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Part

4
Long-Term
Financial
Decisions

Chapter 10
The Cost of Capital

Chapter 11
Leverage
and Capital Structure

Chapter 12
Dividend Policy
Chapter Across the Disciplines


10
Why This Chapter Matters To You
Accounting: You need to understand the
various sources of capital and how their
costs are calculated in order to provide
data used in determining the firm’s overall
cost of capital.

The Cost Information systems: You need to under-
stand the various sources of capital and
how their costs are calculated in order to
of Capital develop systems that will estimate the
costs of those sources of capital, as well
as the overall cost of capital.
Management: You need to understand
the cost of capital in order to assess the
acceptability and relative rankings of pro-
posed long-term investments.
Marketing: You need to understand what
the firm’s cost of capital is because pro-
posed projects will face rejection if their
promised returns are less than the firm’s
LEARNING GOALS cost of capital.
Understand the key assumptions that Operations: You need to understand the
LG1
underlie cost of capital, the basic con- cost of capital in order to assess the eco-
cept of cost of capital, and the spe- nomic viability of investments in plant and
cific sources of capital that it includes. equipment needed to improve or expand
the firm’s capacity.
Determine the cost of long-term debt
LG2
and the cost of preferred stock.
Calculate the cost of common stock
LG3
equity and convert it into the cost of
retained earnings and the cost of new
issues of common stock.
Calculate the weighted average cost
LG4
of capital (WACC) and discuss the
alternative weighting schemes.
Describe the procedures used to de-
LG5
termine break points and the weighted
marginal cost of capital (WMCC).
Explain how the weighted marginal
LG6
cost of capital (WMCC) can be used
with the investment opportunities
schedule (IOS) to make the firm’s
financing/investment decisions.

388
389
CHAPTER 10 The Cost of Capital



T he cost of capital is used to select capital investments that increase share-
holder value. In applying the net present value and internal rate of return
techniques in Chapter 9, we simply assumed a reasonable cost of capital. Now we
will demonstrate how the cost of capital is calculated. This chapter considers the
costs of long-term debt, preferred stock, common stock, and retained earnings
and shows how to combine them to determine cost of capital measures the firm
will use in making long-term financing/investment decisions.



An Overview of the Cost of Capital
LG1

The cost of capital is the rate of return that a firm must earn on the projects in
cost of capital
The rate of return that a firm must which it invests to maintain the market value of its stock. It can also be thought
earn on the projects in which it
of as the rate of return required by the market suppliers of capital to attract their
invests to maintain its market
funds to the firm. If risk is held constant, projects with a rate of return above the
value and attract funds.
cost of capital will increase the value of the firm, and projects with a rate of
return below the cost of capital will decrease the value of the firm.
The cost of capital is an extremely important financial concept. It acts as a
major link between the firm’s long-term investment decisions (discussed in Part
3) and the wealth of the owners as determined by investors in the marketplace. It
is in effect the “magic number” that is used to decide whether a proposed corpo-
rate investment will increase or decrease the firm’s stock price. Clearly, only
those investments that are expected to increase stock price (NPV $0, or IRR
cost of capital) would be recommended. Because of its key role in financial deci-
sion making, the importance of the cost of capital cannot be overemphasized.


Some Key Assumptions
The cost of capital is a dynamic concept affected by a variety of economic and
firm-specific factors. To isolate the basic structure of the cost of capital, we make
some key assumptions relative to risk and taxes:
1. Business risk—the risk to the firm of being unable to cover operating costs—
business risk
The risk to the firm of being is assumed to be unchanged. This assumption means that the firm’s accep-
unable to cover operating costs.
tance of a given project does not affect its ability to meet operating costs.
2. Financial risk—the risk to the firm of being unable to cover required financial
financial risk
The risk to the firm of being obligations (interest, lease payments, preferred stock dividends)—is assumed
unable to cover required
to be unchanged. This assumption means that projects are financed in such a
financial obligations (interest,
way that the firm’s ability to meet required financing costs is unchanged.
lease payments, preferred stock
3. After-tax costs are considered relevant. In other words, the cost of capital is
dividends).
measured on an after-tax basis. This assumption is consistent with the frame-
work used to make capital budgeting decisions.


The Basic Concept
The cost of capital is estimated at a given point in time. It reflects the expected aver-
age future cost of funds over the long run. Although firms typically raise money in
lumps, the cost of capital should reflect the interrelatedness of financing activities.
For example, if a firm raises funds with debt (borrowing) today, it is likely that
390 PART 4 Long-Term Financial Decisions


some form of equity, such as common stock, will have to be used the next time it
needs funds. Most firms attempt to maintain a desired optimal mix of debt and
equity financing. This mix is commonly called a target capital structure—a topic
target capital structure
The desired optimal mix of debt that will be addressed in Chapter 11. Here, it is sufficient to say that although firms
and equity financing that most raise money in lumps, they tend toward some desired mix of financing.
firms attempt to maintain.
To capture the interrelatedness of financing assuming the presence of a target
capital structure, we need to look at the overall cost of capital rather than the
cost of the specific source of funds used to finance a given expenditure.

A firm is currently faced with an investment opportunity. Assume the following:
EXAMPLE
Best project available today
Cost $100,000
Life 20 years
IRR 7%
Cost of least-cost financing source available
Debt 6%
Because it can earn 7% on the investment of funds costing only 6%, the firm
undertakes the opportunity. Imagine that 1 week later a new investment opportu-
nity is available:
Best project available 1 week later
Cost $100,000
Life 20 years
IRR 12%
Cost of least-cost financing source available
Equity 14%
In this instance, the firm rejects the opportunity, because the 14% financing cost
is greater than the 12% expected return.
Were the firm’s actions in the best interests of its owners? No; it accepted a
project yielding a 7% return and rejected one with a 12% return. Clearly, there
should be a better way, and there is: The firm can use a combined cost, which
over the long run will yield better decisions. By weighting the cost of each source
of financing by its target proportion in the firm’s capital structure, the firm can
obtain a weighted average cost that reflects the interrelationship of financing
decisions. Assuming that a 50–50 mix of debt and equity is targeted, the weighted
average cost here would be 10% [(0.50 6% debt) (0.50 14% equity)]. With
this cost, the first opportunity would have been rejected (7% IRR 10%
weighted average cost), and the second would have been accepted (12% IRR
10% weighted average cost). Such an outcome would clearly be more desirable.


