1. Cost of Capital
Minggu 10
Lecture Notes

2. Learning Objectives
Explain the concept and purpose of determining a firm’s cost of capital.
Identify the factors that determine a company’s cost of capital.
Describe the assumptions made in computing a firm’s weighted average cost of capital.
Calculate a corporation’s weighted cost of capital.
Explain how PepsiCo calculates its cost of capital.
Compute the cost of capital for an individual project when the firm’s weighted cost of capital is not appropriate as the discount rate.

3. Required Rates on Projects
An important part of capital budgeting is setting the required rate for the individual project
Example: Consider the following project
+1,100
-1,000
NPV = -1,000 +
1,100
( )
= $9.17
If Required Rate = 9%:
Accept Project since NPV > 0
Remember:
NPV = PV of Cash Inflows - PV of Cash Outflows
(or Initial Outlay)

4. Required Rates on Projects
An important part of capital budgeting is setting the required rate for the individual project
Example: Consider the following project
-1,000
+1,100
1,100
( )
If Required Rate = 9%:
NPV = -1,000 +
= $9.17
Accept Project since NPV > 0
NPV = -1,000 +
1,100
( )
= –$9.01
If Required Rate = 11%:
Reject Project since NPV < 0

5. Required Rates on Projects
An important part of capital budgeting is setting the required rate for the individual project
Example: Consider the following project
-1,000
+1,100
1,100
( )
If Required Rate = 9%:
NPV = -1,000 +
= $9.17
Accept Project since NPV > 0
1,100
( )
If Required Rate = 11%:
NPV = -1,000 +
= –$9.01
In order to estimate correct required rate, companies must find their own unique cost of raising capital

6. Factors Determining Cost of Capital
General Economic Conditions
Affect interest rates
Market Conditions
Affect risk premiums
When the economy is doing well, most companies do well. This reduces the risk that the company will fail.
When the economy is doing poorly, many companies will also do poorly. This increases the risk that a company will fail.
Operating and Financing Decisions
Affect business risk
Affect financial risk
Amount of Financing
Affect flotation costs and market price of security

7. Constant Business Risk
Model Assumptions
Weighted Cost of Capital Model
Constant Business Risk
The company is not undertaking any new projects that will substantially change the risk of the company.
Constant Financial Risk
The financing mix of the company will not substantially change.
Constant Dividend Policy
Assume that there are no major changes in Dividend policy.

8. Computing Weighted Cost of Capital
Weighted Cost of Capital Model
1. Compute the cost of each source of capital
Ex: cost of debt, cost of equity, cost of preferred stock.
2. Determine the weight of each source of capital in the total company’s financing mix.
3. Calculate Weighted Average Cost of Capital (WACC)

9. Computing Cost of Each Source
1. Compute Cost of Debt
Required rate of return for creditors
Same cost found in Chapter 6 as “required rate for debtholders (kd)”
P0 = + $M
(1+kd)n
where:
It = Dollar Interest Payment
Po = Market Price of Debt
M = Maturity Value of Debt

10. Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors 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 $ What is the before tax cost of debt?
P0 = + $M
(1+kd)n
$1,000
(1+kd)10 = +

11. Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors 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 $ What is the before tax cost of debt?
10.00 N I% PV
PMT FV
10 ? $M
(1+kd)n
P0 = +
$1,000
(1+kd)10 = +

12. Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors 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 $ What is the before tax cost of debt?
The before tax cost of debt is 10%
10.00 N I% PV
PMT FV
10 ?

13. Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors 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 $ What is the before tax cost of debt?
The before tax cost of debt is 10%
Interest is tax deductible

14. Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors 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 $ What is the before tax cost of debt?
The before tax cost of debt is 10%
Interest is tax deductible
Marginal Tax Rate = 40%
After tax cost of bonds = kd(1 - T)

15. Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors 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 $ What is the before tax cost of debt?
The before tax cost of debt is 10%
Interest is tax deductible
Marginal Tax Rate = 40%
After tax cost of bonds = kd(1 - T)
= 10.0%(1– 0.40) = 6 %

16. Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
Dividend (D)
Market Price (P0)
Required rate kps =
However, there are floatation costs of issuing preferred stock:
Cost of Preferred Stock with floatation costs
Dividend (D)
Net Price (NP0)
kps =

17. Computing Cost of Each Source
2. Compute Cost Preferred Stock
Example
Your 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.
Cost of Preferred Stock
$5.00
$42.00
= %
kps =
No adjustment is made for taxes as dividends are not tax deductible.

18. Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Management 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 Model
Capital Asset Pricing Model
Risk Premium Model

19. Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends
Cost of internal equity--dividend growth model D1 P0
kcs =
+ g
Example
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.

20. Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM
kcs =
rrf + (rm – rrf)
Cost of internal equity--CAPM
Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.
kcs =
5% + 1.2(13% – 5%)
= 14.6%

21. Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of return.
kcs =
kd + RPc
Cost of internal equity--Risk Premium
Where:
RPc = Common stock risk premium
Example
If the risk premium is 5% and kd is 10%
kcs =
10% + 5%
= 15%

22. Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock.
Using Dividend Growth Model, must adjust for floatation costs of the new common shares.
Cost of new common stock D1
NP0
kcs =
+ g
NP0 = Current stock price - Cost of issuing securities

23. Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock D1
NP0
knc =
+ g
Example
Using 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
Floatation
Costs

24. Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock D1
NP0
knc =
+ g
Example
Using 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
= = 16.25%

25. Capital Structure Weights
Long Term Liabilities and Equity
Weights of each source should reflect expected financing mix
Assume a stable financial mix–so use Balance Sheet percentages to calculate the weighted average cost of capital.
In reality, most companies don’t issue debt, preferred, and equity to finance every project. They usually just issue one.
However, most companies DO have a target capital structure and will stagger the issuance of securities so as to maintain that target.

26. Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000
Firm Raises $10,000 of capital from long term sources

27. Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000
Compute Firm’s Capital Structure (% of each source)
Amount of Bonds
4,000
10,000
Bonds:
= 40%
Total Capital Sources

28. Balance Sheet Green Apple Company
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000
Compute Firm’s Capital Structure (% of each source)
Amount of Preferred Stock
1,000
10,000
Preferred Stock:
= 10%
Total Capital Sources

29. Balance Sheet Green Apple Company
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000
Compute Firm’s Capital Structure (% of each source)
Amount of Common Stock
5,000
10,000
Common Stock:
= 50%
Total Capital Sources

30. Balance Sheet Green Apple Company
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000
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

31. Computing WACC
Green Apple Company estimates the following costs for each component in its capital structure:
Source of Capital 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%

32. Computing WACC
If using retained earnings to finance the common stock 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
Where:
%Bonds = Weight of Debt in company
%Preferred = Weight of Preferred in company
%Common = Weight of Common Stock in co.

33. Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (9%) 4,000
Total Assets $12,000 Preferred Stock (10%) 1,000
Common Stock(13%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
40%
10%
50%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock

34. Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
40%
10%
50%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = x 10% (1-.4)

35. Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
40%
10%
50%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = x 10% (1-.4)
+ .10 x 11.9%

36. Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
40%
10%
50%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15%

37. Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%) 1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
40%
10%
50%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15% = %

38. Computing WACC
If use newly issued common stock, use knc rather than kcs 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
knc

39. Computing WACC-using New Common Shares
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%) 1,000
Common Stock(16.25%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
WACC = x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 16.25% = %

40. Weighted Marginal Cost of Capital
A firm’s cost of capital will changes as it is raising more and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain amount of money raised
Calculate the point at which the cost of capital increases
Break in cost
of capital curve =
Retained earnings
available for reinvesting
Percentage of
common financing

41. Weighted Marginal Cost of Capital
Retained earnings
available for reinvesting
Percentage of
common financing
Break in cost
of capital curve =
If Green Apple Company has $100,000 of internally generated common:
Break in cost
of 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.

42. Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve: 9%
10%
11%
12%
100,000
200,000
300,000
400,000
11.09%
Weighted Cost of Capital
Cost of Capital using internal common stock
Total Financing

43. Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve: 9%
10%
11%
12%
100,000
200,000
300,000
400,000
11.09%
Weighted Cost of Capital
Break-Point for common equity
Total Financing

44. Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve:
Cost of Capital using new common equity 9%
10%
11%
12%
100,000
200,000
300,000
400,000
11.72%
11.09%
Weighted Cost of Capital
Cost of Capital using internal common stock
Total Financing

45. Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve: 9%
10%
11%
12%
100,000
200,000
300,000
400,000
11.72%
11.09%
Weighted Cost of Capital
Total Financing

46. Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Marginal weighted cost of capital curve:
12%
11%
Project 1
IRR = 12.4%
Project 2
IRR = 12.1%
Weighted Cost of Capital
10%
Project 3
IRR = 11.5% 9%
100,000
200,000
300,000
400,000
Total Financing

47. Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital
Weighted Cost of Capital
Total Financing 9%
10%
11%
12%
100,000
200,000
300,000
400,000
Marginal weighted cost of capital curve:
Project 1
IRR = 12.4%
Project 2
IRR = 12.1%
Project 3
IRR = 11.5%

48. Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital
Choose projects whose IRR is above the weighted marginal cost of capital
Weighted Cost of Capital
Total Financing 9%
10%
11%
12%
100,000
200,000
300,000
400,000
Marginal weighted cost of capital curve:
Project 1
IRR = 12.4%
Project 2
IRR = 12.1%
Project 3
IRR = 11.5%
Accept Projects #1 & #2