Cost of Capital, Tool Kit
Chapte
The Weighted Average Cost of Capital
The cost of capital is the weighted average cost of the debt, prefe
ed stock, and common equity that the firm uses to finance its assets, or its WACC.
Definitions
WACC = Weighted average cost of capital
= wd rd(1 – T) + wps rps + ws rs
rd = Cost of debt
rps = Cost of prefe
ed stock
rs = Cost of stock (common equity)
wd = Percent of target capital structure financed with debt
wps = Percent of target capital structure financed with prefe
ed stock
ws = Percent of target capital structure financed with stock (common equity)
T = Tax rate
Choosing Weights for the Weighted Average Cost of Capital
Investor-Supplied Capital
Book Market
Book
Value Percent
of Total Market
Value Percent
of Total
DEBT ?0?? ERROR:#DIV/0! ERROR:#DIV/0!
Prefe
ed stock ?0?? ERROR:#DIV/0! ERROR:#DIV/0!
Total common equity $?0?? ERROR:#DIV/0! ERROR:#DIV/0!
Total $0 ERROR:#DIV/0! $0 ERROR:#DIV/0!
Other Data (Millions, except per share data):
Number of common shares outstanding = ?
Price per share of common stock = ?
Number of prefe
ed shares outstanding = ?
Price per share of prefe
ed stock = ?
After-Tax Cost of Debt: rd (1 − T) and rstd (1 − T)
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 is calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate.
To estimate the cost of debt, use the RATE function to find the yield on the bonds:
The After-Tax Cost of Debt
Tax rate = ?
Long-term debt: rd = ?
After-tax cost of debt = r (1 – T)
Long-term debt: rd (1-T) = ?
Cost of Prefe
ed Stock, rps
The cost of prefe
ed stock is simply the prefe
ed dividend divided by the price the company will receive if it issues new prefe
ed stock. No tax adjustment is necessary, as prefe
ed dividends are not tax deductible.
Pref. Dividend ?
Price ?
Flotation % 2.0%
Net prefe
ed issue price ?
rps = DivPref ÷ Net Pref. Price
rps = ? ÷ ? = ?
Using the CAPM to Estimate the Cost of Common Stock, rs
rs = risk-free rate + (Market risk premium) (Beta)
= rRF + (RPM) bi (Recall that: RPM is the expected return on the market minus the risk-free rate.)
The Risk-Free Rate
Yield on 10-year T-bond = rRF = ?
The Market Risk Premium
The market risk premium is the return in excess of the risk-free rate that is required to induce investors to invest in the stock market.
Assumed market risk premium = RPM = 6.00%
Estimating Beta
Beta for Stock i = bi = ?
The same estimate for beta can be obtained as the estimated slope coefficient in a regression, with the company’s stock returns on the y-axis and market returns on the x-axis. Beta can also be obtained from many Web sources.
Risk-free rate ?
Market risk premium ?
Beta ?
rs = rRF + (RPM) (bi)
rs = ? + 6.0% ?
rs = ?
The Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is calculated using the firm's target capital structure together with its after-tax cost of long-term debt, after-tax cost of short-term debt, cost of prefe
ed stock, and cost of common equity.
WACC = Weighted average cost of capital
= wd rd(1 – T) + wstd(1 – T)rstd + wps rps + ws rs
T = ?
wd = ? rd = ?
wps = ? rps = ?
ws = ? rs = ?
WACC = ?