Cost of Capital

Executive Summary
For an investment to be worthwhile, the expected return on capital has to be higher than the cost of
capital. Given a number of competing investment opportunities, investors are expected to put their
capital to work in order to maximize the return. In other words, the cost of capital is the rate of return
that capital could be expected to earn in the best alternative investment of equivalent risk. If a project
is of similar risk to a company's average business activities it is reasonable to use the company's
average cost of capital as a basis for the evaluation. However, for projects outside the core business
of the company, the current cost of capital may not be the appropriate yardstick to use, as the risks of
the businesses are not the same. A company's securities typically include both debt and equity; one
must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of
capital. Importantly, both cost of debt and equity must be forward looking, and reflect the
expectations of risk and return in the future. This means, for instance, that the past cost of debt is not
a good indicator of the actual forward looking cost of debt. Once cost of debt and cost of equity have
been determined, their blend, the weighted average cost of capital (WACC), can be calculated. This
WACC can then be used as a discount rate for a project's projected cash flows. When companies
borrow funds from outside or take debt from financial institutions or other resources the interest paid
on that amount is called cost of debt. The cost of debt is computed by taking the rate on a risk-free
bond whose duration matches the term structure of the corporate debt, then adding a default
premium. This default premium will rise as the amount of debt increases (since, all other things
being equal, the risk rises as the cost of debt rises). Since in most cases debt expense is a deductible
expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of
equity. The cost of equity is inferred by comparing the investment to other investments (comparable)
with similar risk profiles. Retained earnings are a component of equity, and therefore the cost of
retained earnings (internal equity) is equal to the cost of equity. Dividends (earnings that are paid to
investors and not retained) are a component of the return on capital to equity holders, and influence
the cost of capital through that mechanism. The Weighted Cost of Capital (WACC) is used in
finance to measure a firm's cost of capital. Importantly, is not dictated by management. Rather, it
represents the minimum return that a company must earn on an existing asset base to satisfy its
creditors, owners, and other providers of capital, or they will invest elsewhere. The total capital for a
firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as
the company's market capitalization) plus the cost of its debt (the cost of debt should be continually
updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in
the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance
sheet. To calculate the firm’s weighted cost of capital, we must first calculate the costs of the
individual financing sources: Cost of Debt, Cost of Preference Capital and Cost of Equity Capital,
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity.
At some point, however, the cost of issuing new debt will be greater than the cost of issuing new
equity. This is because adding debt increases the default risk - and thus the interest rate that the
company must pay in order to borrow money. By utilizing too much debt in its capital structure, this
increased default risk can also drive up the costs for other sources (such as retained earnings and
preferred stock) as well. Management must identify the "optimal mix" of financing – the capital
structure where the cost of capital is minimized so that the firm's value can be maximized.

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Cost of Capital
Introduction
The management of a company has the paramount responsibility of directing and controlling the
company in the best interest of the owners (shareholders) and the investors. The main objective of a
business firm is to maximize the wealth of its shareholders in the long run. The management is
therefore expected to invest only in those projects which give a return in excess of cost of funds
invested in the projects of the business. This cost of funds committed to the projects of the business
is what is called Cost of Capital. The cost of capital refers to the rate of return the company has to
pay to various suppliers of funds in the company. It can be described as the minimum rate of return
that a firm must earn on its investments so that market value per share remains unchanged. In other
words, it is the minimum required rate of return on the investment project that keeps the present
wealth of shareholders unchanged. There are variations in the costs of capital due to the fact that
different kinds of investment assume different levels of risk which is compensated for by different
levels of return. Because different sources are opened to a business firm when raising funds,
basically equity and debt, the determination of cost of funds becomes a phenomenon. Cost of capital
is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return and
standard return. It consists of risk-free return plus premium for risk associated with the particular
business. Risk premium represents the additional return paid to the providers of capital and debt in
regards of the associated business and financial risks. Capital structure is a mix of a company's long-
term debt, specific short-term debt, common equity and preferred equity. The capital structure
represents how a firm finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure. A company's proportion of short
and long-term debt is considered when analyzing capital structure. When people refer to capital
structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into
how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this
firm is relatively highly levered. Optimal capital structure is the best debt-to-equity ratio for a firm that
maximizes its value and minimizes the firm's cost of capital. In theory, debt financing generally offers
the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since
a company's risk generally increases as debt increases. A healthy proportion of equity capital, as
opposed to debt capital, in a company's capital structure is an indication of financial fitness
Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity
and preferred equity. The capital structure represents how a firm finances its overall operations and
growth by using different sources of funds. The capital structure of a typical company will include
the following types of long term capital:

a) Ordinary (Equity) Share Capital

b) Preference Share Capital
c) Retained Earnings
d) Debentures and Bonds
e) Term Loans from Financial Institutions and Banks

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Cost of Capital
Definitions
 The cost of funds used for financing a business.

