Weighted Average Cost of Capital

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Weighted Average Cost of Capital

• Once component costs of capital are estimated, we
  can average them out into one overall cost of
  raising funds.
• Ka WiKi WpKp WcKc
• W from each source divided by total in
  capital structure

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Why no WncKnc in formula?

• Firms use available R/E before selling new C/S
  because of flotation costs
• Ka is recalculated when a particular source of
  capital is exhausted and another source must be
  used instead
• Knc is used in formula instead of Kc when R/E run
  out and new common stock must be sold
• Firms have a different Ka for different amounts
  of capital raised

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Calculating Weights

• Book weights how source is listed on balance
  sheet
• Market weights how market currently values
  sources of capital

4
Mix of Capital Sources

• How does firm know what mix of debt, preferred
  stock, and common equity (R/E or new C/S) to use?
• Firms cost out different possible combinations to
  see which mix yields the lowest weighted average
  cost of capital

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Optimal Capital Structure

• Combination of debt and equity that minimizes Ka
• Can locate optimal capital structure by
  calculating Ka at 100 equity financing and then
  incrementally replacing some of the equity with
  debt and recalculating Ka each time more debt is
  added

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• Optimal capital structure for this firm is 50
  debt and 50 common equity.
• Optimal capital structure varies from firm to
  firm - no universal proportions.
• Firm should strive to keep its capital structure
  optimal when raising additional funds keep this
  in mind when calculating MCC later in Chapter 7!

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Important Points in Making Capital Structure
Decision

• 1) Debt is cheaper than equity. (Bondholders
  require lower rates of return than stockholders
  because bonds are a less risky investment.)
• 2) Ki rises as more debt is issued.
• 3) Kc rises as more debt is issued.

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Financial Leverage

• Refers to firms use of debt financing.
• Increased financial leverage leads to increased
  financial risk.
• Financial risk risk that firm wont be able to
  service debt (make interest payments and pay
  principal at maturity).
• More financial leverage a firm has, the more
  expensive it is to raise additional funds from
  any source.

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Use of Debt by Corporations

• Because debt is cheaper than equity, firms should
  use it UP TO A CERTAIN POINT.
• Beyond that level, financial risk becomes too
  great, raising Ka
• Financial managers job is to find that level
  where the firm uses enough debt but not too much.