1 Cost of Capital Chapter 12. 2 Learning Objectives Learning Objectives Explain the concept and purpose of determining a firm’s cost of capital. Identify.

1

Cost of CapitalCost of Capital Chapter 12Chapter 12

3Required Rates on ProjectsRequired Rates on ProjectsAn important part of capital budgeting is setting the An important part of capital budgeting is setting the

required rate for the individual projectrequired rate for the individual project

4Required Rates on ProjectsRequired Rates on ProjectsAn important part of capital budgeting is setting the An important part of capital budgeting is setting the

required rate for the individual projectrequired rate for the individual project

0 1

Example: Consider the following project

+1,100-1,000

5Required Rates on ProjectsRequired Rates on ProjectsAn important part of capital budgeting is setting the An important part of capital budgeting is setting the

required rate for the individual projectrequired rate for the individual project

0 1

Example: Consider the following project

+1,100-1,000

If Required Rate = 9%: NPV = -1,000 + 1,100 (1+ .09 )

= $9.17

6Required Rates on ProjectsRequired Rates on ProjectsAn important part of capital budgeting is setting the An important part of capital budgeting is setting the

required rate for the individual projectrequired rate for the individual project

0 1

Example: Consider the following project

+1,100-1,000

If Required Rate = 9%: NPV = -1,000 + 1,100 (1+ .09 )

= $9.17

Accept Project since NPV > 0

7Required Rates on ProjectsRequired Rates on ProjectsAn important part of capital budgeting is setting the An important part of capital budgeting is setting the

required rate for the individual projectrequired rate for the individual project

0 1

Example: Consider the following project

+1,100-1,000

If Required Rate = 9%: NPV = -1,000 + 1,100 (1+ .09 )

= $9.17

Accept Project since NPV > 0

If Required Rate = 11%: NPV = -1,000 + 1,100 (1+ .11 )

= –$9.01

8Required Rates on ProjectsRequired Rates on ProjectsAn important part of capital budgeting is setting the An important part of capital budgeting is setting the

required rate for the individual projectrequired rate for the individual project

0 1

Example: Consider the following project

+1,100-1,000

If Required Rate = 9%: NPV = -1,000 + 1,100 (1+ .09 )

= $9.17

Accept Project since NPV > 0

If Required Rate = 11%: NPV = -1,000 + 1,100 (1+ .11 )

= –$9.01

Reject Project since NPV < 0

9Required Rates on ProjectsRequired Rates on ProjectsAn important part of capital budgeting is setting the An important part of capital budgeting is setting the

required rate for the individual projectrequired rate for the individual project

0 1

Example: Consider the following project

+1,100-1,000

If Required Rate = 9%: NPV = -1,000 + 1,100 (1+ .09 )

= $9.17

Accept Project since NPV > 0

If Required Rate = 11%: NPV = -1,000 + 1,100 (1+ .11 )

= –$9.01

In order to estimate correct required rate, companies must find their own unique cost of raising capital

In order to estimate correct required rate, companies must find their own unique cost of raising capital

10Factors Affecting Cost of CapitalFactors Affecting Cost of CapitalGeneral Economic Conditions--inflation, investment opportunitiesGeneral Economic Conditions--inflation, investment opportunities

Affect interest ratesThe Following Factors affect risk premiumThe Following Factors affect risk premiumMarket ConditionsMarket ConditionsOperating and Financing DecisionsOperating and Financing Decisions

Affect business riskAffect financial risk

Amount of FinancingAmount of FinancingAffect flotation costs and market price of security

11Model AssumptionsModel Assumptions

Here, we determine the average cost of capital of a Here, we determine the average cost of capital of a firm by assuming that the firm continues with its firm by assuming that the firm continues with its business, financing and dividend policies.business, financing and dividend policies.

Weighted Average Cost of Capital ModelWeighted Average Cost of Capital Model

12Computing Weighted Cost of CapitalComputing Weighted Cost of Capital

Average cost of capital of the firm.Average cost of capital of the firm.

