Chapter 12Cost of Capital

1
Cost of Capital
Chapter 12
2

• Learning Objectives
• Explain the concept and purpose of determining a
  firms cost of capital.
• Identify the factors that determine a companys
  cost of capital.
• Describe the assumptions made in computing a
  firms weighted average cost of capital.
• Calculate a corporations weighted cost of
  capital.
• Explain how PepsiCo calculates its cost of
  capital.
• Compute the cost of capital for an individual
  project when the firms weighted cost of capital
  is not appropriate as the discount rate.

3
Required Rates on Projects

• An important part of capital budgeting is setting
  the required rate for the individual project

4
Required Rates on Projects

• An important part of capital budgeting is setting
  the required rate for the individual project

Example Consider the following project
0
1
1,100
-1,000
5
Required Rates on Projects

• An important part of capital budgeting is setting
  the required rate for the individual project

Example Consider the following project
0
1
1,100
-1,000
1,100 (1 .09 )
If Required Rate 9
NPV -1,000
9.17
6
Required Rates on Projects

• An important part of capital budgeting is setting
  the required rate for the individual project

Example Consider the following project
0
1
1,100
-1,000
1,100 (1 .09 )
If Required Rate 9
NPV -1,000
9.17
Accept Project since NPV gt 0
7
Required Rates on Projects

• An important part of capital budgeting is setting
  the required rate for the individual project

Example Consider the following project
0
1
1,100
-1,000
1,100 (1 .09 )
If Required Rate 9
NPV -1,000
9.17
Accept Project since NPV gt 0
1,100 (1 .11 )
If Required Rate 11
NPV -1,000
9.01
8
Required Rates on Projects

• An important part of capital budgeting is setting
  the required rate for the individual project

Example Consider the following project
0
1
1,100
-1,000
1,100 (1 .09 )
If Required Rate 9
NPV -1,000
9.17
Accept Project since NPV gt 0
1,100 (1 .11 )
If Required Rate 11
NPV -1,000
9.01
Reject Project since NPV lt 0
9
Required Rates on Projects

• An important part of capital budgeting is setting
  the required rate for the individual project

Example Consider the following project
0
1
1,100
-1,000
1,100 (1 .09 )
If Required Rate 9
NPV -1,000
9.17
Accept Project since NPV gt 0
1,100 (1 .11 )
If Required Rate 11
NPV -1,000
9.01
In order to estimate correct required rate,
companies must find their own unique cost of
raising capital
10
Factors Affecting Cost of Capital

• General Economic Conditions--inflation,
  investment opportunities
• Affect interest rates
• The Following Factors affect risk premium
• Market Conditions
• Operating and Financing Decisions
• Affect business risk
• Affect financial risk
• Amount of Financing
• Affect flotation costs and market price of
  security

11
Model Assumptions
Weighted Average Cost of Capital Model

• Here, we determine the average cost of capital of
  a firm by assuming that the firm continues with
  its business, financing and dividend policies.

12
Computing Weighted Cost of Capital
Weighted Average Cost of Capital (WACC)

• Average cost of capital of the firm.
• To find WACC
• 1. Compute the cost of each source of capital
• 2. Determine percentage of each source of capital
• 3. Calculate Weighted Average Cost of Capital

13
Computing Cost of Each Source
1. Compute Cost of Debt

• Required rate of return for creditors
• Same cost found in Chapter 7 as required rate
  for debtholders (kd) YTM

14
Computing Cost of Each Source
1. Compute Cost of Debt

• Required rate of return for creditors
• Same cost found in Chapter 7 as required rate
  for debtholders (kd)

P0

where It Dollar Interest Payment Po Market
Price of Debt M Maturity Value of Debt
15
Computing Cost of Each Source
1. Compute Cost of Debt

• Example
• Investors are willing to pay 985 for a bond
  that pays 90 a year for 10 years. Fees for
  issuing the bonds bring the net price (NP0) down
  to 938.55. What is the before tax cost of debt?

16
Computing Cost of Each Source
1. Compute Cost of Debt

• Example
• Investors are willing to pay 985 for a bond
  that pays 90 a year for 10 years. Fees for
  issuing the bonds bring the net price (NP0) down
  to 938.55. What is the before tax cost of debt?

