Cost of Capital

Lecture 7
Business Finance
 A brief recap
What’s the main goal of a company?
• The main goal of a company is to maximize the shareholder value.
• In order to do so, the financial manager’s task is to make decisions about investment &
financing.
• Companies have different capital components that can utilize in order to pursue long-
term projects. These kind of projects cannot be funded by working capital.
• Hence, Companies wanting to undertake these long term projects, they have to acquire
additional capital from capital markets.
Each of the capital components exist because there is demand from investors
Common stock
Bonds
Preferred stock
 Brief Recap

• Investors expect to be compensated for the specific risks associated with a given investment.

Cost of equity capital > Cost of debt capital

Because equity investors have no guarantee of return on their investment.

• Managers to evaluate potential projects to determine whether these potential projects will
earn enough in such a way that it compensates investors.

• We would like to purchase asset that gives us a higher return on our investment than the
funds cost us to undertake that project. Hence, the project should be undertaken only if the
return on invested capital is greater than its opportunity cost. This is how companies create
wealth.
 The cost of capital & WACC

• The cost of capital is very important in doing the capital budgeting decisions.

• Sometimes we do not use our firm’s cost of capital because we are valuing a

project that has not the same risk average of our firm.

• Valuing a project that is more/ less risky than our firm’s average project. Then, we

should use a higher/ lower cost of capital to adjust for that.

Capital structure

CAPITAL STRUCTURE
Prefrence shares Debt Equity

10%

20%

70%
 Weighted Average cost of capital

What’s Weighted-Average Cost of Capital?

The overall opportunity cost of the firm’s capital is a weighted average of the opportunity costs of
capital from debt, preferred equity, and common equity.

We will weight these according to the capital structure of the firm:

A weighted average
cost of capital (WACC)

Cost of Cost of
debt equity
 Weighted-Average Cost of Capital

Here are some of the symbols we will be used during this lecture:

𝑲𝒅 : Yield to maturity on existing/ new debt; this is the before-tax cost of debt.

𝑲𝒅 (1-t): After-tax cost of debt, where t is the marginal tax rate- only interest in debt is

paid pre-tax.

𝑲𝒑 : Cost of preferred stock.

𝑲𝒆 : Cost of common equity.

 Cost of Capital
The company cost of capital as “the expected return on a portfolio of all the company’s existing
securities.” That portfolio usually includes debt as well as equity.
Hence, the cost of capital is estimated as a blend of the cost of debt (the interest rate) and the cost of
equity (the expected rate of return demanded by investors in the firm’s common stock).
Let’s assume the cost of these securities are:
𝐾𝑒 = 14%, 𝐾𝑑 = 8%, 𝐾𝑝 = 10%.

WACC is based on the proportion of each type.

𝑾𝑨𝑪𝑪 = 𝐾𝑒 × 𝜔𝑒 + 𝐾𝑑 × 𝜔𝑑 + 𝐾𝑝 × 𝜔𝑝

𝑾𝑨𝑪𝑪 = 0.7 × 0.14 + 0.2 × 0.08 + 0.1 × 0.11 = 12.5%.

Here, we are just weighting each type of finance based on their proportion in the structure of our

capital. The 12.5% will be used as a benchmark, so your project returns should be higher than 12.5%.
 Cost of Capital
Now, let’s calculate the After-tax WACC:

After − Tax 𝑾𝑨𝑪𝑪 = (1 − 𝑇𝑐 )𝐾𝑑 × 𝜔𝑑 + 𝐾𝑒 × 𝜔𝑒 + 𝐾𝑝 × 𝜔𝑝

Interest is a tax-deductible expense for corporations, so the after tax cost of debt will

be equal to “(1 − 𝑇𝑐 )𝐾𝑑 ”. Let’s suppose that the 𝑇𝑐 = 35%.

After − Tax 𝑾𝑨𝑪𝑪 = 0.7 × 0.14 + 1 − 0.35 0.2 × 0.08 + 0.1 × 0.11 = 0.119 or 12%.

Here, we are just weighting each type of finance based on their proportion in the

structure of our capital. The 12% will be used as a benchmark, so your project returns

should be higher than 12%.