To find WACCTo find WACC

1. Compute the cost of each source of capital1. Compute the cost of each source of capital2. Determine percentage of each source of capital2. Determine percentage of each source of capital3. Calculate Weighted Average Cost of Capital3. Calculate Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC)Weighted Average Cost of Capital (WACC)

13Computing Cost of Each SourceComputing Cost of Each Source

Required rate of return for creditorsRequired rate of return for creditorsSame cost found in Chapter 7 as “required rate for Same cost found in Chapter 7 as “required rate for

debtholders (kdebtholders (kdd) = YTM”) = YTM”

1. Compute Cost of Debt1. Compute Cost of Debt

14Computing Cost of Each SourceComputing Cost of Each Source

Required rate of return for creditorsRequired rate of return for creditorsSame cost found in Chapter 7 as “required rate for Same cost found in Chapter 7 as “required rate for

debtholders (kdebtholders (kdd)”)”

1. Compute Cost of Debt1. Compute Cost of Debt

P0 = +I

k

t

dn

t

n

( )11 $M

(1+kd)n

where:where:It = Dollar Interest Payment

Po = Market Price of DebtM = Maturity Value of Debt

15Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleInvestors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

1. Compute Cost of Debt1. Compute Cost of Debt

16Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleInvestors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

1. Compute Cost of Debt1. Compute Cost of Debt

P0 = +I

k

t

dn

t

n

( )11 $M

(1+kd)n

17Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleInvestors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

1. Compute Cost of Debt1. Compute Cost of Debt

938.55 = +$90

( )1 121

12

k dt

$1,000

(1+kd)10

P0 = +I

k

t

dn

t

n

( )11 $M

(1+kd)n

18Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleInvestors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

1. Compute Cost of Debt1. Compute Cost of Debt

The before tax cost of debt is 10%

Interest is tax deductibleInterest is tax deductible

19Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleInvestors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

1. Compute Cost of Debt1. Compute Cost of Debt

The before tax cost of debt is 10%

Interest is tax deductibleInterest is tax deductible

After tax cost of bonds = kd(1 - T)

Marginal Tax Rate = 40%Marginal Tax Rate = 40%

20Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleInvestors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

1. Compute Cost of Debt1. Compute Cost of Debt

The before tax cost of debt is 10%

Interest is tax deductibleInterest is tax deductible

After tax cost of bonds = kd(1 - T)

= 10.0%(1– 0.40) = 6 %

Marginal Tax Rate = 40%Marginal Tax Rate = 40%

21Computing Cost of Each SourceComputing Cost of Each Source

Cost to raise a dollar of preferred stock.2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

22Computing Cost of Each SourceComputing Cost of Each Source

Cost to raise a dollar of preferred stock.2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

From Chapter 8:

Dividend (D)Market Price (P0)

Required rate kps =

23Computing Cost of Each SourceComputing Cost of Each Source

Cost to raise a dollar of preferred stock.2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

From Chapter 8:

Dividend (D)Market Price (P0)

Required rate kps =

However, there are floatation costs of issuing preferred stock:However, there are floatation costs of issuing preferred stock:

24Computing Cost of Each SourceComputing Cost of Each Source

Cost to raise a dollar of preferred stock.2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

Cost of Preferred Stock with floatation costsCost of Preferred Stock with floatation costs

Dividend (D)Net Price (NP0)

From Chapter 8:

Dividend (D)Market Price (P0)

Required rate kps =

However, there are floatation costs of issuing preferred stock:However, there are floatation costs of issuing preferred stock:

kps =

25Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleYour company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

26Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleYour company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

Cost of Preferred StockCost of Preferred Stock

$5.00 $42.00

kps =

27Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleYour company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

Cost of Preferred StockCost of Preferred Stock

$5.00 $42.00

= 11.90%kps =

28Computing Cost of Each SourceComputing Cost of Each Source

ExampleExampleYour company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

Cost of Preferred StockCost of Preferred Stock

$5.00 $42.00

= 11.90%kps =

No adjustment is made for taxes as dividends are not tax deductible.

No adjustment is made for taxes as dividends are not tax deductible.

