Chapter five:

The Cost of Capital

5.1. Introduction
It is well understood, two parties are involved in a financial asset under normal
circumstances. One is the party issuing the financial asset. Another is the one that buys or
invests on the financial asset. Between these two parties there is one thing, which is
required rate of return.
The rate of return required by the investor should definitely be provide by some other
party. The party which should provide the investor its required rate of return is the issuing
party. For example, if the required rate of return by an investor on a given bond is 10%,
the issuing company should provide this 10% to the investor. This required rate of return
that should be met by the issuing company becomes its cost. This is a cost on the capital
the issuing company wants to raise.

5.2 The concept of cost of capital

Business requires funds for its investment decisions, and every investment requires a
return to be payable. The term cost of capital refers to the return a firm intends to pay to
its members who contribute the capital to the firm. The rate of return a firm pays to the
investors so as to retain the market value of the shareholding capacity of the investors
which in-turn protects the liquidity option of the investor. If a firm pays the expected
return to the investors of the firm then the firm, will retain its marketability of the share
value in the secondary markets, and if it is unable to pay, then it loses its market value.

A firm’s cost of capital is defined, as “the rate of return the firm requires earning for the
investment in order to increase the value of the firm in the market place”. From the above
definition, it is to be noted that,
I. It is simply a real rate of return that is required on the projects investment.

Prepared by DANIEL B.
II. It is merely the minimum rate of return that will result in minimizing cost of equity
and increasing the value of the equity share.

Cost of capital comprises three components, and they are

(1) Return at zero level risk – also referred as risk free return;

(2) Premium of the business risk – referred as the variability in operating profits with
change in sales; and
(3) Premium in financial risk – referred to the variability caused by patterns of capital
structure.
Empirically the above concepts are expressed as follows:

K = Rf + Rb + Rfr
Where K = Cost of capital Rb = business risk

Rf = risk free rate of return Rfr = financial risk

5.3 Significance of Cost of Capital

 Cost of capital is useful for the firm in evaluating the capital budgeting decisions
and capital structure decisions.
o A capital budgeting decision is considered with the discounting factor that is
used to evaluate the appraisal of a project.
o Cost of capital is the required rate of return usually used in evaluation of the
capital project appraisal as discounting factor.
 Cost of capital plays important role in capital structure decisions.
o It is used in raising capital required, so as to keep the cost of funds at optimum
level.
o It is always required for the firm to determine the market value of the firm and
keep the liquidity option of the share or bond value in the market high.

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5. 4 Determination of Cost of Capital
Cost of capital is determined by taking into account the cost of each component of capital,
known as a specific cost of capital. Specific cost of capital of the given firm is defined as
the cost of equity (returns paid to the equity share holders) or cost of preference (returns
paid to preference shareholders) or cost of debt (returns paid to the debt holders).

5.5 Computation of Specific Costs of Capital

The cost of capital for any particular capital source or security issue is called the specific
cost of capital. It is also called individual cost of capital or component cost of capital.
Each type of capital contained the capital structure of a firm include:
1. Debt
2. Preferred stock
3. Common stock

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Two important points you should bear in mind about the specific cost of capital.
 One is that it is computed on an after-tax basis. Meaning, if there would be any
tax implication on the individual source of capital, it should be considered. In
almost all circumstances, the tax implication is only on debt sources of finance.
 The second point is that the specific cost of capital is expressed as an annual
percentage or rate like 6%, 9%, or 10%. The cost of capital is not stated in terms
of birr.

5.5.1 Cost of Debt

This is the minimum rate of return required by suppliers of debt. The relevant specific
cost of debt is the after-tax cost of new debt. Generally, debt is the cheapest source of
finance to a firm and, hence, the cost of debt is the lowest specific cost of capital. There
are two basic explanations for this.
 First, debt suppliers, generally, assume the lowest risk among all suppliers of
capital. They receive interest payments before preferred and common dividends
are paid. Since they assume the smallest risk, their return is the lowest. Their
lowest return would be the lowest cost of capital to the firm.

 Second, raising capital through debt sources entails interest expense. The interest
expense in turn reduces the firm’s income which ultimately would cause tax
payment to be reduced. So raising money in the form of debt results in the
smallest tax burden, and finally, the firm’s cost of debt would be the lowest.

