THE COST OF CAPITAL

COST OF CAPITAL

The cost of capital of any investment (project, business, or

company) is the rate of return the suppliers of capital
would expect to receive if the capital were invested
elsewhere in an investment (project, business, or company)
of comparable risk

•  The cost of capital reflects expected return

•  The cost of capital represents an opportunity cost

 WEIGHTED AVERAGE
COST OF CAPITAL (WACC)

WACC = wErE + wDrD (1 – tc)

wE = proportion of equity
rE = cost of equity
wD = proportion of debt
rD = pre-tax cost of debt
tc = corporate tax rate
 APPROACHES TO ESTIMATE
COST OF EQUITY

•  CAPM
 CAPM
ri = rf + βi [E(rm) – rf ]
ri = required return on the equity of the company
Rf = risk-free rate
βi = beta of the equity of the company
E(rm) = expected return on the market portfolio

Illustration
rf = 7%, βi = 1.2, E(rm) = 15%
ri = 7 + 1.2 [15 – 7] = 16.6%
 Cost of Debt
  The two most widely used approaches to estimating cost of debt are:
–  Looking up the yield to maturity on a straight bond outstanding from the firm.
The limitation of this approach is that very few firms have long term straight
bonds that are liquid and widely traded
–  Looking up the rating for the firm and estimating a default spread based upon
the rating. While this approach is more robust, different bonds from the same
firm can have different ratings. You have to use a median rating for the firm