The Cost of Capital
ANSWERS TO END-OF-CHAPTER QUESTIONS
The weighted average cost of capital, WACC, is the weighted average of the after-tax
component costs of capital—-debt, preferred stock, and common equity.
weighting factor is the proportion of that type of capital in the optimal, or target,
The after-tax cost of debt, r
(1 - T), is the relevant cost to the firm
Since interest is deductible from taxable income, the after-tax
cost of debt to the firm is less than the before-tax cost.
(1 - T) is the
appropriate component cost of debt (in the weighted average cost of capital).
The cost of preferred stock, r
, is the cost to the firm of issuing new preferred stock.
For perpetual preferred, it is the preferred dividend, D
, divided by the net issuing
Note that no tax adjustments are made when calculating the component
cost of preferred stock because, unlike interest payments on debt, dividend payments
on preferred stock are not tax deductible.
The cost of new common equity, r
, is the
cost to the firm of equity obtained by selling new common stock.
It is, essentially,
the cost of retained earnings adjusted for flotation costs.
Flotation costs are the costs
that the firm incurs when it issues new securities.
The amount actually available to
the firm for capital investment from the sale of new securities is the sales price of the
securities less flotation costs.
Note that flotation costs consist of (1) direct expenses
such as printing costs and brokerage commissions, (2) any price reduction due to
increasing the supply of stock, and (3) any drop in price due to informational
The target capital structure is the relative amount of debt, preferred stock, and
common equity that the firm desires.
The WACC should be based on these target
There are considerable costs when a company issues a new security, including fees to
an investment banker and legal fees.
These costs are called flotation costs.
of new common equity is higher than that of common equity raised internally by
Project’s financed with external equity must earn a higher rate
of return, since they project must cover the flotation costs.
The WACC is an average cost because it is a weighted average of the firm's component
costs of capital.
However, each component cost is a marginal cost; that is, the cost of
Thus, the WACC is the weighted average
cost of capital.
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