Corporate Finance

Cost
Of
Capital

1
 Cost of Capital
 Rate of Return used to evaluate all possible investment opportunities to
determine which ones to invest on behalf of firm’s shareholders

 Represents the firm’s cost of financing and the minimum rate of return that a
project must earn to increase firm value.

 It refers to the cost of next rupee of financing necessary to finance new

investment opportunity. It reflects expected average future cost of funds over
the long run.

 Investments with a rate of return above the cost of capital will increase the value
of firm and vice versa

 Major link between the firm’s long term investment decisions and the wealth of
firm’s owners as determined by the market value of shares.

 To capture all of the relevant financing costs, assuming some desired mix of
financing, we need to look at the overall cost of capital rather than just cost of
capital of any single source 2
 Sources of Long-Term Capital

 Four basic sources of long-term capital

1. Long-term Debt

2. Preferred Stock

3. Common Stock (Equity)

4. Retained Earnings

3
 Certain Basic Concepts

 Net Proceeds are the funds actually received by the firm from the sale of a
security.

 The total proceeds are reduced by Flotation cost – the cost of issuing and
selling a security

 These costs apply to all public offerings of securities – debt, preferred

stock and common stock.
 They include 2 components
1. Underwriting Cost – compensation earned by investment bankers
for selling the security
2. Administrative Cost – issuer expense such as legal, accounting and
printing.

4
 Cost of Long-Term Debt
 The financing cost associated with new funds raised through long-term borrowing

 Before-Tax Cost of Debt (𝒓𝒅 )

 It is simply the rate of return the firm must pay on new borrowing.

Where
𝑟 = before-tax cost of debt
𝐼 = Annual Interest
𝑁 = net proceeds from sale of security
𝑛= number of years
𝐹𝑉 = Face Value

5
 Cost of Long-Term Debt

 After-Tax Cost of Debt (𝒓𝒊 )

 To find the firm’s net cost of debt, the tax savings created by the debt
should be considered.

 The After-Tax Cost of Debt (𝒓𝒊 ) can be found by multiplying Before-Tax Cost
of Debt (𝒓𝒅 ), by 1 minus the tax rate (T)

6
 Cost of Preferred Stock

 Preferred stock represents a special type of ownership interest in the firm.

 It gives preferred stakeholders the right to receive their stated dividends

before the firm can distribute any earnings to common stock holder.

 Cost of Preferred Stock ( 𝒑 ) – the ratio of the preferred stock dividend

to the firm’s net proceeds from the sale of preferred stock.

7
 Cost of Common Stock

 The rate at which investors discount the expected dividends of the firm to
determine its share value.

 There are two forms of common stock financing :

1. Retained Earnings
2. New issues of Common Stock

 Two techniques are used to measure the cost of common stock equity
1. Constant-growth valuation model
2. Capital Asset Pricing Model(CAPM)

 Cost of retained earnings, 𝑟 is the same as the cost of an equivalent fully

subscribed issue of additional common stock, which is equal to the cost of
common stock, 𝑟 .

8
 Constant Growth Valuation Model – Gordon Growth Model

 Assumes that the value of a share of stock equals the present value of all
future dividends (assumed to grow at a constant rate) that it is expected to
provide over an infinite time horizon.

𝐷
𝑃 =
𝑟 −𝑔
Where
𝑃 = Value of common stock
𝐷 = per-share dividend expected at the end of year 1
𝑟 = required return on common stock
𝑔= constant rate of growth in dividends

Solving the equation for 𝑟 results in :

𝐷
𝑟 = +𝑔
𝑃
9
 Capital Asset Pricing Model (CAPM)

 Describes the relationship between the required return and the non-
diversifiable risk of the firm as measured by the beta coefficient.

𝑟 =𝑅 + 𝑏× 𝑟 −𝑅
Where
𝑟 = required return on equity
𝑅 = risk-free rate of return
𝑏= beta coefficient or index of non-diversifiable risk
𝑟 = market return; return on market portfolio of asset

10
 Constant Growth Model v/s CAPM

 CAPM directly considers the firm’s risk as reflected by beta whereas Constant
Growth Model uses the market price as a reflection of the expected risk-return
preference of the investor in the marketplace

 Though theoretically equivalent, in practice estimates from the two methods

do not always agree.

 The another difference is regarding the adjustment for the flotation cost. The
constant growth model can easily be adjusted for flotation cost whereas
CAPM does not provide simple adjustment mechanism.

 As a practical matter, analyst might want to estimate the cost of equity using
both approaches and then take an average of the results to arrive at a final
estimate of cost of equity.

11
 Cost of New Issues of Common Stock & Retained earnings

 Cost of retained earnings is the same as the cost of an equivalent fully

subscribed issue of additional common stock since the stockholders find the
firm’s earnings acceptable only if they expect that it will earn at least their
required return on the reinvested funds.

 Cost of new issues of common stock is net of underpricing and associated

floatation costs

 Cost of new common stock is normally greater than any other long-term
financing cost

 Formula:
𝑟 = +𝑔 or 𝑟 = ×
+𝑔

Where 𝑓 represents % reduction in current market price as a result of

underpricing and floatation cost
12
 Weighted Average Cost of Capital (WACC)

 Reflects the expected average future cost of capital over the long run; found
by weighting the cost of each specific type of capital by its proportion in the
firm’s capital structure.

 It can be computed by multiplying the individual cost of each form of

financing by its proportion in the firm’s capital structure and sum the weighted
values.
𝑟 = 𝑤 ×𝑟 + 𝑤 ×𝑟 + 𝑤 ×𝑟
Where
𝑤 = proportion of long term debt in capital-structure

𝑤 = proportion of preferred stock in capital-structure

𝑤 = proportion of common stock equity in capital-structure

𝑤 +𝑤 +𝑤 = 1

13
 Weighted Average Cost of Capital (WACC)

 Firms can calculate weights on the basis of either book value or market value
using either historical or target proportions.

 Book Value Weights – That use accounting values to measure the proportion
of each type of capital in the firm’s financial structure.

 Market Value Weights – That use market values to measure the proportion of
each type of capital in the firm’s financial structure.

 Historical Weights – Either book or market value weights based on actual

capital structure proportions.

 Target Weights – Either book or market value weights based on desired capital
structure proportions.

14