Debt sources of finance may take several forms like bonds, promissory notes, bank
loans. Here, for our convenience we consider bond issue to illustrate the cost of debt.
Debt capital can also be issued in two types, and they are
 Irredeemable debt, and
 Redeemable debt
Computation of debt capital cost is done as follows:

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  Cost of Irredeemable Debt (Kd):

{Int (1 − t)}
Kd =
𝑃0
Where Int = Interest on the debt capital
t = corporate tax rate applicable to the firm
Po = Issue price of the debt capital
Kd = cost of the debt
 Cost of Redeemable Debt (Kd):

𝐈𝐧𝐭 (𝟏 − 𝐭) + [(𝐑𝐕 − 𝐒𝐕)/𝐧]

𝐊𝐝 =
[𝐑𝐕 + 𝐒𝐕]/𝟐
Where Kd = Cost of debt
Int = Interest paid/payable on the debt
RV = Redeemable value of the debt
SV = Sales proceeds of the debt, which is debt security’s sales price minus Flotation cost.

n = Maturity period in years.

t = corporate tax rate applicable to the firm.
Example
 Find the cost of Debt from the following information given to you: Int = 9%; tax
rate = 40 % and Po = Br. 1000; then Kd =?
Required;-
i. What will be the cost of debt when it is irredeemable?
ii. What will be the cost of Debt when it is redeemed after 5 years at (i) 15 %
premium and (ii) 10 % discount?
Solution:
i. What will be the cost of debt when it is irredeemable?

Prepared by DANIEL B.
 Where Kd = cost of debt
Int = 9 % of Br.1000 = Br. 90
Po = Br. 1000
T = 40 %

Kd = {Br.90(1−.4)}
Br.1000

Kd = Br.54/Br.1000

Kd = 0.054 or 5.4 %

ii. What will be the cost of Debt when it is redeemed after 5 years at (a) 15 % premium
and (b) 10 % discount?

a. With 15 % premium

Int (1-t) + [(RV-SV)/n]

Kd = ------------------------
[RV + SV]/2

Where Kd= Cost of debt

Int= 9 % on Br. 1,000
RV = Br. 1000 + 15 % on Br. 1,000 = Br.1000 + Br. 150 = Br. 1,150
SV = Br. 1000
n = 5 years, T = 40 %
Br. 90 (1 – 0.4) + [(Br. 1,150-Br. 1,000)/5 years]
Kd= ---------------------------------------------------------
[Br. 1,150 + Br. 1,000]/2

Br. 54 + [(Br.150)/5 years]

Kd =----------------------------
[Br. 2,150]/2

Prepared by DANIEL B.
 Br. 54+ Br.30
Kd = ----------------
Br.1,075

Br. 84
Kd = --------------- = 0.0781 or 7.81 %
Br.1,075
(b). With 10 % discount
Int (1-t) + [(RV-SV)/n]
Kd = -------------------------------
[RV + SV]/2

Where Kd= Cost of debt

Int= 9 % on Br. 1,000
RV = Br. 1000 - 10 % on Br. 1,000 = Br.1000 - Br. 100 = Br. 900
SV = Br. 1000
n = 5 years
T = 40 %
Br. 90 (1 – 0.04) + [(Br. 900-Br. 1,000)/5 years]
Kd= ---------------------------------------------------------
[Br. 900 + Br. 1,000]/2

Br. 54 + [(-Br.100)/5 years]

Kd =----------------------------
[Br. 1,900]/2

Br.54− Br.20 Br.34

Kd = = Kd = =0.0358 or 3.58 %
Br.950 Br.950

3.5.2 Cost of Preference

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The cost of preferred stock is the minimum rate of return a firm must earn in order to
satisfy the required rate of return of the firm’s preferred stock investors. It is also the
minimum rate of return a firm’s preferred stock investors require if they are to purchase
the firm’s preferred stock.

When a firm raises capital by issuing new preferred stock, it is expected to pay fixed
amount of dividends to the preferred stockholders. So it is the dividend payment that is
the cost of the preferred stock to the firm stated as an annual rate.

A firm can issue preference shares of two types, and they are:
Permanent preference shares; are shares issued with a condition of non-payment of
the capital to the shareholders, and if at all the payment of the capital arises will be in
the situation of the winding up of the firm.
Redeemable preference shares: They are being issued with a condition to repay after
certain period, say after 10 years or 15 years.

