Principles of Managerial Finance

Sixteenth Edition, Global Edition

Chapter 9
The Cost of Capital

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Learning Goals
LG 1 Understand the 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.
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.
– Managers use the cost of capital.
 To discount an investment’s future cash flows to decide if an
investment is worth undertaking.
and evaluate
 As a benchmark against which they can judge their
performance.
 To value entire companies, when a firm engages in mergers
and acquisitions.

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9.1 Overview of the Cost of Capital
• The Basic Concept
– Capital
 Refers to a firm’s long-term sources of financing, which include
debt and equity.
I
 Firms raise capital by selling securities such as common stock,
preferred stock, and bonds to investors and reinvesting profits
back into the firm.
– Capital Structure i
Totalmust
 The mix of debt and equity financing that a firm employs. s
– 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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Table 9.1 Capital Structures of Well-Known
Companies in 2020
Value of Value of
Outstanding Outstanding Total Capital
Company Debt ($ billions) % Debt Equity ($ billions) % Equity ($ billions)
Alphabet $ 1 0% $ 911 100% $ 912
Johnson & Johnson 29 7 386 93 415
Procter & Gamble 31 10 282 90 313
Facebook 6 1 580 99 586
General Electric 99 66 51 34 150
General Motors 105 77 31 23 136

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Example 9.1
A firm is currently considering two investment opportunities. Two financial
analysts, working independently of each other, are evaluating these
opportunities. The following information is for investment A:

Investment A

Cost $100,000
Life 20 years
Expected Return 7%

The analyst studying this investment recalls that the company recently
issued bonds paying a 6% rate of return. He reasons that because the
investment project earns 7% while the firm can issue debt at 6%, it must
be worth doing, so he recommends that the company undertake
investment A.

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Example 9.1
Investment B

Cost $100,000
Life 20 years
Expected Return 12%

The analyst assigned to investment B knows that the firm has common
stock outstanding and that investors who hold the company’s stock
expect a 14% return on equity. The analyst decides that the firm should
not undertake this investment because it produces only a 12% return
while the company’s shareholders expect a 14% return.

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Example 9.1
In this example, each analyst is making a mistake by focusing on one
source of financing rather than on the overall financing mix. What if,
instead, the analysts used a combined cost of financing?
By weighting the cost of each source of financing by its relative
proportion in the firm’s capital structure, the firm can obtain a weighted
average cost of capital (WACC). Assuming this firm desires a 50–50 mix
of debt and equity (and ignoring taxes for the moment), the WACC is
10% [(0.50 × 6% debt) + (0.50 × 14% equity)].
With this average cost of financing, the firm should reject the first
opportunity (7% expected return < 10% WACC) and accept the second
(12% expected return > 10% WACC).

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9.1 Overview of the Cost of Capital A
• Sources of Long-Term Capital

L
– 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 equi

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9.2 Cost of Long-Term Debt
• Before-Tax Cost of Long-Term Debt
– The before-tax financing cost associated with new funds raised
through long-term borrowing.
• Net Proceeds
– Net Proceeds
h
 Funds actually received by the firm from the sale of a security.
– Flotation Costs
 The total costs of issuing and selling a security
 Two components
– Underwriting costs.
– Administrative costs.

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Example 9.2
Duchess Corporation, a major hardware manufacturer, plans to sell $10
million worth of 20-year, 6% coupon bonds, each with a par value of
$1,000. Because bonds with similar risk earn returns equal to 6%,
Duchess’s bonds will sell in the market at par value, and they will have a
yield to maturity (YTM) equal to the coupon rate, 6%.
However, Duchess will incur flotation costs equal to 2% of the par value
of the bond (0.02 × $1,000), or $20. The net proceeds to the firm from the
sale of each bond are therefore $980.

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9.2 Cost of Long-Term Debt
• 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
– Using Market Quotations
 A simple way to estimate a firm’s before-tax cost of debt is to
go to a financial web site and look up the yield to maturity
(YTM) on the firm’s existing bonds or on bonds of similar risk
issued by other companies.
– Calculating the Cost Directly
 Rather than using the YTMs on other bonds to estimate the
costs associated with a new bond issue, it is possible to do a
YTM calculation to calculate the costs of a new bond issue
directly.

