporate tax effects in the cost
of capital. Therefore, focus on A-T costs
Only cost of debt is affected

Why tax-adjust, i.e. why rd(1-T)?

9-5

9-6

Historical (Embedded) Costs vs.

New (Marginal) Costs

A Three-Step Procedure for

Estimating Firm WACC
1. Define the firms capital structure by

The cost of capital is used in raising

and investing new capital

determining the weight of each source of

capital.

2. Estimate the opportunity cost of each source

So, we should focus on marginal costs

of financing.

We will use the current market value of each source of

capital based on its current, not historical, costs.

3. Calculate a weighted average of the costs of

each source of financing.

9-7

A Template for Calculating WACC

The following template demonstrates how to carry out

the calculation of the WACC from the previous Equation:
(1)
Source of
Capital

(2)

(3)

Determining the Firms Capital

Structure Weights

(4)

The weights are based on debt (excluding A/P

and accruals), preferred stock, and common
equity

Product of (2)
and (3)

Debt

wd

rd (1-T)

wdrd (1-T)

Preferred Stock

wps

rp

wpsrp

Common Stock

wcs

rs

wcsrs

Sum=

Market Value
A-T Cost of
Weights
Financing

9-8

100%

Ideally, the weights should be based on observed

market values
Sometimes all market values may be readily available
We generally use book values for debt and market
values for equity

9-9

9-10

Example: Calculating WACC

Example: Calculating WACC

WACC for Templeton Extended Care Facilities, Inc.

In the spring of 2012, Templeton was considering the
acquisition of a chain of extended care facilities and wanted
to estimate its own WACC as a guide to the cost of capital
for the acquisition. Templetons capital structure consists of
the following:

Templeton contacted the firms investment banker to

get estimates of the firms current cost of financing and
was told that if the firm were to borrow the same
amount of money today, it would have to pay lenders
8%; however, given the firms 25% tax rate, the aftertax cost of borrowing would only be 6% = 8%(1-.25).
Preferred stockholders currently demand a 10% rate of
return, and common stockholders demand 15%.
Templetons CFO knew that the WACC would be
somewhere between 6% and 15% since the firms
capital structure is a blend of the three sources of
capital whose costs are bounded by this range.
9-11

9-12

Example: Calculating WACC

STEP 2: Opportunity cost of each source is given
STEP 3: Solve
(1)

(2)

Source of
Capital

9-13

(4)
=

Product of (2)
and (3)

Debt

0.250

0.060

0.01500

Preferred Stock

0.125

0.100

0.01250

Common Stock

0.625

0.150

Sum=

100%

0.09375
0.12125

STEP 4: Analyze
Templetons CFO estimated that the firm's WACC is 12.125%, which lies
within the range between the highest cost of source of capital (common
stock at 15%) and the lowest (debt at 6%).

9-14

The Cost of Debt (rd)

Example: Check Yourself

After completing her estimate of Templetons WACC, the
CFO decided to explore the possibility of adding more lowcost debt to the capital structure. With the help of the firms
investment banker, the CFO learned that Templeton could
probably push its use of debt to 37.5% of the firms capital
structure by issuing more debt and retiring (purchasing) the
firms preferred shares. This could be done without
increasing the firms costs of borrowing or the required rate
of return demanded by the firms common stockholders.
What is your estimate of the WACC for Templeton under this
new capital structure proposal?

(3)

Market Value
A-T Cost of
Weights
Financing

Method 1: Ask an investment banker what the

coupon rate would be on new debt

Method 2: Find the bond rating for the firm

and use the yield on other bonds with a
similar rating

Method 3: Find the yield on the firms debt, if

it has any

WACC = wdrd(1-T) + wcsrs

=0.375 x 0.06 + 0.625 x 0.15=11.625%.
9-15

Example-1: Before Tax Cost of

Debt

Components of Cost of Debt

The pretax rd is the financing cost associated

with new funds through LT borrowing

A 15-year, 12% semiannual bond sells for $1,153.72.

The before-tax cost of debt (rd) by applying the bond
pricing formula will be as follows:

The rd is the rate of return the firms lenders

demand when they loan money

9-16

The pretax rd =YTM

$1,153.72 =

Net proceeds are the funds received from the sale of

a debt security.