The Cost of Specific Sources of Capital
This chapter focuses on finding the costs of specific sources of capital and com-
bining them to determine the weighted average cost of capital. Our concern is
only with the long-term sources of funds available to a business firm, because
391
CHAPTER 10 The Cost of Capital


these sources supply the permanent financing. Long-term financing supports the
firm’s fixed-asset investments.1 We assume throughout the chapter that such
investments are selected by using appropriate capital budgeting techniques.
There are four basic sources of long-term funds for the business firm: long-
term debt, preferred stock, common stock, and retained earnings. The right-hand
side of a balance sheet can be used to illustrate these sources:


Balance Sheet

Current liabilities

Long-term debt


Assets Stockholders’ equity
Sources of
Preferred stock
long-term funds
Common stock equity
Common stock
Retained earnings



Although not every firm will use all of these methods of financing, each firm is
expected to have funds from some of these sources in its capital structure.
The specific cost of each source of financing is the after-tax cost of obtaining
the financing today, not the historically based cost reflected by the existing financ-
ing on the firm’s books. Techniques for determining the specific cost of each
source of long-term funds are presented on the following pages. Although these
techniques tend to develop precisely calculated values, the resulting values are at
best rough approximations because of the numerous assumptions and forecasts
that underlie them. Although we round calculated costs to the nearest 0.1 percent
throughout this chapter, it is not unusual for practicing financial managers to use
costs rounded to the nearest 1 percent because these values are merely estimates.


Review Questions

10–1 What is the cost of capital? What role does it play in long-term investment
decisions?
10–2 Why do we assume that business risk and financial risk are unchanged
when evaluating the cost of capital? Discuss the implications of these
assumptions on the acceptance and financing of new projects.
10–3 Why is the cost of capital measured on an after-tax basis? Why is use of a
weighted average cost of capital rather than the cost of the specific source
of funds recommended?
10–4 You have just been told, “Because we are going to finance this project
with debt, its required rate of return must exceed the cost of debt.” Do
you agree or disagree? Explain.


1. The role of both long-term and short-term financing in supporting both fixed and current asset investments is
addressed in Chapter 13. Suffice it to say that long-term funds are at a minimum used to finance fixed assets.
392 PART 4 Long-Term Financial Decisions


The Cost of Long-Term Debt
LG2

The cost of long-term debt, ki, is the after-tax cost today of raising long-term
cost of long-term debt, ki
The after-tax cost today of funds through borrowing. For convenience, we typically assume that the funds are
raising long-term funds through raised through the sale of bonds. In addition, as we did in Chapter 6, we assume
borrowing.
that the bonds pay annual (rather than semiannual) interest.


Net Proceeds
Most corporate long-term debts are incurred through the sale of bonds. The net
proceeds from the sale of a bond, or any security, are the funds that are actually
net proceeds
Funds actually received from the received from the sale. Flotation costs—the total costs of issuing and selling a
sale of a security.
security—reduce the net proceeds from the sale. These costs apply to all public
offerings of securities—debt, preferred stock, and common stock. They include
flotation costs
two components: (1) underwriting costs—compensation earned by investment
The total costs of issuing and
selling a security. bankers for selling the security, and (2) administrative costs—issuer expenses
such as legal, accounting, printing, and other expenses.

Duchess Corporation, a major hardware manufacturer, is contemplating selling
EXAMPLE
$10 million worth of 20-year, 9% coupon (stated annual interest rate) bonds,
each with a par value of $1,000. Because similar-risk bonds earn returns greater
than 9%, the firm must sell the bonds for $980 to compensate for the lower
coupon interest rate. The flotation costs are 2% of the par value of the bond
(0.02 $1,000), or $20. The net proceeds to the firm from the sale of each bond
are therefore $960 ($980 $20).


Before-Tax Cost of Debt
The before-tax cost of debt, kd, for a bond can be obtained in any of three ways:
quotation, calculation, or approximation.

Using Cost Quotations
When the net proceeds from sale of a bond equal its par value, the before-tax cost
just equals the coupon interest rate. For example, a bond with a 10 percent
coupon interest rate that nets proceeds equal to the bond’s $1,000 par value
would have a before-tax cost, kd, of 10 percent.
A second quotation that is sometimes used is the yield to maturity (YTM) on
a similar-risk bond2 (see Chapter 6). For example, if a similar-risk bond has a
YTM of 9.7 percent, this value can be used as the before-tax cost of debt, kd.

Calculating the Cost
This approach finds the before-tax cost of debt by calculating the internal rate of
return (IRR) on the bond cash flows. From the issuer’s point of view, this value
is the cost to maturity of the cash flows associated with the debt. The cost to


2. Generally, the yield to maturity of bonds with a similar “rating” is used. Bond ratings, which are published by
independent agencies, were discussed in Chapter 6.
393
CHAPTER 10 The Cost of Capital



In Practice
FOCUS ON e-FINANCE Sold to the Lowest Bidder
In August 2000, Dow Chemical The interest rate on the issue was announced that it would use Open-
became the first industrial corpo- similar to what Dow would have Book for eight auctions. So far,
ration to price and distribute bonds paid using the traditional syndica- most major investment bankers
online. WR Hambrecht Co., a tion process, but the underwriting have resisted endorsing a method
pioneer in online equity IPOs, con- fee was over 50 percent lower. “To that would undercut their more
ducted the 2-hour Dutch auction at me, it’s a no-brainer,” said Dow lucrative traditional underwriting
its OpenBook auction Web site. In treasurer Geoffery Merszei. business. However, both propo-
a Dutch auction (long used to price In the future, market watch- nents and opponents of online
and sell Treasury bonds), investors ers expect Internet auctions to Dutch auctions of corporate debt
place bids to buy a particular lower issuance costs for debt cap- believe that this method works
amount of a security at a specific ital through more efficient pricing best for large, standard-issue
price within a spread set by the that reflects market demand. All bonds from investment-grade
issuer before the auction. The bidders have equal access to issuers.
underwriter accepts the lowest securities, and investors can see a
Sources: Adapted from Shella Calamba,
price at which there is enough real-time, fully visible demand “Wall St. Ignores Online Bond Deals
demand to sell all the bonds curve for a bond issue as it at Its Peril,” Dow Jones Newswires
(August 18, 2000), downloaded from www.
offered (the clearing price). unfolds, resulting in improved dis-
wrhambrecht.com/inst/openbook/media.
Investors who bid that price or tribution and enhanced liquidity. html; Emily S. Plishner, “E-bonds: Will
higher get their requested alloca- Despite Dow’s success, few They Fly?” CFO (March 1, 2001); and
“WR Hambrecht Co’s Core Technology to
tions at the clearing price. corporations have followed it Support the First Dutch Auction of Freddie
Dow’s open bond auction of online. Ford Motor Credit issued Mac Two- and Three-Year Reference
Notes,” press release from WR
$300 million in 5-year bonds was $750 million of 3-year notes in
Hambrecht Co. (February 8, 2001), down-
well received, attracting a broader March 2001. In February 2001, gov- loaded from www.wrhambrecht.com/inst/
investor base that could reduce ernment-sponsored residential openbook/media.html.
volatility in the secondary market. mortgage agency Freddie Mac




maturity can be calculated by using either a trial-and-error technique3 or a finan-
cial calculator. It represents the annual before-tax percentage cost of the debt.

