?The McGraw-Hill Companies,Inc.,2001
11- 1
Irwin/McGraw-Hill
Chapter 11Fundamentals of Corporate FinanceThird Edition
The Cost of
Capital
Brealey Myers Marcus
slides by Matthew Will
?The McGraw-Hill Companies,Inc.,2001
11- 2
Irwin/McGraw-Hill
Topics Covered
?Geothermal’s Cost of Capital
?Weighted Average Cost of Capital (WACC)
?Capital Structure
?Required Rates of Return
?Big Oil’s WACC
?Interpreting WACC
?Flotation Costs
?The McGraw-Hill Companies,Inc.,2001
11- 3
Irwin/McGraw-Hill
Cost of Capital
Cost of Capital - The return the firm’s
investors could expect to earn if they
invested in securities with comparable
degrees of risk.
Capital Structure - The firm’s mix of long
term financing and equity financing.
?The McGraw-Hill Companies,Inc.,2001
11- 4
Irwin/McGraw-Hill
Cost of Capital
Example
Geothermal Inc,has
the following
structure,Given that
geothermal pays 8%
for debt and 14% for
equity,what is the
Company Cost of
Capital?
?The McGraw-Hill Companies,Inc.,2001
11- 5
Irwin/McGraw-Hill
Cost of Capital
Example - Geothermal Inc,has the following
structure,Given that geothermal pays 8% for debt
and 14% for equity,what is the Company Cost of
Capital?
1 0 0 %$ 6 4 7A s s e t s V a l u eM a r k e t
7 0 %$ 4 5 3 E q u i t yV a l u eM a r k e t
3 0 %$ 1 9 4 D e b tV a l u eM a r k e t
?The McGraw-Hill Companies,Inc.,2001
11- 6
Irwin/McGraw-Hill
Cost of Capital
Example - Geothermal Inc,has the following
structure,Given that geothermal pays 8% for debt
and 14% for equity,what is the Company Cost of
Capital?
1 2, 2 %=(, 7 x 1 4 % )+(, 3 x 8 % )= R e t u r nP o r t f o l i o
?The McGraw-Hill Companies,Inc.,2001
11- 7
Irwin/McGraw-Hill
Cost of Capital
Example - Geothermal Inc,has the following
structure,Given that geothermal pays 8% for debt
and 14% for equity,what is the Company Cost of
Capital?
1 2, 2 %=(, 7 x 1 4 % )+(, 3 x 8 % )= R e t u r nP o r t f o l i o
Interest is tax deductible,Given a 35% tax rate,debt only
costs us 5.2% (i.e,8 % x,65).
1 1, 4 %=(, 7 x 1 4 % )+(, 3 x 5, 2 % )= W A CC
?The McGraw-Hill Companies,Inc.,2001
11- 8
Irwin/McGraw-Hill
WACC
Weighted Average Cost of Capital (WACC)
- The expected rate of return on a portfolio of
all the firm’s securities.
Company cost of capital = Weighted average of debt
and equity returns.
?The McGraw-Hill Companies,Inc.,2001
11- 9
Irwin/McGraw-Hill
WACC
r a ss e ts ( D x r ) + ( E x r )Vd e b t e q u ity=
( ) ( )r x r x ra ssets DV debt EV e qu ity= +
r =a sse ts tota l inc o meva lue of i nve stme nts
?The McGraw-Hill Companies,Inc.,2001
11- 10
Irwin/McGraw-Hill
WACC
Three Steps to Calculating Cost of Capital
1,Calculate the value of each security as a
proportion of the firm’s market value.
2,Determine the required rate of return on
each security.
3,Calculate a weighted average of these
required returns.
?The McGraw-Hill Companies,Inc.,2001
11- 11
Irwin/McGraw-Hill
WACC
?Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.
?The McGraw-Hill Companies,Inc.,2001
11- 12
Irwin/McGraw-Hill
WACC
Weighted -average cost of capital=
[ ] [ ]W A C C = x ( 1 - T c ) r + x rDV d e b t EV e q u i t y
?The McGraw-Hill Companies,Inc.,2001
11- 13
Irwin/McGraw-Hill
WACC
Example - Executive Fruit has
issued debt,preferred stock and
common stock,The market
value of these securities are
$4mil,$2mil,and $6mil,
respectively,The required
returns are 6%,12%,and 18%,
respectively.
