2. What types of capital do firms use?
Debt
Preferred stock
Common equity:
Retained earnings
New common stock
3. Stockholders focus on A-T CFs.
Therefore, we should focus on
A-T capital costs, i.e., use A-T
costs in WACC. Only kd needs
adjustment.
Should we focus on before-tax or
after-tax capital costs?
4. The cost of capital is used primarily
to make decisions that involve
raising new capital. So, focus on
today’s marginal costs (for WACC).
Should we focus on historical
(embedded) costs or new (marginal)
costs?
5. A 15-year, 12% semiannual bond, principal
$1000, sells for $1,153.72. What’s kd?
60 60 + 1,000
60
0 1 2 30
i = ?
30 -1153.72 60 1000
5.0% x 2 = kd = 10%
N I/YR PV FV
PMT
-1,153.72
...
INPUTS
OUTPUT
6. Component Cost of Debt
• Interest is tax deductible, so
kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.
• Use nominal rate.
• Flotation costs small.
Ignore.
7. What’s the cost of preferred stock?
Pp = $111.10; 10% Quarterly; Par = $100.
Use this formula:
%.
0
.
9
090
.
0
10
.
111
$
10
$
P
D
k
p
p
p
9. Note:
• Preferred dividends are not tax
deductible, so no tax adjustment. Just
kp.
• Nominal kp is used.
• Our calculation ignores flotation costs.
10. Is preferred stock more or less
risky to investors than debt?
• More risky; company not required to pay
preferred dividend.
• However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred stockholders
may gain control of firm.
11. Why is there a cost for retained
earnings?
• Earnings can be reinvested or paid out as
dividends.
• Investors could buy other securities, earn a
return.
• Thus, there is an opportunity cost if
earnings are retained.
12. • Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
• They could buy similar stocks and
earn ks, or company could
repurchase its own stock and earn
ks. So, ks is the cost of retained
earnings.
13. Three ways to determine cost of
common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.
14. What’s the cost of common equity
based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM – kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
15. What’s the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
D1
P0
D0(1 + g)
P0
$4.19(1.05)
$50
ks = + g = + g
= + 0.05
= 0.088 + 0.05
= 13.8%.
16. Suppose the company has been
earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout =
65%), and this situation is expected to
continue.
What’s the expected future g?
17. Retention growth rate:
g = (1 – Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 – Payout) = Fraction retained.
Close to g = 5% given earlier. Think of bank
account paying 10% with payout = 100%,
payout = 0%, and payout = 50%. What’s g?
18. Could DCF methodology be applied
if g is not constant?
• YES, nonconstant g stocks are expected
to have constant g at some point,
generally in 5 to 10 years.
• But calculations get complicated.
19. Find ks using the own-bond-yield-plus-
risk-premium method.
(kd = 10%, RP = 4%.)
• This RP CAPM RP.
• Produces ballpark estimate of ks.
Useful check.
ks = kd + RP
= 10.0% + 4.0% = 14.0%
20. What’s a reasonable final estimate of ks?
Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%
21. 1. When a company issues new
common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.
Why is the cost of retained earnings
cheaper than the cost of issuing new
common stock?
22. Two approaches that can be used to
account for flotation costs:
• Include the flotation costs as part of the
project’s up-front cost. This reduces the
project’s estimated return.
• Adjust the cost of capital to include flotation
costs. This is most commonly done by
incorporating flotation costs in the DCF
model.
23. New common, F = 15%:
g
)
F
1
(
P
)
g
1
(
D
k
0
0
e
%.
4
.
15
%
0
.
5
50
.
42
$
40
.
4
$
%
0
.
5
15
.
0
1
50
$
05
.
1
19
.
4
$
24. Comments about flotation costs:
• Flotation costs depend on the risk of the
firm and the type of capital being raised.
• The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
• We will frequently ignore flotation costs
when calculating the WACC.
25. • Suppose the firm has a target capital
structure calling for 30% debt, 10%
preferred stock, and 60% common equity
(retain earnings), using the below data we
can calculate the following WACC
– kd = 10%
– kp = 9%
– ks = 14%
What’s the firm’s WACC
(ignoring flotation costs)?
27. What factors influence a
company’s composite WACC?
• Market conditions. (Firm’s out of control)
– Interest rate
– Tax rate
• Under Firm’s control
– The firm’s capital structure and dividend policy.
– The firm’s investment policy. Firms with riskier
projects generally have a higher WACC.
28. WACC Estimates for Some Large
U. S. Corporations, Nov. 1999
Company WACC
Intel 12.9%
General Electric 11.9
Motorola 11.3
Coca-Cola 11.2
Walt Disney 10.0
AT&T 9.8
Wal-Mart 9.8
Exxon 8.8
H. J. Heinz 8.5
BellSouth 8.2
29. 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.
30. Risk and the Cost of Capital
Rate of Return
(%)
WACC
Rejection Region
Acceptance Region
Risk
L
B
A
H
12.0
8.0
10.0
10.5
9.5
0 RiskL RiskA RiskH
31. Divisional Cost of Capital
Rate of Return
(%)
WACC
Project H
Division H’s WACC
Risk
Project L
Composite WACC
for Firm A
13.0
7.0
10.0
11.0
9.0
Division L’s WACC
0 RiskL RiskAverage RiskH
