Cost of Capital and its different types of cost of capital

cost of capital

1. 1
Cost of Capital
Unit III
Sri Ramakrishna College of Arts & Science,
Coimbatore.
M.VADIVEL
AssistantProfessor
SriRamakrishnaCollegeofArts&Science,CBE.

2. 3
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project

3. 4
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
0 1
Example: Consider the following project
+1,100-1,000

4. 5
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
0 1
Example: Consider the following project
+1,100-1,000
If Required Rate = 9%:NPV = -1,000 +
1,100
(1+ .09)
= $9.17

5. 6
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
0 1
Example: Consider the following project
+1,100-1,000
If Required Rate = 9%:NPV = -1,000 +
1,100
(1+ .09)
= $9.17
Accept Project since NPV > 0

6. 7
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
0 1
Example: Consider the following project
+1,100-1,000
If Required Rate = 9%:NPV = -1,000 +
1,100
(1+ .09)
= $9.17
Accept Project since NPV > 0
If Required Rate = 11%:NPV = -1,000 +
1,100
(1+ .11)
= –$9.01

7. 8
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
0 1
Example: Consider the following project
+1,100-1,000
If Required Rate = 9%:NPV = -1,000 +
1,100
(1+ .09)
= $9.17
Accept Project since NPV > 0
If Required Rate = 11%:NPV = -1,000 +
1,100
(1+ .11)
= –$9.01
Reject Project since NPV < 0

8. 9
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
0 1
Example: Consider the following project
+1,100-1,000
If Required Rate = 9%:NPV = -1,000 +
1,100
(1+ .09)
= $9.17
Accept Project since NPV > 0
If Required Rate = 11%:NPV = -1,000 +
1,100
(1+ .11)
= –$9.01
In order to estimate correct required rate, companies
must find their own unique cost of raising capital

9. 10
Factors Affecting Cost of Capital
General Economic Conditions--inflation, investment
opportunities
Affect interest rates
The Following Factors affect risk premium
Market Conditions
Operating and Financing Decisions
Affect business risk
Affect financial risk
Amount of Financing
Affect flotation costs and market price of security

10. 11
Model Assumptions
Here, we determine the average cost of capital of a
firm by assuming that the firm continues with its
business, financing and dividend policies.
Weighted Average Cost of Capital Model

11. 12
Computing Weighted Cost of Capital
Average cost of capital of the firm.
To find WACC
1. Compute the cost of each source of capital
2. Determine percentage of each source of capital
3. Calculate Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC)

12. 13
Computing Cost of Each Source
Required rate of return for creditors
Same cost found in Chapter 7 as “required rate for
debtholders (k
d) = YTM”
1. Compute Cost of Debt

13. 14
Computing Cost of Each Source
Required rate of return for creditors
Same cost found in Chapter 7 as “required rate for
debtholders (k
d)”
1. Compute Cost of Debt
P
0= +I
k
t
d
n
t
n
( )11

$M
(1+k
d)
n
where:
I
t =Dollar Interest Payment
P
o=Market Price of Debt
M =Maturity Value of Debt

14. 15
Computing Cost of Each Source
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP
0) down to $938.55. What is the
before tax cost of debt?
1. Compute Cost of Debt

15. 16
Computing Cost of Each Source
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP
0) down to $938.55. What is the
before tax cost of debt?
1. Compute Cost of Debt
P
0= +I
k
t
d
n
t
n
( )11

$M
(1+k
d)
n

16. 17
Computing Cost of Each Source
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP
0) down to $938.55. What is the
before tax cost of debt?
1. Compute Cost of Debt
938.55 = +$90
( )1
12
1
12


k
dt
$1,000
(1+k
d)
10
P
0= +I
k
t
d
n
t
n
( )11

$M
(1+k
d)
n

17. 18
Computing Cost of Each Source
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP
0) down to $938.55. What is the
before tax cost of debt?
1. Compute Cost of Debt
The before tax cost of debt is 10%
Interest is tax deductible