In the preceding example, the net proceeds of a $1,000, 9% coupon interest rate,
EXAMPLE
20-year bond were found to be $960. The calculation of the annual cost is quite
simple. The cash flow pattern is exactly the opposite of a conventional pattern; it
consists of an initial inflow (the net proceeds) followed by a series of annual out-
lays (the interest payments). In the final year, when the debt is retired, an outlay
representing the repayment of the principal also occurs. The cash flows associ-
ated with Duchess Corporation’s bond issue are as follows:


End of year(s) Cash flow

0 $ 960
1–20 $ 90
20 $1,000



WW
W
3. The trial-and-error technique is presented at the book’s Web site, www.aw.com/gitman.
394 PART 4 Long-Term Financial Decisions


The initial $960 inflow is followed by annual interest outflows of $90 (9%
Input Function
coupon interest rate $1,000 par value) over the 20-year life of the bond. In year
N
20
20, an outflow of $1,000 (the repayment of the principal) occurs. We can deter-
960 PV
mine the cost of debt by finding the IRR, which is the discount rate that equates
90 PMT
the present value of the outflows to the initial inflow.
1000 FV
CPT Calculator Use [Note: Most calculators require either the present (net proceeds)
or the future (annual interest payments and repayment of principal) values to be
I
input as negative numbers when we calculate cost to maturity. That approach is
Solution
used here.] Using the calculator and the inputs shown at the left, you should find
9.452
the before-tax cost (cost to maturity) to be 9.452%.

Approximating the Cost
The before-tax cost of debt, kd, for a bond with a $1,000 par value can be
approximated by using the following equation:
$1,000 Nd
I
n
kd (10.1)
Nd $1,000
2
where

I annual interest in dollars
Nd net proceeds from the sale of debt (bond)
n number of years to the bond’s maturity

Substituting the appropriate values from the Duchess Corporation example into
EXAMPLE
the approximation formula given in Equation 10.1, we get
$1,000 $960
I
20 $90 2
kd
$980
$960 $1,000
2

$92
9.4%
$980
This approximate before-tax cost of debt is close to the 9.452% value calculated
precisely in the preceding example.



After-Tax Cost of Debt
However, as indicated earlier, the specific cost of financing must be stated on
an after-tax basis. Because interest on debt is tax deductible, it reduces the
firm’s taxable income. The after-tax cost of debt, ki, can be found by multiply-
ing the before-tax cost, kd, by 1 minus the tax rate, T, as stated in the following
equation:
ki kd (1 T) (10.2)
395
CHAPTER 10 The Cost of Capital


Duchess Corporation has a 40% tax rate. Using the 9.4% before-tax debt cost
EXAMPLE
calculated above, and applying Equation 10.2, we find an after-tax cost of debt
of 5.6% [9.4% (1 0.40)]. Typically, the explicit cost of long-term debt is less
than the explicit cost of any of the alternative forms of long-term financing, pri-
marily because of the tax deductibility of interest.


Review Questions

10–5 What are the net proceeds from the sale of a bond? What are flotation
costs and how do they affect a bond’s net proceeds?
10–6 What three methods can be used to find the before-tax cost of debt?
10–7 How is the before-tax cost of debt converted into the after-tax cost?



The Cost of Preferred Stock
LG2


Preferred stock represents a special type of ownership interest in the firm. It gives
preferred stockholders the right to receive their stated dividends before any earn-
ings can be distributed to common stockholders. Because preferred stock is a form
of ownership, the proceeds from its sale are expected to be held for an infinite
period of time. The key characteristics of preferred stock were described in Chap-
ter 7. However, the one aspect of preferred stock that requires review is dividends.



Preferred Stock Dividends
Most preferred stock dividends are stated as a dollar amount: “x dollars per
year.” When dividends are stated this way, the stock is often referred to as “x-
dollar preferred stock.” Thus a “$4 preferred stock” is expected to pay preferred
stockholders $4 in dividends each year on each share of preferred stock owned.
Sometimes preferred stock dividends are stated as an annual percentage rate.
This rate represents the percentage of the stock’s par value, or face value, that
equals the annual dividend. For instance, an 8 percent preferred stock with a $50
par value would be expected to pay an annual dividend of $4 a share (0.08 $50
par $4). Before the cost of preferred stock is calculated, any dividends stated as
percentages should be converted to annual dollar dividends.



Calculating the Cost of Preferred Stock
The cost of preferred stock, kp, is the ratio of the preferred stock dividend to the
cost of preferred stock, kp
The ratio of the preferred stock firm’s net proceeds from the sale of the preferred stock. The net proceeds repre-
dividend to the firm’s net
sents the amount of money to be received minus any flotation costs. Equation
proceeds from the sale of
10.3 gives the cost of preferred stock, kp, in terms of the annual dollar dividend,
preferred stock; calculated by
Dp, and the net proceeds from the sale of the stock, Np:
dividing the annual dividend, Dp ,
by the net proceeds from the sale
Dp
of the preferred stock, Np. kp (10.3)
Np
396 PART 4 Long-Term Financial Decisions


Because preferred stock dividends are paid out of the firm’s after-tax cash flows,
a tax adjustment is not required.

Duchess Corporation is contemplating issuance of a 10% preferred stock that is
EXAMPLE
expected to sell for its $87-per-share par value. The cost of issuing and selling the
stock is expected to be $5 per share. The first step in finding the cost of the stock
is to calculate the dollar amount of the annual preferred dividend, which is $8.70
(0.10 $87). The net proceeds per share from the proposed sale of stock equals
the sale price minus the flotation costs ($87 $5 $82). Substituting the annual
dividend, Dp, of $8.70 and the net proceeds, Np, of $82 into Equation 10.3 gives
the cost of preferred stock, 10.6% ($8.70 $82).

