Vicentiu Covrig FIN303
Cost of Capital
(chapter 10)
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Vicentiu Covrig FIN303
What sources of long-term capital
do firms use?
Long-Term Capital
Long-Term Debt Preferred Stock Common Stock
Retained Earnings New Common Stock
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Vicentiu Covrig FIN303
Calculating the weighted average
cost of capital
WACC = wdrd(1-T) + wprp + wcrs
The w’s refer to the firm’s capital structure weights.
d: debt; p: preferred; c: common equity
T: tax rate
The r’s refer to the cost of each component.
We will ignore the preferred stock. You DON’T 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
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Vicentiu Covrig FIN303
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)?
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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%.
INPUTS 30 -1153.72 60 1000
N I/YR PV PMT FV
OUTPUT 5
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Vicentiu Covrig FIN303
Component cost of equity
WACC = wdrd(1-T) + wc rs
rs is the cost of common equity
CAPM: ks = kRF + (kM – kRF) β
If the kRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the
cost of common equity based upon the CAPM? 14.2%
DCF: ks = D1 / P0 + g
^ D1
[ This formula above is a rearrangement of P0 ]
ks - g
If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common
equity based upon the DCF approach? 13.8%
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What is the firm’s WACC?
Tax rate = 40%
WACC = wdkd(1-T) + wpkp + wcks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
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Vicentiu Covrig FIN303
What factors influence a company’s
composite WACC?
Market conditions.
The firm’s capital structure and dividend policy.
The firm’s investment policy. Firms with riskier
projects generally have a higher WACC.
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Vicentiu Covrig FIN303
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 project’s
WACC should be adjusted to reflect the project’s risk.
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Vicentiu Covrig FIN303
Exam type question
Wyden Brothers has no retained earnings. The company uses the CAPM to
calculate the cost of equity capital. The company’s capital structure consists
of common stock and debt. Which of the following events will reduce the
company’s WACC?
a. A reduction in the market risk premium. *
b. An increase in the company’s credit risk.
c. An increase in the company’s beta.
d. An increase in expected inflation.
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Vicentiu Covrig FIN303
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 company’s tax rate is 40 percent.
The risk-free rate is 5.5 percent.
The market risk premium is 5 percent.
The stock’s beta is 1.4.
What is the company’s WACC?
a. 9.71%
b. 9.66% *
c. 8.31%
d. 11.18%
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Vicentiu Covrig FIN303
Learning objectives
Know how to calculate the WACC based on the equity and debt components
Discuss several factors that can affect the composite cost of capital (see slide 8)
Cost of preferred (section 10.4), and sections 10.6, 10.9 and 10.10 will NOT be on
the exam
Recommended end-of-chapter problems: 10-1,10-3, 10-4 (without floatation),
10-8
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