$60
$1,000
{1 (1 + rd / 2) 215 } +
rd / 2
(1 + rd / 2) 215

rd = 10%

Flotation costs are the total costs of issuing and

selling a security which include underwriting costs
and administrative costs
9-17

9-18

Example-1: Cost of Debt with

Flotation Cost

Example-2: The Cost of Debt

Humble Manufacturing is interested in measuring its overall

cost of capital. The firm is in the 40% tax bracket. The firm
can raise an unlimited amount of debt by selling $1,000par-value, 10% coupon interest rate, 10-year bonds on
which annual interest payments will be made. To sell the
issue, an average discount of $30 per bond must be given.
The firm must also pay flotation costs of $20 per bond.
What is the after-tax cost of debt?
(VB F) =

CI
M
{1 (1 + rd ) n } +
rd
(1 + rd )n

($1,000 $50) =

$100
$1,000
{1 (1 + rd ) 10 } +
rd
(1 + rd )10

= 10.83%

What will be the YTM on a debt that has par value of

$1,000, a coupon interest rate of 5%, time to
maturity of 10 years and is currently trading at $900?
What will be the cost of debt if the tax rate is 30%?
Solution:

(VB F) =

CI
M
{1 (1 + rd ) n } +
rd
(1 + rd )n

$50
$1000
{1 (1 + rd ) 10 } +
= 0.0638
rd
(1 + rd )10
Thus, A - T cost of debt (YTM) = rd (1 - T)

Net proceeds: $1,000$30-$20= $950

$900 =

A-T cost of debt (YTM)

will be: rd = rd (1-T)
=10.83% (1-0.40) =
6.5%

= 0.0638 (1 - 0.30) = 4.47%

*F= Flotation costs are very small, so ignore them

9-19

9-20

The Cost of Preferred Stock (rp)

Example-3: The Cost of Debt

Basket Wonders has a 15-year, 12% semiannual
coupon bond which sells for $1,153.72 with 0
flotation cost. What is the cost of debt (r d) given
the tax rate 40%?

The rp is the rate of return on investment of

the preferred shareholders

Solution:

$120 / 2
$1000
$1153.7 =
{1 (1 + rd / 2) 30 } +
rd / 2
(1 + rd / 2)30
Annualized rd = 5% 2 = 10%

The rp can be inferred from its trading price and

the fixed dividend:

rP = DPs / P0

Thus, A - T cost of debt (YTM) = rd (1 - T)

= 0.10 (1 - 0.40) = 6%
*Flotation costs are small, so ignore them

The cost is not adjusted for taxes since

dividends are paid to preferred stockholders out
of A-T income.

9-21

9-22

Example-2: The Cost of Preferred

Stock

Example-1: The Cost of Preferred

Stock
Assume that Basket Wonders has preferred
stock outstanding with par value of $100,
dividend per share of $10, and a current market
value of $111.10 per share.

rp = $10 / $111.10= 9%

9-23

Preferred stock: The

firm can sell 11% (annual
dividend) preferred stock
at its $100-per-share par
value. The cost of issuing
and selling the preferred
stock is expected to be $4
per share. An unlimited
amount of preferred stock
can be sold under these
terms.

rps =

Dps
Nps

Dps = 0.11 $100 = $11

Nps = $100 $4 (flo. cos t)
= $96
$11
rps =
= 11.5%
$96
9-24

Example-3: The Cost of Preferred

Stock

Example-4: The Cost of Preferred

Stock

Preferred stock:
The cost of preferred
stock if PPs =
$113.10; dividend =
10% paid quarterly,
Par = $100; flotation
cost (F) = $2, will
be:

Preferred stock:
The Cost of preferred
stock if PPs =
$116.95; dividend =
10% paid quarterly,
Par = $100; flotation
cost (F) = $5%, will
be

Dps
Pps - FlotationCost)
$10
$113.10 - $2
= 0.090 = 9.00%
=

Dps
Pps (1 - F)
0.1($100)
$116.95(1 - 0.05)
$10
=
$111.10
= 0.090 = 9.00%
=

9-25

Is Preferred Stock More or Less Risky

to Investors Than Debt?
More risky!

9-26

Why Is the Yield on Preferred Stock

Lower Than Debt?