Q,Determine the WACC for
Executive Fruit,Inc,
?The McGraw-Hill Companies,Inc.,2001
11- 14
Irwin/McGraw-Hill
WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
[ ] ( ) ( )W A C C = x (1 -,3 5 ),0 6 + x, 1 2 + x, 1 8
=, 1 2 3 o r 1 2, 3 %
4
12
2
12
6
12
?The McGraw-Hill Companies,Inc.,2001
11- 15
Irwin/McGraw-Hill
WACC
Issues in Using WACC
Debt has two costs,1)return on debt and 2)increased cost of
equity demanded due to the increase in risk
?Betas may change with capital structure
?Corporate taxes complicate the analysis and may change
our decision
[ ] [ ]B = x B + x Ba s s e t s DV d e b t EV e q u i t y
?The McGraw-Hill Companies,Inc.,2001
11- 16
Irwin/McGraw-Hill
Measuring Capital Structure
?In estimating WACC,do not use the Book
Value of securities.
?In estimating WACC,use the Market Value
of the securities.
?Book Values often do not represent the true
market value of a firm’s securities.
?The McGraw-Hill Companies,Inc.,2001
11- 17
Irwin/McGraw-Hill
Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.
?The McGraw-Hill Companies,Inc.,2001
11- 18
Irwin/McGraw-Hill
Measuring Capital Structure
B i g O i l B o o k V a l u e B a l a n c e S h e e t ( m i l )
B a n k D e b t 200$ 25%
L T B o n d s 200$ 25%
C o m m o n S t o c k 100$ 13%
R e t a i n e d E a r n i n g s 300$ 38%
T o t a l 800$ 100%
?The McGraw-Hill Companies,Inc.,2001
11- 19
Irwin/McGraw-Hill
Measuring Capital Structure
B i g O i l B o o k V a l u e B a l a n c e S h e e t ( m i l )
B a n k D e b t 200$ 25%
L T B o n d s 200$ 25%
C o m m o n S t o c k 100$ 13%
R e t a i n e d E a r n i n g s 300$ 38%
T o t a l 800$ 100%
If the long term bonds pay an
8% coupon and mature in 12
years,what is their market
value assuming a 9% YTM?
70.1 8 5$
09.1
2 1 6
.,,,
09.1
16
09.1
16
09.1
16
1232
?
?????PV
?The McGraw-Hill Companies,Inc.,2001
11- 20
Irwin/McGraw-Hill
Measuring Capital Structure
B i g O i l M A R K E T V a l u e B a l a n c e S h e e t ( m i l )
B a n k D e b t ( m i l ) 2 0 0, 0$ 1 2, 6 %
L T B o n d s 1 8 5, 7$ 1 1, 7 %
T o t a l D e b t 3 8 5, 7$ 2 4, 3 %
C o m m o n S t o c k 1,2 0 0, 0$ 7 5, 7 %
T o t a l 1,5 8 5, 7$ 1 0 0, 0 %
?The McGraw-Hill Companies,Inc.,2001
11- 21
Irwin/McGraw-Hill
Required Rates of Return
Bonds
Common Stock
r = Y T Md
r = C A P M
= r + B ( r - r )
e
f m f
?The McGraw-Hill Companies,Inc.,2001
11- 22
Irwin/McGraw-Hill
Required Rates of Return
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
solve for re
P = D i v
r - g0
1
e
r = D i v
P
+ ge 1
0
?The McGraw-Hill Companies,Inc.,2001
11- 23
Irwin/McGraw-Hill
Required Rates of Return
Expected Return on Preferred Stock
Price of Preferred Stock =
solve for preferred
P = D i v
r0
1
p re fe rre d
r = D i v
Pp r ef er r ed
1
0
?The McGraw-Hill Companies,Inc.,2001
11- 24
Irwin/McGraw-Hill
Flotation Costs
?The cost of implementing any financing
decision must be incorporated into the cash
flows of the project being evaluated.
?Only the incremental costs of financing
should be included.