18. 19
Computing Cost of Each Source
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP
0) down to $938.55. What is the
before tax cost of debt?
1. Compute Cost of Debt
The before tax cost of debt is 10%
Interest is tax deductible
After tax cost of bonds = k
d(1 -T)
Marginal Tax Rate = 40%

19. 20
Computing Cost of Each Source
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP
0) down to $938.55. What is the
before tax cost of debt?
1. Compute Cost of Debt
The before tax cost of debt is 10%
Interest is tax deductible
After tax cost of bonds = k
d(1 -T)
= 10.0%(1–0.40) = 6 %
Marginal Tax Rate = 40%

20. 21
Computing Cost of Each Source
Cost to raise a dollar of preferred stock.
2. Compute Cost Preferred Stock

21. 22
Computing Cost of Each Source
Cost to raise a dollar of preferred stock.
2. Compute Cost Preferred Stock
From Chapter 8:
Dividend (D)
Market Price (P
0)
Required rate k
ps=

22. 23
Computing Cost of Each Source
Cost to raise a dollar of preferred stock.
2. Compute Cost Preferred Stock
From Chapter 8:
Dividend (D)
Market Price (P
0)
Required rate k
ps=
However, there are floatation costs of issuing preferred stock:

23. 24
Computing Cost of Each Source
Cost to raise a dollar of preferred stock.
2. Compute Cost Preferred Stock
Cost of Preferred Stock with floatation costs
Dividend (D)
Net Price (NP
0)
From Chapter 8:
Dividend (D)
Market Price (P
0)
Required rate k
ps=
However, there are floatation costs of issuing preferred stock:
k
ps=

24. 25
Computing Cost of Each Source
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
2. Compute Cost Preferred Stock

25. 26
Computing Cost of Each Source
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
2. Compute Cost Preferred Stock
Cost of Preferred Stock
$5.00
$42.00
k
ps=

26. 27
Computing Cost of Each Source
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
2. Compute Cost Preferred Stock
Cost of Preferred Stock
$5.00
$42.00
= 11.90%k
ps=

27. 28
Computing Cost of Each Source
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
2. Compute Cost Preferred Stock
Cost of Preferred Stock
$5.00
$42.00
= 11.90%k
ps=
No adjustment is made for taxes as
dividends are not tax deductible.

28. 29
Computing Cost of Each Source
Two kinds of Common Equity
Retained Earnings (internal common equity)
Issuing new shares of common stock
3. Compute Cost of Common Equity

29. 30
Computing Cost of Each Source
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
3. Compute Cost of Common Equity

30. 31
Computing Cost of Each Source
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
3. Compute Cost of Common Equity

31. 32
Computing Cost of Each Source
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
Cost of internal equity must equal common
stockholders’ required rate of return.
3. Compute Cost of Common Equity

32. 33
Computing Cost of Each Source
Cost of Internal Common Equity
Management should retain earnings only if they earn
as much as stockholder’s next best investment
opportunity.
Cost of Internal Equity = opportunity cost of common
stockholders’ funds.
Cost of internal equity must equal common
stockholders’ required rate of return.
Three methods to determine
Dividend Growth Model
Capital Asset Pricing Model
Risk Premium Model
3. Compute Cost of Common Equity

33. 34
Computing Cost of Each Source
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
3. Compute Cost of Common Equity

34. 35
Computing Cost of Each Source
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
3. Compute Cost of Common Equity
Cost of internal equity--dividend growth model
D
1
P
0
k
cs= + g

35. 36
Computing Cost of Each Source
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
3. Compute Cost of Common Equity
Cost of internal equity--dividend growth model
D
1
P
0
k
cs= + g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.

