Principles of Managerial Finance
Fifteenth Edition, Global Edition
Chapter 9
The Cost of Capital
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Learning Goals (1 of 2)
LG 1 Understand the basic concept of the cost of capital.
LG 2 List the primary sources of capital available to firms.
LG 3 Determine the cost of long-term debt, and explain why
the after-tax cost of debt is the relevant cost of debt.
LG 4 Determine the cost of preferred stock.
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Learning Goals (2 of 2)
LG 5 Calculate the required return on a company’s common
stock, and explain how it relates to the cost of retained
earnings and the cost of new issues of common stock.
LG 6 Calculate the weighted average cost of capital
(WACC), and discuss alternative weighting schemes.
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9.1 Overview of the Cost of Capital
• Cost of Capital
– Represents the firm’s cost of financing and is the minimum
rate of return that a project must earn to increase the firm’s
value
• The Basic Concept
– Weighted Average Cost of Capital (WACC)
A weighted average of a firm’s cost of debt and equity
financing, where the weights reflect the percentage of each
type of financing used by the firm
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9.1 Overview of the Cost of Capital
• Sources of Long-Term Capital
– Long-term capital for firms derives from four basic sources:
long-term debt, preferred stock, common stock, and
retained earnings
– Not every firm will use all of these financing sources
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9.2 Cost of Long-Term Debt
Typically, the funds are raised through:
– The sale of corporate bonds (pretax cost of debt – yield to
maturity YTM)
– Bank loan (pretax cost of debt – interest rate)
• Before-Tax Cost of Debt
– The before-tax cost of debt, rd, is simply the rate of return
the firm must pay on new borrowing
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9.2 Cost of Long-Term Debt (4 of 4)
• After-Tax Cost of Debt
– The interest payments paid to bondholders or financial
institution are tax deductible for the firm, so the interest
expense on debt reduces the firm's taxable income
After-Tax Cost of Debt = rd × (1-T) (9.2)
– where T = The tax rate
– rd, is the rate of return the firm must pay on new borrowing
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Example 9.5
Duchess Corporation has a 21% tax rate. Using the 6.177% before-tax
debt cost and applying Equation 9.2, we find an after-tax cost of debt of
4.88% [6.177% × (1 – 0.21)].
Incorporating the issuance costs and the tax benefit of debt, the firm’s
after-tax cost of debt is just 4.88%, quite a bit less than the 6% return
offered to bondholders.
In most cases, debt is the least expensive form of financing available to a
firm. Debt is a relatively inexpensive form of financing for two main
reasons:
• First, debt is less risky than preferred or common stock. That alone
makes debt a low-cost form of financing because investors accept
lower returns on bonds than on stock.
• Second, the firm enjoys a tax benefit from issuing debt that it does not
receive when it uses equity capital.
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9.3 Cost of Preferred Stock
• Preferred Stock Dividends
– When companies issue preferred shares, the shares usually
pay a fixed dividend and have a fixed par value
• Calculating the Cost of Preferred Stock
– Cost of Preferred Stock, rp
Dp
rp (9.3)
Np
where:
– Dp = Annual dollar dividend
– Np = Net proceeds from the sale of the stock
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Example 9.7
Duchess Corporation is contemplating issuance of an 8%
preferred stock they expect to sell at par value for $80 per
share. The cost of issuing and selling the stock will be $2.50
per share. The first step in finding the cost of the stock is to
calculate the dollar amount of the annual preferred dividend,
which is $6.40 (0.08 × $80). The net proceeds per share
from the proposed sale of stock equals the sale price minus
the flotation costs ($80 – $2.50 = $77.50). Substituting the
annual dividend, Dp, of $6.40 and the net proceeds, Np, of
$77.50 into Equation 9.3 gives the cost of preferred stock,
8.258% ($6.4 ÷ $77.50).