Both types differ with each other in only one way, i.e., in repayment of the capital.
Preference shareholders are entitled for the payment of dividends every year, which will
be the cost for the firm, identified as the cost of preference.
(i) Cost of Irredeemable preference shares (Kp):
Kp = Pd/Po
Where Kp = cost of preference share
Pd = Preferential dividend for the year
Po = Issue price of the preference share
ii Cost of Redeemable preference shares (Kp):

Pd + [(RV − SV)/n]
Kp =
[(RV + SV)/2]

Where Kp = Cost of preference share

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 Pd = Preferential dividend for the year
RV = Redeemable value of the preference share
SV = Sales proceeds of the preference share
n = Maturity period in years.
It is essential to know at this point that, when a firm issues cumulative preference
shares, then the value of the cost of preference share should be changed with the
cumulative value of the preferential dividend i.e., current year dividend with default
dividend from the past years.

Example
Find the cost of the preference from the following information given to you: P d = Br.7;
and Po = Br. 100; then Kp =? What will the cost of preference when the share is
redeemed after 5 years at (i) 10 % premium and (ii) 5 % discount?
Sol:
 When it is irredeemable.
Kp = Pd/Po
Where Kp = cost of preference share

Pd = Br. 7
Po = Br. 100
Kp = Br. 7/Br. 100
Kp = 0.07 or 7

 When the preference share is redeemable, then Kp will be:

(i) With 10 % premium

Pd + [(RV-SV)/n]
Kp = ------------------------
[RV + SV]/2

Prepared by DANIEL B.
 Where Kp = Cost of preference share
Pd = Br. 7
RV = Br. 100 + 10 % on Br. 100 = Br.100 + Br. 10 = Br. 110
SV = Br. 100
n = 5 years

Br. 7+ [(Br. 110-Br. 100)/5 years]

Kp = -----------------------------------
[Br. 110 + Br. 100]/2

Br. 7+ [(Br.10)/5 years]

Kp =----------------------------
[Br. 210]/2

Br. 7+ Br.2
Kp = ----------------
Br.105

Br. 9
Kp = --------------- = 0.0857 or 8.57 %
Br.105

(ii) With 5 % discount

Pd + [(RV-SV)/n]
Kp = ------------------------
[RV + SV]/2

Where Kp = Cost of preference share

Pd = Br. 7

Prepared by DANIEL B.
 RV = Br. 100 - 5 % on Br. 100 = Br.100 - Br. 5 = Br. 95
SV = Br. 100
n = 5 years

Br. 7+ [(Br. 95-Br. 100)/5 years]

Kp = -----------------------------------
[Br. 95 + Br. 100]/2

Br. 7+ [(-Br.5)/5 years]

Kp =----------------------------
[Br. 195]/2

Br. 7- Br.1
Kp = ----------------
Br.97.50

𝐵𝑟.6
K p = 𝐵𝑟.97.5 =0.0615 or 6.15 %

3.2.1.1. Cost of Equity

Under this specific cost of capital, we will see cost of new equity/cost of common stock
and cost of retained earnings.
3.2.1.1.1. The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its
common stockholders in order to maintain the value of the firm. A firm does not make
explicit commitment to pay dividends to common stockholders. However, when
common stockholders invest their money in a corporation, they expect returns in the
form of dividends. Therefore, common stocks implicitly involve a return in terms of the
dividends expected by investors and hence, they carry cost.

Generally, common stock dividends are paid after interest and preferred dividends are
paid. As a result, common stock investors assume the maximum risk in corporate

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investment. They compensate the maximum risk by requiring the highest return. This
highest return expected by common stockholders make common stock the most
expensive source of capital.

The cost of common stock can be computed using the constant growth valuation model.
𝐷1
Ks = +𝑔
𝑁𝑃0
Where:
Ks = The cost of new common stock issue
D1 = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate

The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f
Where:
Po = The current market price of the common stock
f = flotation costs

Illustration 3.3:
An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50
per share and it is expected to grow at 6% annual rate. Compute the specific cost of this
common stock issue.

Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:

i) NPo = Br. 20 – Br. 1 = Br. 19

ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments
that are financed by the new common stock issue.

 Generally the cost of new common stock equity can be computed in the
following ways:
1. Dividend price (D/P) approach.

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 2. Dividend price plus growth (D/P + g) approach.
3. Earning price (E/P) approach.
4. Realized yield approach.

