Cost of Capital

1
Cost of Capital

• Ch. 12.1-12.4

2
Harrys Lemonade Stand

• Needs to raise 200
• Raises 100 from bank, charging 10 interest
• Raises 100 from credit card, charging 20
  interest
• Average cost of capital 15

3
Computing a Firms Cost of Capital

• Same process as Harrys Lemonade
• Sources of funds slightly different

4
Why compute cost of capital?

• Use in capital budgeting

5
Cost of Preferred Stock

• RD/P
• Example
• Dividend 1
• Price 10
• RD/P
• R1/10
• R10

6
Cost of Common Stock

• RD/P g
• Example
• D1
• P10
• g 5
• RD/Pg
• R1/10 5
• R10 5
• R15

7
Cost of Debt

• RY(1-T)
• Always use market Yield to Maturity, versus
  coupon rate.
• Adjust for after-tax basis to be consistent with
  other forms of capital
• Example Yield 10, Tax rate 50
• RY(1-T)
• R10(1- 0.5)
• R5

8
Weighted Average Cost of Capital

• Overall cost of capital, weighted to reflect
  mixture of debt, common, and preferred stock.

9
WACC

• Example
• Cost of debt 5
• Cost of common equity 10
• Weights debt50 of capital, common 50 of
  capital
• WACC
• Debt 5 x 50 2.5
• Common 10 x 50 5
• 2.5 5 WACC of 7.5

10
WACC

• Compute
• Cost of debt 7, 50 total weight
• Cost of common 11, 25 total weight
• Cost of preferred 9, 25 total weight
• WACC ?
• Answer 8.5