29Computing Cost of Each SourceComputing Cost of Each Source

Two kinds of Common EquityTwo kinds of Common EquityRetained Earnings (internal common equity)Issuing new shares of common stock

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

30Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityManagement should retain earnings only if they earn

as much as stockholder’s next best investment opportunity.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

31Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityManagement should retain earnings only if they earn

as much as stockholder’s next best investment opportunity.

Cost of Internal Equity = opportunity cost of common stockholders’ funds.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

32Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityManagement should retain earnings only if they earn

as much as stockholder’s next best investment opportunity.

Cost of Internal Equity = opportunity cost of common stockholders’ funds.

Cost of internal equity must equal common stockholders’ required rate of return.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

33Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityManagement should retain earnings only if they earn as much as

stockholder’s next best investment opportunity.Cost of Internal Equity = opportunity cost of common stockholders’

funds.Cost of internal equity must equal common stockholders’ required

rate of return.Three methods to determine

Dividend Growth ModelCapital Asset Pricing ModelRisk Premium Model

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

34Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityDividend Growth Model

Assume constant growth in dividends (Chap. 8)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

35Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityDividend Growth Model

Assume constant growth in dividends (Chap. 8)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of internal equity--dividend growth modelCost of internal equity--dividend growth model

D1 P0

kcs = + g

36Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityDividend Growth Model

Assume constant growth in dividends (Chap. 8)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of internal equity--dividend growth modelCost of internal equity--dividend growth model

D1 P0

kcs = + gExampleExample

The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

37Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityDividend Growth Model

Assume constant growth in dividends (Chap. 8)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of internal equity--dividend growth modelCost of internal equity--dividend growth model

D1 P0

kcs = + gExampleExample

The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

3(1+0.10) 60

kcs = + .10

38Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityDividend Growth Model

Assume constant growth in dividends (Chap. 8)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of internal equity--dividend growth modelCost of internal equity--dividend growth model

D1 P0

kcs = + gExampleExample

The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

3(1+0.10) 60

kcs = + .10 = .155 = 15.5%

39Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityDividend Growth Model

Assume constant growth in dividends (Chap. 8)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of internal equity--dividend growth modelCost of internal equity--dividend growth model

D1 P0

kcs = + gExampleExample

The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

3(1+0.10) 60

kcs = + .10 = .155 = 15.5%

The main limitation in this method is estimating growth accurately.The main limitation in this method is estimating growth accurately.

40Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityCapital Asset Pricing Model

Estimate the cost of equity from the CAPM (Chap. 6)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

41Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityCapital Asset Pricing Model

Estimate the cost of equity from the CAPM (Chap. 6)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

kcs = krf + (km – krf)

Cost of internal equity--CAPMCost of internal equity--CAPM

42Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityCapital Asset Pricing Model

Estimate the cost of equity from the CAPM (Chap. 6)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

ExampleExampleThe estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.

kcs = krf + (km – krf)

Cost of internal equity--CAPMCost of internal equity--CAPM

43Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityCapital Asset Pricing Model

Estimate the cost of equity from the CAPM (Chap. 6)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

ExampleExampleThe estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.

kcs = krf + (km – krf)

Cost of internal equity--CAPMCost of internal equity--CAPM

kcs = 5% + 1.2(13% – 5%)

44Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityCapital Asset Pricing Model

Estimate the cost of equity from the CAPM (Chap. 6)

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

ExampleExampleThe estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.

kcs = krf + (km – krf)

Cost of internal equity--CAPMCost of internal equity--CAPM

kcs = 5% + 1.2(13% – 5%) = 14.6%

45Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityRisk Premium Approach

Adds a risk premium to the bondholder’s required rate of return.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

46Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityRisk Premium Approach

Adds a risk premium to the bondholder’s required rate of return.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

kcs = kd + RPc

Cost of internal equity--Risk PremiumCost of internal equity--Risk PremiumWhere:Where:

RPc = Common stock risk premium

47Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityRisk Premium Approach

Adds a risk premium to the bondholder’s required rate of return.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

ExampleExampleIf the risk premium is 5% and kd is 10%

kcs = kd + RPc

Cost of internal equity--Risk PremiumCost of internal equity--Risk PremiumWhere:Where:

