Finance Chapter 10 - The Cost of Capital

Weighted Average Cost of Capital (WACC)

The weighted average of all component costs (debt, preferred stock, and common equity)
most firms use several different types of capital - each have different risk which then creates different required rates of returns

capital components

one of the types of capital used by firms to raise funds

component cost

the required rate of return on each capital component
cost of each component

What are 3 types of Capital?

Long term debt, preferred stock, and common equity

What is cost of capital typically used for?

used primarily to make decisions which involve raising and investing new capital

What are the 3 methods to calculate the cost of debt?

Method 1: Ask an investment banker what the coupon rate would be on a new debt
Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating
Method 3: Find the yield on the company's debt, if it has any.
- this prov

Calculating the Cost of Debt

- focus on marginal costs
- don't use coupon rate on existing debt
- use the current interest rate on new debt

After Tax Capital Costs for Debt

the interest rate on new debt less the tax savings that result because interest is tax deductible.
-this used to calculate WACC
- interested in maximizing the value of firm's stock, and stock price depends on after-tax cash flows
-interest in cost of new

Flotation Costs

costs paid to the investment bank of company that is issuing the debt
fee for helping with the issuing
flotation costs for debt are usually small
costs depend on the risk of the firm and the type of capital being raised
they are the highest costs among eq

Cost of Preferred Stock

- the rate of return investors require on a firm's preferred stock
- preferred stocks usually more risky than debt because firms don't have to pay dividend
-no tax adjustment when calculating cost because ps dividends are not tax deductible

target capital structure

the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects.

What are 2 ways companies can raise common equity

1. directly, by issuing new shares of common stock
2. indirectly, by reinvesting earnings that are not paid out as dividends (retained earnings)

Cost of equity (retained earnings)

-cost is based on rate of return that investors require on the company's common stock

what are 3 ways to determine the cost of equity

2. Discounted Cash Flows
3. Own Bond Yield Plus Judgmental Risk Premium

What are the Capital Asset Pricing Model (CAPM) steps to for estimating the cost of equity?

1. Estimating the risk free asset
2. estimating beta
3. estimating the risk premium
CAPM is the most widely used measure

Discounted Cash Flow approach to finding cost of equity

using dividend yield + growth rate equation to find required rate of return
- assume market is in equilibrium yields

estimating the growth rate for DCG approach

Sometimes difficult to determine proper growth rate when for DCF
can use historic, if believe future will be like past
If past rates fluctuate too much will obtain the growth rate in some other manner such has analysts estimates from value line, Zacks, an

Bond Yield Plus Risk Premium Approach

takes the cost of debt and some risk premium that accounts for how much riskier stock is then debt
-add judgmental risk premium to long term debt
r = company's own bond yield + judgmental risk premium
not the most accurate but gets a close estimate
used p

Averaging the 3 approaches to estimating cost of equity

If not confident or don't have resources to use one approach can take weighted average of 3 methods

Cost of Issuing New Common Stock

-when issue new stock often have to pay flotation costs to underwriter which can often be a substantial cost and should be considered when determining cost of equity
could send negative signal to capital markets, which may depress stock price
to help avoi

Flotation Cost Adjustment

the amount that must be added to Rs to account for Flotation costs to retained earnings

Determining the weights for the WACC

the weights are the percentages of the firm that will be financed by each component
weights are derived from amount of financing done with each component

What are Uncontrollable Factors that influence company's WACC

market conditions, especially interest rates
market risk premium
tax rates

What are controllable Factors that influence company's WACC

capital structure policy (where do want to get financing from)
dividend policy
investment policy
- firms with riskier project generally have a higher cost of equity

When should a project be accepted?

should accept if and only if their estimated returns exceed the cost of capital
cost of capital is hurdle rate
- this rate should reflect the risk of the project, not the risk associated with the firms average project as reflected in its composite WACC