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Example 9.3
In the preceding example, Duchess receives proceeds of $980 by issuing
a 20-year bond with a $1,000 par value and 6% coupon interest rate. To
calculate the before-tax cost of debt, begin by writing down the cash flows
associated with this bond issue. The cash flow pattern consists of an initial
inflow (the net proceeds) followed by a series of annual outflows (the
interest payments). In the final year, when the debt is retired, an outflow
representing the repayment of the principal also occurs.

The cash flows associated with Duchess Corporation’s bond issue are as
follows:

The before-tax cost of debt associated with this bond issue is the YTM,
which is the discount rate that equates the present value of the bond’s
coupon and principal payments to the initial net proceeds.

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Example 9.3 s
Spreadsheet use The following Excel spreadsheet shows that Excel’s
RATE function calculates the 6.177% YTM by referencing the cells
containing the bond’s net proceeds, coupon payment, years to maturity,
and par value.

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9.2 Cost of Long-Term Debt

• After-Tax Cost of Debt

– Unlike dividends on stock, interest payments on bonds are tax
deductible, so the interest expense on debt reduces taxable
income (as long as interest does not exceed 30% of EBIT) and,
therefore, the firm’s tax liability

After-Tax Cost of Debt = rd × (1 - T) (9.1)

Where:
– T : is the tax rate
– rd : is the before-tax cost of debt

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Example 9.4
Duchess Corporation pays a 21% tax rate. Using the 6.177% before-tax
debt cost calculated above and applying Equation 9.1, we find an after-
tax cost of debt of 4.88% [6.177% × (1 - 0.21)].
If Duchess’ interest expense reaches 30% of EBIT, then any additional
interest expense is not deductible and for any additional borrowing the
before- and after-tax cost of debt are equal.
Recall that when bondholders purchase a Duchess bond at par value,
they expect to earn a 6% YTM. 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.

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9.2 Cost of Long-Term Debt n
• After-Tax Cost of Debt
– For two main reasons, debt is usually the least expensive form of
financing available to a firm
– Debt is less risky than preferred or common stock
– Investors accept lower returns on bonds than on stock
– The firm enjoys a tax benefit from issuing debt that it does not
receive when it uses equity capital
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yeild s

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maturity

inxy.fi
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Example 9.5: Personal Finance
Kait and Kasim Sullivan, a married couple in the 28% income-tax bracket,
wish to borrow $60,000 to pay for improvements to their home. To finance
the purchase, either they can borrow from a relative at an annual interest
rate of 4.5%, or they can take a second mortgage on their home. The best
annual rate they can get on the second mortgage is 5.5%. If they borrow
from the relative, the interest will not be deductible for federal tax purposes.
However, the interest on the second mortgage would be deductible because
the tax law allows individuals to deduct home mortgage interest.
To choose the least-cost financing, the Sullivans calculate the after-tax cost
of both loans. Because interest on the loan from a relative is not deductible,
its after-tax cost equals its before-tax cost of 4.5%. The after-tax cost of the
second mortgage is 3.96%:
After-tax cost of debt = 5.5% × (1 − 0.28) = 5.5% × 0.72 = 3.96%
Because the 3.96% after-tax cost of the second mortgage is less than 4.5%,
the Sullivans may decide to use the second mortgage to finance the home
improvement project.

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9.2 Cost of Long-Term Debt
• After-Tax Cost of Debt
– This does not imply that firms should always finance their
investments with debt:
 Financing with debt puts the firm’s existing shareholders in a
riskier position because the firm must repay lenders regardless
of whether it is profitable.
 Existing shareholders will then demand a higher return, thus
raising the firm’s cost of equity.
 The increase in the cost of equity could partially or fully offset
the benefit of using low-cost debt as a financing source.
 Firms must carefully weigh the tradeoffs when using different
sources of 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
 The ratio of the preferred stock dividend to the firm’s net
proceeds from the sale of preferred stock.
Dp
rp  (9.2)
Np
Where:
 Dp = Annual dollar dividend
 Np = Net proceeds from the sale of the stock