P0

17
Computing Cost of Each Source
1. Compute Cost of Debt

• Example
• Investors are willing to pay 985 for a bond
  that pays 90 a year for 10 years. Fees for
  issuing the bonds bring the net price (NP0) down
  to 938.55. What is the before tax cost of debt?

P0


938.55
18
Computing Cost of Each Source
1. Compute Cost of Debt

• Example
• Investors are willing to pay 985 for a bond
  that pays 90 a year for 10 years. Fees for
  issuing the bonds bring the net price (NP0) down
  to 938.55. What is the before tax cost of debt?

The before tax cost of debt is 10
Interest is tax deductible
19
Computing Cost of Each Source
1. Compute Cost of Debt

• Example
• Investors are willing to pay 985 for a bond
  that pays 90 a year for 10 years. Fees for
  issuing the bonds bring the net price (NP0) down
  to 938.55. What is the before tax cost of debt?

The before tax cost of debt is 10
Interest is tax deductible
Marginal Tax Rate 40
After tax cost of bonds kd(1 - T)
20
Computing Cost of Each Source
1. Compute Cost of Debt

• Example
• Investors are willing to pay 985 for a bond
  that pays 90 a year for 10 years. Fees for
  issuing the bonds bring the net price (NP0) down
  to 938.55. What is the before tax cost of debt?

The before tax cost of debt is 10
Interest is tax deductible
Marginal Tax Rate 40
After tax cost of bonds kd(1 - T)
10.0(1 0.40) 6
21
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Cost to raise a dollar of preferred stock.

22
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Cost to raise a dollar of preferred stock.

From Chapter 8
Dividend (D) Market Price (P0)
Required rate kps
23
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Cost to raise a dollar of preferred stock.

From Chapter 8
Dividend (D) Market Price (P0)
Required rate kps
However, there are floatation costs of issuing
preferred stock
24
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Cost to raise a dollar of preferred stock.

From Chapter 8
Dividend (D) Market Price (P0)
Required rate kps
However, there are floatation costs of issuing
preferred stock
Cost of Preferred Stock with floatation costs
Dividend (D) Net Price (NP0)
kps
25
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Example
• Your company can issue preferred stock for a
  price of 45, but it only receives 42 after
  floatation costs. The preferred stock pays a 5
  dividend.

26
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Example
• Your company can issue preferred stock for a
  price of 45, but it only receives 42 after
  floatation costs. The preferred stock pays a 5
  dividend.

Cost of Preferred Stock
5.00 42.00
kps
27
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Example
• Your company can issue preferred stock for a
  price of 45, but it only receives 42 after
  floatation costs. The preferred stock pays a 5
  dividend.

Cost of Preferred Stock
5.00 42.00
kps
11.90
28
Computing Cost of Each Source
2. Compute Cost Preferred Stock

• Example
• Your company can issue preferred stock for a
  price of 45, but it only receives 42 after
  floatation costs. The preferred stock pays a 5
  dividend.

Cost of Preferred Stock
5.00 42.00
kps
11.90
No adjustment is made for taxes as dividends are
not tax deductible.
29
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Two kinds of Common Equity
• Retained Earnings (internal common equity)
• Issuing new shares of common stock

30
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Management should retain earnings only if they
  earn as much as stockholders next best
  investment opportunity.

31
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Management should retain earnings only if they
  earn as much as stockholders next best
  investment opportunity.
• Cost of Internal Equity opportunity cost of
  common stockholders funds.

32
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Management should retain earnings only if they
  earn as much as stockholders next best
  investment opportunity.
• Cost of Internal Equity opportunity cost of
  common stockholders funds.
• Cost of internal equity must equal common
  stockholders required rate of return.