RPc = Common stock risk premium

48Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityRisk Premium Approach

Adds a risk premium to the bondholder’s required rate of return.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

ExampleExampleIf the risk premium is 5% and kd is 10%

kcs = kd + RPc

Cost of internal equity--Risk PremiumCost of internal equity--Risk Premium

kcs = 10% + 5%

Where:Where:

RPc = Common stock risk premium

49Computing Cost of Each SourceComputing Cost of Each Source

Cost of Internal Common EquityCost of Internal Common EquityRisk Premium Approach

Adds a risk premium to the bondholder’s required rate of return.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

ExampleExampleIf the risk premium is 5% and kd is 10%

kcs = kd + RPc

Cost of internal equity--Risk PremiumCost of internal equity--Risk Premium

kcs = 10% + 5% = 15%

Where:Where:

RPc = Common stock risk premium

50Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common StockIf retained earnings cannot provide all the equity

capital that is needed, firms may issue new shares of common stock.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

51Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common StockIf retained earnings cannot provide all the equity

capital that is needed, firms may issue new shares of common stock.

Dividend Growth Model--Must adjust for floatation costs of the new common shares.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

52Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common StockIf retained earnings cannot provide all the equity

capital that is needed, firms may issue new shares of common stock.

Dividend Growth Model--must adjust for floatation costs of the new common shares.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of new common stockCost of new common stock

D1 NP0

kcs = + g

53Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common Stock3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of new common stockCost of new common stock

D1 NP0

knc = + g

54Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common Stock3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of new common stockCost of new common stock

D1 NP0

knc = + g

ExampleExampleUsing the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

55Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common Stock3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of new common stockCost of new common stock

D1 NP0

knc = + g

ExampleExampleUsing the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

FloatationCosts

FloatationCosts

56Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common Stock3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of new common stockCost of new common stock

D1 NP0

knc = + g

ExampleExampleUsing the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

3(1+0.10) 52.80

kcs = + .10

57Computing Cost of Each SourceComputing Cost of Each Source

Cost of New Common StockCost of New Common Stock3. Compute Cost of Common Equity3. Compute Cost of Common Equity

Cost of new common stockCost of new common stock

D1 NP0

knc = + g

ExampleExampleUsing the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

3(1+0.10) 52.80

kcs = + .10 = .1625 = 16.25%

58Capital Structure WeightsCapital Structure WeightsLong Term Liabilities and EquityLong Term Liabilities and Equity

Weights of each source should reflect expected Weights of each source should reflect expected financing mixfinancing mix

Assume a stable financial mix–so use Balance Sheet Assume a stable financial mix–so use Balance Sheet percentages to calculate the weighted average cost percentages to calculate the weighted average cost of capital.of capital.

59Capital Structure WeightsCapital Structure WeightsLong Term Liabilities and EquityLong Term Liabilities and Equity

Balance Sheet Green Apple Company

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds 4,000Total Assets $12,000 Preferred Stock 1,000

Common Stock 5,000 Total Liabilities and

Owners Equity $12,000

Assets Liabilities

Firm Raises $10,000 of capital from long term sources

60Capital Structure WeightsCapital Structure WeightsLong Term Liabilities and EquityLong Term Liabilities and Equity

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds 4,000Total Assets $12,000 Preferred Stock 1,000

Common Stock 5,000 Total Liabilities and

Owners Equity $12,000

Assets Liabilities

Compute Firm’s Capital Structure (% of each source)

Bonds: 4,000 10,000

= 40%

Amount of Bonds

Total Capital Sources

Balance Sheet Green Apple Company

61Capital Structure WeightsCapital Structure WeightsLong Term Liabilities and EquityLong Term Liabilities and Equity

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds 4,000Total Assets $12,000 Preferred Stock 1,000

Common Stock 5,000 Total Liabilities and

Owners Equity $12,000

Assets Liabilities

Compute Firm’s Capital Structure (% of each source)Amount of Preferred Stock

Total Capital Sources

Preferred Stock: 1,000 10,000

= 10%

Balance Sheet Green Apple Company

62Capital Structure WeightsCapital Structure WeightsLong Term Liabilities and EquityLong Term Liabilities and Equity