The cost of Duchess’s preferred stock (10.6%) is much greater than the cost
of its long-term debt (5.6%). This difference exists primarily because the cost of
long-term debt (the interest) is tax deductible.



Review Question

10–8 How would you calculate the cost of preferred stock?




The Cost of Common Stock
LG3


The cost of common stock is the return required on the stock by investors in the
marketplace. There are two forms of common stock financing: (1) retained earn-
ings and (2) new issues of common stock. As a first step in finding each of these
costs, we must estimate the cost of common stock equity.



Finding the Cost of Common Stock Equity
The cost of common stock equity, ks, is the rate at which investors discount the
cost of common stock equity, ks
The rate at which investors expected dividends of the firm to determine its share value. Two techniques are
discount the expected dividends used to measure the cost of common stock equity. One relies on the constant-
of the firm to determine its share
growth valuation model, the other on the capital asset pricing model (CAPM).
value.


Using the Constant-Growth Valuation
(Gordon) Model
In Chapter 7 we found the value of a share of stock to be equal to the present value
constant-growth
of all future dividends, which in one model were assumed to grow at a constant
valuation (Gordon) model
annual rate over an infinite time horizon. This is the constant-growth valuation
Assumes that the value of a share
model, also known as the Gordon model. The key expression derived for this
of stock equals the present value
of all future dividends (assumed model was presented as Equation 7.4 and is restated here:
to grow at a constant rate) that it
is expected to provide over an D1
P0 (10.4)
infinite time horizon.
ks g
397
CHAPTER 10 The Cost of Capital


where
P0 value of common stock
D1 per-share dividend expected at the end of year 1
ks required return on common stock
g constant rate of growth in dividends
Solving Equation 10.4 for ks results in the following expression for the cost
of common stock equity:
D1
ks g (10.5)
P0
Equation 10.5 indicates that the cost of common stock equity can be found by
dividing the dividend expected at the end of year 1 by the current price of the
stock and adding the expected growth rate. Because common stock dividends are
paid from after-tax income, no tax adjustment is required.

Duchess Corporation wishes to determine its cost of common stock equity, ks.
EXAMPLE
The market price, P0, of its common stock is $50 per share. The firm expects to
pay a dividend, D1, of $4 at the end of the coming year, 2004. The dividends paid
on the outstanding stock over the past 6 years (1998–2003) were as follows:


Year Dividend

2003 $3.80
2002 3.62
2001 3.47
2000 3.33
1999 3.12
1998 2.97


Using the table for the present value interest factors, PVIF (Table A–2), or a finan-
cial calculator in conjunction with the technique described for finding growth
rates in Chapter 4, we can calculate the annual growth rate of dividends, g. It turns
out to be approximately 5% (more precisely, it is 5.05%). Substituting D1 $4,
P0 $50, and g 5% into Equation 10.5 yields the cost of common stock equity:
$4
ks 0.05 0.08 0.05 0.130, or 13.0%
$50
The 13.0% cost of common stock equity represents the return required by exist-
ing shareholders on their investment. If the actual return is less than that, share-
holders are likely to begin selling their stock.

Using the Capital Asset Pricing Model (CAPM)
capital asset pricing model
Recall from Chapter 5 that the capital asset pricing model (CAPM) describes the
(CAPM)
Describes the relationship relationship between the required return, ks, and the nondiversifiable risk of the
between the required return, ks,
firm as measured by the beta coefficient, b. The basic CAPM is
and the nondiversifiable risk of
the firm as measured by the beta
ks RF [b (km RF)] (10.6)
coefficient, b.
398 PART 4 Long-Term Financial Decisions


where

RF risk-free rate of return
km market return; return on the market portfolio of assets

Using CAPM indicates that the cost of common stock equity is the return
required by investors as compensation for the firm’s nondiversifiable risk, mea-
sured by beta.

Duchess Corporation now wishes to calculate its cost of common stock equity,
EXAMPLE
ks, by using the capital asset pricing model. The firm’s investment advisers and
its own analyses indicate that the risk-free rate, RF, equals 7%; the firm’s beta,
b, equals 1.5; and the market return, km, equals 11%. Substituting these values
into Equation 10.6, the company estimates the cost of common stock equity, ks,
to be
ks 7.0% [1.5 (11.0% 7.0%)] 7.0% 6.0% 13.0%
The 13.0% cost of common stock equity represents the required return of investors
in Duchess Corporation common stock. It is the same as that found by using the
constant-growth valuation model.



The Cost of Retained Earnings
As you know, dividends are paid out of a firm’s earnings. Their payment, made
in cash to common stockholders, reduces the firm’s retained earnings. Let’s say a
firm needs common stock equity financing of a certain amount; it has two
choices relative to retained earnings: It can issue additional common stock in
that amount and still pay dividends to stockholders out of retained earnings. Or
it can increase common stock equity by retaining the earnings (not paying the
cash dividends) in the needed amount. In a strict accounting sense, the retention
of earnings increases common stock equity in the same way that the sale of addi-
tional shares of common stock does. Thus the cost of retained earnings, kr , to
cost of retained earnings, kr
The same as the cost of an the firm is the same as the cost of an equivalent fully subscribed issue of addi-
equivalent fully subscribed issue
tional common stock. Stockholders find the firm’s retention of earnings accept-
of additional common stock,
able only if they expect that it will earn at least their required return on the rein-
which is equal to the cost of
vested funds.
common stock equity, ks.
Viewing retained earnings as a fully subscribed issue of additional common
stock, we can set the firm’s cost of retained earnings, kr , equal to the cost of com-
mon stock equity as given by Equations 10.5 and 10.6.4
kr ks (10.7)
It is not necessary to adjust the cost of retained earnings for flotation costs, because
by retaining earnings, the firm “raises” equity capital without incurring these costs.