?This is sometimes called Adjusted Present
Value.
11- 1
Irwin/McGraw-Hill
Chapter 11Fundamentals of Corporate FinanceThird Edition
The Cost of
Capital
Brealey Myers Marcus
slides by Matthew Will
?The McGraw-Hill Companies,Inc.,2001
11- 2
Irwin/McGraw-Hill
Topics Covered
?Geothermal’s Cost of Capital
?Weighted Average Cost of Capital (WACC)
?Capital Structure
?Required Rates of Return
?Big Oil’s WACC
?Interpreting WACC
?Flotation Costs
?The McGraw-Hill Companies,Inc.,2001
11- 3
Irwin/McGraw-Hill
Cost of Capital
Cost of Capital - The return the firm’s
investors could expect to earn if they
invested in securities with comparable
degrees of risk.
Capital Structure - The firm’s mix of long
term financing and equity financing.
?The McGraw-Hill Companies,Inc.,2001
11- 4
Irwin/McGraw-Hill
Cost of Capital
Example
Geothermal Inc,has
the following
structure,Given that
geothermal pays 8%
for debt and 14% for
equity,what is the
Company Cost of
Capital?
?The McGraw-Hill Companies,Inc.,2001
11- 5
Irwin/McGraw-Hill
Cost of Capital
Example - Geothermal Inc,has the following
structure,Given that geothermal pays 8% for debt
and 14% for equity,what is the Company Cost of
Capital?
1 0 0 %$ 6 4 7A s s e t s V a l u eM a r k e t
7 0 %$ 4 5 3 E q u i t yV a l u eM a r k e t
3 0 %$ 1 9 4 D e b tV a l u eM a r k e t
?The McGraw-Hill Companies,Inc.,2001
11- 6
Irwin/McGraw-Hill
Cost of Capital
Example - Geothermal Inc,has the following
structure,Given that geothermal pays 8% for debt
and 14% for equity,what is the Company Cost of
Capital?
1 2, 2 %=(, 7 x 1 4 % )+(, 3 x 8 % )= R e t u r nP o r t f o l i o
?The McGraw-Hill Companies,Inc.,2001
11- 7
Irwin/McGraw-Hill
Cost of Capital
Example - Geothermal Inc,has the following
structure,Given that geothermal pays 8% for debt
and 14% for equity,what is the Company Cost of
Capital?
1 2, 2 %=(, 7 x 1 4 % )+(, 3 x 8 % )= R e t u r nP o r t f o l i o
Interest is tax deductible,Given a 35% tax rate,debt only
costs us 5.2% (i.e,8 % x,65).
1 1, 4 %=(, 7 x 1 4 % )+(, 3 x 5, 2 % )= W A CC
?The McGraw-Hill Companies,Inc.,2001
11- 8
Irwin/McGraw-Hill
WACC
Weighted Average Cost of Capital (WACC)
- The expected rate of return on a portfolio of
all the firm’s securities.
Company cost of capital = Weighted average of debt
and equity returns.
?The McGraw-Hill Companies,Inc.,2001
11- 9
Irwin/McGraw-Hill
WACC
r a ss e ts ( D x r ) + ( E x r )Vd e b t e q u ity=
( ) ( )r x r x ra ssets DV debt EV e qu ity= +
r =a sse ts tota l inc o meva lue of i nve stme nts
?The McGraw-Hill Companies,Inc.,2001
11- 10
Irwin/McGraw-Hill
WACC
Three Steps to Calculating Cost of Capital
1,Calculate the value of each security as a
proportion of the firm’s market value.
2,Determine the required rate of return on
each security.
3,Calculate a weighted average of these
required returns.
?The McGraw-Hill Companies,Inc.,2001
11- 11
Irwin/McGraw-Hill
WACC
?Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.
?The McGraw-Hill Companies,Inc.,2001
11- 12
Irwin/McGraw-Hill
WACC
Weighted -average cost of capital=
[ ] [ ]W A C C = x ( 1 - T c ) r + x rDV d e b t EV e q u i t y
?The McGraw-Hill Companies,Inc.,2001
11- 13
Irwin/McGraw-Hill
WACC
Example - Executive Fruit has
issued debt,preferred stock and
common stock,The market
value of these securities are
$4mil,$2mil,and $6mil,
respectively,The required
returns are 6%,12%,and 18%,
respectively.
