2. The top panel assumes all earnings are reinvested from 2005 to 2009. In 2010 and later years, two-thirds
of earnings are paid out as dividends and one-third reinvested.
3. The bottom panel assumes two-thirds of earnings are paid out as dividends in all years.
4. Columns may not add up because of rounding.
Mike GordonÔÇ™s Saloon, where Francine Firewater, the companyÔÇ™s
current book value per share, but Mr. Breezeway had inter-
CFO, was having her usual steak-and-beans breakfast. He asked
vened and convinced the would-be seller to wait.
Ms. Firewater to prepare a formal report to Prairie Home stock-
Prairie HomeÔÇ™s value did not just depend on its current book
holders, valuing the company on the assumption that its shares
value or earnings, but on its future prospects, which were good.
were publicly traded.
One financial projection (shown in the top panel of Table 3.8)
Ms. Firewater asked two questions immediately. First, what
called for growth in earnings of over 100 percent by 2011. Un-
should she assume about investment and growth? Mr. Breezeway
fortunately this plan would require reinvestment of all of Prairie
suggested two valuations, one assuming more rapid expansion (as
HomeÔÇ™s earnings from 2006 to 2010. After that the company
in the top panel of Table 3.8) and another just projecting past
could resume its normal dividend payout and growth rate. Mr.
growth (as in the bottom panel of Table 3.8).
Breezeway believed this plan was feasible.
Second, what rate of return should she use? Mr. Breezeway said
He was determined to step aside for the next generation of
that 15 percent, Prairie HomeÔÇ™s usual return on book equity,
top management. But before retiring he had to decide whether
sounded right to him, but he referred her to an article in the Jour-
to recommend that Prairie Home Stores ÔÇťgo publicÔÇŁÔÇ”and be-
nal of Finance indicating that investors in rural supermarket
fore that decision he had to know what the company was worth.
chains, with risks similar to Prairie Home Stores, expected to earn
The next morning he rode thoughtfully to work. He left his
about 11 percent on average.
horse at the south corral and ambled down the dusty street to
452 SECTION FOUR
relative risks, at least in industries they are used to, but not about absolute risk or re-
quired rates of return. Therefore, they set a company- or industrywide cost of capital as
a benchmark. This is not the right hurdle rate for everything the company does, but
judgmental adjustments can be made for more risky or less risky ventures.
SOME COMMON MISTAKES
One danger with the weighted-average formula is that it tempts people to make logical
errors. Think back to your estimate of the cost of capital for Big Oil:
[ ]( )
├— (1 ÔÇ“ Tc)rdebt + ├— requity
= [.243 ├— (1 ÔÇ“ .35) 9%] + (.757 ├— 13.5%) = 11.6%
Now you might be tempted to say to yourself, ÔÇťAha! Big Oil has a good credit rating. It
could easily push up its debt ratio to 50 percent. If the interest rate is 9 percent and the
required return on equity is 13.5 percent, the weighted-average cost of capital would be
WACC = [.50 ├— (1 ÔÇ“ .35) 9%] + (.50 ├— 13.5%) = 9.7%
At a discount rate of 9.7 percent, we can justify a lot more investment.ÔÇŁ
That reasoning will get you into trouble. First, if Big Oil increased its borrowing, the
lenders would almost certainly demand a higher rate of interest on the debt. Second, as
the borrowing increased, the risk of the common stock would also increase and there-
fore the stockholders would demand a higher return.
There are actually two costs of debt finance. The explicit cost of debt is the
rate of interest that bondholders demand. But there is also an implicit cost,
because borrowing increases the required return to equity.
When you jumped to the conclusion that Big Oil could lower its weighted-average cost
of capital to 9.7 percent by borrowing more, you were recognizing only the explicit cost
of debt and not the implicit cost.
Jo Ann CoxÔÇ™s boss has pointed out that Geothermal proposes to finance its expansion
entirely by borrowing at an interest rate of 8 percent. He argues that this is therefore the
appropriate discount rate for the projectÔÇ™s cash flows. Is he right?
HOW CHANGING CAPITAL STRUCTURE
AFFECTS EXPECTED RETURNS
We will illustrate how changes in capital structure affect expected returns by focusing
on the simplest possible case, where the corporate tax rate Tc is zero.