4. Technically, if a stockholder received dividends and wished to invest them in additional shares of the firm’s stock,
he or she would first have to pay personal taxes on the dividends and then pay brokerage fees before acquiring addi-
tional shares. By using pt as the average stockholder’s personal tax rate and bf as the average brokerage fees stated
as a percentage, we can specify the cost of retained earnings, kr, as kr ks (1 pt) (1 bf). Because of the diffi-
culty in estimating pt and bf, only the simpler definition of kr given in Equation 10.7 is used here.
399
CHAPTER 10 The Cost of Capital


The cost of retained earnings for Duchess Corporation was actually calculated in
EXAMPLE
the preceding examples: It is equal to the cost of common stock equity. Thus kr
equals 13.0%. As we will show in the next section, the cost of retained earnings is
always lower than the cost of a new issue of common stock, because it entails no
flotation costs.



The Cost of New Issues of Common Stock
Our purpose in finding the firm’s overall cost of capital is to determine the after-
tax cost of new funds required for financing projects. The cost of a new issue of
cost of a new issue
of common stock, kn common stock, kn, is determined by calculating the cost of common stock, net of
The cost of common stock, net of underpricing and associated flotation costs. Normally, for a new issue to sell, it
underpricing and associated
has to be underpriced—sold at a price below its current market price, P0.
flotation costs.
Firms underprice new issues for a variety of reasons. First, when the market
underpriced is in equilibrium (that is, the demand for shares equals the supply of shares),
Stock sold at a price below its
additional demand for shares can be achieved only at a lower price. Second, when
current market price, P0.
additional shares are issued, each share’s percent of ownership in the firm is
diluted, thereby justifying a lower share value. Finally, many investors view the
issuance of additional shares as a signal that management is using common stock
equity financing because it believes that the shares are currently overpriced. Rec-
ognizing this information, they will buy shares only at a price below the current
market price. Clearly, these and other factors necessitate underpricing of new
offerings of common stock. Flotation costs paid for issuing and selling the new
issue will further reduce proceeds.
We can use the constant-growth valuation model expression for the cost of
existing common stock, ks, as a starting point. If we let Nn represent the net pro-
ceeds from the sale of new common stock after subtracting underpricing and
flotation costs, the cost of the new issue, kn, can be expressed as follows:
D1
kn g (10.8)
Nn
The net proceeds from sale of new common stock, Nn, will be less than the
current market price, P0. Therefore, the cost of new issues, kn, will always be
greater than the cost of existing issues, ks, which is equal to the cost of retained
earnings, kr. The cost of new common stock is normally greater than any other
long-term financing cost. Because common stock dividends are paid from after-
tax cash flows, no tax adjustment is required.

In the constant-growth valuation example, we found Duchess Corporation’s cost
EXAMPLE
of common stock equity, ks, to be 13%, using the following values: an expected
dividend, D1, of $4; a current market price, P0, of $50; and an expected growth
rate of dividends, g, of 5%.
To determine its cost of new common stock, kn, Duchess Corporation has
estimated that on the average, new shares can be sold for $47. The $3-per-share
underpricing is due to the competitive nature of the market. A second cost associ-
ated with a new issue is flotation costs of $2.50 per share that would be paid to
issue and sell the new shares. The total underpricing and flotation costs per share
are therefore expected to be $5.50.
400 PART 4 Long-Term Financial Decisions


Subtracting the $5.50 per share underpricing and flotation cost from the cur-
rent $50 share price results in expected net proceeds of $44.50 per share ($50.00
$5.50). Substituting D1 $4, Nn $44.50, and g 5% into Equation 10.8
results in a cost of new common stock, kn, as follows:
$4.00
kn 0.05 0.09 0.05 0.140, or 14.0%
$44.50
Duchess Corporation’s cost of new common stock is therefore 14.0%. This is the
value to be used in subsequent calculations of the firm’s overall cost of capital.


Review Questions

10–9 What premise about share value underlies the constant-growth valuation
(Gordon) model that is used to measure the cost of common stock
equity, ks?
10–10 Why is the cost of financing a project with retained earnings less than the
cost of financing it with a new issue of common stock?



The Weighted Average Cost of Capital
LG4

Now that we have calculated the cost of specific sources of financing, we can
determine the overall cost of capital. As noted earlier, the weighted average cost
weighted average cost
of capital (WACC), ka of capital (WACC), ka, reflects the expected average future cost of funds over the
Reflects the expected average
long run. It is found by weighting the cost of each specific type of capital by its
future cost of funds over the long
proportion in the firm’s capital structure.
run; found by weighting the cost
of each specific type of capital
by its proportion in the firm’s
Calculating the Weighted Average
capital structure.
Cost of Capital (WACC)
Calculating the weighted average cost of capital (WACC) is straightforward:
Multiply the specific cost of each form of financing by its proportion in the firm’s
capital structure and sum the weighted values. As an equation, the weighted aver-
age cost of capital, ka, can be specified as follows:
ka (wi ki) (wp kp) (ws kr or n) (10.9)
where
wi proportion of long-term debt in capital structure
wp proportion of preferred stock in capital structure
ws proportion of common stock equity in capital structure
wi wp ws 1.0
Three important points should be noted in Equation 10.9:

1. For computational convenience, it is best to convert the weights into decimal
form and leave the specific costs in percentage terms.
401
CHAPTER 10 The Cost of Capital


2. The sum of the weights must equal 1.0. Simply stated, all capital structure
components must be accounted for.
3. The firm’s common stock equity weight, ws, is multiplied by either the cost of
retained earnings, kr , or the cost of new common stock, kn. Which cost is
used depends on whether the firm’s common stock equity will be financed
using retained earnings, kr , or new common stock, kn.

In earlier examples, we found the costs of the various types of capital for Duchess
EXAMPLE
Corporation to be as follows:
Cost of debt, ki 5.6%
Cost of preferred stock, kp 10.6%
Cost of retained earnings, kr 13.0%
Cost of new common stock, kn 14.0%
The company uses the following weights in calculating its weighted average cost
of capital:


Source of capital Weight

Long-term debt 40%
Preferred stock 10
Common stock equity 50
Total 100%



Because the firm expects to have a sizable amount of retained earnings avail-
able ($300,000), it plans to use its cost of retained earnings, kr , as the cost of
common stock equity. Duchess Corporation’s weighted average cost of capital is
calculated in Table 10.1. The resulting weighted average cost of capital for
Duchess is 9.8%. Assuming an unchanged risk level, the firm should accept all
projects that will earn a return greater than 9.8%.