33
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Management should retain earnings only if they
  earn as much as stockholders next best
  investment opportunity.
• Cost of Internal Equity opportunity cost of
  common stockholders funds.
• Cost of internal equity must equal common
  stockholders required rate of return.
• Three methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model
• Risk Premium Model

34
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model
• Assume constant growth in dividends (Chap. 8)

35
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model
• Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model
D1 P0
kcs
g
36
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model
• Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model
D1 P0
kcs
g
Example The market price of a share of common
stock is 60. The dividend just paid is 3, and
the expected growth rate is 10.
37
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model
• Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model
D1 P0
kcs
g
Example The market price of a share of common
stock is 60. The dividend just paid is 3, and
the expected growth rate is 10.
3(10.10) 60
kcs
.10
38
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model
• Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model
D1 P0
kcs
g
Example The market price of a share of common
stock is 60. The dividend just paid is 3, and
the expected growth rate is 10.
3(10.10) 60
kcs
.10
.155 15.5
39
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model
• Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model
D1 P0
kcs
g
Example The market price of a share of common
stock is 60. The dividend just paid is 3, and
the expected growth rate is 10.
3(10.10) 60
kcs
.10
.155 15.5
The main limitation in this method is estimating
growth accurately.
40
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Capital Asset Pricing Model
• Estimate the cost of equity from the CAPM (Chap.
  6)

41
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Capital Asset Pricing Model
• Estimate the cost of equity from the CAPM (Chap.
  6)

Cost of internal equity--CAPM
krf b(km krf)
kcs
42
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Capital Asset Pricing Model
• Estimate the cost of equity from the CAPM (Chap.
  6)

Cost of internal equity--CAPM
krf b(km krf)
kcs
Example The estimated Beta of a stock is 1.2.
The risk-free rate is 5 and the expected market
return is 13.
43
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Capital Asset Pricing Model
• Estimate the cost of equity from the CAPM (Chap.
  6)

Cost of internal equity--CAPM
krf b(km krf)
kcs
Example The estimated Beta of a stock is 1.2.
The risk-free rate is 5 and the expected market
return is 13.
5 1.2(13 5)
kcs
44
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Capital Asset Pricing Model
• Estimate the cost of equity from the CAPM (Chap.
  6)

Cost of internal equity--CAPM
krf b(km krf)
kcs
Example The estimated Beta of a stock is 1.2.
The risk-free rate is 5 and the expected market
return is 13.
5 1.2(13 5)
kcs
14.6
45
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Risk Premium Approach
• Adds a risk premium to the bondholders required
  rate of return.

46
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Risk Premium Approach
• Adds a risk premium to the bondholders required
  rate of return.

Cost of internal equity--Risk Premium
Where RPc Common stock risk premium
kd RPc
kcs
47
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Risk Premium Approach
• Adds a risk premium to the bondholders required
  rate of return.

Cost of internal equity--Risk Premium
Where RPc Common stock risk premium
kd RPc
kcs
Example If the risk premium is 5 and kd is 10
48
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Risk Premium Approach
• Adds a risk premium to the bondholders required
  rate of return.

Cost of internal equity--Risk Premium
Where RPc Common stock risk premium
kd RPc
kcs
Example If the risk premium is 5 and kd is 10
10 5
kcs
49
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Risk Premium Approach
• Adds a risk premium to the bondholders required
  rate of return.

Cost of internal equity--Risk Premium
Where RPc Common stock risk premium
kd RPc
kcs
Example If the risk premium is 5 and kd is 10
10 5
kcs
15
50
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock
• If retained earnings cannot provide all the
  equity capital that is needed, firms may issue
  new shares of common stock.

51
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock
• If retained earnings cannot provide all the
  equity capital that is needed, firms may issue
  new shares of common stock.
• Dividend Growth Model--Must adjust for floatation
  costs of the new common shares.

52
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock
• If retained earnings cannot provide all the
  equity capital that is needed, firms may issue
  new shares of common stock.
• Dividend Growth Model--must adjust for floatation
  costs of the new common shares.

Cost of new common stock
D1 NP0
kcs
g
53
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock

Cost of new common stock
D1 NP0
knc
g
54
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock

Cost of new common stock
D1 NP0
knc
g
Example Using the above example. Common stock
price is currently 60. If additional shares are
issued floatation costs will be 12. D0 3.00
and estimated growth is 10.
55
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock

Cost of new common stock
D1 NP0
knc
g
Example Using the above example. Common stock
price is currently 60. If additional shares are
issued floatation costs will be 12. D0 3.00
and estimated growth is 10.
NP0 60.00 (.12x 60) 52.80
Floatation Costs
56
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock

Cost of new common stock
D1 NP0
knc
g
Example Using the above example. Common stock
price is currently 60. If additional shares are
issued floatation costs will be 12. D0 3.00
and estimated growth is 10.
NP0 60.00 (.12x 60) 52.80
3(10.10) 52.80
kcs
.10
57
Computing Cost of Each Source
3. Compute Cost of Common Equity

• Cost of New Common Stock

Cost of new common stock
D1 NP0
knc
g
Example Using the above example. Common stock
price is currently 60. If additional shares are
issued floatation costs will be 12. D0 3.00
and estimated growth is 10.
NP0 60.00 (.12x 60) 52.80
3(10.10) 52.80
kcs
.10
.1625 16.25
58
Capital Structure Weights
Long Term Liabilities and Equity
Weights of each source should reflect expected
financing mix Assume a stable financial mixso
use Balance Sheet percentages to calculate the
weighted average cost of capital.
59
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds 4,000 Total
Assets 12,000 Preferred Stock 1,000 Common
Stock 5,000 Total Liabilities and Owners
Equity 12,000
Firm Raises 10,000 of capital from long term
sources
60
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds 4,000 Total
Assets 12,000 Preferred Stock 1,000 Common
Stock 5,000 Total Liabilities and Owners
Equity 12,000
Compute Firms Capital Structure ( of each
source)
Amount of Bonds
4,000 10,000
40
Bonds
Total Capital Sources
61
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds 4,000 Total
Assets 12,000 Preferred Stock 1,000 Common
Stock 5,000 Total Liabilities and Owners
Equity 12,000
Compute Firms Capital Structure ( of each
source)
Amount of Preferred Stock
1,000 10,000
10
Preferred Stock
Total Capital Sources
62
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds 4,000 Total
Assets 12,000 Preferred Stock 1,000 Common
Stock 5,000 Total Liabilities and Owners
Equity 12,000
Compute Firms Capital Structure ( of each
source)
Amount of Common Stock
5,000 10,000
50
Common Stock
Total Capital Sources
63
Capital Structure Weights
Long Term Liabilities and Equity
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds 4,000 Total
Assets 12,000 Preferred Stock 1,000 Common
Stock 5,000 Total Liabilities and Owners
Equity 12,000
40 10 50
When money is raised for capital projects,
approximately 40 of the money comes from selling
bonds, 10 comes from selling preferred stock and
50 comes from retaining earnings or selling
common stock
64
Computing WACC
Green Apple Company estimates the following costs
for each component in its capital structure
Source of Capital Cost Bonds kd
10 Preferred Stock kps 11.9 Common
Stock Retained Earnings kcs 15 New
Shares knc 16.25
Green Apples tax rate is 40
65
Computing WACC

• If using retained earnings to finance the common
  stock portion the capital structure

WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
66
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds (9) 4,000 Total
Assets 12,000 Preferred Stock (10) 1,000 Commo
n Stock(13) 5,000 Tax Rate 40 Total
Liabilities and Owners Equity 12,000
40 10 50
WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
67
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds (10) 4,000 Total
Assets 12,000 Preferred Stock (11.9) 1,000 Com
mon Stock(15) 5,000 Tax Rate 40 Total
Liabilities and Owners Equity 12,000
40 10 50
WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
WACC .40 x 10 (1-.4)
68
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds (10) 4,000 Total
Assets 12,000 Preferred Stock (11.9) 1,000 Com
mon Stock(15) 5,000 Tax Rate 40 Total
Liabilities and Owners Equity 12,000
40 10 50
WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
WACC .40 x 10 (1-.4) .10 x 11.9
69
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds (10) 4,000 Total
Assets 12,000 Preferred Stock (11.9) 1,000 Com
mon Stock(15) 5,000 Tax Rate 40 Total
Liabilities and Owners Equity 12,000
40 10 50
WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
WACC .40 x 10 (1-.4) .10 x 11.9 .50
x 15
70
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds (10) 4,000 Total
Assets 12,000 Preferred Stock (11.9) 1,000 Com
mon Stock(15) 5,000 Tax Rate 40 Total
Liabilities and Owners Equity 12,000
40 10 50
WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
WACC .40 x 10 (1-.4) .10 x 11.9 .50
x 15 11.09
71
Computing WACC

• If use newly issued common stock, use knc rather
  than kcs for the cost of the equity portion.

WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
knc
72
Computing WACC - using New Common Shares
Balance Sheet
Assets Liabilities
Current Assets 5,000 Current Liabilities 2,000 P
lant Equipment 7,000 Bonds (10) 4,000 Total
Assets 12,000 Preferred Stock (11.9) 1,000 Com
mon Stock(16.25) 5,000 Tax Rate 40 Total
Liabilities and Owners Equity 12,000
WACC k0 Bonds x Cost of Bonds x (1-T)
Preferred x Cost of Preferred Common x Cost
of Common Stock
WACC .40 x 10 (1-.4) .10 x 11.9 .50
x 16.25 11.72
73
Weighted Marginal Cost of Capital

• A firms cost of capital will change as it is
  raises more and more capital
• Retained earnings will be used up at some level
• The cost of other sources may rise beyond a
  certain amount of money has been raised

74
Weighted Marginal Cost of Capital

• A firms cost of capital will changes as it is
  raising more and more capital
• Retained earnings will be used up at some level
• The cost of other sources may rise beyond a
  certain amount of money raised
• Therefore, beyond a point, the WACC will rise.
• Calculate the point at which the cost of capital
  increases

75
Weighted Marginal Cost of Capital

• A firms cost of capital will changes as it is
  raising more and more capital
• Retained earnings will be used up at some level
• The cost of other sources may rise beyond a
  certain amount of money raised
• Calculate the point at which the cost of capital
  increases

Break in cost of capital curve

76
Weighted Marginal Cost of Capital
Break in cost of capital curve

If Green Apple Company has 100,000 of internally
generated common
77
Weighted Marginal Cost of Capital
Break in cost of capital curve

If Green Apple Company has 100,000 of internally
generated common
100,000 .50
Break in cost of capital curve

78
Weighted Marginal Cost of Capital
Break in cost of capital curve

If Green Apple Company has 100,000 of internally
generated common
100,000 .50
Break in cost of capital curve

200,000
79
Weighted Marginal Cost of Capital
Break in cost of capital curve

If Green Apple Company has 100,000 of internally
generated common
100,000 .50
Break in cost of capital curve

200,000
Once 200,000 is raised from all sources, the
cost of capital will rise because all the lower
cost retained earnings will be used up.
80
Weighted Marginal Cost of Capital

• Marginal weighted cost of capital curve

11.09
Cost of Capital using internal common stock
Weighted Cost of Capital
Total Financing
81
Weighted Marginal Cost of Capital

• Marginal weighted cost of capital curve

11.09
Weighted Cost of Capital
Break-Point for common equity
Total Financing
82
Weighted Marginal Cost of Capital

• Marginal weighted cost of capital curve

Cost of Capital using new common equity
11.72
11.09
Cost of Capital using internal common stock
Weighted Cost of Capital
Total Financing
83
Weighted Marginal Cost of Capital

• Marginal weighted cost of capital curve

11.72
11.09
Weighted Cost of Capital
Total Financing
84
Making Decisions

• Choosing Projects Using Weighted Marginal Cost of
  Capital
• Graph IRRs of potential projects

Marginal weighted cost of capital curve
12
Project 1 IRR 12.4
11
Project 2 IRR 12.1
Weighted Cost of Capital
10
Project 3 IRR 11.5
9
400,000
0
100,000
200,000
300,000
Total Financing
85
Making Decisions

• Choosing Projects Using Weighted Marginal Cost of
  Capital
• Graph IRRs of potential projects
• Graph Weighted Marginal Cost of Capital

Marginal weighted cost of capital curve
12
Project 1 IRR 12.4
11
Project 2 IRR 12.1
Weighted Cost of Capital
10
Project 3 IRR 11.5
9
400,000
0
100,000
200,000
300,000
Total Financing
86
Making Decisions

• Choosing Projects Using Weighted Marginal Cost of
  Capital
• Graph IRRs of potential projects
• Graph Weighted Marginal Cost of Capital
• Choose projects whose IRR is above the weighted
  marginal cost of capital

Marginal weighted cost of capital curve
Accept Projects 1 2
12
Project 1 IRR 12.4
11
Project 2 IRR 12.1
Weighted Cost of Capital
10
Project 3 IRR 11.5
9
400,000
0
100,000
200,000
300,000
Total Financing
87
(No Transcript)