### Essentials of Finance - Ramkhamhaeng University

```Chapter 11
The Cost of Capital
1
Learning Outcomes
Chapter 11

Compute the component cost of capital for (a) debt, (b) preferred
stock, (c) retained earnings, and (d) new common equity.

Describe the weighted average cost of capital (WACC) and discuss
the logic of using WACC to make informed financial decisions.

Describe how the marginal cost of capital (MCC) is used to make
capital budgeting decisions.

Discuss the relationship between the firm’s weighted average cost
of capital (WACC) and investor’s’ required rates of return.
2
Cost of Capital

Firm’s average cost of funds, which is the
average return required by firm’s investors

What must be paid to attract funds
3
Required Rate of Return
(Opportunity Cost Rate)

The return that must be raised on invested
funds to cover the cost of financing such
investments
4
Basic Definitions

Capital Component
 Types of capital used by firms to raise money
• rd
= before tax interest cost
• rdT = rd(1-T) = after tax cost of debt
• rps = cost of preferred stock
• rs
= cost of retained earnings
• re
= cost of external equity (new stock)
5
Basic Definitions

WACC
Weighted Average Cost of Capital

Capital Structure
A combination of different types of
capital(debt and equity) used by a firm
6
After-Tax Cost of Debt

The relevant cost of new debt

Taking into account the tax deductibility of
interest

Used to calculate the WACC
7
Cost of Preferred Stock

Rate of return investors require on the firm’s
preferred stock

The preferred dividend divided by the net
issuing price
F = percentage flotation costs as a decimal
NP0 = per share net proceeds firm receives from the issue
8
Cost of Retained Earnings

Rate of return investors require on the firm’s
common stock
rs = required rate of return
RPs = risk premium for Stock S
rˆs = expected rate of return
g
= constant growth rate
rRF = risk-free rate of return
P0 = current stock price
ˆ = next period’s expected dividend
D
1
9
The CAPM Approach
rs
rRF
rM
RPs
βs
= cost of retained earnings
= risk-free rate of return
= risk-free rate of return
= risk premium for Stock S
= beta coefficient for Stock S
10
The Discounted Cash Flow Approach
(Expected Rate of Return)

Price and expected rate of return on a share
of common stock depends on the dividends
expected on the stock.
rs = cost of retained earnings
P0 = current stock price
rˆs = expected rate of return
g
= constant growth rate
ˆ = next period’s expected dividend
D
1
11
The Bond-Yield-Plus-Premium Approach

Estimating a risk premium above the bond
interest rate

Judgmental estimate for premium

“Ballpark” figure only
12
Cost of Newly Issued Common Stock

External equity, re
 Based on the cost of retained earnings
 Adjusted for flotation costs (the expenses of selling new
issues)
re = cost of new equity
g = constant growth rate
ˆ = next period’s expected dividend
D
1
F = percentage flotation cost stated as a decimal
P0 = current stock price
13
Target Capital Structure

Optimal Capital Structure
 Percentage of debt, preferred stock, and common equity in
the capital structure that will maximize the price of the firm’s
stock
14
Weighted Average Cost of Capital, WACC

A weighted average of the component costs
of debt, preferred stock, and common equity
wd = proportion of debt in firm’s capital structure
wps = proportion of preferred stock in firm’s capital structure
ws = proportion of common stock in firm’s capital structure
15
The Logic of the Weighted Average Cost
of Capital

The use of debt impacts the ability to use
equity, and vice versa, so the weighted
average cost must be used to evaluate
projects, regardless of the specific financing
used to fund a particular project.
16
Marginal Cost of Capital

Marginal Cost of Capital Schedule
 A graph that relates the firm’s weighted average
of each dollar of capital to the total amount of
new capital raised
 Reflects changing costs, depending on amounts of
capital raised
17
MCC Schedule for Unilate Textiles
18
Break Point (BP)

The dollar value of new capital that can be
raised before an increase in the firm’s
weighted average cost of capital occurs
19
MCC Schedule Using Retained Earnings, New Common
Stock and Higher-Cost Debt
20
Combining the MCC and Investment
Opportunity Schedules

Use the MCC schedule to find the cost of
capital for determining projects’ net present
values.

Investment Opportunity Schedule (IOS)
 Graph of the firm’s investment opportunities ranked in order
of the projects’ internal rate of return
21
Combining the MCC and Investment
Opportunity Schedules
22
```