TABLE 10.1 Calculation of the Weighted
Average Cost of Capital for
Duchess Corporation

Weighted cost
Weight Cost [(1) (2)]
Source of capital (1) (2) (3)

Long-term debt 0.40 5.6% 2.2%
Preferred stock 0.10 10.6 1.1
Common stock equity 0.50 13.0 6.5
Totals 1.00 9.8%

Weighted average cost of capital 9.8%
402 PART 4 Long-Term Financial Decisions


Weighting Schemes
Weights can be calculated on the basis of either book value or market value and
using either historical or target proportions.

Book Value Versus Market Value
Book value weights use accounting values to measure the proportion of each type
book value weights
Weights that use accounting of capital in the firm’s financial structure. Market value weights measure the pro-
values to measure the proportion
portion of each type of capital at its market value. Market value weights are appeal-
of each type of capital in the
ing, because the market values of securities closely approximate the actual dollars
firm’s financial structure.
to be received from their sale. Moreover, because the costs of the various types of
market value weights capital are calculated by using prevailing market prices, it seems reasonable to use
Weights that use market values
market value weights. In addition, the long-term investment cash flows to which
to measure the proportion of
the cost of capital is applied are estimated in terms of current as well as future mar-
each type of capital in the firm’s
ket values. Market value weights are clearly preferred over book value weights.
financial structure.


Historical Versus Target
Historical weights can be either book or market value weights based on actual
historical weights
Either book or market value capital structure proportions. For example, past or current book value propor-
weights based on actual capital tions would constitute a form of historical weighting, as would past or current
structure proportions.
market value proportions. Such a weighting scheme would therefore be based on
real—rather than desired—proportions.
Target weights, which can also be based on either book or market values,
target weights
Either book or market value reflect the firm’s desired capital structure proportions. Firms using target weights
weights based on desired capital establish such proportions on the basis of the “optimal” capital structure they
structure proportions.
wish to achieve. (The development of these proportions and the optimal structure
are discussed in detail in Chapter 11 .)

When one considers the somewhat approximate nature of the calculation of
weighted average cost of capital, the choice of weights may not be critical. However,
from a strictly theoretical point of view, the preferred weighting scheme is target
market value proportions, and these are assumed throughout this chapter.


Review Questions

10–11 What is the weighted average cost of capital (WACC), and how is it
calculated?
10–12 Describe the logic underlying the use of target capital structure weights, and
compare and contrast this approach with the use of historical weights. What
is the preferred weighting scheme?



The Marginal Cost and Investment Decisions
LG5 LG6

The firm’s weighted average cost of capital is a key input to the investment
decision-making process. As demonstrated earlier in the chapter, the firm
should make only those investments for which the expected return is greater
403
CHAPTER 10 The Cost of Capital


than the weighted average cost of capital. Of course, at any given time, the
firm’s financing costs and investment returns will be affected by the volume of
financing and investment undertaken. The weighted marginal cost of capital
and the investment opportunities schedule are mechanisms whereby financing
and investment decisions can be made simultaneously.


The Weighted Marginal Cost of Capital (WMCC)
The weighted average cost of capital may vary over time, depending on the vol-
ume of financing that the firm plans to raise. As the volume of financing increases,
the costs of the various types of financing will increase, raising the firm’s weighted
average cost of capital. Therefore, it is useful to calculate the weighted marginal
weighted marginal cost
of capital (WMCC) cost of capital (WMCC), which is simply the firm’s weighted average cost of cap-
The firm’s weighted average cost ital (WACC) associated with its next dollar of total new financing. This marginal
of capital (WACC) associated
cost is relevant to current decisions.
with its next dollar of total new
The costs of the financing components (debt, preferred stock, and common
financing.
stock) rise as larger amounts are raised. Suppliers of funds require greater returns
in the form of interest, dividends, or growth as compensation for the increased
risk introduced by larger volumes of new financing. The WMCC is therefore an
increasing function of the level of total new financing.
Another factor that causes the weighted average cost of capital to increase is
the use of common stock equity financing. New financing provided by common
stock equity will be taken from available retained earnings until this supply is
exhausted and then will be obtained through new common stock financing.
Because retained earnings are a less expensive form of common stock equity
financing than the sale of new common stock, the weighted average cost of capi-
tal will rise with the addition of new common stock.

Finding Break Points
To calculate the WMCC, we must calculate break points, which reflect the level
break point
The level of total new financing of total new financing at which the cost of one of the financing components rises.
at which the cost of one of the
The following general equation can be used to find break points:
financing components rises,
thereby causing an upward shift
AFj
BPj (10.10)
in the weighted marginal cost of
wj
capital (WMCC).

where

BPj break point for financing source j
AFj amount of funds available from financing source j at a given cost
wj capital structure weight (stated in decimal form) for financing
source j

When Duchess Corporation exhausts its $300,000 of available retained earnings
EXAMPLE
(at kr 13.0%), it must use the more expensive new common stock financing (at
kn 14.0%) to meet its common stock equity needs. In addition, the firm expects
that it can borrow only $400,000 of debt at the 5.6% cost; additional debt will
have an after-tax cost (ki) of 8.4%. Two break points therefore exist: (1) when
the $300,000 of retained earnings costing 13.0% is exhausted, and (2) when the
$400,000 of long-term debt costing 5.6% is exhausted.
404 PART 4 Long-Term Financial Decisions


The break points can be found by substituting these values and the corre-
sponding capital structure weights given earlier into Equation 10.10. We get the
dollar amounts of total new financing at which the costs of the given financing
sources rise:
$300,000
BPcommon equity $600,000
0.50
$400,000
BPlong-term debt $1,000,000
0.40

Calculating the WMCC
Once the break points have been determined, the next step is to calculate the
weighted average cost of capital over the range of total new financing between
break points. First, we find the WACC for a level of total new financing between
zero and the first break point. Next, we find the WACC for a level of total new
financing between the first and second break points, and so on. By definition, for
each of the ranges of total new financing between break points, certain compo-
nent capital costs (such as debt or common equity) will increase. This will cause
weighted marginal cost of the weighted average cost of capital to increase to a higher level than that over
capital (WMCC) schedule the preceding range.
Graph that relates the firm’s
Together, these data can be used to prepare a weighted marginal cost of cap-
weighted average cost of
ital (WMCC) schedule. This is a graph that relates the firm’s weighted average
capital to the level of total new
cost of capital to the level of total new financing.
financing.

