11

Cost of Capital

Block, Hirt, and Danielsen

Foundations of Financial Management
18th edition

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 Learning Objectives
• Recall that the cost of capital represents the weighted average
cost of the source of financing to the firm.
• Understand the cost of capital is normally the discount rate to
use in analyzing an investment.
• Recognize that the cost of capital is based on the valuation
techniques from the previous chapter and is applied to bonds,
preferred stock, and common stock.
• Explain how a firm attempts to find a minimum cost of capital
through varying the mix of its sources of financing.
• Recall that the cost of capital may eventually increase as
larger amounts of financing are utilized.

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 Chapter Opening
• Cost of capital in the corporate finance setting
• Investment is made for anticipated future return
• Vital to know appropriate discount rate
• Cost of acquiring funds
• Earning return equal to acquisition costs
represents the minimum acceptable return

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 The Overall Concept

• Investment
• Should not be judged against specific means of
financing used to implement
• Makes investment selection decisions inconsistent
• Low-cost debt must be chosen carefully
• May increase overall risk of the firm
• May eventually make all forms of financing more
expensive

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 Table 11-1 Cost of Capital—
Baker Corporation
• Best understood through firm’s capital structure
• Aftertax costs of the individual sources of financing are
shown, then weights are assigned to each, and finally a
weighted average cost is determined.

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 Cost of Debt
• Measured by interest rate at which company
raises new capital
• Example: $1,000 bond paying $100 annual interest
thus provides 10 percent yield
• Calculation is more complex if bond is priced at
discount or premium from par value
• To determine cost of new debt in
marketplace
• Firm computes yield on currently outstanding
debt
• Not the rate old debt was issued but the rate
investors are demanding today
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 Table 11-2 Yield to Maturity

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 Cost of Debt Continued

• Adjusting yield for tax considerations

• Yield to maturity indicates what firm must pay on
before-tax basis
• Interest payment on debt is tax-deductible
• True cost less than stated cost
• Aftertax cost of debt
Kd (Cost of debt) = Y(1 – T)

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 Cost of Debt Concluded

• Yield is interchangeable with yield to maturity

or approximate yield to maturity
• Yield = 10.84%; Tax rate = 35%
Kd (Cost of debt) = Y(1 – T)
Kd (Cost of debt) = 10.84% (1 – 0.35)
= 10.84% × 0.65
= 7.05%

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 Table 11-3 Excerpt from S&P Capital IQ
Net Advantage

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 Cost of Preferred Stock
• Constant annual payment with no maturity
date for principal payment
• Divide annual dividend by current price
• Represents rate of return to preferred
stockholders and annual cost to corporation for
preferred stock issue
• Proceeds to firm are equal to selling price in
market minus flotation cost

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 Cost of Preferred Stock Continued
• The cost of preferred stock is as follows
Kp (Cost of preferred stock) = Dp / (Pp – F)

• Kp = Cost of preferred stock; Dp = Annual dividend on

preferred stock; Pp = Price of preferred stock;
F = Flotation, or selling cost
• Assume annual dividend $10.50; preferred stock
$100; flotation or selling cost $4

Kp = Dp / (Pp – F) = $10.50 / ($100 – 4) = $10.50 / $96

= $10.94%
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 Cost of Common Equity -
Valuation Approach
• To determine cost of common stock, the firm must be
sensitive to pricing and performance demands of
current and future stockholders
• Dividend valuation model:
P0 = D1 / (Ke – g)

• P0 = Price of the stock today

• D1 = Dividend at the end of the year (or period)
• Ke = Required rate of return
• g = Constant growth rate in dividends
• Assuming D1 = $2, P0 = $40, and g = 7%, Ke =
12%
K = (D / P ) + g = ($2 / $40) + 7% = 5% +7% = 12%
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 Required Return on Common Stock
Using the Capital Asset Pricing Model
• Capital asset pricing model (CAPM)
Kj = Rf + β(Km − Rf)
• Kj = Required return on common stock
• Rf = Risk-free rate of return, usually the current rate on
Treasury bill securities
• β = Beta coefficient (measures the historical volatility
of an
individual stock’s return relative to a stock market
index)
• Km = Return expected in the market as measured by
an
approximate index
• Assuming Rf = 5.5%, Km = 12%, and β = 1.0, Kj
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 Cost of Retained Earnings
• Sources of capital for common stock equity
• Purchaser of new shares—external source
• Retained earnings—internal source
• Represent present and past earnings of firm minus
previously distributed dividends
• Belong to current stockholders—paid as dividends or
reinvested in firm
• Reinvestments represent source of equity capital
supplied by current stockholders
• Opportunity cost involved