A firm is not bound to pay preferred dividend

However, firms try to pay preferred dividend,
otherwise,

Firms cannot pay common dividend

It is difficult to raise additional funds

Preferred stockholders may gain control of firm

Corporations own most preferred stock,

because 70% of preferred dividends are
nontaxable to corporations

For the issuing firm, preferred stock often has a

lower B-T yield than the B-T yield on debt
The A-T yield to investors and A-T cost to the
issuer are higher on preferred than on debt
Consistent with the higher risk and the A-T yield

9-27

Illustrating the differences between

A-T yield on debt and preferred stock

Recall, that the firms tax rate is 40%, and its BT costs of debt and preferred stock are r d =
10% and rps = 9%, respectively.

A-T rps = rps {rps (1 0.3)(T)}

= 9% - {9% (0.7)(0.4)} = 6.48%
A-T rd = 10% - 10% (0.4)
= 6.00%

A-T Risk Premium on Preferred = 0.48%

9-28

The Cost of Common Stock (rs)

The rs is the rate of return investors expect

to receive from investing in firms stock

This return comes in the form DY and CGY

Harder to estimate since stockholders do not
have a contractually defined return
Three approaches to estimating the rs

9-29

Dividend growth model

CAPM
Before-tax cost of debt plus risk premium
9-30

Three Ways to Determine the Cost

of Common Stock, rs

DGM:
Or

CAPM:

Example of DGM: Cost of Common

Stock
Humble Manufacturing is interested in measuring its
overall cost of capital. The firm is in the 40% tax bracket.

rs = D1 / P0 + g

Current investigation has gathered the following data:

rs = D1 / Ns+ g

Common Stock: The firms common stock is currently

selling for $80 per share. The firm expects to pay cash
dividends of $6 per share next year. The firms dividends
have been growing at an annual rate of 6%, and this rate
is expected to continue in the future. The stock will have
to be underpriced by $4 per share, and flotation costs are
expected to amount to $4 per share. The firm can sell an
unlimited amount of new common stock under these
terms.

rs = rRF + (rM rRF)

B-T Cost of Debt Plus Risk-Premium*:

rs = rd + RP

Ns =Net proceeds from the sale of common stock

*A RP is expected return for common stock over debt, not the same
as RP in CAPM
9-31

Example of DGM: Cost of Common

Stock

rs =

Example of DGM: Cost of Common

Stock
If D0 = $4.19, P0 = $50, and g = 5%, whats
the cost of common equity based upon the DCF
approach?

When g is constant
rs =

9-32

D1
+g
Ns

D1 = D0 (1+g)
D1 = $4.19 (1 + .05)= $4.3995
rs = D1 / P0 + g
= $4.3995 / $50 + 0.05 = 13.8%

$6
+ 6%
$80 - $4
= 8.3% + 6% = 14.3%
9-33

Example of CAPM: Cost of Common

Stock

9-34

Example of B-T Cost of Debt Plus RiskPremium: Cost of Common Stock

If rd = 10% and RP = 4%, what is rs using
B-T Cost of Debt Plus Risk-Premium?

If the rRF = 7%, RPM = 6%, and the firms

beta is 1.2, whats the cost of common
equity based upon the CAPM?

Solution: rs = kd + RP

rs = 10.0% + 4.0% = 14.0%

rs = rRF + (rM rRF)

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

9-35

This RP is not the same as the RPM in CAPM;

rather it is RP in expected return for common
stock over debt
This method produces a ballpark estimate of rs,
and can serve as a useful check.
9-36

Why Is There a Cost for Retained

Earnings?

What Is a Reasonable Final

Estimate of rs?
Method
CAPM
DGM
B-T rd + RP
Average

Estimate
14.2%
13.8%
14.0%
14.0%

R/Es can be reinvested or paid out as dividends

Investors could buy other securities and earn a
return
If retained, there is an opportunity cost

Generally, the three methods will not agree.

We must decide how to weight we will use an average
of these three.
9-37

Example of Cost of Retained

Earnings

Investors could buy similar stocks and earn rs

Firm could repurchase its own stock and earn rs
Therefore, rs is the cost of R/Es

9-38

Example of Cost of Retained

Earnings

Humble Manufacturing is interested in measuring

its overall cost of capital. The firm is in the 40%
tax bracket. Current investigation has gathered
the following data:

rr = rs =

Retained earnings: The firm expects to have

$225,000 of retained earnings available in the
coming year. Once these retained earnings are
exhausted, the firm will use new common stock
as the form of common stock equity financing.