Table 10.2 summarizes the calculation of the WACC for Duchess Corporation
EXAMPLE
over the three ranges of total new financing created by the two break points—


TABLE 10.2 Weighted Average Cost of Capital for Ranges
of Total New Financing for Duchess Corporation

Weighted cost
Range of total Source of capital Weight Cost [(2) (3)]
new financing (1) (2) (3) (4)

$0 to $600,000 Debt .40 5.6% 2.2%
Preferred .10 10.6 1.1
Common .50 13.0 6.5
Weighted average cost of capital 9.8%

$600,000 to $1,000,000 Debt .40 5.6% 2.2%
Preferred .10 10.6 1.1
Common .50 14.0 7.0
Weighted average cost of capital 10.3%

$1,000,000 and above Debt .40 8.4% 3.4%
Preferred .10 10.6 1.1
Common .50 14.0 7.0
Weighted average cost of capital 11.5%
405
CHAPTER 10 The Cost of Capital


FIGURE 10.1




Weighted Average Cost of Capital (%)
WMCC Schedule
11.5%
Weighted marginal cost of
11.5
capital (WMCC) schedule for WMCC
Duchess Corporation 11.0

10.5 10.3%

10.0 9.8%

9.5




0 500 1,000 1,500
Total New Financing ($000)

Range of total new financing WACC
$0 to $600,000 9.8%
10.3
$600,000 to $1,000,000
$1,000,000 and above 11.5




$600,000 and $1,000,000. Comparing the costs in column 3 of the table for each
of the three ranges, we can see that the costs in the first range ($0 to $600,000)
are those calculated in earlier examples and used in Table 10.1. The second range
($600,000 to $1,000,000) reflects the increase in the common stock equity cost
to 14.0%. In the final range, the increase in the long-term debt cost to 8.4% is
introduced.
The weighted average costs of capital (WACC) for the three ranges are sum-
marized in the table shown at the bottom of Figure 10.1. These data describe the
weighted marginal cost of capital (WMCC), which increases as levels of total
new financing increase. Figure 10.1 presents the WMCC schedule. Again, it is
clear that the WMCC is an increasing function of the amount of total new
financing raised.


The Investment Opportunities Schedule (IOS)
At any given time, a firm has certain investment opportunities available to it.
These opportunities differ with respect to the size of investment, risk, and return.5
The firm’s investment opportunities schedule (IOS) is a ranking of investment pos-
investment opportunities
schedule (IOS) sibilities from best (highest return) to worst (lowest return). Generally, the first
A ranking of investment possibil- project selected will have the highest return, the next project the second highest,
ities from best (highest return) to
and so on. The return on investments will decrease as the firm accepts additional
worst (lowest return).
projects.


5. Because the calculated weighted average cost of capital does not apply to risk-changing investments, we assume
that all opportunities have equal risk similar to the firm’s risk.
406 PART 4 Long-Term Financial Decisions


Column 1 of Table 10.3 shows Duchess Corporation’s current investment oppor-
EXAMPLE
tunities schedule (IOS) listing the investment possibilities from best (highest
return) to worst (lowest return). Column 2 of the table shows the initial investment
required by each project. Column 3 shows the cumulative total invested funds nec-
essary to finance all projects better than and including the corresponding invest-
ment opportunity. Plotting the project returns against the cumulative investment
(column 1 against column 3) results in the firm’s investment opportunities sched-
ule (IOS). A graph of the IOS for Duchess Corporation is given in Figure 10.2.

Using the WMCC and IOS to Make
Financing/Investment Decisions
As long as a project’s internal rate of return is greater than the weighted marginal
cost of new financing, the firm should accept the project.6 The return will
decrease with the acceptance of more projects, and the weighted marginal cost of
capital will increase because greater amounts of financing will be required. The
decision rule therefore would be: Accept projects up to the point at which the
marginal return on an investment equals its weighted marginal cost of capital.
Beyond that point, its investment return will be less than its capital cost.
This approach is consistent with the maximization of net present value (NPV)
for conventional projects for two reasons: (1) The NPV is positive as long as the
IRR exceeds the weighted average cost of capital, ka. (2) The larger the difference
between the IRR and ka, the larger the resulting NPV. Therefore, the acceptance
of projects beginning with those that have the greatest positive difference between
IRR and ka, down to the point at which IRR just equals ka, should result in the
maximum total NPV for all independent projects accepted. Such an outcome is
completely consistent with the firm’s goal of maximizing owner wealth.

Figure 10.2 shows Duchess Corporation’s WMCC schedule and IOS on the same
EXAMPLE
set of axes. By raising $1,100,000 of new financing and investing these funds in


TABLE 10.3 Investment Opportunities Schedule
(IOS) for Duchess Corporation

Internal rate Initial Cumulative
investmenta
Investment of return (IRR) investment
opportunity (1) (2) (3)

A 15.0% $100,000 $ 100,000
B 14.5 200,000 300,000
C 14.0 400,000 700,000
D 13.0 100,000 800,000
E 12.0 300,000 1,100,000
F 11.0 200,000 1,300,000
G 10.0 100,000 1,400,000
aThe cumulative investment represents the total amount invested in projects with higher
returns plus the investment required for the corresponding investment opportunity.




6. Although net present value could be used to make these decisions, the internal rate of return is used here because
of the ease of comparison it offers.
407
CHAPTER 10 The Cost of Capital


FIGURE 10.2




Weighted Average Cost of Capital and IRR (%)
IOS and WMCC 15.5
A
Schedules 15.0
B
Using the IOS and WMCC 14.5
C
to select projects for Duchess
14.0
Corporation
13.5
D
13.0
12.5
E
12.0
11.5% WMCC
11.5
F
11.0
10.3%
10.5
G
9.8%
10.0
IOS
9.5



0 500 1,000 1,500
1,100
X
Total New Financing or Investment ($000)




projects A, B, C, D, and E, the firm should maximize the wealth of its owners,
because these projects result in the maximum total net present value. Note that
the 12.0% return on the last dollar invested (in project E) exceeds its 11.5%
weighted average cost. Investment in project F is not feasible, because its 11.0%
return is less than the 11.5% cost of funds available for investment.

The firm’s optimal capital budget of $1,100,000 is marked with an X in Fig-
ure 10.2. At that point, the IRR equals the weighted average cost of capital, and
the firm’s size as well as its shareholder value will be optimized. In a sense, the
size of the firm is determined by the market—the availability of and returns on
investment opportunities, and the availability and cost of financing.
In practice, most firms operate under capital rationing. That is, management
imposes constraints that keep the capital expenditure budget below optimal (where
IRR ka). Because of this, a gap frequently exists between the theoretically optimal
capital budget and the firm’s actual level of financing/investment.