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds 4,000Total Assets $12,000 Preferred Stock 1,000

Common Stock 5,000 Total Liabilities and

Owners Equity $12,000

Assets Liabilities

Compute Firm’s Capital Structure (% of each source)Amount of Common Stock

Total Capital Sources

Common Stock: 5,000 10,000

= 50%

Balance Sheet Green Apple Company

63Capital Structure WeightsCapital Structure WeightsLong Term Liabilities and EquityLong Term Liabilities and Equity

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds 4,000Total Assets $12,000 Preferred Stock 1,000

Common Stock 5,000 Total Liabilities and

Owners Equity $12,000

Assets Liabilities

40%10%50%

When money is raised for capital projects, approximately 40% of the money comes from selling bonds, 10% comes from selling preferred stock and 50% comes from retaining earnings or selling common stock

Balance Sheet Green Apple Company

64Computing WACCComputing WACC

Green Apple Company estimates the following costs Green Apple Company estimates the following costs for each component in its capital structure:for each component in its capital structure:

Source of CapitalSource of Capital Cost Cost

Bonds kd = 10%Preferred Stock kps = 11.9%Common Stock

Retained Earnings kcs = 15%New Shares knc = 16.25%

Green Apple’s tax rate is 40%

65Computing WACCComputing WACC If using retained earnings to finance the common If using retained earnings to finance the common

stock portion the capital structurestock portion the capital structure

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

66

Balance Sheet

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (9%) 4,000Total Assets $12,000 Preferred Stock (10%) 1,000

Common Stock(13%) 5,000Tax Rate = 40% Total Liabilities and

Owners Equity $12,000

Assets Liabilities

40%10%50%

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

Computing WACC - using Retained EarningsComputing WACC - using Retained Earnings

67

Balance Sheet

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (10%) 4,000Total Assets $12,000 Preferred Stock (11.9%)1,000

Common Stock(15%) 5,000Tax Rate = 40% Total Liabilities and

Owners Equity $12,000

Assets Liabilities

40%10%50%

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

Computing WACC - using Retained EarningsComputing WACC - using Retained Earnings

WACC = .40 x 10% (1-.4)

68

Balance Sheet

Assets Liabilities

40%10%50%

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

Computing WACC - using Retained EarningsComputing WACC - using Retained Earnings

WACC = .40 x 10% (1-.4)+ .10 x 11.9%

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (10%) 4,000Total Assets $12,000 Preferred Stock (11.9%)1,000

Common Stock(15%) 5,000Tax Rate = 40% Total Liabilities and

Owners Equity $12,000

69

Balance Sheet

Assets Liabilities

40%10%50%

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

Computing WACC - using Retained EarningsComputing WACC - using Retained Earnings

WACC = .40 x 10% (1-.4)+ .10 x 11.9%+ .50 x 15%

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (10%) 4,000Total Assets $12,000 Preferred Stock (11.9%)1,000

Common Stock(15%) 5,000Tax Rate = 40% Total Liabilities and

Owners Equity $12,000

70

Balance Sheet

Assets Liabilities

40%10%50%

WACC = .40 x 10% (1-.4)+ .10 x 11.9%+ .50 x 15% = 11.09%

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

Computing WACC - using Retained EarningsComputing WACC - using Retained Earnings

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (10%) 4,000Total Assets $12,000 Preferred Stock (11.9%)1,000

Common Stock(15%) 5,000Tax Rate = 40% Total Liabilities and

Owners Equity $12,000

71Computing WACCComputing WACC If use newly issued common stock, use kIf use newly issued common stock, use kncnc rather rather

than kthan kcscs for the cost of the equity portion. for the cost of the equity portion.

