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09model 10/6/2009 8:16 12/2/2002 Chapter 9. Model for evaluating the cost of capital The cost of capital is a vital element in the capital budgeting process. For a project to be accepted, it must provide a return that exceeds its cost of capital, or hurdle rate. The cost of capital also serves three other purposes: (1) It is used to help determine the EVA, (2) Managers use the cost of capital when deciding between buying and leasing, and (3) the cost of capital is used in the regulation of electric, gas, and telephone companies. The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm uses to finance its assets, or its WACC. There is an overall, or corporate, WACC which reflects the average riskiness of all the firm's assets. However, since different assets may have more or less risk than the average, the overall WACC must be adjusted up or down to reflect the riskiness of different proposed capital budgeting projects. The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The after-tax cost of new debt is calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate. PROBLEM Find the after-tax cost of debt for a company that pays 10% interest on debt and is subject to a 40% marginal tax rate. 10% Tax rate 40% 6% The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it issues new preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible. PROBLEM What is the cost of preferred stock for a company that pays a preferred dividend of $10 per share if the company could sell new preferred for $97.50 per share? Pref. Dividend $10.00 Pref. Price $97.50 10.26% There are two sources of equity capital, common stock and retained earnings. Since there are no flotation costs relating to raising retained earnings, the cost of retained earnings is simply an opportunity cost equal to the The cost of equity raised by issuing new common stock is higher than that for retained earnings because of flotation costs. Several procedures can be used to find the cost of retained earnings, including the CAPM approach which was introduced in Chapter 5, the DCF approach as introduced in Chapter 8, and a risk premium approach based on the discussion in Chapter 5. The CAPM Approach Recall, that the CAPM equation was that of the Security Market Line. The required return of a stock, or in this case the cost of equity, can be determined using the risk-free rate, market risk premium, and the stock's beta. COST OF DEBT, k d B-T k d A-T k d COST OF PREFERRED STOCK, k p k p COST OF EQUITY FROM RETAINED EARNINGS, k s return investors expect to earn on the firm's stock, or k s .
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