D1
+g
P0

$6
+ 6%
$80
= 7.5% + 6% = 13.5%
=

9-39

If issuing new common stock incurs a

flotation cost of 15% of the proceeds,
what is re? P0 = $50, g=5%, D0=$4.19

Why is the cost of retained earnings

cheaper than the cost of issuing new
common stock?

9-40

When a company issues new common stock

they also have to pay flotation costs to the
underwriter

re =

D 0 (1 + g)
+g
P0 (1 - F)

Issuing new common stock may send a

negative signal to the capital markets, which
may depress the stock price

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

$4.3995
+ 5.0%
$42.50
= 15.4%
=

9-41

9-42

Ignoring floatation costs, what is

the firms WACC?

Flotation costs

Flotation costs depend on the risk of the firm

and the type of capital being raised.

WACC

The flotation costs are highest for common

equity. However, since most firms issue equity
infrequently, the per-project cost is fairly small.

= wdrd(1-T) + wpsrp + wcsrs

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

We will frequently ignore flotation costs when

calculating the WACC.

9-43

Should the company use the

composite WACC as the hurdle rate
for each of its projects?

What factors influence a

companys composite WACC?

Market conditions

9-44

The firms capital structure and dividend

policy

The firms investment policy. Firms with

riskier projects generally have a higher
WACC

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.

9-45

What are the three types of

project risk?

Risk and the Cost of Capital

Rate of Return
(% )

Acceptance Region
W ACC

12.0

Rejection Region

10.5
10.0
9.5
8.0

9-46

Risk L

Risk A

Risk H

Stand-alone risk
Corporate risk
Market risk

Risk

9-47

9-48

How is each type of risk used?

Problem Areas in Cost of Capital

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

Depreciation-generated funds

Privately owned firms

Measurement problems

Adjusting costs of capital for different risk

Capital structure weights

9-49

How are risk-adjusted costs of capital

determined for specific projects or
divisions?

9-50

Finding a divisional cost of capital:

Using similar stand-alone firms to
estimate a projects cost of capital

Subjective adjustments to the firms

composite WACC.

Comparison firms have the following

characteristics:

Attempt to estimate what the cost of capital

would be if the project/division were a standalone firm. This requires estimating the
projects beta.

Target capital structure consists of 40%

debt and 60% equity.
rd = 12%
rRF = 7%
RPM = 6%
DIV = 1.7
Tax rate = 40%

9-51

Calculating a divisional cost of capital

Divisions required return on equity

= rRF + (rM rRF)

= 7% + (6%)1.7 = 17.2%

Divisions weighted average cost of capital

rs

WACC = wd rd ( 1 T ) + wc rs
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%

Typical projects in this division are acceptable if

their returns exceed 13.2%.
9-53

9-52

Exercise Problem:9-1
David Ortiz Motors has a target capital structure
of 40% debt and 60% equity. The yield to
maturity on the companys outstanding bonds is
9%, and the companys tax rate is 40%. Ortizs
CFO has calculated the companys WACC as
9.96%. What is the companys cost of equity
capital?
Solution:
0.0996 = 0.6(requity ) + 0.4(1 - 0.4)(0.09)
requity = 13%
9-54

Exercise Problem:9-2

Exercise Problem:9-7
A companys 6% coupon rate, semiannual
payment, $1,000 par value bond which matures
in 30 years sells at a price of $515.16. The
companys federal-plus-state tax rate is 40%.
What is the firms component cost of debt for
purposes of calculating the WACC?
Solution:

Tunney Industries can issue perpetual preferred

stock at a price of $50 a share. The issue is
expected to pay a constant annual dividend of
$3.80 a share. The flotation cost on the issue is
estimated to be 5%. What is the companys cost
of preferred stock, rpref
Solution:
rPr ef

515.16 =

3.8
=
= 8%
50(1 - 0.05)

30
[1
i/2

(1 + i / 2)

60

1,000
(1 + i / 2)60

i = 12%
Cost
9-55

of

debt = 12%(1

0.4) = 7.2%
9-56

10