Cost of Capital

1

• Cost of Capital
• (chapter 10)

2
What sources of long-term capital do firms use?
3
Calculating the weighted average cost of capital

• WACC wdrd(1-T) wprp wcrs
• The ws refer to the firms capital structure
  weights.
• d debt p preferred c common equity
• T tax rate
• The rs refer to the cost of each component.
• We will ignore the preferred stock. You DONT
  have to prepare preferred stock for the Final
  exam.
• WACC wdrd(1-T) wcrs without prefer stock
• Ex. Capital structure of a firm might be 300m. in
  debt and 700m. in common stock. Calculate the
  weight of each security.
• wd 0.3 and wc 0.7

4
Component cost of debt

• WACC wd rd(1-T) wcrs
• rd is the marginal cost of debt capital.
• The yield to maturity on outstanding long-term
  debt is often used as a measure of kd.
• Why tax-adjust, i.e. why rd(1-T)?

5
A 15-year, 12 semiannual coupon bond sells for
1,153.72. What is the cost of debt (rd)?

• Remember, the bond pays a semiannual coupon, so
  rd 5.0 x 2 10.

30
60
1000
-1153.72
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
5
6
Component cost of equity

• WACC wdrd(1-T) wc rs
• rs is the cost of common equity

• CAPM rs rRF (rM rRF) ß
• If the rRF 7, RPM 6, and the firms beta is
  1.2, whats the cost of common equity based upon
  the CAPM? 14.2
• DCF rs D1 / P0 g
• This formula above is a rearrangement of
• If D0 4.19, P0 50, and g 5, whats the
  cost of common equity based upon the DCF
  approach? 13.8

7
What is the firms WACC?Tax rate 40
WACC wdrd(1-T) wcrs 0.3(10)(0.6)
0.7(14) 1.8 9.8 11.6
8
What factors influence a companys composite WACC?

• Market conditions.
• The firms capital structure and dividend policy.
• The firms investment policy. Firms with riskier
  projects generally have a higher WACC.

9
Should the company use the composite WACC as the
hurdle rate for each of its projects?

• NO! The composite WACC reflects the risk of an
  average project undertaken by the firm.
  Therefore, the WACC only represents the hurdle
  rate for a typical project with average risk.
• Different projects have different risks. The
  projects WACC should be adjusted to reflect the
  projects risk.

10
Exam type question
Wyden Brothers has no retained earnings. The
company uses the CAPM to calculate the cost of
equity capital. The companys capital structure
consists of common stock and debt. Which of the
following events will reduce the companys
WACC? a. A reduction in the market risk premium.
b. An increase in the companys credit
risk. c. An increase in the companys beta. d. An
increase in expected inflation.
11
Exam type question
Billick Brothers is estimating its WACC. The
company has collected the following
information Its capital structure consists of
40 percent debt and 60 percent common equity. The
company has 20-year bonds outstanding with a 9
percent annual coupon that are trading at
par. The companys tax rate is 40 percent. The
risk-free rate is 5.5 percent. The market risk
premium is 5 percent. The stocks beta is
1.4. What is the companys WACC? a. 9.71 b.
9.66 c. 8.31 d. 11.18