Cost of Capital

Where we’ve been...

 Financial Performance
 Time value of money
 Risk and Return
 The Investment Decision

(Capital Budgeting)
 Where we’re going...

 The financing decision

Cost of capital
Leverage
Capital Structure
Working Capital
 Cost of Capital
 When we talk about the “cost” of capital, we
are talking about the required rate of return
on invested funds
 It is also referred to as a “hurdle” rate because
this is the minimum acceptable rate of return
 Any investment which does not cover the
firm’s cost of funds will reduce shareholder
wealth (just as if you borrowed money at 10%
to make an investment which earned 7%
would reduce your wealth)
 Cost of Capital

 For Investors the rate of return on a

security is a benefit of investing.
 For Financial Managers that same
rate of return is a cost of raising
funds that are needed to operate the
firm.
 In other words, the cost of raising
funds is the firm’s cost of capital.
 How can the firm raise
capital?
 Debentures
 Preferred Stock or Share Capital
 Equity Share Capital
 Each of these offers a rate of return to
investors.
 This return is a cost to the firm.
 “Cost of capital” actually refers to the
weighted cost of capital - a weighted
average cost of financing sources.
 The Weighted Cost of Capital
 To calculate the firm’s weighted
cost of capital, we must first
calculate the costs of the individual
financing sources:
 Cost of Debentures
 Cost of Preference Shares
 Cost of Equity Shares
 Weighted Cost of Capital

 The weighted cost of capital is just

the weighted average cost of all of
the financing sources.
 Weighted Cost of Capital

Capital
Source Cost Structure

debt 6% 20%
preferred 10% 10%
common 16% 70%
 Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)

 Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16)
= 13.4%
 Finding the Weights

 The weights that we use to calculate the

WACC will obviously affect the result
 Therefore, the obvious question is:
“where do the weights come from?”
 There are two possibilities:
– Book-value weights
– Market-value weights
 Book-value Weights

 One potential source of these weights is

the firm’s balance sheet, since it lists the
total amount of long-term debt, preferred
equity, and common equity
 We can calculate the weights by simply
determining the proportion that each
source of capital is of the total capital
 Book-value Weights (cont.)

The following table shows the calculation of the

book-value weights
 Market-value Weights
 The problem with book-value weights is that
the book values are historical, not current,
values
 The market recalculates the values of each
type of capital on a continuous basis.
Therefore, market values are more
appropriate
 The main difference is that we need to first
calculate the total market value (price times
quantity) of each type of capital
 Calculating the Market-value
Weights
The following table shows the current market prices:
 Market vs Book Values

 It is important to note that market-values

is always preferred over book-value
 The reason is that book-values represent
the historical amount of securities sold,
whereas market-values represent the
current amount of securities outstanding.
The Cost of Retained Earnings
 The firm may choose to finance new projects using
only internally generated funds (retained earnings)
 These funds are not free because they belong to the
common shareholders (i.e., there is an opportunity
cost)
 Therefore, the cost of retained earnings is exactly
the same as the cost of new common equity.
THANKS