 Cost of Capital
The company cost of capital is “the expected return on a portfolio of all the
company’s existing securities.” That portfolio usually includes debt as well as equity.
Hence, the cost of capital is estimated as a blend of the cost of debt (the interest rate)
and the cost of equity (the expected rate of return demanded by investors in the
firm’s common stock).

The values of debt and equity add up to overall firm value ( D + E = V) and firm value V
equals asset value.
Company cost of capital:
𝑪𝒐𝒎𝒑𝒂𝒏𝒚 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 = 𝐾𝑒 × 𝜔𝑒 + 𝐾𝑑 × 𝜔𝑑 + 𝐾𝑝 × 𝜔𝑝
𝐷 𝐸 𝑃
𝐾𝑑 = , 𝐾𝑒 = , 𝐾𝑝 = .
𝑉 𝑉 𝑉
 Cost of Capital

The values of debt and equity add up to overall firm value ( D + E = V) and firm value V equals
asset value.
Company cost of capital:
𝑪𝒐𝒎𝒑𝒂𝒏𝒚 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 = 𝐾𝑒 × 𝜔𝑒 + 𝐾𝑑 × 𝜔𝑑
𝐷 𝐸
𝐾𝑑 = , 𝐾𝑒 = .
𝑉 𝑉
𝐾𝑒 = 15%, 𝐾𝑑 = 7.5%
WACC is based on the proportion of each type.
𝑾𝑨𝑪𝑪 = 𝐾𝑒 × 𝜔𝑒 + 𝐾𝑑 × 𝜔𝑑
𝑩𝒆𝒇𝒐𝒓𝒆 − 𝑻𝒂𝒙 𝑾𝑨𝑪𝑪 = 0.7 × 0.15 + 0.3 × 0.075 = 12.75%.
Suppose t=35%. Then after-tax WACC is:
After − Tax 𝑾𝑨𝑪𝑪 = 0.7 × 0.15 + 1 − 0.35 × 0.075 × 0.3 = 0.1196 or 12%.
 Deciding on Weightings

• Weightings are decided based on one on these approaches:

1. Target capital structure.
2. Market Value.
Important : Do not confuse between Book Value & Market Value.
What’s the target capital structure?
Target capital structure: is the proportions (based on the market value) of debt,
common stocks, and preferred stocks that the company achieve to get over time.

How do we calculate the K’s ?

 The Role of the WACC in determining
NPV of projects
• The WACC is the appropriate discount rate (cost of capital) for projects that have
the same level of risk as the firm existing projects.

• For a project with greater than average risk, use a discount rate greater than the
firm’s existing WACC.

• For a project with below-average risk, use a discount rate less than the firm’s
WACC.

• The company cost of capital is not the correct discount rate if the new projects are
more or less risky than the firm’s existing business.
 In this case, we assume the company has no debt, so its cost of capital
Company & is just the expected rate of return on the firm’s stock.
Project Cost
The company cost of capital is not the correct discount rate if the new
of Capital projects are more or less risky than the firm’s existing business. The
company cost of capital is the correct discount rate only if the project
beta is 0.5.

What’s the difference between the company and the project costs of capital? The difference is that using the
company cost of capital leads you to accept any project regardless of its risk as long as this project provides higher
returns than the company’s cost of capital. (In our case, any project that gives a return more than 3.8%). Yet, a high-
risk project needs a higher return than a low risk one. Hence, using the SLM line leads us to say that any project
lying above the SML line should be accepted.
Estimating Beta
We are interested in the future beta if
the company’s stock, but we need first
to turn to historical evidence. The
Figure shows how a line was fitted
through the points, which are from
January 1999 to December 2003. The
slope of this fitted line is Beta.
What does beta tell us?
It tells us how much on average the
stock price changed when the market
return was 1% higher or lower.
We can see from the diagrams that
only a small portion of each stock’s
total risk comes from movement in the
market. How did we know?
From the R-squared (𝑹𝟐 ) which
measures the proportion of the total
variance in the stocks returns that can
be explained by the market
movement.
 Calculating the Cost of capital for a Project
Calculating the cost of capital for project:
• Calculate the cost of equity for the project using the pure play method.
• Calculate the cost of debt of the company.
• Calculate the cost of capital for the project using the debt/equity ratio of the subject
company and the WACC formula.
Calculating the cost of equity using the pure play method:
1. Calculate the beta of a company that is a pure play in the industry. (we try to find a company that operates in the same
industry (oil industry) of our project and look at their risk.
2. Unlever it to adjust for differences in debt/equity ratio- this is called the asset beta. (the leverage of our company maybe
different than the other company).
1 D
𝛽𝐴𝑠𝑠𝑒𝑡 = 𝛽𝑃𝑢𝑟𝑒 𝑝𝑙𝑎𝑦 , we use the the debt to equity ratio and the marginal tax of the pure play company.
𝐷 E
1+ 1−𝑡 𝐸

