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Chapter 10
The Cost of
Capital
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Learning Goals
1. Concept of cost of capital
2. Determine the annual percentage cost of individual
sources of capital.
3. Calculate the weighted average cost of capital
(WACC).
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Learning Goals (cont.)
4.Determine break points and the marginal cost of
capital (MCC).
5.Use the marginal cost of capital (MCC) and the
investment opportunities schedule (IOS) to make
financing and investment decisions.
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An Overview of the Cost of Capital
• The cost of capital is the annual % cost of
financing projects in the capital budget.
• The relevant cost of capital is the annual
percentage cost of new, long-term financing on
an after-tax basis.
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Key Considerations
• The firm’s cost of capital is the required return
on investment projects of average risk.
• If the project under consideration has high or
low risk, the cost of capital must be adjusted to
determine the risk adjusted discount rate
(RADR).
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Cost of Capital
• To calculate the cost of capital, we must:
– Calculate the annual percentage cost of financing
from each source of capital
– Determine the percentage of financing from each
source (the “weights”)
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Sources of capital
• The sources of capital are long-term and
permanent financing:
– Long-term debt
– Preferred stock
– Common equity
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Specific Sources of Capital:
The Cost of Common Equity
• There are two sources of common equity
financing: retained earnings and new issues of
common stock.
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Specific Sources of Capital:
The Cost of Retained Earnings
• The cost of retained earnings is an opportunity
cost: the earnings belong to the shareholders.
Unless the firm can invest those earnings at a
rate of return acceptable to the shareholders,
they should be paid out as dividends.
• The cost of retained earnings is the required
return on the firm’s common stock (rs).
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The Weighted Average Cost of Capital
WACC = ra = wiri + wprp + wsrs or rn
• Capital Structure Weights
The weights in the above equation represent a specific
financing mix (where wi = % of debt, wp = % of preferred,
and ws= % of common).
Specifically, these weights should be the target
percentages of debt and equity that will minimize the firm’s
overall cost of raising funds.
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Weighted Average Cost of Capital
• In some cases, the target weights are not
available, and we must use alternatives. The
weights can be determined by:
– Firm’s policy (target weights)
– Market values of firm’s debt and equity
– Book values of firm’s debt and equity
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The Marginal Cost
& Investment Decisions
• The Marginal Cost of Capital (MCC)
– The WACC typically increases as the volume of new capital
raised within a given period increases.
– This is true because companies need to raise the return to
investors in order to entice them to invest to compensate them
for the increased risk introduced by larger volumes of capital
raised.
– In addition, the cost will eventually increase when the firm
runs out of cheaper retained equity and is forced to raise new,
more expensive equity capital.
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Table 10.2 Weighted Average Cost of Capital
for Ranges of Total New Financing for
Duchess Corporation
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Figure 10.1 MCC Schedule
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Table 10.3 Investment Opportunities
Schedule (IOS) for Duchess Corporation
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Figure 10.2 IOS and WMCC
Schedules
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