 The cost incurred in owning or borrowing capital, including interest payments and dividend
obligation

 “The cost of capital is simply the return expected by those who provide capital for the
business”

 Cost of capital is the cost an organization pays to raise funds, e.g., through bank loans or
issuing bonds. Cost of capital is expressed as an annual percentage.

 Cost of Capital is the required rate of return on the various types of financing. The overall
cost of capital is a weighted average of the individual required rates of return.
 The appropriate discount rate on a new project is the minimum expected rate of return an
investment must offer to be attractive. This minimum required return is often called the cost
of capital

 Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of

return that could have been earned by putting the same money into a different investment
with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor
to make a given investment.

  The cost of capital is the cost of a company's funds (both debt and equity) or from an

investor's point of view "the required rate of return on a portfolio company's existing
securities”. It is used to evaluate new projects of a company. It is the minimum return that
investors expect for providing capital to the company, thus setting a benchmark that a new
project has to meet.

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Cost of Capital
Types of Cost of capital
 Explicit Cost of Capital:
Explicit cost of any source may be defined as the discount rate that equates the present value of
the funds received by a firm with the present value of expected cash outflows.

It can be computed by using the following equation:

 Implicit Cost of Capital

The implicit cost may be defined as the rate of return associated with the best investment
opportunity for the firm and its shareholders that will be foregone if the project under
consideration by the firm is accepted. If a firm retains its earnings, implicit cost will be the
income, the shareholders could have earned if such earnings would have been distributed and
invested by them elsewhere.

 Specific Cost of Capital

The cost of each component of capital is known as specific cost of capital. A firm raises capital
from different sources such as equity, preference, debentures, etc. Specific cost of capital is the
cost of equity share capital, cost of preference share capital, cost of debentures, etc., individually.

 Weighted Average Cost of Capital

The weighted average cost of capital is the combined cost of each component of funds employed
by the firm. The weights are the proportion of the value of each component of capital in the total
capital.

 Marginal Cost of Capital

Marginal cost is defined as the cost of raising one extra rupee of capital. It is also called the
incremental or differential cost of capital. It refers to the change in overall cost of capital
resulting from the raising of one more rupee of fund. In other words, it is described as the
relevant cost of new funds required to be raised by the company.

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Cost of Capital
Controllable Factors Affecting Cost of Capital
These are the factors affecting cost of capital that the company has control over:

 Capital Structure Policy

A firm has control over its capital structure, and it targets an optimal capital structure. As more
debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity
increases.

 Dividend Policy
The firm has control over its payout ratio; the breakpoint of the marginal cost of capital schedule
can be changed. For example, as the payout ratio of the company increases, the breakpoint
between lower-cost internally generated equity and newly issued equity is lowered.

 Investment Policy
It is assumed that, when making investment decisions, the company is making investments with
similar degrees of risk. If a company changes its investment policy relative to its risk, both the
cost of debt and cost of equity change.

 Level of Interest Rates

The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For
example, when interest rates increase the cost of debt increases, which increases the cost of
capital.

 Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.

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Cost of Capital
Sources of Capital

Corporate finance, capital – the money a business uses to fund operations – comes from two sources:
debt and equity. While both types of financing have their benefits, each also carries a cost.

Cost of Debt

Debt capital refers to funds that are borrowed and must be repaid at a later date. While debt allows a
company to leverage a small amount of money into a much greater sum, lenders typically require the
payment of interest in return for the privilege. This interest rate is the cost of debt capital. If a
company takes out a $100,000 loan with a 7% interest rate, the cost of capital for the loan is 7%.
However, because payments on debts are often tax-deductible, businesses account for the corporate
tax rate when calculating the real cost of debt capital by multiplying the interest rate by the inverse of
the corporate tax rate. Assuming the corporate tax rate is 30%, the loan in the above example then
has a cost of capital of 0.07 * (1 - 0.3), or 4.9%.

Cost of Equity
Equity capital typically comes from funds invested by shareholders; the cost of equity capital is
slightly more complex. While equity funds need not be repaid, there is a level of return on
investment that shareholders can reasonably expect based on the performance of the market in
general and the volatility of the stock in question. Companies must be able to produce returns – in
the form of healthy stock valuation and dividends – that meet or exceed this level in to retain
shareholder investment. The capital asset pricing model (CAPM) utilizes the risk-free rate and risk
premium of the wider market and the beta value of the company's stock to determine the expected
rate of return, or cost of equity.

Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to
lenders, since payment on debt is required by law regardless of a company's profit margins.

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Cost of Capital
Cost of Debt
The cost of debt is the return the firm’s creditor’s demand on new borrowing. In principle, we could
determine the beta for the firm’s debt and then use the SML to estimate the required return on debt
just as we estimated the required return on equity. This isn’t really necessary, unlike a firm’s cost of
equity; its cost of debt can normally be observed either directly or indirectly: The cost of debt is
simply the interest rate the firm must pay on new borrowing, and we can observe interest rates in the
financial markets.

For example, if the firm already has bonds outstanding, then the yield to maturity on those bonds is
the market required rate on the firm’s debt. Alternatively, if we know that the firm’s bonds are rated,
say, AA, then we can simply find the interest rate on newly issued AA-rated bonds. Either way, there
is no need to estimate a beta for the debt because we can directly observe the rate we want to know.
There is one thing to be careful about, though.

The coupon rate on the firm’s outstanding debt is irrelevant here. That rate just tells us roughly what
the firm’s cost of debt was back when the bonds were issued, not what the cost of debt is today. This
is why we have to look at the yield on the debt in today’s marketplace. For consistency with our
other notation, we will use the symbol R D for the cost of debt.

Cost of debt is the rate of return required by a business' debt holders. It is normally estimated as the
yield to maturity on a business' bonds payable. It is important for a business to estimate it cost of
debt because after-tax cost of debt which equals before tax cost of debt multiplied by (1 − tax rate), is
an important input in the calculation of weighted average cost of capital.

Calculation
Cost of debt is estimated by calculating the yield to maturity on the debt which is calculated by
solving the following equation:
1−(1+r)-n Face Value of Debt
Current Market Value of Debt = Coupon Payment × +
r (1+r)n
Where,
Stated Rate on the Bond
Coupon Payment = × Face Value of Debt
Number of Payments per Year
Yield to Maturity
r=
Number of Periods per Year

n = Number of Coupon Payments = Number of Periods per Year × Maturity in Years

Cost of debt is then expressed as an annual APR i.e. cost of debt is equal to number of payments per
year times r.

In rare situations when it is not feasible to estimate yield to maturity, current yield and coupon rate
are used as estimates for cost of debt.

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Cost of Capital
Example
Lockheed Martin Corporation has $900 million $1,000 per value bonds payable carrying semi-
annual coupon rate of 4.25%. They are maturing on 15 November 2019. The bonds have a market
value per bond of 112.5 as at 15 November 2012. If the tax rate is 35%, find the before tax and after
tax cost of debt.

Before tax cost of debt equals the yield to maturity on the bond. Yield to maturity is calculated using
the IRR function on a mathematical calculator or MS Excel. Semiannual yield to maturity in this
example is calculated by finding r in the following equation:

1−(1+r)(-2×7) 1
$1,125 = $21.25 × +
r (1+r)(2×7)
r comes out to be 1.15%. Relevant annual before tax cost of debt is just the relevant APR which his
2.3% (2 times 1.15%)

Corresponding after tax cost of debt is 1.495% (2.3% × (1 − 35%))

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Cost of Capital
The Cost of Equity
The cost of equity is the return that stockholders require for their investment in a company. The
traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning
the asset and bearing the risk of ownership.

Here's a very simple example: let's say you require a rate of return of 10% on an investment in TSJ
Sports. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a
combination of dividends and share appreciation you require a $1.00 return on your $10.00
investment. Therefore the stock will have to appreciate by $0.70, which, combined with the $0.30
from dividends, gives you your 10% cost of equity.

A company that earns a return on equity in excess of its cost of equity capital has added value.

Calculating the Cost of Equity

The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost. Unlike
debt, which the company must pay in the form of predetermined interest, equity does not have a
concrete price that the company must pay, but that doesn't mean no cost of equity exists.

Common shareholders expect to obtain a certain return on their equity investment in a company. The
equity holders' required rate of return is a cost from the company's perspective because if the
company does not deliver this expected return, shareholders will simply sell their shares, causing the
price to drop. The cost of equity is basically what it costs the company to maintain a share price that
is theoretically satisfactory to investors.

