Cost of Capital (1) - The Cost of Capital Unlocking the...

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Cost of Capital 1 The Cost of Capital Unlocking the Firm’s Required Rate of Return
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Cost of Capital 2 The Cost of Capital The cost of capital is defined as the rate of return which a firm must earn on its investments in order to meet the costs of the various sources of capital - long-term debt and bonds, preferred stock, and common stock. If a firm is unable to generate a return equal to or above the cost of capital the value of the firm will decrease and the firm will have difficulty attracting additional funds.
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Cost of Capital 3 The Cost of Capital In determining the cost of capital the firm must consider what returns the various providers of long-term capital desire. In doing so, the firm must consider the providers’ perception of the firm’s risk. This risk is based upon the business risk for the firm and the financial risk for the firm. Any changes in the providers’ perception of these risks will result in changes in the providers desired returns from their investments. Two methods for calculating the cost of capital are the weighted average cost of capital and project/group specific cost of capital.
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Cost of Capital 4 Weighted Average Cost of Capital The WACC takes into consideration the required rates of return for the company’s capital and weighted it according to the proportion of the firm’s capital structure that each source of capital contributes. We find that the firm's cost of capital is: WACC = (w d x k d(at) ) + (w p x k p ) + (w e x k e ) where: k d(at) = The after tax cost of debt k p = The cost of preferred stock k e = The cost of equity (common stock) w d, w p, and w e = The weights of debt, preferred and equity, respectively.
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Cost of Capital 5 WACC and the Cost of Debt The cost of debt for non-securitized long-term debt can be determined by finding current borrowing rate the firm would have to pay upon the long-term bank debt. The cost of securitized debt (bonds) can be found by determining the yield to maturity for the company’s bonds. In all instances the cost of debt is determined on an after tax basis since they interest paid on the debt instruments is tax deductible. This adjustment is made such that: k d(at) = k d x (1-t) Where: k d(at) = The firm’s after-tax cost of debt k d = The firm’s before tax cost of debt (YTM) t = The firm’s marginal tax rate
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Cost of Capital 6 WACC and the Cost of Preferred The cost of preferred stock can be found by rearranging the formula for determining the value of preferred. The firm’s cost of preferred k p is determined by: k p = D/P 0 Where: D = The dividend paid on the preferred stock P 0 = The current market of the preferred stock. Note that the cost of preferred is not adjusted for an after tax basis since the dividends paid on preferred stock are paid out of after tax income and are not tax deductible. In essence, the before and after tax cost of preferred stock are the same.
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Cost of Capital 7 WACC and the Cost of Equity The cost of equity can be found several ways. These
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This note was uploaded on 06/04/2011 for the course ECON business taught by Professor A during the Spring '11 term at Purdue University-West Lafayette.

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Cost of Capital (1) - The Cost of Capital Unlocking the...

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