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9.4 Cost of Common Stock (1 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
The costs associated with using common stock equity
financing
The cost of common stock equity is equal to the required
return on the firm’s common stock in the absence of flotation
costs
Thus, the cost of common stock equity is the same as the cost
of retained earnings, but the cost of issuing new common
equity is higher
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9.4 Cost of Common Stock (3 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
Constant-Growth Valuation (Gordon Growth) Model
– Solving for rs results in the following expression for the
required return on common stock:
D1
rs g (9.5)
P0
where:
– P0 = Current value of common stock
– D1 = Dividend expected in 1 year
– rs = Required return on common stock
– g = Constant rate of growth in dividends
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Example 9.8 (1 of 3)
Duchess Corporation wishes to determine the required
return on its common stock, rs. The market price, P0, of its
common stock is $50 per share. Duchess recently paid a
$3.80 dividend. The company has increased its dividend for
several consecutive years. Just 5 years ago, Duchess paid a
dividend of $2.98 on its common stock.
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Example 9.8 (2 of 3)
Using a financial calculator or electronic spreadsheet, in
conjunction with the technique described earlier in this text
for finding growth rates, we can calculate the average annual
dividend growth rate, g, over the past 5 years. The average
dividend growth rate is about 5%. If Duchess continues to
increase the dividend at this rate, then next year’s dividend
will be 5% more than the $3.80 dividend that it just paid, or
$3.99. Substituting D1 = $3.99, P0 = $50, and g = 5% into
Equation 9.5 yields the cost of common stock equity:
$3.99
rs 0.05 0.0798 0.05 0.1298 12.98%
$50
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9.4 Cost of Common Stock (4 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
Using the Capital Asset Pricing Model (CAPM)
– Capital Asset Pricing Model (CAPM)
• Describes the relationship between the required
return, rs, and the nondiversifiable risk of the firm as
measured by the beta coefficient, βj
rj RF j rm RF (9.6)
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9.4 Cost of Common Stock (5 of 9)
• Finding the Cost of Common Stock Equity
where
– rj = Expected return or required return on asset j
– RF = Risk-free rate of return
– βj = Beta coefficient for asset j
– Rm = Market return; expected return on the market portfolio
of assets
rj RF j rm RF (9.6)
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Example 9.9 (1 of 2)
Duchess Corporation now wishes to calculate the required
return on its common stock, rs, by using the CAPM. The
firm’s investment advisors and its own analysts indicate that
the risk-free rate, RF, equals 3%; the firm’s beta, β, equals
1.5; and the market return, rm, equals 9%. Substituting these
values into Equation 9.6, the company estimates that the
required return on its common stock, rs, is 12%:
rs = 3.0% + [1.5 × (9.0% – 3.0%)] = 3.0% + 9% = 12.0%
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Example 9.9 (2 of 2)
Notice that this estimate of the required return on Duchess
stock does not line up exactly with the estimate obtained
from the constant-growth model. That is to be expected
because the two models rely on different assumptions. In
practice, analysts at Duchess might average the two figures
to arrive at a final estimate for the required return on
common stock.
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9.4 Cost of Common Stock (6 of 9)
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
Comparing the Constant-Growth and CAPM Techniques
– The CAPM technique differs from the constant-growth
valuation model in that it directly considers the firm’s risk,
as reflected by beta, in determining the required return on
common stock equity
– The constant-growth model does not look at risk directly; it
uses an indirect approach to infer what return shareholders
expect based upon the price they are willing to pay for the
stock today, given estimates of the firm’s future dividends
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9.4 Cost of Common Stock (9 of 9)
• Cost of Retained Earnings
– Cost of Retained Earnings, rr
The cost of retained earnings is equal to the required return on
a firm’s common stock, rs
rr = rs (9.8)
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Example 9.11
The cost of retained earnings for Duchess Corporation
equals the required return on equity. Recall that we
calculated the required return using two methods. With the
constant-growth model, we estimated the required return on
equity to be 13% (before accounting for flotation costs and
underpricing), and with the CAPM, the required return on
equity was 12%. Thus, the cost for Duchess Corporation to
finance investments through retained earnings, rr, falls
somewhere in the range of 12.0% to 13.0%. Both estimates
are lower than the cost of a new issue of common stock
because by using retained earnings the firm avoids the
additional costs associated with issuing new equity.