Think back to our earlier example of Geothermal. Geothermal, you may remember,
has the following market-value balance sheet:
Assets Liabilities and ShareholdersÔÇ™ Equity
Assets = value of GeothermalÔÇ™s $647 Debt $194 (30%)
Equity $453 (70%)
Total value $647 Value $647 (100%)
The Cost of Capital 453
GeothermalÔÇ™s debtholders require a return of 8 percent and the shareholders require a
return of 14 percent. Since we assume here that Geothermal pays no corporate tax, its
weighted-average cost of capital is simply the expected return on the firmÔÇ™s assets:
WACC = rassets = (.3 ├— 8%) + (.7 ├— 14%) = 12.2%
This is the return you would expect if you held all GeothermalÔÇ™s securities and therefore
owned all its assets.
Now think what will happen if Geothermal borrows an additional $97 million and
uses the cash to buy back and retire $97 million of its common stock. The revised mar-
ket-value balance sheet is
Assets Liabilities and ShareholdersÔÇ™ Equity
Assets = value of GeothermalÔÇ™s $647 Debt $291 (45%)
Equity 356 (55%)
Total value $647 Value $647 (100%)
If there are no corporate taxes, the change in capital structure does not affect the total
cash that Geothermal pays out to its security holders and it does not affect the risk of
those cash flows. Therefore, if investors require a return of 12.2 percent on the total
package of debt and equity before the financing, they must require the same 12.2
percent return on the package afterward. The weighted-average cost of capital is there-
fore unaffected by the change in the capital structure.
Although the required return on the package of the debt and equity is unaffected, the
change in capital structure does affect the required return on the individual securities.
Since the company has more debt than before, the debt is riskier and debtholders are
likely to demand a higher return. Increasing the amount of debt also makes the equity
riskier and increases the return that shareholders require.
WHAT HAPPENS WHEN THE CORPORATE
TAX RATE IS NOT ZERO
We have shown that when there are no corporate taxes the weighted-average cost of cap-
ital is unaffected by a change in capital structure. Unfortunately, taxes can complicate
the picture.7 For the moment, just remember
ÔÇó The weighted-average cost of capital is the right discount rate for average-
risk capital investment projects.
ÔÇó The weighted-average cost of capital is the return the company needs to
earn after tax in order to satisfy all its security holders.
ÔÇó If the firm increases its debt ratio, both the debt and the equity will
become more risky. The debtholders and equity holders require a higher
return to compensate for the increased risk.
7 ThereÔÇ™snothing wrong with our formulas and examples, provided that the tax deductibility of interest pay-
ments doesnÔÇ™t change the aggregate risk of the debt and equity investors. However, if the tax savings from
deducting interest are treated as safe cash flows, the formulas get more complicated. If you really want to dive
into the tax-adjusted formulas showing how WACC changes with capital structure, we suggest later
in R. A. Brealey and S. C. Myers, Principles of Corporate Finance, 6th ed. (New York: Irwin/McGraw-Hill,
454 SECTION FOUR
Flotation Costs and the Cost of Capital
To raise the necessary cash for a new project, the firm may need to issue stocks, bonds,
or other securities. The costs of issuing these securities to the public can easily amount
to 5 percent of funds raised. For example, a firm issuing $100 million in new equity
may net only $95 million after incurring the costs of the issue.
Flotation costs involve real money. A new project is less attractive if the firm must
spend large sums on issuing new securities. To illustrate, consider a project that will
cost $900,000 to install and is expected to generate a level perpetual cash-flow stream
of $90,000 a year. At a required rate of return of 10 percent, the project is just barely
viable, with an NPV of zero: ÔÇ“$900,000 + $90,000/.10 = 0.
Now suppose that the firm needs to raise equity to pay for the project, and that
flotation costs are 10 percent of funds raised. To raise $900,000, the firm actually
must sell $1 million of equity. Since the installed project will be worth only $90,000/.10
= $900,000, NPV including flotation costs is actually ÔÇ“$1 million + $900,000 =
In our example, we recognized flotation costs as one of the incremental costs of un-
dertaking the project. But instead of recognizing these costs explicitly, some companies
attempt to cope with flotation costs by increasing the cost of capital used to discount
project cash flows. By using a higher discount rate, project present value is reduced.
This procedure is flawed on practical as well as theoretical grounds. First, on a
purely practical level, it is far easier to account for flotation costs as a negative cash
flow than to search for an adjustment to the discount rate that will give the right NPV.
Finding the necessary adjustment is easy only when cash flows are level or will grow
indefinitely at a constant trend rate. This is almost never the case in practice, however.
