1) The CFO provided information on the firm's capital structure, bond yields, stock prices, tax rates, and growth expectations to estimate the WACC. 2) The costs of debt, preferred stock, and retained earnings were calculated using the bond yield, dividend yield, CAPM, and DCF approaches. 3) The WACC was estimated to be 7.58% using a 40% weight on debt at 3.6%, 10% weight on preferred stock at 7.4%, and 50% weight on retained earnings at 10.08%.

1. WACC
Calculation

2. WACC calculation
You have been just hired as a financial consultant by Harry Davis
Industries. Your assignment is to estimate the firm's cost of capital.
The CFO assembled the following information for you:
1. The firm's marginal tax rate is 40 percent.
2. The firm has outstanding an issue of 8 percent, semiannual coupon, $1,000 par
value bonds with 10 years remaining to maturity. They sell at a price of
$1,148.77. New bonds will be privately placed with no flotation cost.
3. The current price of the firm's perpetual preferred stock (8 percent, $100 par
value) is $114.29. New perpetual preferred stock could be sold to the public at
this price, but Davis would incur flotation costs of 5%.
4. The firm's common stock is currently selling at $50 per share. Its last dividend
was $3, and investors expect the dividend to grow at a constant 4 percent
annual rate into the foreseeable future. The firm's beta is 1; the current yield on
T-bonds is 5 percent; and the market risk premium is estimated at 6 percent.
When using the firm's own bond-yield-plus-risk-premium approach, the
managers assume a risk premium of 4 percentage points.
5. The firm's target capital structure is 40 percent long-term debt, 10 percent
preferred stock, and 50 percent common equity.

3. PARTS OF THE QUESTION
A. Calculate the firm's component costs of debt.
B. Calculate the firm's cost of preferred stock.
C. Assume that the firm is using only retained earnings as equity capital.
Calculate the firm’s cost of retained earnings with the following three
methods:
 Calculate the firm's estimated cost of retained earnings based on the
CAPM approach.
 Calculate the estimate of the firm's cost of retained earnings based on the
DCF approach.
 Calculate the firm's cost of retained earnings based on the bond-yield-
plus-risk premium approach.
D. Calculate the firm's weighted average cost of capital (WACC).
E. Assume that the firm used up all of its retaining earnings and it has to start
issuing common stock with a flotation cost of 20 percent. What will its
cost of common equity be?

4. LET’S SEE WHAT WE HAVE ALREADY
1. -Marginal tax rate is 40%
-Outstanding is 8%
-Semiannual coupon
-Par value of bonds $1,000
-Maturity is 10 years
-Selling price is $1,148.77
-No flotation cost.
2. -Perpetual preferred stock is $114.29
-Par value of bonds $100
-Outstanding is 8%
-Stock could be sold

5. 3. -Common stock selling price is $50 per share
-Dividend is $3
-Expect the dividend to grow at a constant 4 percent
annual rate into the foreseeable future.
-Beta is 1
-T-bonds is 5%
-RPm is 6%
* own bond-yield-plus-risk-premium approach,
assume a risk premium of 4 percentage points.
4. -capital structure is;
40% long-term debt, - Wd
10% preferred stock, - Wps
50% common equity. - Ws

6. NOW LET’S SEE THE QUESTIONS
AGAIN
A. Calculate the firm's component costs of debt.
B. Calculate the firm's cost of preferred stock.
C. Assume that the firm is using only retained earnings as equity capital.
Calculate the firm’s cost of retained earnings with the following three
methods:
 Calculate the firm's estimated cost of retained earnings based on the
CAPM approach.
 Calculate the estimate of the firm's cost of retained earnings based on the
DCF approach.
 Calculate the firm's cost of retained earnings based on the bond-yield-
plus-risk premium approach.
D. Calculate the firm's weighted average cost of capital (WACC).
E. Assume that the firm used up all of its retaining earnings and it has to start
issuing common stock with a flotation cost of 20 percent. What will its
cost of common equity be?

7. *Capital Components
Capital components are sources of
funding that come from investors.
Accounts payable, accruals, and deferred
taxes are not sources of funding that
come from investors, so they are not
included in the calculation of the cost of
capital.

8. *Before-Tax vs.
After-Tax Capital Costs
Firms should incorporate the tax effects
in the cost of capital. They should focus
on the after-tax costs.
Only the cost of debt is affected because
interest is a tax-deductable expense.