36. 37
Computing Cost of Each Source
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
3. Compute Cost of Common Equity
Cost of internal equity--dividend growth model
D
1
P
0
k
cs= + g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
3(1+0.10)
60
k
cs= + .10

37. 38
Computing Cost of Each Source
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
3. Compute Cost of Common Equity
Cost of internal equity--dividend growth model
D
1
P
0
k
cs= + g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
3(1+0.10)
60
k
cs= + .10= .155 = 15.5%

38. 39
Computing Cost of Each Source
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
3. Compute Cost of Common Equity
Cost of internal equity--dividend growth model
D
1
P
0
k
cs= + g
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
3(1+0.10)
60
k
cs= + .10= .155 = 15.5%
The main limitation in this method is estimating growth accurately.

39. 40
Computing Cost of Each Source
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
3. Compute Cost of Common Equity

40. 41
Computing Cost of Each Source
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
3. Compute Cost of Common Equity
k
cs=k
rf+ b(k
m–k
rf)
Cost of internal equity--CAPM

41. 42
Computing Cost of Each Source
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
3. Compute Cost of Common Equity
Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.
k
cs=k
rf+ b(k
m–k
rf)
Cost of internal equity--CAPM

42. 43
Computing Cost of Each Source
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
3. Compute Cost of Common Equity
Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.
k
cs=k
rf+ b(k
m–k
rf)
Cost of internal equity--CAPM
k
cs=5% + 1.2(13% –5%)

43. 44
Computing Cost of Each Source
Cost of Internal Common Equity
Capital Asset Pricing Model
Estimate the cost of equity from the CAPM (Chap. 6)
3. Compute Cost of Common Equity
Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.
k
cs=k
rf+ b(k
m–k
rf)
Cost of internal equity--CAPM
k
cs=5% + 1.2(13% –5%)= 14.6%

44. 45
Computing Cost of Each Source
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
3. Compute Cost of Common Equity

45. 46
Computing Cost of Each Source
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
3. Compute Cost of Common Equity
k
cs=k
d+ RP
c
Cost of internal equity--Risk Premium
Where:
RP
c= Common stock
risk premium

46. 47
Computing Cost of Each Source
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
3. Compute Cost of Common Equity
Example
If the risk premium is 5% and k
dis 10%
k
cs=k
d+ RP
c
Cost of internal equity--Risk Premium
Where:
RP
c= Common stock
risk premium

47. 48
Computing Cost of Each Source
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
3. Compute Cost of Common Equity
Example
If the risk premium is 5% and k
dis 10%
k
cs=k
d+ RP
c
Cost of internal equity--Risk Premium
k
cs=10% + 5%
Where:
RP
c= Common stock
risk premium

48. 49
Computing Cost of Each Source
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
3. Compute Cost of Common Equity
Example
If the risk premium is 5% and k
dis 10%
k
cs=k
d+ RP
c
Cost of internal equity--Risk Premium
k
cs=10% + 5%= 15%
Where:
RP
c= Common stock
risk premium

49. 50
Computing Cost of Each Source
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
3. Compute Cost of Common Equity

50. 51
Computing Cost of Each Source
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
Dividend Growth Model--Must adjust for floatation
costs of the new common shares.
3. Compute Cost of Common Equity

51. 52
Computing Cost of Each Source
Cost of New Common Stock
If retained earnings cannot provide all the equity
capital that is needed, firms may issue new shares of
common stock.
Dividend Growth Model--must adjust for floatation
costs of the new common shares.
3. Compute Cost of Common Equity
Cost of new common stock
D
1
NP
0
k
cs= + g

52. 53
Computing Cost of Each Source
Cost of New Common Stock
3. Compute Cost of Common Equity
Cost of new common stock
D
1
NP
0
k
nc= + g

53. 54
Computing Cost of Each Source
Cost of New Common Stock
3. Compute Cost of Common Equity
Cost of new common stock
D
1
NP
0
k
nc= + g
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D
0=
$3.00 and estimated growth is 10%.