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9.5 Weighted Average Cost of Capital
(1 of 3)
• Calculating the Weighted Average Cost of Capital (WACC)
rwacc ( wd rd )(1 T ) ( wp rp ) ( ws rs or n ) (9.9)
– where
wd = 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
wd + wp + ws = 1.0
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9.5 Weighted Average Cost of Capital
(2 of 3)
• Calculating the Weighted Average Cost of Capital (WACC)
– Important Points:
The weights must be nonnegative and sum to 1.0
The weights are based on the market value of each capital
source as a percentage of the market value of the firm’s total
capital
We multiply the firm’s common stock equity weight, ws, by
either the required return on the firm’s stock, rs, or the cost of
new common stock, rn
We multiply the firm’s cost of debt by (1 − T) to capture the tax
deduction tied to interest payments
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Example 9.12 (1 of 3)
In earlier examples, we found the costs of the various types of
capital for Duchess Corporation to be as follows:
rd (1 – T ) = 4.880% = 4.88%
rp = 8.258% = 8.26%
rs = 13.00%
Duchess has total capital with a market value of $1 billion. The
market value of the firm’s outstanding long-term debt is $400 million,
the value of its preferred stock is $100 million, and the market value
of its common stock is $500 million. Thus, the weights for the
weighted average cost of capital (WACC) calculation are as follows:
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Example 9.12 (2 of 3)
Source of capital Weight
Long-term debt 40%
Preferred stock 10
Common stock equity 50
Total 100%
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Table 9.2 Calculation of the Weighted Average
Cost of Capital for Duchess Corporation
Blank Weight Cost Weighted cost
Source of capital w r w×r
Long-term debt 0.40 4.88% 1.95%
Preferred stock 0.10 8.26 0.83
Common stock equity 0.50 13.00 6.50
Totals 1.00 WACC = 9.28%
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9.5 Weighted Average Cost of Capital
(3 of 3)
• Capital Structure Weights
– Market Value Weights
Weights that use market values to measure the proportion of
each type of capital in the firm’s financial structure
In calculating a firm’s WACC, market value weights should be
used rather than book or par values
– Target Capital Structure
The mix of debt and equity financing that a firm desires over
the long term
The target capital structure should reflect the optimal mix of
debt and equity for a particular firm
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Review of Learning Goals (1 of 6)
• LG 1
– Understand the basic concept of the cost of capital.
The cost of capital is the minimum rate of return that a firm
must earn on its investments to increase the firm’s value
The weighted average cost of capital is a number that blends
the costs of each type of capital that a firm uses and
establishes a minimum rate of return that the firm’s investment
should earn
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Review of Learning Goals (2 of 6)
• LG 2
– List the primary sources of capital available to firms.
The primary sources of capital for most firms include debt,
preferred stock, common stock, and retained earnings
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Review of Learning Goals (3 of 6)
• LG 3
– Determine the cost of long-term debt, and explain why the
after-tax cost of debt is the relevant cost of debt.
Managers can find the before-tax cost of long-term debt by
using cost quotations, calculations (either by calculator or
spreadsheet), or an approximation
The after-tax cost of debt is the product of the before-tax cost
of debt and 1 minus the tax rate
The after-tax cost of debt is the relevant cost of debt because it
is the lowest possible cost of debt for the firm due to the
deductibility of interest expenses
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Review of Learning Goals (4 of 6)
• LG 4
– Determine the cost of preferred stock.
The cost of preferred stock is the ratio of the preferred stock
dividend to the firm’s net proceeds from the sale of preferred
stock
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Review of Learning Goals (5 of 6)
• LG 5
– Calculate the required return on a company’s common
stock, and explain how it relates to the cost of retained
earnings and the cost of new issues of common stock.
The required return on the firm’s stock can be calculated by
using the constant-growth valuation (Gordon growth) model or
the CAPM
The cost of retained earnings is equal to the required return on
common stock equity
An adjustment to the required return on common stock equity
to reflect underpricing and flotation costs is necessary to find
the cost of new issues of common stock
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Review of Learning Goals (6 of 6)
• LG 6
– Calculate the weighted average cost of capital (WACC), and
discuss alternative weighting schemes.
The firm’s WACC is a weighted average of the firm’s cost of
debt and equity capital, where the weights are based on the
market values of each type of financing relative to the total
market value of all financing used by the firm
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