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Matter of Fact

Becoming Less Preferred

Preferred stock is in many ways a dying security. Of the 50 largest firms
in the United States, only banks such as JPMorgan and Bank of America
raise money through preferred stock. Banks use preferred shares to
meet regulatory minimum capital requirements without diluting their
common stock ownership. Many companies do not use preferred stock
because it has many of the disadvantages of debt (e.g., fixed dividend
payments that resemble interest payments on bonds), but it does not
enjoy debt’s main advantage, which is tax deductibility of interest.

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Example 9.6
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 9.2 gives the cost of preferred stock, 8.258%
($6.4 ÷ $77.50).

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9.4 Cost of Common Stock
• 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

• Finding the Cost of Common Stock Equity

– Cost of Common Stock Equity
 Using the Constant-Growth Valuation (Gordon Growth) Model
D1
P0  (9.3)
rs  g
Where: a
– P0 = Current value of common stock
– D1 = Dividend expected in one year Po

– rs = Required return on common stock

– g = Constant rate of growth in dividends

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9.4 Cost of Common Stock
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 Constant-Growth Valuation (Gordon Growth) Model s
– Solving Equation 9.3 for rs results in the following
expression for the required return on common stock:

D1
rs   g (9.4)
P0
• The first term captures the return that shareholders expect
to earn from dividends.
• The second term captures the return they expect to earn
from capital gains.

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Example 9.7
Duchess Corporation wishes to determine the required return, rs, on its
common stock. The market price, P0, is $50 per share. Duchess recently
paid a $3.80 dividend. The company has increased its dividend for
several consecutive years. Just five years ago, Duchess paid a dividend
of $2.98 on its common stock.
First, we find that the average annual dividend growth rate, g, over the
past five years is about 5%, as follows:
a
/
𝐹𝑉 3.80
𝑔= −1 = − 1 = 5%
𝑃𝑉 2.98

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Example 9.7
9
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 9.4
yields the cost of common stock equity:

$3.99
rs   0.05  0.0798  0.05  0.1298  12.98% 13
$50 I

Because this estimate depends on an imprecise forecast of the

company’s long-run dividend growth rate, a kind of false precision arises
in concluding that the required return on equity is 12.98%, so we will just
round up to 13%.

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9.4 Cost of Common Stock
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity 4
 Using the Capital Asset Pricing Model (CAPM)
– Capital Asset Pricing Model (CAPM): Describes the
relationship between the required or expected return on some
asset j, rj, and the nondiversifiable risk of the firm as
measured by the beta coefficient, βj . The CAPM says that

rj  RF    j   rm  RF   (9.5)
Where;
– rj = Expected return or required return on asset j
– RF = Risk-free rate of return
– βj = Beta coefficient for asset j
– rm = expected market return; expected return on the market
portfolio

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Example 9.8
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 9.5, 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%
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
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 Comparing 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, P0, given estimates of the firm’s future
dividends.

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9.4 Cost of Common Stock
• Finding the Cost of Common Stock Equity
– Cost of Common Stock Equity
 Flotation Costs and the Cost of Common Equity
– Flotation costs increase the cost of capital to the firm
 Cost of a New Issue of Common Stock, rn
– The cost of common stock, net of underpricing and
associated flotation costs
D1 I
rn   g (9.6)
Nn
 Where;
– Nn = net proceeds per share from sale of new common stock
after subtracting underpricing and flotation costs
– D1 = Dividend expected in one year
– g = Constant rate of growth in dividends

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Example 9.9 u
In the constant-growth valuation example, we found that Duchess
Corporation’s required return on common stock, rs, was 13%, using the
following values: an expected dividend, D1, of $3.99; a current market price,
P0, of $50; and an expected growth rate of dividends, g, of 5%.
To determine its cost of new common stock, rn, Duchess Corporation
estimates that new shares will sell for $48. Thus, Duchess’s shares will be
underpriced by $2 per share. A second cost associated with a new issue is
flotation costs of $1.50 per share that would be paid to issue and sell the
new shares. The total underpricing and flotation costs per share are
therefore $3.50.
Subtracting the $3.50-per-share underpricing and flotation cost from the
current $50 share price results in expected net proceeds of $46.50 per
share. Substituting D1 = $3.99, Nn = $46.50, and g = 5% into Equation 9.6
results in a cost of new common stock, rn:
$3.99