On this basis, the most commonly accepted method for calculating cost of equity comes from the
Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed
formulaically below:

Re = rf + (rm – rf) * β 

Where:
Re = the required rate of return on equity
rf = the risk free rate
rm – rf = the market risk premium
β = beta coefficient = unsystematic risk

Rf – Risk-free rate - This is the amount obtained from investing in securities considered free from
credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury
Bills is frequently used as a proxy for the risk-free rate.

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Cost of Capital
ß – Beta - This measures how much a company's share price reacts against the market as a whole. A
beta of one, for instance, indicates that the company moves in line with the market. If the beta is in
excess of one, the share is exaggerating the market's movements; less than one means the share is
more stable. Occasionally, a company may have a negative beta (e.g. a gold-mining company),
which means the share price moves in the opposite direction to the broader market
For public companies, you can find database services that publish betas. Few services do a better job
of estimating betas than BARRA. While you might not be able to afford to subscribe to the beta
estimation service, this site describes the process by which they come up with "fundamental" betas.
Bloomberg and Ibbotson are other valuable sources of industry betas.

(Rm – Rf) = Equity Market Risk Premium (EMRP) - The equity market risk premium (EMRP)
represents the returns investors expect to compensate them for taking extra risk by investing in the
stock market over and above the risk-free rate. In other words, it is the difference between the risk-
free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has
gone up due to the notion that holding shares has become more risky.
The EMRP frequently cited is based on the historical average annual excess return obtained from
investing in the stock market above the risk-free rate. The average may either be calculated using an
arithmetic mean or a geometric mean. The geometric mean provides an annually compounded rate of
excess return and will in most cases be lower than the arithmetic mean. Both methods are popular,
but the arithmetic average has gained widespread acceptance.

Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific
to the company, which may increase or decrease a company's risk profile. Such factors include the
size of the company, pending lawsuits, concentration of customer base and dependence on key
employees. Adjustments are entirely a matter of investor judgment, and they vary from company to
company. 

Cost of Newly Issued Stock

Cost of newly issued stock (Rc) is the cost of external equity, and it is based on the cost of retained
earnings increased for flotation costs (cost of issuing common stock). For a constant-growth
company, this can be calculated as follows:

Rc = D1__ + g
P0 (1-F)
where:
F = the percentage flotation cost, or (current stock price -
funds going to company) / current stock price

It is important to note that the cost of newly issued stock is higher than the company's cost of
retained earnings. This is due to the flotation costs.

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Cost of Capital
Weighted Average Cost of Equity
weighted average cost of equity (WACE) is a way to calculate the cost of a company's equity that
gives different weight to different aspects of the equities. Instead of lumping retained earnings,
common stock and preferred stock together, WACE provides a more accurate idea of a company's
total cost of equity.

Here is an example of how to calculate WACE:

First, calculate the cost of new common stock, the cost of preferred stock and the cost of retained
earnings. Let's assume we have already done this and the cost of common stock, preferred stock and
retained earnings are 24%, 10% and 20% respectively.

Now, calculate the portion of total equity that is occupied by each form of equity. Again, let's assume
this is 50%, 25% and 25%, for common stock, preferred stock and retained earnings, respectively.

Finally, multiply the cost of each form of equity by its respective portion of total equity, and sum of
the values to get WACE. Our example results in a WACE of 19.5%.

WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5%

Determining an accurate cost of equity for a firm is integral in order to be able to calculate the firm's
cost of capital. In turn, an accurate measure of the cost of capital is essential when a firm is trying to
decide if a future project will be profitable or not.

Cost of Preferred Stock

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Cost of Capital
Preferred stock is an equity security with properties of both equity and a debt instrument. It is
generally considered a hybrid instrument. Preferred stock represents some degree of ownership in a
company, but usually doesn't come with the same voting rights. In the event of liquidation, preferred
shareholders are paid off before the common shareholder, but after debt holders. Preferred stock may
also be callable or convertible, meaning that the company has the option to purchase the shares from
shareholders at any time for any reason - usually for a premium - or convert the shares to common
stock. Similar to bonds, preferred stocks are rated by the major credit rating companies. Some people
consider preferred stock to be more like debt than equity.

Contribution To Cost of Capital

Because preferred stock carries a differing amount of risk than other types of securities, we must
calculate its asset specific cost of capital to work into our overall weighted average cost of capital.
Similar to debt, this can be a relatively simple process since we can observe values needed as inputs
in the market. With preferred shares, investors are usually guaranteed a fixed dividend forever. This
is different than common stock, which has variable dividends that are never guaranteed. If preferred
dividend is known and fixed, we can use the following equation to calculate the cost of capital for
preferred stock.

The cost of preferred stock is equal to the preferred dividend divided by the preferred stock price,
plus the growth rate.

