Cost of Capital

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Cost of Capital
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WACC

• WACC
• Weighted average cost of capital
• Cost of financing long-term projects
• rd cost of debt
• rp cost of preferred stock
• rs cost of common equity
• ws capital structure weights
• Percentage of each component in capital structure

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Capital Structure
Capital Structure
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Cost of Debt

• rd(1-T) is the after-tax cost of debt
• Interest expense paid before taxes
• Lowers taxable income
• Lowers tax bill
• Lowers the effective cost of debt
• rd(1-T) rd - rdT pre-tax cost interest
  tax shield
• rd is bonds yield after adjust price for
  flotation costs

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Cost of Debt(example)

• A firm can issue new debt with a yield of 12
• The firm has a 35 tax rate
• The after-tax cost of debt is
• rd(1-T) 12 ( 1 - .35) 7.80
• 12 yield - 4.2 interest tax shield

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Cost of Preferred Stock

• PriceNet Price Flotation Costs
• Flotation cost cost of issuing new stock in the
  primary market

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Cost of Preferred Stock(example)

• A firm can issue new preferred stock with
• 100 par value
• 11 dividend
• Market Price of 97
• Flotation Cost of 5
• PriceNet 97 - 97 x 5 92.15

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Cost of Common Equity

• Two Sources of Common Equity
• Internally generated (rs)
• Retained Earnings generated in the current
  accounting period
• Externally generated (re)
• New common stock issued in the primary market

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Cost of Common Equity(example)

• A firms stock current sells for 46.75
• The next dividend is expected to be 2.34
• Dividends are expected to grow at 12
• Flotation costs for issuing new stock are 5
• Cost of Using Retained Earnings
• Cost of New Common Stock

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Equity Breakpoint

• A firm will generate a finite amount of retained
  earnings in any given period
• Must issue more expensive new stock when retained
  earnings are exhausted
• Breakpoint
• Amount of total capital spending before new
  stock is issued

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Equity Breakpoint(example)

• A firm estimates it will generate 2 million of
  retained earnings this year
• It finances projects using the capital structure
  weights
• wd 50, wp 10, wc 40

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WACC

• wd 50, wp 10, wc 40
• rd(1-T) 12 (1 - .35) 7.80
• rp11.94, rs17.00, re17.27
• Cost with retained earnings
• Cost with new common stock

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WACC

• This firm can finance up to 5,000,000 using
  retained earnings
• WACC 11.94
• After that it must issue new common stock
• WACC 12.00
• This Increasing WACC is referred to as the
  Marginal Cost of Capital

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