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 Cost of Retained Earnings Continued
• The cost of retained earnings is equivalent to the rate
of return on the firm’s common cost, representing
the opportunity cost
• Ke represents both the required rate of return on
common stock and the cost of equity in the form of
retained earnings
Ke = (D1 / P0) + g
• Ke = Cost of common equity in the form of retained earnings
• D1 = Dividend at the end of the first year, $2
• P0 = Price of stock today, $40
• g = Constant growth rate in dividends, 7%
Ke = (D1 / P0) + g = ($2 / $40) + 7% = 5% + 7% = 12%
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 Cost of New Common Stock
• Slightly higher return than Ke expected
• Represents required rate of return of present
stockholders
• Needed to cover distribution costs of new
securities
Common Stock
Ke = (D1 / P0) + g

New common
stock
Kn = [D1 / (P0 – F)] + g
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 Cost of New Common Stock Continued
• Assuming
• D1 = $2
• P0 = $40
• F (Flotation or selling costs) = $4
• g = 7%

Kn = [$2 / ($40 +4)] + 7%

= ($2 / $36) + 7%
= 5.6% + 7%
= 12.6%

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 Optimum Capital Structure—
Weighting Costs
• Desire to achieve minimum overall cost of
capital
• Calculated decisions required on appropriate
weights for
• Debt
• Preferred stock
• Common stock financing
• Capital mix determined by
• Considering present capital structure
• Ascertaining if current position optimal

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 Optimum Capital Structure—
Weighting Costs Continued
• Assessment of different plans:
• Firm able to initially reduce weighted average cost of
capital with debt financing
• Beyond Plan B, continued use of debt becomes
unattractive and greatly increases costs of sources of
financing

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 Figure 11-1 Cost of Capital Curve

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 Table 11-4 2018 and 2021 Long-Term Debt
as a Percentage of Debt + Equity (MV)

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 Capital Acquisition and
Investment Decision Making
• Financial capital consists of bonds, preferred
stock, common equity
• Money raised by sale is invested in
• Real capital of firm, long-term productive assets of
plant and equipment
• To minimize equity cost, firm may sell common
stock when prices are relatively high
• Balance between debt and equity required to
achieve minimum cost of capital

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 Figure 11-2 Cost of Capital Over Time

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 Cost of Capital in the Capital
Budgeting Decision
• Current cost of capital for each source of
funds important for capital budgeting decision
• Required rate of return, or discount rate, will be
weighted average cost of capital
• Common stock value of firm will stay same or
increase as long as firm earns cost of capital
• Stockholders’ expectations being met

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 Table 11-5 Investment Projects
Available to the Baker Corporation

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 Figure 11-3 Cost of Capital and Investment
Projects for the Baker Corporation

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 The Marginal Cost of Capital

• Market may demand higher cost of capital for

each each amount of funds if large amount of
financing required
• Equity (ownership) capital represented by
retained earnings
• Retained earnings cannot grow indefinitely,
as firm’s
capital must expand
• Retained earnings limited to past and
present earnings
that can be redeployed into investments

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 The Marginal Cost of Capital
Continued
• Assumptions:
• Firm has $23.40 million of retained earnings available for
investment
• Since retained earnings are 60 percent of the capital
structure, there are adequate retained earnings to support
up to $39 million
• Adequate retained earnings to support capital
structure
X = Retained earnings / Percent of retained earnings in
the
capital structure
• Where X represents size of capital structure that retained earnings will
support
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 Table 11-6 Costs of Capital for
Different Amounts of Financing

Kmc in bottom right-hand portion of table represents marginal cost of capital

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 Increasing Marginal Cost of Capital

• Both Kmc and Ka represent cost of capital

• mc subscript after K indicates increase in marginal
cost of capital
• Increase because common equity is now in
form of new common stock rather than
retained earnings
• Aftertax cost of new common stock more
expensive than retained earnings because of
flotation costs
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 Marginal Cost of Capital
• Equation for cost of new common stock:
Kn = [D1 / (P0 – F) + g + [$2 / ($40 – $4)] + 7%
= ($2 / $36) + 7%
= 5.6% + 7%
= 12.6%
• $50 million figure can be derived thus:
Z = Amount of lower-cost debt / Percent of debt in the capital
structure
Z = $15 million / 0.30 = $50 million
• Where Z represents size of capital structure in which lower-cost debt
can be used

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 Table 11-7 Cost of Capital for
Increasing Amounts of Financing

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 Marginal Costs of Capital

• Changes in the marginal costs of capital

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 Figure 11-4 Marginal Cost of Capital
and Baker Corporation Projects

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 Table 11-8 Cost of Components
in the Capital Structure

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 Table 11A-1 Performance of
PAI and the Market

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 Figure 11A-1 Linear Regression of
Returns Between PAI and the Market

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 Figure 11A-2 The Security Market Line
(SML)
• Under CAPM model, investor expects extra return above that of
riskless asset in order to justify additional risk
• Security Market Line (SML) identifies risk-return trade-off of any
common stock (asset) relative to company’s beta

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 Figure 11A-3 The Security Market Line
and Changing Interest Rates

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 Figure 11A-4 The Security Market Line and
Changing Investor Expectations
•Pessimistic investors require larger premiums
for assuming risks

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