3. Relever it to reflect the debt/equity ratio of our company (subject company)- this is called the project beta.
𝐷 D
𝛽𝑝𝑟𝑜𝑗𝑒𝑐𝑡 = 𝛽𝑎𝑠𝑠𝑒𝑡 1 + 1−𝑡 , we use the the debt to equity ratio and the marginal tax of the subject our company.
𝐸 E
4. Use the project beta to calculate the cost of equity for the project(instead of the firm current cost of equity).
5. Use the cost of equity to calculate the WACC.
 Cost of Equity
The cost of equity is the rate of return that the company must pay to entice investors
to purchase common stock issued by the company.
An investor expect to earn a return on investing in a company’s stock through
appreciation of the share price and through the receipt of dividend payments, if
applicable.
For companies that do not pay dividends, they compensate the investor by making the
right capital allocation decisions that grow the overall value of the company, and thus
the value of each individual’s share of the company’s value.
Metrics for calculating the value of common stock and the required rate of return:
1. Discounted Cash Flow analysis (e.g., Gordon Growth Model and FCF model) :
𝐷0 (1:𝑔) 𝐷1
𝐾𝑒 = 𝑃0
+ 𝑔 or 𝐾𝑒 = 𝑃0
+𝑔
2. Capital Asset Pricing Model (CAPM): 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓
3. Bond yield plus risk premium method.
 Measuring the cost of equity using CAPM
In order to estimate the cost of equity, you need to use the Capital asset pricing model (CAPM).
As we discussed, the Security Market Line (SML) shows the link between the expected return of a
security and the expected return on the market, the risk-free rate of interest, and the riskiness of
the security relative to the market, captured by the security’s estimated 𝛽𝑖 .
The CAPM formula is as follows:

𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒔𝒕𝒐𝒄𝒌 𝒓𝒆𝒕𝒖𝒓𝒏 = 𝒓𝒇 + 𝜷 𝒓𝒎 − 𝒓𝒇

 Estimating the Cost of Debt
The method of estimating cost of debt depends on the type of debt, debt liquidity and
credit rating and debt currency.
Traded- debts: A company with straight debt can estimate its cost of issuing debt and
the yield to maturity on the company’s existing debt with the longest maturity.

Non-traded debts: The analyst will estimate the company’s cost of capital by using the
YTM bonds with similar credit ratings and maturities from other companies and apply
matrix pricing to estimate the subject company’s bond’s YTM.
 Cost of Debt

The cost of debt is the interest rate that companies must pay to attract investors to
purchase the debt that the company issued .This value is the Yield to Maturity (YTM).
YTM is the yield an investor would get if it purchased a bond today and held it until
maturity.
• The cost of debt is the return that the investors demand.
• The cost of debt is the interest rate the firm must pay to investors.
• If a company already has bonds outstanding: then the yield to maturity on these
bonds is the market’s required rate of return on the company’ debt.
 Cost of Debt