Q,Determine the WACC for
Executive Fruit,Inc,
?The McGraw-Hill Companies,Inc.,2001
11- 14
Irwin/McGraw-Hill
WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
[ ] ( ) ( )W A C C = x (1 -,3 5 ),0 6 + x, 1 2 + x, 1 8
=, 1 2 3 o r 1 2, 3 %
4
12
2
12
6
12
?The McGraw-Hill Companies,Inc.,2001
11- 15
Irwin/McGraw-Hill
WACC
Issues in Using WACC
Debt has two costs,1)return on debt and 2)increased cost of
equity demanded due to the increase in risk
?Betas may change with capital structure
?Corporate taxes complicate the analysis and may change
our decision
[ ] [ ]B = x B + x Ba s s e t s DV d e b t EV e q u i t y
?The McGraw-Hill Companies,Inc.,2001
11- 16
Irwin/McGraw-Hill
Measuring Capital Structure
?In estimating WACC,do not use the Book
Value of securities.
?In estimating WACC,use the Market Value
of the securities.
?Book Values often do not represent the true
market value of a firm’s securities.
?The McGraw-Hill Companies,Inc.,2001
11- 17
Irwin/McGraw-Hill
Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.
?The McGraw-Hill Companies,Inc.,2001
11- 18
Irwin/McGraw-Hill
Measuring Capital Structure
B i g O i l B o o k V a l u e B a l a n c e S h e e t ( m i l )
B a n k D e b t 200$ 25%
L T B o n d s 200$ 25%
C o m m o n S t o c k 100$ 13%
R e t a i n e d E a r n i n g s 300$ 38%
T o t a l 800$ 100%
?The McGraw-Hill Companies,Inc.,2001
11- 19
Irwin/McGraw-Hill
Measuring Capital Structure
B i g O i l B o o k V a l u e B a l a n c e S h e e t ( m i l )
B a n k D e b t 200$ 25%
L T B o n d s 200$ 25%
C o m m o n S t o c k 100$ 13%
R e t a i n e d E a r n i n g s 300$ 38%
T o t a l 800$ 100%
If the long term bonds pay an
8% coupon and mature in 12
years,what is their market
value assuming a 9% YTM?
70.1 8 5$
09.1
2 1 6
.,,,
09.1
16
09.1
16
09.1
16
1232
?
?????PV
?The McGraw-Hill Companies,Inc.,2001
11- 20
Irwin/McGraw-Hill
Measuring Capital Structure
B i g O i l M A R K E T V a l u e B a l a n c e S h e e t ( m i l )
B a n k D e b t ( m i l ) 2 0 0, 0$ 1 2, 6 %
L T B o n d s 1 8 5, 7$ 1 1, 7 %
T o t a l D e b t 3 8 5, 7$ 2 4, 3 %
C o m m o n S t o c k 1,2 0 0, 0$ 7 5, 7 %
T o t a l 1,5 8 5, 7$ 1 0 0, 0 %
?The McGraw-Hill Companies,Inc.,2001
11- 21
Irwin/McGraw-Hill
Required Rates of Return
Bonds
Common Stock
r = Y T Md
r = C A P M
= r + B ( r - r )
e
f m f
?The McGraw-Hill Companies,Inc.,2001
11- 22
Irwin/McGraw-Hill
Required Rates of Return
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
solve for re
P = D i v
r - g0
1
e
r = D i v
P
+ ge 1
0
?The McGraw-Hill Companies,Inc.,2001
11- 23
Irwin/McGraw-Hill
Required Rates of Return
Expected Return on Preferred Stock
Price of Preferred Stock =
solve for preferred
P = D i v
r0
1
p re fe rre d
r = D i v
Pp r ef er r ed
1
0
?The McGraw-Hill Companies,Inc.,2001
11- 24
Irwin/McGraw-Hill
Flotation Costs
?The cost of implementing any financing
decision must be incorporated into the cash
flows of the project being evaluated.
?Only the incremental costs of financing
should be included.
?This is sometimes called Adjusted Present
Value.