9. A. Calculate the firm's component costs of debt.
Since the bond is selling above par, the cost of
debt is less than the coupon interest rate.
The cost of debt is the discount rate that
makes the bond's future cash flows (i.e.,
coupon interest and par value payments)
equal to the market price of the bond. It is
3% semiannually and 6% annually. Therefore
after tax cost of capital is:
Rd AT = rd BT(1 – T)0.036= 0.06(1-0.40)

10. B. Calculate the firm's cost of preferred stock
Cost of preferred stock: Pps = $114.29, Div=8%, Par =
$100, F = 5%
formula:
Dps 0.08 ($100)
Rps= =
Pps (1 – F) $114.29 (1 – 0.05)
$8
= = 0.074 = 7.4%
$108.57
10

11. *Cost of Preferred Stock
Flotation costs for preferred stock are
significant, so are reflected. Use net
price.
Preferred dividends are not tax
deductible, so no tax adjustment.

12. Three ways to determine
the cost of retained earnings
1. CAPM: rs = rRF + (rM – rRF) b
= rRF + (RPM) b
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield + Judgmental
Risk Premium: rs = rd + JRP
12

13. *What are the two ways that
companies can raise common
equity?
•By retaining earnings that are not paid
out as dividends.
•By issuing new shares of common
stock.

14. *Cost for Retained Earnings
Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
They could buy similar stocks and earn rs,
or company could repurchase its own
stock and earn rs. So, rs, is the cost of
reinvested earnings and it is the cost of
common equity.

15. C. Assume that the firm is using only retained earnings as equity
capital. Calculate the firm's estimated cost of retained earnings
based on the CAPM approach.
 Rs = Rrf + (RPm)b
Rs = 4% + 6%.1 = 10%

16. C. Calculate the estimate of the firm's cost of retained
earnings based on the DCF approach.
• Rs = [D0 * (1+g)] / P0 + g
• Rs = 3 * (1.04) / 50 + 0.04 = 0.1024

17. C. Calculate the firm's cost of retained earnings
based on the bond-yield-plus-risk premium
approach.
the own bond yield is 6%. The risk
premium is given as 4%. Therefore, the
cost of retained earnings with the third
method is:
6%+4%=10%

18. *Comparing and Awerage of the
Three Methods
In practice, most firms use the CAPM to
estimate the cost of equity capital.
Many firms use the DCF method.
Some firms estimate the cost of equity
capital by adding a risk premium to their
bond interest rate.
Brigham and Ehrhardt suggest that the
average of the three methods can be used
in estimating the cost of equity capital.

19. What’s a reasonable final estimate
of rs?
Method Estimate
CAPM 10.24%
DCF 10%
rd + JRP 10%
Average 10.08%

20. Awerage of the three methods;
The cost of equity capital with the
retained earnings is the average of the
three methods:
10.24%+10%+10%=10.08%

21. *Determining the Weights for the
WACC
The weights are the percentages of the
firm that will be financed by each
component.
Ifpossible, always use the target weights
for the percentages of the firm that will
be financed with the various types of
capital.

22. *Estimating Weights for the Capital
Structure
Ifyou don’t know the targets, it is better
to estimate the weights using current
market values than current book values.
Ifyou don’t know the market value of
debt, then it is usually reasonable to use
the book values of debt, especially if the
debt is short-term.

23. *What factors influence a
company’s WACC?
Uncontrollable factors:
◦ Market conditions, especially interest rates.
◦ The market risk premium.
◦ Tax rates.
Controllable factors:
◦ Capital structure policy.
◦ Dividend policy.
◦ Investment policy. Firms with riskier projects
generally have a higher cost of equity.

24. D.Calculate the firm's weighted average
cost of capital (WACC).
WACC = wd rd (1 – T) + wps rps + ws rs
= 0.4 (0.036) + 0.1 (0.074)+ 0.5
(0.108)
= 0.0758 ≈ 7.58%
24

25. *Is the firm’s WACC correct for
each of its divisions?
No! The composite WACC reflects the
risk of an average project undertaken by
the firm.
Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk and
capital structure.

26. E.Assume that the firm used up all of its retaining earnings and it
has to start issuing common stock with a flotation cost of 20
percent. What will its cost of common equity be?
Re = [ D0 * (1+ g) ] / [P0 * (1-F) ] + g
Re = [3 * ( 1+0.04) ] / [ 50 * ( 1- 0.2)] + 0.04
= 0.118