Chapter 8: Cost of capital

The minimum required rate of return expected

by investors for providing funds to a business
organization is called cost of capital. It is the
minimum rate of payments from the part of
business organization against raising of funds
and the minimum rate of receipts from the
part of the suppliers of funds. Generally cost
of capital means weighted average cost of
capital.
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 Chapter 8: Cost of capital

It is the sum of multiplicative results of

proportion of different sources of funds and
respective percentage cost of each source. For
calculating WACC the weight of each is
required and for this if there is no specific
requirement then generally market value of all
sources is considered. It is determined by
applying the following formula:
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 Chapter 8: Cost of capital
WACC= Wd Kd + WP KP + We Ke + Wr Kr
Wd = proportion / weight / percentage of debt fund to total
fund; Wp = proportion / weight / percentage of fund from
preferred stock to total fund; We = proportion / weight /
percentage of fund from common stock to total fund; Wr =
proportion / weight / percentage of fund retained earnings
to total fund.
Kd= percentage cost of debt financing; Kp = percentage cost
of financing from preferred stock; Ke = percentage cost of
financing from common stock; Kr = percentage cost of
financing from retained earnings. 8-3
 1 . Cost of debt capital (bonds /
debentures / long term loans):

(a) Kd = [Kb (1-Tc)] / (1-f); % form of floatation

cost, borrowing rate and tax rate are given
(b) Kd = I (1- Tc) / Po (1-f); Amount form of
interest and % form of floatation cost and tax
rate are given
(c) Kd = I (1-Tc) / (Po-F); Amount form of
interest and floatation cost and tax rate are given

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 2. Cost of preferred stock:

(a) Kp = Dp / Po (1-f); % form of

floatation cost is given
(b) Kp = Dp / (Po-F); amount form of
floatation cost is given

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 3. Cost of common stock:

(a) Ke = D0 / P0 (1-f); Constant amount of dividend

and % form of floatation cost
(b) Ke=Do /(P0-F); Constant amount of dividend and
amount form of floatation cost
(c) Ke = [D1/ (P0-F)] + g; Constant growth rate of
dividend and amount form of floatation cost
(d) Ke = [D1/ P0 (1-f)] + g; Constant growth rate of
dividend and % form of floatation cost

* Ke = Rf + (Rm - Rf)β (according to CAPM approach)

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 4. Cost of Retained Earnings:

Cost of retained earnings is equal to cost

of common stock in absence of
floatation cost
(a) Kr = D0 / P0 Constant amount of dividend
(b) Kr = [D1/ P0] + g; Constant growth rate of
dividend
* Kr = Rf + (Rm - Rf)β (according to CAPM
approach)
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 If Wild Widgets Inc. (WWI) were an all-equity firm, it
would have a beta of 0.9. WWI has a target debt-to-
equity ratio of 0.50. The expected return on the market
portfolio is 16 percent, and Treasury bills currently yield
8 percent per annum. WWI one-year $1000 par value
bonds carry a 7 percent annual coupon and are currently
selling for $909.73. The yield on WWI’s longer term
debt is equal to the yield on its one-year bonds. The
corporate tax rate is 34 percent.
(a) What is WWI’s cost of debt?
(b) What is WWI’s cost of equity?
© What is WWI’s weighted average cost of capital?
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Solution:
Beta = 0.9 D/E = 0.50 Tax rate = 34%
(a) Bonds par value = 1000 Selling price (Bo) = 909.73
FV 1000
Bo = or, 909.73 = or, Kd= 10%
1  kd 1  kd
(b)D/E = 0.50

V = D+E = 0.5+1 = 1.5

K =
e
R f  beta( Rm  R f ) = 0.08 +0.9 (0.16- 0.08) = 0.152
(c) We = E/V = 1/1.5 = .667 Wd = D/V = .5/1.5 =.333
WACC = We*Ke +Wd*Kd*(1-Tc) = 0.667*0.152+0.333*0.10*0.66
= 12.33%

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 Example of WACC
 Weighted Average Cost of Capital is the weighted
average of individual sources of capital. With the
following capital structure, the WACC of Ciba is 7.57%.

Source Amount Weight Cost Wi.ki

Equity 200 0.40 0.093 0.0372
Debt 200 0.40 0.060 0.0240
Pref. Cap. 100 0.20 0.073 0.0145
Total 500 1.00 0.0757
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 Problem # 1

Hilishia Ltd. is currently paying Tk.12 dividend on its

common stock and is expected to grow @3.5% forever.
The current market price per share is Tk.120 and it has
50000 shares in the market. Related issuing cost is Tk.2.5
per share. It is paying 10% preferred dividend of Tk.500
par value stock that’s market price is Tk.525 per share
and it has 20000 preferred shares in the market with 2%
floatation cost. It has also Tk.3000000 long-term bank
loan @9.5% interest rate along with 0.8% loan processing
fee. The corporate tax rate in the country is 35%. The
balance in retained earnings account is
Tk.2000000.Determine the WACC for the firm.
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 Marginal cost of capital

The weighted average cost of capital of the last unit of

fund raised by the business is called marginal cost of
capital. The new percentage of required cost for
raising one unit additional fund is also marginal cost
of capital. For example, when total financing is Tk.10
lac then weighted average cost of capital is 13%. But
when total financing is Tk.11 lac then weighted
average cost of capital is 14%. Here marginal cost of
capital is 14%.

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H.W.
Problems:
From 11-1 to 11-10

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