Cost of Capital

Rakesh Arrawatia
Significance of Cost of Capital
Evaluating Investment Decisions
Decision on Firm’s debt policy
Appraising the financial performance of top
management

Firm’s cost of capital or project’s cost of capital?

Calculating the weighted average
cost of capital

WACC = wdkd(1-T) + wpkp + wcks

The w’s refer to the firm’s capital structure weights.

The k’s refer to the cost of each component.
A 15-year, 12% semiannual coupon bond sells
for $1,153.72. What is the cost of debt (kd)?
Component cost of debt
Interest is tax deductible and tax rate is 40%, so
After Tax kd = Before Tax kd (1-T)
= 10% (1 - 0.40) = 6%
What is the cost of preferred stock?
Find the cost of preference stock selling at $111.10
coupon rate of 10%
Is preferred stock more or less risky to
investors than debt?

More risky; company not required to pay preferred

dividend.
Three ways to determine the cost of common
equity, ks
CAPM: ks = kRF + (kM – kRF) β

DCF: ks = D1 / P0 + g

Own-Bond-Yield-Plus-Risk Premium:
ks = kd + RP
If the kRF = 7%, RPM = 6%, and the firm’s beta is
1.2, what’s the cost of common equity based upon the
CAPM?
If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost
of common equity based upon the DCF approach?
If kd = 10% and RP = 4%, what is ks using the own-
bond-yield-plus-risk-premium method?
What is a reasonable final estimate of ks?
Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%
 What is the firm’s WACC?
Wd=0.3, wp=0.1 and wc=0.6
WACC = wdkd(1-T) + wpkp + wcks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
Should we take book value or the market value for
weight calculations?
Flotation costs
Flotation costs depend on the risk of the firm and
the type of capital being raised.
The flotation costs are highest for common equity.
However, since most firms issue equity
infrequently, the per-project cost is fairly small.
We will frequently ignore flotation costs when
calculating the WACC.
If D0 = $4.19, P0 = $50, and g = 5% and If issuing
new common stock incurs a flotation cost of 15%
of the proceeds, what is ke?
How are risk-adjusted costs of capital
determined for specific projects or divisions?
Subjective adjustments to the firm’s composite
WACC.
Attempt to estimate what the cost of capital
would be if the project/division were a stand-
alone firm. This requires estimating the
project’s beta.
 Finding a divisional cost of capital: Pure play
approach

Sera Ltd which is a steel manufacturing firm is considering a dairy

project for which it will be having a debt-equity ratio of 2:1 and
pre-tax cost of debt of 16%. It has found a pure play firm in
dairy which has a beta of 1.2 and debt equity ratio of 2.25. If the
risk free rate is 11%, expected return on market portfolio is
16%, calculate the required rate of return for the dairy project.
Assume tax rate as 30%.
Problems

1. The firm can sell a 20 year, Rs 1000 face value

debenture with a 16% rate of interest. Market price is
Rs 950 and flotation cost is 1%. Calculate Kd
2. The 11%, Rs 100 face value preference issue can
fetch Rs 120 per share with flotation cost of 1.5%.
Calculate Kp
3. The firm’s ordinary shares are selling for Rs 150. It
is expected the firm will pay a dividend of Rs 12 per
share next year and grow at a rate if 7% and flotation
cost is 2%.The new share can be sold at a rate of Rs
145. Calculate Ks.
Neeraj industries is considering the possibility of raising Rs 100 crores by
issuing debt, preference capital and equity and retained earning. The book
values and market values are as follows:
Book Value Market Value
Ordinary shares 20 50
Reserves 10 -
Preference shares 10 15
Debt 60 35
Assume Tax Rate as 35%
The firm can sell Rs 100 debenture with 10% coupon rate and flotation cost
of 3% and market price of Rs 95. The maturity period is 15 years
Rs 100 preference share with 11% dividend payment selling at Rs 110 and
flotation cost of Rs 8.
The ordinary shares of the firm is selling for Rs 180 and the firm is
expected to pay a dividend of Rs 15 and the dividend payment would
grow at a rate of 5%. Flotation cost on issue of new shares is Rs 10.
Calculate the WACC using both book value and market value.