COST OF CAPITAL

COMPANY
ISSUANCE OF
NEW STOCK
PROJECT

MONEY or RETAINING
CAPITAL EANINGS

PREFERRED COMMON
DEBT
STOCK EQUITY
 Capital debtholders
investors bondholders
stockholders Equity Debt
Sale of bonds
owners
Cost of equity Borrowing cost bank loans

Required rate of return

Interest cost
 RATE OF RETURN
OR INTEREST COST

COST

COST OF CAPITAL
 COST OF CAPITAL

COST OF CAPITAL
▪ rate of return
▪ “magic number”
▪ guideline
▪ price paid to the investor or cost of a
company's fund
 LONG TERM SOURCES OF FUNDS
Cost

LONG TERM PREFERRED COMMON RETAINED

DEBT STOCK STOCK EARNINGS

WEIGHTED AVERAGE COST OF CAPITAL

(WACC)
Best project available today Best project available 1 week later
Least costly financing source Least costly financing source
available available
Cost = $100,000 Cost = $100,000
Life = 20 years Life = 20 years
Expected Return = 7% Expected Return = 12%
Debt = 6% Equity = 14%
TARGET CAPITAL STRUCTURE

CAPITAL STRUCTURE

DEBT = 40% DEBT = 60%

COMMON EQUITY = 60% COMMON EQUITY = 30%
PREFERRED EQUITY = 10%
OPTIMAL CAPITAL STRUCTURE

“A proportion which can minimize the cost of

capital and maximize the value of the firm.”
 ACCEPT REJECT
Best project available today Best project available 1 week later
Least costly financing source Least costly financing source
available available
Cost = $100,000 Cost = $100,000
Life = 20 years Life = 20 years
Expected Return = 7% Expected Return = 12%
Debt = 6% Equity = 14%

Were the firms action in the best

interests of its owners?
 COMBINED COST OF FINANCING
Assuming a 50-50 mix of debt and equity
WACC = (.50 * 6% DEBT) + (.50 * 14% EQUITY)
The weighted average cost would be 10%

FIRST OPPORTUNITY SECOND OPPORTUNITY

EXPECTED RETURN = 7% EXPECTED RETURN = 12%

Vs. Vs.
WACC = 10% WACC = 10%
Allied Food Products: Capital structure used to calculate the WACC (Weighted Average Cost of Capital)
All Liabilities Actual Investor-Supplied Target Capital
REGULAR BALANCE SHEET: at 12/31/08 and Equity Capital Structure
Cash 10 Accounts Payable 60 3%
Receivables 375 Accruals 140 7
Inventories 615 Spontaneous debt 200 10
Total C.A 1000 Notes Payable 110 5.5 110
Total C.L. 310 15.5
Long term debt 750 37.5 750
Net Fixed Asset 1000 Total debt 1060 53.0 860 47.8% 45.0%
Preferred Stock 0 0 0 0 2.0%
Common Stock 130 6.5 130
Retained Earnings 810 40.5 810
Total Equity 940 47.0% 940 52.2% 53.0%

Total 2000 Total 2000 100% 1800 100% 100%

COST OF CAPITAL