Example: Corporation B wants to determine its cost of debt. The Company has a debt
issue with 12 years to maturity that is quoted at 93% of face value. The issue makes
semiannual payments and has a cost of 6% annually. What is the Company’s pre-tax
cost of debt? And the after-tax cost of debt if tax-rate is 38%?
Present Value: 93 TL; Coupon Payments: 3%; Number of periods: 24 (12*2)
Important:
1. The bond's face value is generally set at $100. So, the bond is trading at 93% of its
face value means its PV is $93.
2. Semiannual payments:
Pre-tax Cost: 𝐾𝑑 = (93; 3%; 24) = 6,87% and
After-tax Cost 𝐾𝑑 = 6,87% * (1 – 0,38) = 4,26 %
 Cost of Preferred Stock
Preferred Stock: Preferred stock operates differently from common stock in that owners do not
have ownership in the company, but it pays a perpetual dividend.
The required return on preferred stock is:

𝑫𝑰𝑽
𝒓𝒑 = 𝒌𝒑 =
𝑷𝟎
Example: A preferred stock with a dividend of $8.5 has a value of $100/share. What’s the firm’s
cost of preferred stock?
𝑫𝑰𝑽 $𝟖. 𝟓
𝒌𝒑 = = = 𝟎. 𝟎𝟖𝟓 = 𝟖. 𝟓%
𝑷𝟎 $𝟏𝟎𝟎
 Practice questions
1. The ordinary shares of Corporation S are quoted at $7.5 per share. A dividend of
$0.6 per share is about to be paid. There is no growth in dividend expected.
Calculate the cost of equity using the dividend valuation model?
The cumulative divided price (𝑃0 ) is: $7.5.
The Ex-dividend price is (𝑃0 ) = 7.5 – 0.6= $6.9.
Why? Because it is mentioned that the share is about to be paid. Since the dividend
has not been paid. Hence, it still includes the potential dividend that will be given in it
(So, cumulative dividend 𝑃0 = 𝐸𝑥 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑃0 − 𝐷0 ) .
𝑃0 = 6.9, 𝐷0 = $0.6, 𝑔 = 0
𝐷0 (1:𝑔) 𝐷0 0.6
𝐾𝑒 = + 𝑔; since 𝑔 = 0. Thus: 𝐾𝑒 = = 6.9 = 8.7%.
𝑃0 𝑃0
 Practice questions
2. The cost of equity of M is 12.5% and the shares are currently quoted at $6.5. A
dividend has recently been paid and the expected growth in dividends is 4%.
What’s the dividend per share that was paid out?
𝑃0 = $6.5, 𝑔 = 4%, 𝐾𝑒 = 12.5%, 𝐷0 =?
We have:
𝐷0 (1:𝑔) 𝐷0 (1:0.04)
𝐾𝑒 = + 𝑔 => 𝐾𝑒 = + 0.04 = 12.5% => 𝐷0 = 53 cents.
𝑃0 6.5
 Practice questions
3. H Corporation has an issue 5% irredeemable debentures currently quoted at $88
per $100 nominal value. H pays corporate income tax at a rate of %20. Calculate
the post-tax cost of debt of these irredeemable debentures .
5% represents the coupon rate and it’s based on the nominal value which is $100.
We will pay 5% × 100 = $5 of interest per bond.
The market value is: $88.
Now, let’s calculate the pre-tax yield:
If you are an investor you would get a $5 of interest on a bond that costs $88.
$5
𝑇ℎ𝑒 𝑝𝑟𝑒 − 𝑡𝑎𝑥 𝑦𝑖𝑒𝑙𝑑: = 5.7%. This is the required return of an investor.
$88
𝑇ℎ𝑒 𝑝𝑜𝑠𝑡 − 𝑡𝑎𝑥 𝑦𝑖𝑒𝑙𝑑: 𝐾𝑑 × 1 − 𝑇𝐶 = 5.7% × 1 − 20% = 4.5%.
 Resources
Mainly:
Introduction to Business Finance: Techniques & Tools.
Jeffrey S. Smith, Ph.D. Department of Economics and
Business Virginia Military Institute
Extra:
Brealey, Stewart C. Myers, and Franklin Allen, Principles
of Corporate Finance, 13th edition (McGraw‐Hill Irwin,
2020).
Lecture Notes of:
https://timmurrayecon.com/wp-
content/uploads/2022/07/Business-Finance-Lecture-
Notes-June-2022.pdf