The Cost of Capital【Dr. Deric】

Fundamentals of Capital Structure and Cost
📌 The capital structure of a firm is the specific combination of long-term debt, preferred stock, and common stock (retained earnings and new issues) used to finance operations and growth.
💰 The cost of capital represents the minimum rate of return a firm must earn on its projects to satisfy its creditors and stockholders.
📈 If an investment's rate of return exceeds the Weighted Average Cost of Capital (WACC), the firm's value increases; if it is lower, the value decreases.

Calculating Costs of Capital Components
🔹 Cost of Debt: Determined by the Yield to Maturity (YTM) adjusted for flotation costs and tax benefits, since interest expenses are tax-deductible. The after-tax cost of debt is always lower than the pre-tax cost.
🔹 Cost of Preferred Stock: Calculated by dividing the preferred dividend by the net proceeds (issuance price minus flotation costs).
🔹 Cost of Common Equity: Comprises Internal Equity (Retained Earnings) and External Equity (New Common Stock). External equity is generally more expensive due to flotation costs (underwriting, legal, and registration fees).

Estimation Models & WACC
📊 The Dividend Valuation Model ($K_{cs} = \frac{D_1}{P_0} + G$) and the Capital Asset Pricing Model (CAPM) ($R_f + \beta(R_m - R_f)$) are the primary methods for estimating the cost of common stock.
⚖️ The WACC is the weighted average of the after-tax costs of all financing sources, where weights reflect the proportion of total capital raised from each source.
🏢 When calculating WACC, always prioritize market values over book values to ensure the weights accurately reflect the current capital structure.

Weighted Marginal Cost of Capital (WMCC)
🚀 The WMCC typically increases as the volume of new capital raised rises because capital is a limited resource and investors demand higher returns to compensate for increased risk.
📉 Firms utilize retained earnings first because they are cheaper; once these are exhausted, companies must issue new common stock, which carries higher flotation costs, leading to an increase in the marginal cost of capital.

Key Points & Insights
➡️ Maximize Tax Shields: Always calculate the after-tax cost of debt ($Pre\text{-}tax\ Cost \times (1 - \text{Tax Rate})$) to reflect the actual cost burden to the company.
➡️ Account for Flotation Costs: Never ignore transaction costs when issuing new securities; they effectively reduce the net proceeds and raise the cost of financing.
➡️ Prioritize Internal Funds: Since retained earnings do not incur flotation costs, they are the most cost-effective form of equity financing; shifting to new common stock issues should only occur after exhausting internal reserves.
➡️ Use Market Values: For accurate financial decision-making, always use current market values to determine the weights in your WACC calculation rather than historical book values.

📸 Video summarized with SummaryTube.com on Mar 26, 2026, 04:26 UTC