8
rn   0.05  0.0858  0.05  0.1358  13.58%
$46.50

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9.4 Cost of Common Stock
• Cost of Retained Earnings
– Cost of Retained Earnings, rr
 The cost of using retained earnings as a financing source
 The cost of retained earnings is equal to the required return on
a firm’s common stock, rs

rr = rs (9.7) E

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Example 9.10
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
O I
O Both estimates are lower than the cost of a new issue of common
13.0%.
stock because by using retained earnings the firm avoids the additional
costs associated with issuing new equity.

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Matter of Fact
u
Retained Earnings, the Preferred Source of Financing
In the United States and most other countries, firms rely more heavily on
retained earnings than any other financing source. In 2019 the Federal
Reserve conducted a survey of 5,514 small businesses and found that
for 77% of companies, the most important source of financing was
retained earnings.

irs
equity
betteggygt.in
Internal
A
6
is

p.ci
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9.5 Weighted Average Cost of Capital
• Calculating the Weighted Average Cost of Capital (WACC)

rwacc  ( wd  rd )(1  T )  ( wp  rp )  ( ws  rs or n ) (9.8)

– 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
q
• 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

i
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Example 9.11
In earlier examples, we found that the costs of the various types of
capital for Duchess Corporation were:
𝑟 (1– 𝑇) = 4.880% = 4.88%
𝑟 = 8.258% = 8.26%
𝑟 = 13.00%

Duchess has total capital with a market value of $1 billion. The market
values of the firm’s outstanding long-term debt, preferred stock, and
common stock are $400 million, $100 million, and $500 million,
respectively. Thus, the weights for the weighted average cost of capital
(WACC) calculation are as follows:

Source of capital Weight

Long-term debt 40%
Preferred stock 10
Common stock equity 50
Total 100%
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Example 9.11 w

Because Duchess has retained earnings available, its cost of common

equity is the required return on equity, rs (or, equivalently, the cost of retained
earnings, rr). The calculation for Duchess Corporation’s WACC is as follows:

The resulting WACC for Duchess is 9.28%. This establishes a hurdle rate for
Duchess, meaning that the company should accept investment opportunities
that promise returns above 9.28% as long as those investment opportunities
are not riskier than the firm’s current investments.

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Table 9.3 WACC Calculations for Well-Known
Companies 4
Company % Debt Cost of Debt % Equity Beta Cost of WACC
Equity
Procter & Gamble 10% 3.0% 90% 0.4 4.4% 4.2%
General Electric 66 5.0 34 0.9 7.4 5.1
Johnson & Johnson 7 2.0 93 0.7 6.2 5.9
Target 19 3.5 81 0.9 7.4 6.5
General Motors 77 7.5 23 1.3 9.8 6.8
Alphabet 0 NA 100 1.0 8.0 8.0
Apple 8 2.3 92 1.1 8.6 8.1
Amazon 4 3.3 96 1.3 9.8 9.5
Facebook 0 NA 100 1.3 9.8 9.8

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9.5 Weighted Average Cost of Capital E
• 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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9.5 Weighted Average Cost of Capital
make
• WACC as a Hurdle Rate
– WACC is a kind of hurdle rate that a firm’s investments must clear if
they are to create value for investors. to acceptproject asan investorf
– Using the WACC in this way is appropriate as long as the investment
being held to that standard is about as risky as the average
investment that the firm makes
 If the investment is riskier than typical, a higher rate that reflects
the investment’s greater risk is appropriate
 If the investment is atypically low risk, then the WACC is an
inappropriately high hurdle rate and a lower rate is fitting.
 When considering an acquisition, make sure to use a WACC that
is appropriate for the target you are acquiring.

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