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Cost of Capital Slides PDF
Cost of Capital Slides PDF
Cost of Capital
15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Overall Cost of
Capital of the Firm
Cost of Capital is the required rate
of return on the various types of
financing. The overall cost of
capital is a weighted average of the
individual required rates of return
(costs).
15.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Market Value of
Long-Term Financing
Type of Financing Mkt Val Weight
Long-Term Debt $ 35M 35%
Preferred Stock $ 15M 15%
Common Stock Equity $ 50M 50%
$ 100M 100%
15.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Debt
ki = kd ( 1 – T )
15.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of
the Cost of Debt
Assume that Basket Wonders (BW) has
$1,000 par value zero-coupon bonds
outstanding. BW bonds are currently
trading at $385.54 with 10 years to
maturity. BW tax bracket is 40%.
$0 + $1,000
$385.54 =
(1 + kd)10
15.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of
the Cost of Debt
(1 + kd)10 = $1,000 / $385.54
= 2.5938
(1 + kd) = (2.5938) (1/10)
= 1.1
kd = 0.1 or 10%
ki = 10% ( 1 – .40 )
ki = 6%
15.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
kP = DP / P0
15.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of the
Cost of Preferred Stock
Assume that Basket Wonders (BW)
has preferred stock outstanding with
par value of $100, dividend per share
of $6.30, and a current market value of
$70 per share.
kP = $6.30 / $70
kP = 9%
15.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Equity
Approaches
• Dividend Discount Model
• Capital-Asset Pricing Model
• Before-Tax Cost of Debt plus
Risk Premium
15.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
15.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
ke = ( D1 / P0 ) + g
Determination of the
Cost of Equity Capital
Assume that Basket Wonders (BW) has
common stock outstanding with a current
market value of $64.80 per share, current
dividend of $3 per share, and a dividend
growth rate of 8% forever.
ke = ( D1 / P0 ) + g
ke = ($3(1.08) / $64.80) + 0.08
ke = 0.05 + 0.08 = 0.13 or 13%
15.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Asset
Pricing Model
The cost of equity capital, ke, is
equated to the required rate of
return in market equilibrium. The
risk-return relationship is described
by the Security Market Line (SML).
ke = Rj = Rf + (Rm – Rf)j
15.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of the
Cost of Equity (CAPM)
Assume that Basket Wonders (BW) has a
company beta of 1.25. Research by Julie
Miller suggests that the risk-free rate is
4% and the expected return on the market
is 11.4%
ke = Rf + (Rm – Rf)j
= 4% + (11.4% – 4%)1.25
ke = 4% + 9.25% = 13.25%
15.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of the
Cost of Equity (kd + R.P.)
Assume that Basket Wonders (BW)
typically adds a 2.75% premium to the
before-tax cost of debt.
ke = kd + Risk Premium
= 10% + 2.75%
ke = 12.75%
15.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Comparison of the
Cost of Equity Methods
Constant Growth Model 13.00%
Capital Asset Pricing Model 13.25%
Cost of Debt + Risk Premium 12.75%
Generally, the three methods will not agree.
We must decide how to weight –
we will use an average of these three.
15.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = kx(Wx)
x=1
1. Weighting System
• Marginal Capital Costs
15.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.