This tells us that the cost of preferred stock is equal to the preferred dividend divided by the
preferred stock price, plus the expected growth rate. The dividend is usually specified as a
percentage of the par value or as a fixed amount. Sometimes, dividends on preferred shares may be
negotiated as floating - they may change according to a benchmark interest rate index.

The Cost of Retained Earnings

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Cost of Capital
Retained earnings refer to the portion of net income (or loss) that is retained by a company rather
than distributed to its owners as dividends. Retained earnings and losses are cumulative from year to
year, with losses offsetting earnings. Retained earnings can be expressed as a ratio known as the
"retention rate"

Retention Rate
The retention rate equals retained earnings divided by net income.

The retention rate also can be expressed in terms of the dividend payout ratio: . The retention rate
and the dividend payout rate are opposites, as are retained earnings and dividends paid out.
Therefore, we also can calculate retained earnings by subtracting dividends paid out from total net
income.

The cost of retained earnings or internal funds within a capital structure is similar to the cost of
common stock, since it is a component of equity. We can think of the cost of retained earnings in
relation to the opportunity cost of how we can use these funds elsewhere. Generally, the cost of
retained earnings is slightly less than the cost of common stock.

Financing Decisions
When deciding how to finance a new project, companies have a tendency to guard capital and
minimize the distribution of dividends to shareholders. This follows with the so-called "pecking
order" of financing whereby companies prefer internal sources of capital to external sources of
capital. Moreover, internal financing is generally thought to be less expensive for the firm than
external financing, because the firm does not have to incur transaction costs to obtain it, nor does it
have to pay the taxes associated with paying dividends.

Conclusion
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Cost of Capital
The management of a company has the paramount responsibility of directing and controlling the
company in the best interest of the owners (shareholders) and the investors. The main objective of a
business firm is to maximize the wealth of its shareholders in the long run. The management is
therefore expected to invest only in those projects which give a return in excess of cost of funds
invested in the projects of the business. This cost of funds committed to the projects of the business
is what is called Cost of Capital. The cost of capital refers to the rate of return the company has to
pay to various suppliers of funds in the company. It can be described as the minimum rate of return
that a firm must earn on its investments so that market value per share remains unchanged. The cost
of capital is the cost of a company's funds (both debt and equity) or from an investor's point of view
"the required rate of return on a portfolio company's existing securities”. It is used to evaluate new
projects of a company. It is the minimum return that investors expect for providing capital to the
company, thus setting a benchmark that a new project has to meet. Explicit cost of any source may
be defined as the discount rate that equates the present value of the funds received by a firm with the
present value of expected cash outflows. There are five types of cost which include; the implicit cost
may be defined as the rate of return associated with the best investment opportunity for the firm and
its shareholders that will be foregone if the project under consideration by the firm is accepted. The
cost of each component of capital is known as specific cost of capital. A firm raises capital from
different sources such as equity, preference, debentures, etc. The weighted average cost of capital is
the combined cost of each component of funds employed by the firm. The weights are the proportion
of the value of each component of capital in the total capital. Marginal cost is defined as the cost of
raising one extra rupee of capital. It is also called the incremental or differential cost of capital.
These are the factors affecting cost of capital that the company has control over. A firm has control
over its capital structure, and it targets an optimal capital structure. As more debt is issued, the cost
of debt increases, and as more equity is issued, the cost of equity increases. The firm has control over
its payout ratio; the breakpoint of the marginal cost of capital schedule can be changed. For example,
as the payout ratio of the company increases, the breakpoint between lower-cost internally generated
equity and newly issued equity is lowered. It is assumed that, when making investment decisions, the
company is making investments with similar degrees of risk. The level of interest rates will affect the
cost of debt and, potentially, the cost of equity. Tax rates affect the after-tax cost of debt. As tax rates
increase, the cost of debt decreases, decreasing the cost of capital. Debt capital refers to funds that
are borrowed and must be repaid at a later date. While debt allows a company to leverage a small
amount of money into a much greater sum, lenders typically require the payment of interest in return
for the privilege. Equity capital typically comes from funds invested by shareholders; the cost of
equity capital is slightly more complex. While equity funds need not be repaid, there is a level of
return on investment that shareholders can reasonably expect based on the performance of the market
in general and the volatility of the stock in question. Weighted average cost of equity (WACE) is a
way to calculate the cost of a company's equity that gives different weight to different aspects of the
equities. Instead of lumping retained earnings, common stock and preferred stock together, WACE
provides a more accurate idea of a company's total cost of equity.

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