Of course, there always exists some discount rate that will give the right measure of the
projectÔÇ™s NPV, but this rate could no longer be interpreted as the rate of return available
in the capital market for investments with the same risk as the project.
The cost of capital depends only on interest rates, taxes, and the risk of the
project. Flotation costs should be treated as incremental (negative) cash flows;
they do not increase the required rate of return.
Why do firms compute weighted-average costs of capital?
They need a standard discount rate for average-risk projects. An ÔÇťaverage-riskÔÇŁ project is
one that has the same risk as the firmÔÇ™s existing assets and operations.
What about projects that are not average?
The weighted-average cost of capital can still be used as a benchmark. The benchmark is
adjusted up for unusually risky projects and down for unusually safe ones.
How do firms compute weighted-average costs of capital?
HereÔÇ™s the WACC formula one more time:
The Cost of Capital 455
WACC = rdebt ├— (1 ÔÇ“ Tc) ├— D/V + requity ├— E/V
The WACC is the expected rate of return on the portfolio of debt and equity securities
issued by the firm. The required rate of return on each security is weighted by its proportion
of the firmÔÇ™s total market value (not book value). Since interest payments reduce the firmÔÇ™s
income tax bill, the required rate of return on debt is measured after tax, as rdebt ├— (1 ÔÇ“ Tc).
This WACC formula is usually written assuming the firmÔÇ™s capital structure includes just
two classes of securities, debt and equity. If there is another class, say preferred stock, the
formula expands to include it. In other words, we would estimate rpreferred, the rate of return
demanded by preferred stockholders, determine P/V the fraction of market value accounted
for by preferred, and add rpreferred ├— P/V to the equation. Of course the weights in the WACC
formula always add up to 1.0. In this case D/V + P/V + E/V = 1.0.
How are the costs of debt and equity calculated?
The cost of debt (rdebt) is the market interest rate demanded by bondholders. In other words,
it is the rate that the company would pay on new debt issued to finance its investment
projects. The cost of preferred (rpreferred) is just the preferred dividend divided by the market
price of a preferred share.
The tricky part is estimating the cost of equity (requity), the expected rate of return on the
firmÔÇ™s shares. Financial managers use the capital asset pricing model to estimate expected
return. But for mature, steady-growth companies, it can also make sense to use the constant-
growth dividend discount model. Remember, estimates of expected return are less reliable
for a single firmÔÇ™s stock than for a sample of comparable-risk firms. Therefore, some
managers also consider WACCs calculated for industries.
What happens when capital structure changes?
The rates of return on debt and equity will change. For example, increasing the debt ratio
will increase the risk borne by both debt and equity investors and cause them to demand
higher returns. However, this does not necessarily mean that the overall WACC will
increase, because more weight is put on the cost of debt, which is less than the cost of
equity. In fact, if we ignore taxes, the overall cost of capital will stay constant as the
fractions of debt and equity change.
Should WACC be adjusted for the costs of issuing securities to finance a project?
No. If acceptance of a project would require the firm to issue securities, the flotation costs
of the issue should be added to the investment required for the project. This reduces project
NPV dollar for dollar. There is no need to adjust WACC.
www.geocities.com/WallStreet/Market/1839/irates.html Incorporating risk premiums into the
Related Web cost of capital
Links www.financeadvisor.com/coc.htm Another approach to calculating cost of capital
capital structure weighted-average cost of capital (WACC)
1. Cost of Debt. Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon
Quiz rate of 9 percent, paid annually. Today, the debt is selling at $1,050. If the firmÔÇ™s tax bracket
is 35 percent, what is its after-tax cost of debt?
456 SECTION FOUR
2. Cost of Preferred Stock. Micro Spinoffs also has preferred stock outstanding. The stock
pays a dividend of $4 per share, and the stock sells for $40. What is the cost of preferred
3. Calculating WACC. Suppose Micro SpinoffsÔÇ™s cost of equity is 12.5 percent. What is its
WACC if equity is 50 percent, preferred stock is 20 percent, and debt is 30 percent of total
4. Cost of Equity. Reliable Electric is a regulated public utility, and it is expected to provide
steady growth of dividends of 5 percent per year for the indefinite future. Its last dividend
was $5 per share; the stock sold for $60 per share just after the dividend was paid. What is
the companyÔÇ™s cost of equity?
5. Calculating WACC. Reactive Industries has the following capital structure. Its corporate tax
rate is 35 percent. What is its WACC?
Security Market Value Required Rate of Return
Debt $20 million 8%
Preferred stock $10 million 10%