54. 55
Computing Cost of Each Source
Cost of New Common Stock
3. Compute Cost of Common Equity
Cost of new common stock
D
1
NP
0
k
nc= + g
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D
0=
$3.00 and estimated growth is 10%.
NP
0= $60.00 –(.12x 60) = $52.80
Floatation
Costs

55. 56
Computing Cost of Each Source
Cost of New Common Stock
3. Compute Cost of Common Equity
Cost of new common stock
D
1
NP
0
k
nc= + g
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D
0=
$3.00 and estimated growth is 10%.
NP
0= $60.00 –(.12x 60) = $52.80
3(1+0.10)
52.80
k
cs= + .10

56. 57
Computing Cost of Each Source
Cost of New Common Stock
3. Compute Cost of Common Equity
Cost of new common stock
D
1
NP
0
k
nc= + g
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D
0=
$3.00 and estimated growth is 10%.
NP
0= $60.00 –(.12x 60) = $52.80
3(1+0.10)
52.80
k
cs= + .10= .1625 = 16.25%

57. 58
Capital Structure Weights
Long Term Liabilities and Equity
Weights of each source should reflect expected
financing mix
Assume a stable financial mix–so use Balance Sheet
percentages to calculate the weighted average cost
of capital.

58. 59
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds 4,000
Total Assets $12,000Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity$12,000
Assets Liabilities
Firm Raises $10,000 of capital from long term sources

59. 60
Capital Structure Weights
Long Term Liabilities and Equity
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds 4,000
Total Assets $12,000Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity$12,000
Assets Liabilities
Compute Firm’s Capital Structure (% of each source)
Bonds:
4,000
10,000
= 40%
Amount of Bonds
Total Capital Sources
Balance Sheet Green Apple Company

60. 61
Capital Structure Weights
Long Term Liabilities and Equity
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds 4,000
Total Assets $12,000Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity$12,000
Assets Liabilities
Compute Firm’s Capital Structure (% of each source)
Amount of Preferred Stock
Total Capital Sources
Preferred Stock:
1,000
10,000
= 10%
Balance Sheet Green Apple Company

61. 62
Capital Structure Weights
Long Term Liabilities and Equity
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds 4,000
Total Assets $12,000Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity$12,000
Assets Liabilities
Compute Firm’s Capital Structure (% of each source)
Amount of Common Stock
Total Capital Sources
Common Stock:
5,000
10,000
= 50%
Balance Sheet Green Apple Company

62. 63
Capital Structure Weights
Long Term Liabilities and Equity
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds 4,000
Total Assets $12,000Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity$12,000
Assets Liabilities
40%
10%
50%
When money is raised for capital projects, approximately
40% of the money comes from selling bonds, 10%
comes from selling preferred stock and 50% comes from
retaining earnings or selling common stock
Balance Sheet Green Apple Company

63. 64
Computing WACC
Green Apple Company estimates the following costs
for each component in its capital structure:
Source of Capital Cost
Bonds kd = 10%
Preferred Stock k
ps = 11.9%
Common Stock
Retained Earningsk
cs = 15%
New Shares k
nc= 16.25%
Green Apple’s tax rate is 40%

64. 65
Computing WACC
If using retained earnings to finance the common
stock portion the capital structure
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock

65. 66
Balance Sheet
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds (9%) 4,000
Total Assets $12,000Preferred Stock (10%)1,000
Common Stock(13%)5,000
Tax Rate = 40% Total Liabilities and
Owners Equity$12,000
Assets Liabilities
40%
10%
50%
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
Computing WACC -using Retained Earnings

66. 67
Balance Sheet
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds (10%) 4,000
Total Assets $12,000Preferred Stock (11.9%)1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
Assets Liabilities
40%
10%
50%
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
Computing WACC -using Retained Earnings
WACC =.40 x 10% (1-.4)

67. 68
Balance Sheet
Assets Liabilities
40%
10%
50%
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
Computing WACC -using Retained Earnings
WACC =.40 x 10% (1-.4)
+ .10 x 11.9%
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds (10%) 4,000
Total Assets $12,000Preferred Stock (11.9%)1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

