Chapter 14 Cost of Capital The Cost of Capital Some Preliminaries weighted average cost of capital WACC cost of capital as a whole can be interpreted as the required return on the overall firm the security market line SML can be used to explore the relationship between the expected return on a security and its systematic risk cost of capital for a risk free investment is the risk free rate cost of capital for a risky investment is greater than the risk free rate and the discount rate would exceed the risk free rate the cost of capital depends primarily on the use of the funds not the source The Cost of Equity cost of equity return that equity investors require on their investments P0 D0 1 g RE g D1 RE g RE D1 P0 g o D0 is the dividend just paid observed o D1 is the projected dividend o RE is the required return o g is the expected growth rate for dividends estimated SML Approach Required return on a risky investment depends on 3 things o Risk free rate Rf o Market risk premium Rm Rf o Systematic risk B RE Rf B Rm Rf The Costs of Debt Preferred Stock o To use SML we need a risk free rate an estimate of market risk premium an estimate of beta cost of debt RD return that lenders required on the firm s debt new borrowing there is no need to estimate beta for the debt because we can directly observe the rate we want to know preferred stock has a fixed dividend paid every period forever cost of preferred stock RP D P0 o D is the fixed dividend o P0 is the current price per share of preferred stock The Weighted Average Cost of Capital we use E equity to stand for the market value of the firm s equity o E number of shares outstanding x price per share We use D debt to stand for the market value of the firm s debt o D market price of a single bond x number of bonds outstanding We use V value to stand for the combined market value of debt and equity o V D E 100 E V D V o Capital structure weights E V and D V Interested paid by a corporation is deductable for tax purposes dividends are not After tax interest rate pretax rate x 1 tax rate o After tax rate RD x 1 Tc Weighted average cost of capital WACC weighted average of the cost of equity and the after tax cost of debt o Firm s overall cost of capital capital structure weights x associated costs o WACC E V x RE D V x RD x 1 Tc o o It is the overall return the firm must earn on existing assets to maintain the value of its stock It is the required return on any investments by the firm If the firm uses preferred stock o WACC E V x RE P V x RP D V x RD x 1 Tc o Rp is the cost of preferred stock Flotation Costs the WACC if a company accepts a new project it may be required to float new bonds stocks this means the firm will incur some costs flotation costs we calculate a weighted average flotation cost FA by multiplying the equity flotation cost FE by the percentage of equity E V and the debt flotation cost FD by the percentage of debt D V o FA E V x FE D V x FD PV CF WACC NPV PV initial investment