Transcript The Cost of Capital Chapter 10 Besley

The Cost of Capital
Chapter 10
Besley
The Cost of Capital
Cost of Capital is the minimum rate of return that must be
earned from investments to ensure that the firm’s value does
not decrease.
Basic Definitions
Cost of capital used in capital budgeting should be calculated as a
weighted average of the various types of funds used by the firm,
regardless of the specific financing used to fund the project.
WACC = Weighted Average Cost of Capital
kd
= before tax interest cost on firm debt
kdT
= kd(1-T) = after tax cost of debt
kps
= cost of preferred stock
ks
= cost of retained earnings
ke
= cost of external equity (new stock); ke > ks
Basic Definitions
Capital Structure – Combination of different
types of capital used by the firm.
Cost of Debt, kdT




The relevant cost of new debt
Taking into account the tax deductibility of interest
Used to calculate the WACC
Value of the firm’s stock depends on after-tax cash flows,
which is why we look at kdT
 A firm with losses has a tax rate of zero.
kdT = bondholders’ required rate of return minus tax savings
kdT = kd - (kd x T) = kd(1-T)
Cost of Preferred Stock, kps
 Rate of return investors require on the firm’s
preferred stock
 The preferred dividend divided by the net issuing
price
kps = Dps/NP = Dps/P0-Flotation Costs
 Since there is no tax savings related to preferred
stock, no tax-adjustment is made for kps
Cost of Retained Earnings, ks
Rate of return required by stockholders on
the firm’s existing common stock.
Cost of Retained Earnings
 Rate of return investors require on the firm’s
common stock
D̂
k k
 RP  1  g  k̂
s
RF
s
P
0
The Bond-Yield-Plus-Premium
Approach
 Estimating a risk premium above the bond
interest rate
 Judgmental estimate for premium
 “Ballpark” figure only
k  Bond yield  Risk premium
s
 10%  4%  14%
The Discounted Cash Flow
(DCF) Approach
 Price and expected rate of return on a share
of common stock depend on the dividends
expected on the stock
D̂
D̂
D̂
1
2

P 

 ... 
0
1 k 1 1 k 2
1 k 
s
s
s
D̂

t
 
t
1

k
t 1
s

 





The Discounted Cash Flow
(DCF) Approach
D̂
D̂
D̂
1
2

P 

 ... 
0 1 k 1 1 k 2
1 k 
s
s
s
D̂
D̂

t 
1 if g is constant
 
t
k

g
1

k
t 1
s
s
D̂
1
k  k̂ 
g
s
s P
0

 





Cost of Newly Issued
Common Stock
 External equity, ke


based on the cost of retained earnings
adjusted for flotation costs (the expenses of
selling new issues)
D̂
D̂
1
1
k 
g 
g
s NP
P 1  F 
0
Weighted Average Cost of
Capital, WACC
 A weighted average of the component costs
of debt, preferred stock, and common equity
 Proportion   After - tax   Proportion   Cost of   Proportion   Cost of 
 
 
 
 
 


 
of

cost
of

of
preferred

preferred

of
common

common
 
 
 
 
 

 debt   debt   stock   stock   equity   equity 

 
 


W
d

k
dT

W
ps

k
ps

W
s

k
s