1. Dividend Price Approach

The value of the common share may be interpreted by the shareholder as the present
value of the expected stream of future dividends. Although in the short-run
stockholders may be influenced by a change in earnings or other variables, the ultimate
value of any holdings rests with the distribution of earnings in the form of dividend
payments. Though the stockholders may benefit from the retention and reinvestment of
earnings by the corporation, at some point the earnings must be translated into cash
flows for the stockholders. A stock valuation model based on future expected
dividends, which is termed as dividend valuation model, can be ascertained as follows:
𝑫𝟏 𝑫𝟐 𝐃œ
𝐏𝐨 = + +
(𝟏 + 𝐊𝐞)𝟏 (𝟏 + 𝐊𝐞)𝟐 (𝟏 + 𝐊𝐞)œ

Where Po = Price of the Equity/Common share

D = Dividend for each year
Ke = Cost of equity or required rate of return or discounting rate

2. Dividend Price Plus Growth Approach

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 A firm that increases dividends at a constant rate is more likely circumstances. As per
this model the growth is expressed in dividends for valuation is always assumed to be
constant. Market price of the common share is ascertained as follows:

𝐷1
𝐾𝑒 = +𝑔
𝑃0

Where P0 = Price of common shares

D1 = Dividend for year
g = growth rate
Ke = required rate of return.
Market value of the common share can be ascertained by transposing the above
equation. This can be done as follows:
𝐷1
𝑃0 =
𝐾𝑒−𝑔

3. Earnings Price Approach

According to this method market price per share is determined by capitalizing the future
dividends per share, derived from the earnings per share. The cost of capital according to
this method remains constant as the earnings percentage keeps to the share price constant.
Cost of equity is estimated using this method as follows:
E
Ke =
NP

Where E = Earnings per share

NP= Net proceeds per share.

4. Realized Yield Approach

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According to this approach the cost of equity capital is determined on the basis of return
actually realized by the investor in a given firm on their investment. Cost of equity is
computed based on the past records of the given firm according to this approach.

3.2.1.1.2. The cost of Retained Earnings

Retained earnings represent profits available for common stockholders that the
corporation chooses to reinvest in itself rather than payout as dividends. Retained
earnings are not securities like stocks and bonds and hence do not have market price
that can be used to compute costs of capital.

The cost of retained earnings is the rate of return a corporation’s common stockholders
expect the corporation to earn on their reinvested earnings, at least equal to the rate
earned on the outstanding common stock. Therefore, the specific cost of capital of
retained earnings is equated with the specific cost of common stock. However, flotation
costs are not involved in the case of retained earnings.

Computing the cost of retained earnings involves just a single procedure of applying the
following formula:
𝐷1
Kr = +𝑔
𝑃0
Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firm’s common stock
g = The expected annual dividend growth rate.
Illustration 3.4:
Zeila Auto Spare Parts Manufacturing company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12 months. The firm’s current common
stock price is Br. 50 per share and the expected dividend growth rate is 7%. A flotation
cost of Br. 3 is involved to sale a share of common stock.
Required: Compute the cost of retained earnings

Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr = ?
Then apply the formula:

Prepared by DANIEL B.
 Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50

5.6 Simple average cost of capital

Simple average method is the simple arithmetic mean of the specific costs of capital,

Illustration 3.5:
From the following information supplied to you calculate the overall cost of capital of
the firm. Cost of equity is given as 15%; cost of preference is 8 %; and cost of debt is 7
%.

Sol:
Calculation of simple average cost of capital:
Ko = (Ke + Kp + Kd)/3
Where Ke = 15 %
Kp = 8 %
Kd = 7%
Ko = (15% + 8 % + 7 %)/3
Ko = (30%)/3
Ko = 10 %

3.3. The weighted Average cost of capital

Weighted average is the weights multiplied by the specific costs and the whole divided
by the total weights of the capital components.

Illustration 3.6:

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Computation of cost of capital using weighted average cost of capital with the following
weights Ke : Kp : Kd in 2:1:2 proportions and specific cost of capital for Ke : Kp : Kd
15%,8% and 7% respectively.

Sol:
Weighted average cost of capital (WACC) is calculated as follows:

Ko = (We Ke + Wp Kp + Wd Kd)/ (We + Wp + Wd)

Ko = (2 X 15 % + 1 X 8 % + 2 X 7 %)/ (2 + 1 + 2)
Ko = (30 % + 8 % + 14 %)/ (5)
Ko = (52 %)/ (5)
Ko = 10.4 %

Illustration 3.7:
From the following Statement given to you calculate the cost of capital using (i) SACC;
(ii) WACC using the Book values; and (iii) WACC using market values.

