Sources of capital Component costs WACC Cost of Capital
• The cost of capital represents the overall cost of
financing to the firm • The cost of capital is normally the relevant discount rate to use in analyzing an investment • The overall cost of capital is a weighted average of the various sources, including debt, preferred stock, and common equity: WACC = Weighted Average Cost of Capital WACC = After-tax costs x weights What sources of long-term capital do firms use? Long-Term Capital
Long-Term Preferred Common
Debt Stock Stock
Retained New Common
Earnings Stock Calculating the weighted average cost of capital WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• The x’s refer to the firm’s capital structure
weights. • The k’s refer to the cost of each component. Should our analysis focus on historical costs or new (marginal) costs? • The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC). Weighting example Bonds 40 Pref. Stock 100 Common 100 Ret. Earn. 160 Total L & E 400 What is weight of each component? Weighting example Bonds 40 Pref. Stock 100 Common 100 Ret. Earn. 160 Total L & E 400
Bonds = 40/400 = 10%
Pref. Stock = 100/400 = 25% Component cost of preferred stock • Preferred dividends are not tax- deductible, so no tax adjustments necessary. Why is there a cost for retained earnings? • Earnings can be reinvested or paid out as dividends. • Investors could buy other securities, earn a return. • If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). Calculate WACC • If 40% of your financing is from debt at an after tax cost of 8% and 60% is from pref. stock at 10%, what is the WACC? • 40% (.08) + 60% (.10) • .032 + .06 = .092 • 9.2% WACC • You are analyzing the cost of capital for a firm that is financed with 60 percent equity and 40 percent debt. The after-tax cost of debt capital is 10 percent, while the cost of equity capital is 20 percent for the firm. What is the overall cost of capital for the firm? • (.6 x .2) + (.4 x .1) = 16% Equity + Debt