CHAPTER 5:

THE COST OF CAPITAL

 Understa Understand the concepts underlying the
firm’s overall cost of capital and the purpose
nd for its calculation.

LEARNIN Evaluate
Evaluate a firm’s capital structure and
determine the relative importance (weight)

G of each source of financing.

OUTCOM Calculate Calculate the after-tax cost of debt, preferred

ES stock, and common equity.

Calculate a firm’s weighted average cost of

Calculate capital.
Cost of capital for a firm as a
weighted average of the

THE
required rates of return of
securities that are used to
finance its business.

The WACC incorporates the

COST OF
required rates of return
demanded by the firm’s lenders CAPITAL:
and investors along with the
particular mix of financing
sources that the firms uses.
AN
Most firm raise capital to fund
OVERVIE
investments with a combination
of debt, equity, and hybrid W
securities, which have
attributes of both and equity.
The riskiness of a firm affects
its WACC in two ways:
THE
1) The required rate of return
COST OF
on the debt and equity
securities that the firm issues
CAPITAL:
will be higher if the firm is
riskier.
AN
2) Risk influences how the firm
OVERVIE
chooses the extent to which it
is financed with debt and
W
equity securities.
WHY THE FIRM’S USED
WACC?

Firms often use the Firms used WACC to

WACC as the starting evaluating their
point for determining performance-
The WACC is used to
the discount rate for specifically, whether
value entire firms.
individual investment the firm generates
projects that might sufficient returns on
undertake. the invested capital.
INVESTO Two things that can drive a wedge between
R’S the firm’s cost of capital and the investors’
expected rate of return.
REQUIRE 1) Transaction costs

D 2) Taxes

RETURN Specifically, the cost of debt is less than

the investors’ required rate of return

AND THE because of the tax deductibility of interest.

The after taxes cost of debt to the firm is
FIRM’S less than the investor’s required rate of
return because of tax savings that the firm
COST OF receives from deducting interest expense
from the firm’s taxable income.
CAPITAL.
WACC EQUATION

Note that only the cost of debt is adjusted for the effects of taxes. The reason for this is
that only interest is tax-deductible.

That is, interest expense is deducted from operating earnings before income taxes are
calculated, whereas preferred and common stock dividends are paid out of the firm’s net
income after taxes have been paid.
THREE STEP PROCEDURE FOR
ESTIMATING THE FIRM’S WACC
Step 1: Define the firm’s capital structure.
-evaluate the firm’s mix of debt and equity financing (commonly
referred to as its capital structure).
Step 2: Estimate the cost of each of the sources of
financing.
-These costs are equal to the investor’s required rates of return after
adjusting the cost of debt for the effects of taxes.
Step 3: Calculate a weighted average cost of capital from all
sources of financing.
 DETERMI
NING THE In theory, we should determine the weights used to
FIRM’S calculate WACC based on observed

CAPITAL
market prices for each of the firm’s securities (be they
debt or equity) multiplied by the

STRUCTU number of outstanding securities.

RE
WEIGHTS
 In practice, however, capital structure
DETERMI weights are often calculated using
market values for equity securities

NING THE (preferred and common stock) and book

values for debt securities.

FIRM’S The market prices of equity securities are

readily available, so an analyst can

CAPITAL simply multiply the current market prices

of the securities by the number of shares

STRUCTU outstanding to calculate total market

values.
For debt securities, book values are often
RE substituted for market values because
market prices for corporate debt are
WEIGHTS often difficult to obtain. However, when
market values of debt are available, they
should be used in place of book values
ESTIMATING THE COST OF
INDIVIDUAL SOURCES OF CAPITAL

Cost of Cost of
Cost of
preferred common
debt
shares shares
 Cost of debt is the rate of return the
firm’s lenders demand when they loan
money to the firm.
COST OF Do not confuse the cost of new debt with

DEBT coupon rate on a firm’s outstanding debt

Coupon rate is the contractual rate of
interest the firm must pay on the
outstanding principal amount of debt.
COST OF DEBT
Kd = I + 1000 – Nd
n
Nd + 1000
2
Where:
I = annual interest before tax.
Nd = net proceeds from the sale of debt (bond).
n = number of years to the bonds maturity.
Kd = required rate of return for redeemable bond

After tax;

Ki = Kd x (1 – T)
COST OF The cost of preferred share is the rate
of return investors require of the firm when
PREFERR they purchase its preferred stock.
Note that because the dividends paid to
ED preferred stockholders come out of after-

SHARE tax income, we do not adjust the cost of

preferred stock for taxes.
COST OF PREFERRED SHARE
Kps = Dividend for preferred stock
Market Price of preferred stock

Kps = D
Po
Where:
Po = market value value of preferred stock
D = annuals dividend
Kp = required rate of return for preferred stock
 Cost of common shares financing to the
firm, which is the rate of return investors
expect to receive from investing in the
firm’s stock, which in turn reflects the risk

COST OF of investing in the equity of the firm.

The return comes in the form of cash
COMMON distributions (dividends and cash proceeds
from the sales of the stock)
SHARE There are two approached for calculating
cost of equity:
1) Dividend growth model
2) Capital asset pricing model
 Using this approach, we estimate
the expected stream of dividends
that common stock is expected to
THE provide to the stockholder.
DIVIDEN Requires estimates for the
D dividends that will be paid each
year for the foreseeable future.
GROWTH This model assume that the
MODEL dividends are expected to grow
forever at a constant rate, which
is less investor’s required rate of
return.
COST OF COMMON SHARE
Ke = D1 + g
Po

Where:
Po = price of the stock today
D1 = dividend at the end of the first year
Ke = required rate of return on equity
g = constant growth rate of dividends
PROS AND CONS OF THE
CONSTANT DIVIDEND GROWTH
RATE APPROACH

To estimate an
investor’s required
rate of return, the
The primary appeal of analyst needs only to
the constant dividend observe the current
growth rate model is dividend and stock
its simplicity. price and then
estimate the rate of
growth in future
dividend.
 THE
CAPM is a theory that describes the
relationship between systematic risk and

CAPITAL expected rate of return of risky

investments.

ASSET The expected return on theses

investments is determined by:
PRICING 1) The risk-free rate of interest
MODEL 2) The beta of systematic risk of common
stock’s returns
(CAPM) 3) The market risk premium
 SUMMIN
G UP: 1) Market – Based Weights
CALCULA 2) Market- Based Cost of Capital
TING THE 3) Forward –Looking Weights and
Opportunity Costs
FIRM’S
WACC
 The weight should be based on the
MARKET market values of the firm’s securities

– BASED
rather than their book values because
market value represent the relative values

WEIGHTS
placed on the firm’s securities at the time
of the analysis (rather than the time the
securities were issued).
MARKET For the capital structure weights, the cost
BASED of capital for each source of funds should
reflect the current market price and
COST OF expected returns rather than historical
rates from the past.
CAPITAL
 FORWAR
D
LOOKING
WEIGHTS Analysist assume that the weight for each
sources of financing, the cost of capital for
AND debt and equity, and the corporate tax
rate are constant.
OPPORTU
NITY
COSTS
 HOW TO CALCULATE THE WACC?

1. Calculate cost of individual components of the

firm’s financing ;
a. Cost of debt
b. Preferred stock

WACC IN c. Common stock

PRACTICE
2. Determine the percentage (%) of;
a. Debt
b. Preferred stock
c. Common stock

3. Calculate firm’s WACC by multiplying cost by

percentage.
End of Chapter 5