68. 69
Balance Sheet
Assets Liabilities
40%
10%
50%
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
Computing WACC -using Retained Earnings
WACC =.40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15%
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds (10%) 4,000
Total Assets $12,000Preferred Stock (11.9%)1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

69. 70
Balance Sheet
Assets Liabilities
40%
10%
50%
WACC =.40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 15% = 11.09%
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
Computing WACC -using Retained Earnings
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds (10%) 4,000
Total Assets $12,000Preferred Stock (11.9%)1,000
Common Stock(15%) 5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

70. 71
Computing WACC
If use newly issued common stock, use k
ncrather
than k
csfor the cost of the equity portion.
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
k
nc

71. 72
Balance Sheet
Assets Liabilities
WACC =.40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 16.25% = 11.72%
WACC= k
0=%Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
Computing WACC -using New Common Shares
Current Assets $5,000Current Liabilities$2,000
Plant & Equipment7,000Bonds (10%) 4,000
Total Assets $12,000Preferred Stock (11.9%)1,000
Common Stock(16.25%)5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

72. 73
Weighted Marginal Cost of Capital
A firm’s cost of capital will change as it is raises more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money has been raised

73. 74
Weighted Marginal Cost of Capital
A firm’s cost of capital will changes as it is raising more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money raised
Therefore, beyond a point, the WACC will rise.
Calculate the point at which the cost of capital
increases

74. 75
Weighted Marginal Cost of Capital
A firm’s cost of capital will changes as it is raising more
and more capital
Retained earnings will be used up at some level
The cost of other sources may rise beyond a certain
amount of money raised
Calculate the point at which the cost of capital
increases
Break in cost
of capital curve
Amt of lower cost capital that can
be raised before component cost rises
Weight of this kind of capital
in the capital structure
=

75. 76
Weighted Marginal Cost of Capital
Break in cost
of capital curve
Retained earnings
available for reinvesting
Percentage of
common financing
=
If Green Apple Company has $100,000 of internally
generated common:

76. 77
Weighted Marginal Cost of Capital
Break in cost
of capital curve
Retained earnings
available for reinvesting
Percentage of
common financing
=
If Green Apple Company has $100,000 of internally
generated common:
Break in cost
of capital curve
$100,000
.50
=

77. 78
Weighted Marginal Cost of Capital
Break in cost
of capital curve
Retained earnings
available for reinvesting
Percentage of
common financing
=
If Green Apple Company has $100,000 of internally
generated common:
Break in cost
of capital curve
$100,000
.50
= = $200,000

78. 79
Weighted Marginal Cost of Capital
Break in cost
of capital curve
Retained earnings
available for reinvesting
Percentage of
common financing
=
If Green Apple Company has $100,000 of internally
generated common:
Break in cost
of capital curve
$100,000
.50
= = $200,000
Once $200,000 is raised from all sources, the
cost of capital will rise because all the lower
cost retained earnings will be used up.

79. 80
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
11.09%
Cost of Capital
using internal
common stock

80. 81
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
11.09%
Break-Point for
common equity

81. 82
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
11.09%
Cost of Capital
using internal
common stock
11.72%
Cost of Capital using
new common equity

82. 83
Weighted Marginal Cost of Capital
Weighted Cost of Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
11.09%
11.72%

83. 84
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Weighted Cost of Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
Project 1
IRR = 12.4%
Project 2
IRR = 12.1% Project 3
IRR = 11.5%

84. 85
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital
Weighted Cost of Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
Project 1
IRR = 12.4%
Project 2
IRR = 12.1% Project 3
IRR = 11.5%

85. 86
Making Decisions
Choosing Projects Using Weighted Marginal Cost of Capital
Graph IRR’s of potential projects
Graph Weighted Marginal Cost of Capital
Choose projects whose IRR is above the weighted
marginal cost of capital
Weighted Cost of Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
Project 1
IRR = 12.4%
Project 2
IRR = 12.1% Project 3
IRR = 11.5%
Accept Projects #1 & #2

86. 87
Thank You…….