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

kkncnckkncnc

72

Balance Sheet

Assets Liabilities

WACC = .40 x 10% (1-.4)+ .10 x 11.9%+ .50 x 16.25% = 11.72%

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

Computing WACC - using New Common SharesComputing WACC - using New Common Shares

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (10%) 4,000Total Assets $12,000 Preferred Stock (11.9%)1,000

Common Stock(16.25%)5,000Tax Rate = 40% Total Liabilities and

Owners Equity $12,000

73Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

A firm’s cost of capital will change as it is raises more A firm’s cost of capital will change as it is raises more and more capitaland more capitalRetained earnings will be used up at some levelThe cost of other sources may rise beyond a certain

amount of money has been raised

74Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

A firm’s cost of capital will changes as it is raising more A firm’s cost of capital will changes as it is raising more and more capitaland more capitalRetained earnings will be used up at some levelThe cost of other sources may rise beyond a certain

amount of money raisedTherefore, beyond a point, the WACC will rise.

Calculate the point at which the cost of capital Calculate the point at which the cost of capital increasesincreases

75Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

A firm’s cost of capital will changes as it is raising more A firm’s cost of capital will changes as it is raising more and more capitaland more capitalRetained earnings will be used up at some levelThe cost of other sources may rise beyond a certain

amount of money raisedCalculate the point at which the cost of capital Calculate the point at which the cost of capital

increasesincreases

Break in costof capital curve

Amt of lower cost capital that can be raised before component cost rises

Weight of this kind of capitalin the capital structure

=

76Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

Break in costof capital curve

Retained earningsavailable for reinvesting

Percentage of common financing

=

If Green Apple Company has $100,000 of internally generated common:

77Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

Break in costof capital curve

Retained earningsavailable for reinvesting

Percentage of common financing

=

If Green Apple Company has $100,000 of internally generated common:

Break in costof capital curve

$100,000.50

=

78Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

Break in costof capital curve

Retained earningsavailable for reinvesting

Percentage of common financing

=

If Green Apple Company has $100,000 of internally generated common:

Break in costof capital curve

$100,000.50

= = $200,000

79Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

Break in costof capital curve

Retained earningsavailable for reinvesting

Percentage of common financing

=

If Green Apple Company has $100,000 of internally generated common:

Break in costof capital curve

$100,000.50

= = $200,000

Once $200,000 is raised from all sources, the cost of capital will rise because all the lower cost retained earnings will be used up.

Once $200,000 is raised from all sources, the cost of capital will rise because all the lower cost retained earnings will be used up.

80Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

11.09%

Cost of Capital using internal common stock

Cost of Capital using internal common stock

81Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

11.09%

Break-Point for common equity

Break-Point for common equity

82Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

11.09%

Cost of Capital using internal common stock

Cost of Capital using internal common stock

11.72%Cost of Capital using new common equity

Cost of Capital using new common equity

83Weighted Marginal Cost of CapitalWeighted Marginal Cost of Capital

We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

11.09%

11.72%

84Making DecisionsMaking Decisions

Choosing Projects Using Weighted Marginal Cost of CapitalChoosing Projects Using Weighted Marginal Cost of CapitalGraph IRR’s of potential projects

We

igh

ted

Co

st

of

Ca

pit

al

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

Project 1IRR = 12.4%

Project 2IRR = 12.1% Project 3

IRR = 11.5%

85Making DecisionsMaking Decisions

Choosing Projects Using Weighted Marginal Cost of CapitalChoosing Projects Using Weighted Marginal Cost of CapitalGraph IRR’s of potential projectsGraph Weighted Marginal Cost of Capital

We

igh

ted

Co

st

of

Ca

pit

al

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

Project 1IRR = 12.4%

Project 2IRR = 12.1% Project 3

IRR = 11.5%

86Making DecisionsMaking Decisions

Choosing Projects Using Weighted Marginal Cost of CapitalChoosing Projects Using Weighted Marginal Cost of CapitalGraph IRR’s of potential projectsGraph Weighted Marginal Cost of CapitalChoose projects whose IRR is above the weighted

marginal cost of capital

We

igh

ted

Co

st

of

Ca

pit

al

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

Project 1IRR = 12.4%

Project 2IRR = 12.1% Project 3

IRR = 11.5%

Accept Projects #1 & #2Accept Projects #1 & #2

87