Overall Cost of

Capital of the Firm

Cost of Capital is the required

The Cost of rate of return on the various
Capital types of financing. The overall
cost of capital is a weighted
average of the individual
required rates of return (costs).

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Introduction
 The cost of capital is the cost of using the funds of
Significance of the Cost of Capital
creditors and owners.
 Creating value requires investing in capital projects that Evaluating Investment Decisions
provide a return greater than the project’s cost of
capital.
Designing a firm’s debt policy
 When we view the firm as a whole, the firm creates value
when it provides a return greater than its cost of capital.
Appraising the financial
 Estimating the cost of capital is challenging.
 We must estimate it because it cannot be observed. performance of top Management
 We must make a number of assumptions.
 For a given project, a firm’s financial manager must
estimate its cost of capital.

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Cost of capital Market Value of

 The cost of capital is the rate of return that the
Long-Term Financing
suppliers of capital—bondholders and owners—
require as compensation for their contributions of
capital. Type of Financing Mkt Val Weight
This cost reflects the opportunity costs of the suppliers of

capital.
Long-Term Debt Rs. 35M 35%
 The cost of capital is a marginal cost: the cost of Preferred Stock Rs. 15M 15%
raising additional capital.
 The weighted average cost of capital (WACC) is the
Common Stock Equity Rs. 50M 50%
cost of raising additional capital, with the weights
Rs. 100M 100%
representing the proportion of each source of
financing that is used.
 Also known as the marginal cost of capital (MCC).
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 Cost of Equity Determination of the
Approaches Cost of Equity Capital
Assume that Amit Corp (AC) has common
 Dividend Discount Model stock outstanding with a current market
value of Rs.64.80 per share, current
 Capital-Asset Pricing dividend of Rs.3 per share, and a dividend
Model growth rate of 8% forever.
 Before-Tax Cost of Debt ke = ( D1 / P0 ) + g
plus Risk Premium ke = (Rs.3(1.08) / Rs.64.80) + .08

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ke = .05 + .08 = .13 or 13%

 You are interested to buy a stock of

Dividend Discount Model ABC Ltd. The last year EPS and
dividend payout ratio was Rs. 10 and
The cost of equity capital, ke, is 40% respectively. The Return on Equity
is 12%. The current market Price is Rs.
the discount rate that equates the
100. Calculate the cost of equity.
present value of all expected
future dividends with the current
market price of the stock.
D1 D2 D
P0 = + +...+
(1+ke)1 (1+ke)2 (1+ke)

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Constant Growth Model
The constant dividend growth
assumption reduces the model to:
ke = ( D1 / P0 ) + g
Assumes that dividends will grow
at the constant rate “g” forever.
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Capital Asset
Pricing Model
The cost of equity capital, ke, is
equated to the required rate of
return in market equilibrium. The
risk-return relationship is described
by the Security Market Line (SML).
ke = Rj = Rf + b j (Rm - Rf)
 Determination of the Determination of
Cost of Equity (CAPM) the Cost of Debt
Assume that Amit Corp (AC) has a (1 + kd)10 = Rs.1,000 / Rs.385.54
company beta of 1.25. Research by = 2.5938
Angel suggests that the risk-free rate is (1 + kd) = (2.5938) (1/10)
4% and the expected return on the = 1.1
market is 11.2% kd = .1 or 10%
ke = Rf + b j (Rm - Rf)
ki = 10% ( 1 - .40 )
= 4% + 1.25 (11.2% - 4%)
ki = 6%
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ke = 4% + 9% = 13% 16

Cost of Debt Cost of Debt for Non-Zero Debt

Cost of Debt is the required rate Cost of Debt is the required rate
of return on investment of the of return on investment of the
lenders of a company. lenders of a company.
n
Ij + M j
P0 = S (1 + kd)j
j =1

ki = kd ( 1 - T )
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Determination of the Cost of Debt Determination of the Cost of Debt

Zero Coupon Bond Non-zero Coupon Bond

Assume that Amit Corp (AC) has
Rs.1,000 par value zero-coupon bonds
outstanding. AC bonds are currently
trading at Rs.385.54 with 10 years to
maturity. AC tax bracket is 40%.
Rs.0 + Rs.1,000
Rs.385.54 =
(1 + kd)10
Century ltd. issued 10 year bond, Rs.
1000 face value bond carrying 13%
coupon interest. The current selling
price of the bond is Rs. 1090.
(A) Calculate pre-tax cost of debt.
(B) What will be after tax cost of debt,
assuming 35% tax?

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Cost of Preferred Stock
Cost of Preferred Stock is the
required rate of return on
investment of the preferred
shareholders of the company.
kP = DP / P0
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Determination of the Cost of
Irredeemable Preferred Stock
Assume that Amit Corp (AC) has
preferred stock outstanding with par
value of Rs.100, dividend per share of
Rs.6.30, and a current market value of
Rs.70 per share.
kP = Rs.6.30 / Rs.70
kP = 9%
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Determination of the Cost of
Irredeemable Preferred Stock
Assume that Amit Corp (AC) has
preferred stock outstanding with par
value of Rs.100 redeemable after 5
years at a premium of 5%, dividend
per share of Rs.6.30, and a current
market value of Rs.70 per share.
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Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = S kx(Wx)
x=1
WACC = .35(6%) + .15(9%) +
.50(13%)
WACC = .021 + .0135 + .065
= .0995 or 9.95%
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Weighted Average Cost of Capital
Emerald Limited has the following book value capital structure:
Equity Share Capital (150 million @ Rs. 10 par) Rs. 1,500 million
Reserves and Surplus Rs. 2,250 million
10.5% P’ Share Capt. (1 million @ Rs. 100 par) Rs. 100 million
9.5% Debentures (1.5 million @ Rs. 1000 par) Rs. 1,500 million
8.5% Term Loans from Financial Institutions Rs. 500 million
The debentures of a company are redeemable after three years and are
quoting at Rs. 981.05 per debenture. The applicable income tax rate for
the company is 35%. The preferred stock of the company is redeemable
after 5 years is currently selling at Rs. 98.15 per preference share.
The current market price per equity share is Rs. 60. The prevailing
default-risk free interest rate on 10-year GOI Treasury Bonds is 5.5%. The
average market risk premium is 8%. The beta of the company is 1.18.
Calculate Cost of Equity (Ke), Cost of Preference Share (Kp), Cost of Debt (After
Tax) (Kd), Cost of Term Loan (After Tax) (Kt), Calculate the weighted average cost
of capital (Ko)
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