Sources of Capital
What is cost of capital
Component of cost of capital
Cost of equity capital: The required rate of
return on investment of the common
shareholders of the company.
Cost of debt (capital): The required rate of
return on investment of the lenders of a
company.
Cost of preferred stock (capital): The
required rate of return on investment of the
preferred shareholders of the company
Why cost of capital is
important?
• We know that the return earned on assets
depends on the risk of those assets.
• The return to an investor is the same as the
cost to the company.
• Our cost of capital provides us with an
indication of how the market views the risk of
our assets.
• Knowing our cost of capital can also help us
determine our required return for capital
budgeting projects.
12-5
Cost of debt (capital)
The after-tax cost of debt, which we denote by ki
Kd cost of debt before tax
t is now defined as the company’s marginal tax rate.
Hedging (maturity matching)
approach
A method of financing where
each asset would be offset with
a financing instrument of the
same approximate maturity.
Cost of Preferred Stock
kp cost of preferred stock
Dp is the stated annual dividend
P0 is the current market price of the preferred stock.
Cost of Equity
The required rate of return on
investment of the common
shareholders of the company.
Cost of Equity: Capital-Asset
Pricing Model Approach
Weighted Average Cost of
Capital (WACC)
Weighted average cost of capital (WACC) is a
company's average after-tax cost of capital from all
sources, including common stock, preferred stock,
bonds, and other forms of debt. It represents the
average rate that a company expects to pay to
finance its business.
The weighted average cost of capital (WACC) is
calculated by averaging the rate of all of the
company's sources of capital (both debt and equity),
weighted by the proportion of each component.
Weighted Average Cost of
Capital
The weighted average cost of capital (WACC), ra, reflects the
expected average future cost of capital over the long run; found by
weighting the cost of each specific type of capital by its proportion in the
firm’s capital structure.
ra = (wi ri) + (wp rp) + (ws rr or n)
where
wi = proportion of long-term debt in capital structure
wp = proportion of preferred stock in capital structure
ws = proportion of common stock equity in capital
structure
wi + wp + ws = 1.0
Cost of capital
Cost of debt (capital) = 6%
Cost of preferred stock = 9%
Cost of equity = 13%
Weighted Average Cost of Capital (WACC)
Exercise # 1
calculate WACC
Answer = 11.40%
Exercise #
2
The costs of the various types The company uses the following weights in
of capital for Duchess calculating its weighted average cost of
Corporation to be as follows: capital:
Cost of debt = 5.6%
Cost of preferred stock =
10.6%
Cost of retained earnings =
13.0%
Cost of new common stock =
14.0%
WACC =
9.8%
Exercise # 3
Webster Company has compiled the information shown in the following table.
Source of capital Book value Market value
After-tax cost
Long-term debt $4,000,000 $3,840,000
6.0%
Preferred stock 40,000 60,000
13.0
Common stock equity 1,060,000 3,000,000
17.0
Totals $5,100,000 $6,900,000
a. Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value weights.
c. Compare the answers obtained in parts a & b. Explain the differences.
Illustration
# 1 The Sprouts-N-Steel Company has two divisions: health foods and
specialty metals. Each division employs debt equal to 30 percent and
preferred stock equal to 10 percent of its total requirements, with
equity capital used for the remainder. The current borrowing rate is 15
percent, and the company’s tax rate is 40 percent. At present,
preferred stock can be sold yielding 13 percent.
Sprouts-N-Steel wishes to establish a minimum return standard
for each division based on the risk of that division. This standard then
would serve as the transfer price of capital to the division. The
company has thought about using the capital-asset pricing model in
this regard. It has identified two samples of companies, with modal
value betas of 0.90 for health foods and 1.30 for specialty metals.
(Assume that the sample companies had similar capital structures to
that of Sprouts-N-Steel.) The risk-free rate is currently 12 percent and
the expected return on the market portfolio 17 percent. Using the
CAPM approach, what weighted average required returns on
Solution # 1
Cost of debt = 15%(1 − 0.4) = 9%
Cost of preferred stock = 13%
Cost of equity for health foods division = 0.12 + (0.17 − 0.12)0.90 =
16.5%
Cost of equity for specialty metals division = 0.12 + (0.17 −
0.12)1.30 = 18.5%
Weighted average required return for health foods division =
9%(0.3) + 13%(0.1) + 16.5%(0.6) = 13.9%
Weighted average required return for specialty metals division =
9%(0.3) + 13%(0.1) + 18.5%(0.6) = 15.1%
As mentioned in the text, a conceptual case can be made for
adjusting the non-equity costs of financing
