Understanding The Cost of Capital

Understanding the Cost
of Capital
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Cost of Capital
 The Cost of Capital is defined as the rate of
return that a company must offer on its
securities in order to maintain its market
value.
Cost of Capital
 Financial managers must know the cost of
capital in order to
 Make capital budgeting decisions,
 Help establish the optimal capital structure
and
 Make decisions concerning leasing, bond
refunding and working capital management.
Cost of Capital
 The cost of capital is computed as a weighted
average of the various capital components,
items on the right hand side of the balance
sheet such as debt, preferred stock, common
stock and retained earnings.
Weighted Average Cost of Capital
 Each element of capital has a component cost
that is identified by the following:
 ki = before tax cost of debt
 kd = ki (1-t) = after tax cost of debt, where t
= tax rate
 kp = cost of preferred stock
Weighted Average Cost of Capital
 ks = cost of retained earnings (or internal
equity)
 ke = cost of external equity, or cost of
issuing new common stock

 ko = company’s overall cost of capital , or a
weighted average cost of capital

 The after tax weighted average cost of capital
(WACC) is given by the following formula:

 WACC = ka = ke = (S/V) + kd (1-t) (D/V)
An Example of Cost of Capital
Market Value (1) Required Return Earnings Required
(2) (3) = (1) *(2)
Debt(D) $700 6.0% $42
Equity (S) $2500 12.0% $300
V= D+S = $3200 $342
Formula for Cost of Capital
 Suppose this firm faces a corporate tax rate
of 40%, has variable expenses equal to 30% of
sales, and has fixed costs of $158.
 Working back from these requirements we
can forecast the level of sales the firm must

earn in order to achieve these operating
results…thereby setting a sales performance
target for management.
 Working backwards, we get:
 Sales X
 Variable Costs 0.3X
 Fixed Costs 158
 EBIT
 Interest 42
 Taxes (40%)
 Net Income: 300
 If sales = X, then VC = .3X and X - .3X – 158
= EBIT
 (EBIT – I)(1-T) = NI so (EBIT – 42)(1-.4) = 300
=> EBIT = 542 which => X = 1000, and so

VC = 300 and also Taxes = (542-42)(.4) =
200, so:
 Sales 1000
 Variable costs 300
 Fixed costs 158
 EBIT 542
 Interest 42
 Taxes (40%) 200
 Net Income: 300
 This working backwards process is the
approach taken by regulators to set pricing
for rate of return regulated industries, like
utilities. So cost of capital drives utility rate
increases!
 Assuming earnings are a perpetuity, we have
 P = EPS/Ke = ROE* BVPS/Ke
 Firm ABC has:
 Debt D of 8% annual coupon bonds with 10
years to maturity and book value of $1 m.

 Preferred shares P with 10% annual dividend
and book value of $1 m.

 100,000 Common shares originally issued at
$15/share for a value of $1.5 m.

 Retained earnings of $0.5
 Total of $4 m.
 Market values:
 The present market rate of similar risk 10
year bonds is 6% so the market value of the

bonds is given by 80,000PVIFA(10 years, 6%)
= [80000/.06](1-1/1.06^10) +
1,000,000/1.06^10 = $1,147,202.
 Similar risk preferred shares are providing
yields of 8%, so the market value of the
preferred shares is 100,000/.08 =
$1,250,000.
 The market value of the common shares is
currently $25/share, so the total market

value of the shares is $2,500,000.
 The market value of the firm’s balance sheet
V = D + P + SE = $1,147,202 + $1,250,000
+ $2,500,000 = $4,897,202 and D/V = .234,
P/V = .255 and SE/V = .511.
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Understanding the Cost

refunding and working capital management.

issuing new common stock

weighted average cost of capital

(WACC) is given by the following formula:

Equity (S) $2500 12.0% $300

V= D+S = $3200 $342

can forecast the level of sales the firm must

=> EBIT = 542 which => X = 1000, and so

years to maturity and book value of $1 m.

and book value of $1 m.

$15/share for a value of $1.5 m.

year bonds is 6% so the market value of the

currently $25/share, so the total market

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