Particulars Book Values in Market values in Specific costs

Br. Br.
Common Share Br. 200,000 Br. 500,000 Ke = 13.5 %
Capital
Retained 250,000
Earnings
Preference Share 150,000 150,000 Kp = 7.9 %
capital
Bonds 150,000 100,000 Kd = 5.8 %
Sol (i):
Calculation of simple average cost of capital:
Ko = (Ke + Kp + Kd)/3
Where Ke = 13.5 %
Kp = 7.9 %

Prepared by DANIEL B.
 Kd = 5.8%
Ko = (13.5 % + 7.9 % + 5.8 %)/3
Ko = (27.2 %)/3= 9.33 %
(i) Calculation of WACC using Book weights:

Particulars Book Specific Book Cost X

values Cost weights weights
Common Share Br. 13.5 % 0.267 3.6045 %
capital 200,000
Retained 250,000 13.5 % 0.333 4.4955 %
earnings
Preferred share 150,000 7.9 % 0.200 1.5800 %
capital
Bond capital 150,000 5.8 % 0.200 1.1600 %
Total: Br. 1.000 10.8400 %
750,000

WACC Ko= 10.84 %

(iii) Calculation of Weighted cost of capital using market weights:

Particulars Book Specific Market Cost X

values Cost weights weights
Common Share Br. 13.5 % 0.667 9.00 %
capital 500,000
Preferred share 150,000 7.9 % 0.200 1.58 %
capital
Bond capital 100,000 5.8 % 0.133 0.77 %
Total: Br. 1.000 11.35 %
750,000

Ko= 11.35 %

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 3.4. The Marginal Cost of capital (MCC)

As a firm tries to have more new capital, the cost of each birr will rise at some point.
Thus, the marginal cost of capital (MCC) is the cost of obtaining additional new capital.
Technically speaking, the MCC is the weighted average cost of the last birr of new
capital obtained. So the concept of marginal cost of capital is discussed in the context of
the weighted average cost of capital.

As a firm raises larger and larger amounts of capital, the weighted average cost of
capital also rises. But the question would be at what point the firm’s costs of debt,
preferred stock, and common equity as well as WACC increase?

The first point, therefore, in computing the MCC is to determine the breaking points
where the cost of capital will increase.

The technical aspects of the MCC can be better understood using an illustration.

Illustration 3.8:
The target capital structure of Sheko Corporation and other pertinent data are given
below.
Long-term debt ------------------ 40%; cost of preferred stock (Kps) = 12.06%
Preferred stock -------------------10% cost of retained earnings (Kr) = 14%
Common equity ----------------- 50% cost of common stock (Ks) = 15%

Sheko Corporation has Br. 900,000 available retained earnings. But when the firm fully
utilizes its retained earnings, it must use the more expensive new common stock
financing to meet its equity needs. In addition, the firm expects that it can borrow up to
Br. 1,200,000 of debt at 7.3% after-tax cost. Additional debt will have an after-tax cost
of 9.1%.
Required
1) What is the breaking point associated with the
a. Exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2) Determine the ranges of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance.
Solutions
1) a. Breaking point (BP) common equity = Br. 900,000 = Br. 1,800,000
50%
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000

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 40%
The breaking points computed above can be interpreted as:
Sheko can meet its equity needs using retained earnings until its total finance need is
Br. 1,800,000. But when total capital required is more than Br. 1,800,000, its equity
needs should be met with common stock. Similarly, until the firm’s total finance need
reaches Br. 3,000,000, Sheko can raise any debt at 7.3% cost. Any further finance need
beyond Br. 3,000,000 will cause the cost of debt to rise to 9.1%.

2) There are three ranges of finance that could be identified on the basis of the breaking
points:
1st Range : Br. 0 to Br. 1,800,000,
2nd Range : Br. 1,800,000 to Br. 3,000,000, and
3rd Range : Br. 3,000,000 and above

3) WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)

= 2.92% + 1.21% + 7.00%
= 11.13%
nd
WACC (2 range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50%
= 11.63%
rd
WACC (3 range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 12.35%

Prepared by DANIEL B.