Review Questions

10–13 What is the weighted marginal cost of capital (WMCC)? What does the
WMCC schedule represent? Why does this schedule increase?
10–14 What is the investment opportunities schedule (IOS)? Is it typically
depicted as an increasing or a decreasing function? Why?
10–15 How can the WMCC schedule and the IOS be used to find the level of
financing/investment that maximizes owner wealth? Why do many firms
finance/invest at a level below this optimum?
408 PART 4 Long-Term Financial Decisions




SUMMARY
FOCUS ON VALUE
The cost of capital is an extremely important rate of return used by the firm in the long-
term decision process, particularly in capital budgeting decisions. It is the expected average
future cost to the firm of funds over the long run. Because the cost of capital is the pivotal
rate of return used in the investment decision process, its accuracy can significantly affect
the quality of these decisions.
Even with good estimates of project cash flows, the application of NPV and IRR deci-
sion techniques, and adequate consideration of project risk, a poorly estimated cost of capi-
tal can result in the destruction of shareholder value. Underestimation of the cost of capital
can result in the mistaken acceptance of poor projects, whereas overestimation can cause
good projects to be rejected. In either situation, the firm’s action could be detrimental to
the firm’s value. By applying the techniques presented in this chapter to estimate the firm’s
cost of capital, the financial manager will improve the likelihood that the firm’s long-term
decisions are consistent with the firm’s overall goal of maximizing stock price (owner
wealth).




REVIEW OF LEARNING GOALS
the ratio of the preferred stock dividend to the
Understand the key assumptions that underlie
LG1
firm’s net proceeds from the sale of preferred stock.
cost of capital, the basic concept of cost of capi-
The key formulas for the before- and after-tax cost
tal, and the specific sources of capital that it
of debt and the cost of preferred stock are given in
includes. The cost of capital is the rate of return
Table 10.4.
that a firm must earn on its investments to maintain
its market value and attract needed funds. It is
Calculate the cost of common stock equity and
affected by business and financial risks, which are
LG3
convert it into the cost of retained earnings and
assumed to be unchanged. To capture the interrelat-
the cost of new issues of common stock. The cost of
edness of financing, a weighted average cost of capi-
common stock equity can be calculated by using the
tal should be used to find the expected average
constant-growth valuation (Gordon) model or the
future cost of funds over the long run. The specific
CAPM. The cost of retained earnings is equal to the
costs of the basic sources of capital (long-term debt,
cost of common stock equity. An adjustment in the
preferred stock, retained earnings, and common
cost of common stock equity to reflect underpricing
stock) can be calculated individually.
and flotation costs is necessary to find the cost of
new issues of common stock. The key formulas for
Determine the cost of long-term debt and the
LG2
the cost of common stock equity, the cost of re-
cost of preferred stock. The cost of long-term
tained earnings, and the cost of new issues of com-
debt is the after-tax cost today of raising long-term
mon stock are given in Table 10.4.
funds through borrowing. Cost quotations, calcula-
tion (using either a trial-and-error technique or a fi-
Calculate the weighted average cost of capital
nancial calculator), or an approximation can be
LG4
(WACC) and discuss the alternative weighting
used to find the before-tax cost of debt, which must
schemes. The firm’s WACC reflects the expected
then be tax-adjusted. The cost of preferred stock is
409
CHAPTER 10 The Cost of Capital


TABLE 10.4 Summary of Key Definitions and Formulas for Cost of
Capital

Definitions of variables

AFj amount of funds available from financing Nn net proceeds from the sale of new common
source j at a given cost stock
b beta coefficient or measure of nondiversi- Np net proceeds from the sale of preferred
fiable risk stock
BPj break point for financing source j P0 value of common stock
D1 per share dividend expected at the end of RF risk-free rate of return
year 1 T firm’s tax rate
Dp annual preferred stock dividend (in wi proportion of long-term debt in capital
dollars) structure
g constant rate of growth in dividends wj capital structure proportion (historical or
I annual interest in dollars target, stated in decimal form) for financing
source j
ka weighted average cost of capital
wp proportion of preferred stock in capital
kd before-tax cost of debt
structure
ki after-tax cost of debt
ws proportion of common stock equity in
km required return on the market portfolio
capital structure
kn cost of a new issue of common stock
kp cost of preferred stock
kr cost of retained earnings
ks required return on common stock
n number of years to the bond’s maturity
Nd net proceeds from the sale of debt
(bond)

Cost of capital formulas

Before-tax cost of debt (approximation):
$1,000 Nd
I
n
kd [Eq. 10.1]
Nd $1,000
2
After-tax cost of debt: ki kd (1 T) [Eq. 10.2]
Dp
Cost of preferred stock: kp [Eq. 10.3]
Np
Cost of common stock equity:
Using constant-growth
D1
valuation model: ks g [Eq. 10.5]
P0
Using CAPM: ks RF [b (km RF)] [Eq. 10.6]
Cost of retained earnings: kr ks [Eq. 10.7]
D1
Cost of new issues of common stock: kn g [Eq. 10.8]
Nn
Weighted average cost of capital (WACC):
ka (wi ki) (wp kp) (ws kr or n) [Eq. 10.9]

AFj
Break point: BPj [Eq. 10.10]
wj
410 PART 4 Long-Term Financial Decisions


average future cost of funds over the long run. It cost of one of the financing components rises, caus-
can be determined by combining the costs of spe- ing an upward shift in the WMCC. The general for-
cific types of capital after weighting each of them by mula for break points is given in Table 10.4. The
its proportion using historical book or market value WMCC schedule relates the WACC to each level of
weights, or target book or market value weights. total new financing.
The theoretically preferred approach uses target
weights based on market values. The key formula Explain how the weighted marginal cost of cap-
LG6
for WACC is given in Table 10.4. ital (WMCC) can be used with the investment
opportunities schedule (IOS) to make the firm’s
Describe the procedures used to determine financing/investment decisions. The IOS presents a
LG5
break points and the weighted marginal cost of ranking of currently available investments from best
capital (WMCC). As the volume of total new fi- (highest return) to worst (lowest return). It is used
nancing increases, the costs of the various types of in combination with the WMCC to find the level of
financing will increase, raising the firm’s WACC. financing/investment that maximizes owner wealth.
The WMCC is the firm’s WACC associated with its The firm accepts projects up to the point at which

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