__Lecture
Notes 33 - - Cost of Capital__

__ __

The cost of capital is
part of the discount rate. The discount
rate is made up of two parts 1.) the cost of capital and 2.) the risk premium.

The cost of capital is
what money/funds cost. There are four
different sources, which are called the Four Components of the Cost of Capital.

1.) Debt (Bonds)

2.) Preferred
Stock

3.) Common Stock

4.) Retained
Earnings

These four components are
also called the Capital Structure of the Firm.

The cost of capital is
expressed in a percentage form and can be looked at either historically
(actuals) or future (expected).

__Future (Expected) Cost
of Capital__

__ __

There are three questions
that a firm must ask itself 1.) Where do you get money 2.)
What are you going to do with the money and 3.) How do you distribute the money.

To determine the future
cost of capital you have to draw an IOS/MCC Graph. IOS is the investment opportunity schedule and MCC is the
marginal cost of capital.

To get further explanation
on the IOS/MCC Graph please see Prof. Harding.

__Historical (Actual)
Cost of Capital__

__ __

To determine the
historical cost of capital you must determine the weighted average cost of
capital (WACC).

Calculate the WACC given
the following component costs- -

DEBT 10%

PREF 11%

COMM 13%

RE 12%

The first step is to
calculate the tax rate. To calculate
the tax rate you have to look at the actuals on the income statement and take
the Taxes divided by the Before Tax Income.
So using the actuals form the previous class handout titled “A Quick and
Dirty Financial Planning Model” we can determine the tax rate …

Taxes - - 27300 27300/91000=30%

Income B/T - - 91000

It is VERY IMPORTANT that
you know who to calculate the tax rate.

The next step after you
have determined the tax rate is to calculate the after tax cost of debt. NOTE:
The cost of debt (10%) is a before tax cost of debt

After Tax Cost of Debt = Before Tax Cost of Debt (1-Tax
Rate)

= .10(1-.30)

= .10 * .70

= .07 or 7%

The After Tax Cost of
Debt is 7%.

Now you can solve for
WACC…

__B/T Cost__ __A/T Cost__ __Dollars *__

DEBT .10 .07 X 513000 = 35910

PREF .11 .11 X 234000 = 25740

COMM .13 .13 X 122000 = 15860

RE .12 .12 X __600000 __ = __72000__

1469000 149510

* Taken from the balance sheet “Quick and Dirty Financial
Planning Model”

149510/1469000 = .1018 or 10.18%

The WACC is 10.18%

End Of Lecture Notes 33

Copyright Kelley Dahlquist 2000