Cost of Capital

Concept of the Cost of Capital

• When a firm invests money in a project, it should earn at least
as much as it cost the firm to acquire the funds. Therefore, the
cost of capital may be defined as the minimum acceptable rate
of return.

• is a cost of raising funds that are needed to operate the firm.

• In other words, the cost of raising funds is the firm’s cost of

capital.
Cost of Capital

 Sources of capital
 Component costs
 WACC
 Adjusting for flotation costs
 Adjusting for risk
What sources of long-term capital
do firms use?

Long-Term
Capital

Long-Term Preferred Common

Debt Stock Stock

Retained New Common

Earnings Stock
 The financing decision
Assets Liabilities & Equity
Current Assets Current Liabilities

Fixed Assets Long-term Debt

Preferred Stock
Common Equity

The cost of capital is used primarily to make decisions that involve raising
new capital.
How the Firm can raise Capital?

• Bonds
• Preferred Stock
• Common Stock
• Each of these offers a rate of return to investors.
• This return is a cost to the firm.
• HOW ARE WE GOING TO DECIDE WHICH FINANCING OPTION
SHOULD WE CHOSE?

• The required rate of return on each capital component is called its

component cost.
Cost of Debt

For the issuing firm, the cost of debt is:

• the rate of return required by investors,
• adjusted for flotation costs (any costs associated with issuing new
bonds), and
• adjusted for taxes.

• The yield to maturity on outstanding L-T debt is often used as a

measure of rd/kd
Floatation Cost

 The cost paid by the companies when floating new securities/

shares or bonds in the market
 Proposal expenditure
 Registration fee
 Printing fee
 Advertisement
 Investment banker’s fee etc.
 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000

Now, suppose the firm pays $50,000 in dividends to the stockholders.

 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
After tax % (Before tax % (1 – Marginal tax rate)
cost of debt = cost of debt )

Kd = kd (1 - T)
 Why do we take after tax cost of debt?
Our analysis focus will be on after-tax capital
costs because:

• Stockholders focus on A-T CFs. Therefore, we should

focus on A-T capital costs, i.e. use A-T costs of capital
in WACC. Only Kd needs adjustment, because interest
is tax deductible.

• The value of the firm’s stock, which we want to

maximize, depends on after tax cash flows.
 A 15-year, 12% semiannual coupon bond sells
for $1,153.72. What is the cost of debt (rd)?
• Remember, the bond pays a semiannual coupon, so rd = 5.0% x 2 =
10%.

INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5
Component cost of debt

• Interest is tax deductible, so

A-T rd = B-T rd (1-T)
= 10% (1 - 0.40) = 6%

• Flotation costs are small, so ignore them.

Cost of Preferred Stock
• Kp is the marginal cost of preferred stock, which is the return investors
require on a firm’s preferred stock.

• Preferred dividends are not tax deductable that’s why no tax adjustment
is used when calculating cost of preferred stock. Just use nominal Kp.

 Component cost of preferred stock= Kp

 Kp = Dp / Po(1-F)
 DP is the preferred dividend, Po is the preferred stock Price, and F is
the flotation cost (if any) as a percentage of the proceeds.
Cost of Common Stock, Kc
• The rate of return investors require on the firm’s common equity-Kc

There are two sources of Common Equity:

1) Internal common equity (retained
earnings).
2) External common equity (new common
stock issue).
Do these two sources have the same cost?
Why is there a cost for retained earnings?

• Earnings can be reinvested or paid out as

dividends.
• Investors could buy other securities, earn a return.
• If earnings are retained, there is an opportunity
cost (the return that stockholders could earn on
alternative investments of equal risk).
• Investors could buy similar stocks and earn kc.
• Firm could repurchase its own stock and earn kc.
• Therefore, kc is the cost of retained earnings.
To determine the cost of common equity, ks

• CAPM: kc = kRF + (kM – kRF) β

K RF = rate offered by the government on T – bill
β = stock’s beta co – efficient
K m = expected rate of return on the market

• DCF: kc = (D1 / P0 )+ g
If the rRF = 7%, RPM = 6%, and the firm’s beta
is 1.2, what’s the cost of common equity
based upon the CAPM?

Kc = rRF + (rM – rRF) b

= 7.0% + (6.0%)1.2 = 14.2%
 If D0 = $4.19, P0 = $50, and g = 5%, what’s
the cost of common equity based upon the
DCF approach?
D1 = D0 (1 + g)
D1 = $4.19 (1 + .05)
D1 = $4.3995

Kc = (D1 / P0) + g
= ($4.3995 / $50) + 0.05
= 13.8%
 What is the expected future growth
rate?
• The firm has been earning 15% on equity (ROE =
15%) and retaining 35% of its earnings (dividend
payout = 65%). This situation is expected to
continue.

g = ( 1 – Payout ) (ROE)
= (0.35) (15%)
= 5.25%

• Very close to the g that was given before.

What is a reasonable final estimate of rs?

Method Estimate
CAPM 14.2%
DCF 13.8%
Average 14.0%
Weighted Cost of Capital
• The weighted cost of capital is just the weighted average cost of all
of the financing sources.

• WACC = w d k d (1 – T) + w p k p + w c k c

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

• The k’s refer to the cost of each component.

Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%
Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)

Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16%)
= 13.4%
What factors influence a company’s
composite WACC?

• Market conditions (Int rate, tax rate)

• The firm’s capital structure policy ,
• Dividend policy.
•
WEGHTED AVERAGE COST OF
CAPITAL (WACC):
• Most firms set percentages for the different financing sources.

• So firms who want to maximize the value they will determine its optimal
capital structure, use it as a target and then raise new capital designed in
such a manner so that capital structure does not change.
 
• Different projects have different risks. The project’s WACC should be
adjusted to reflect the project’s risk.

• A high cost of capital is not bad if it is accompanied by the projects

with high rates of return.
Company ABC estimates that its WACC is 10.5%. The company is
considering the following seven investment projects: (The firm may
accept all the projects, which set of projects should be accepted?)

Project Size Rate of Return

•A $1 Million 12.0%
•B 2 Million 11.5
•C 2 Million 11.2
•D 2 Million 11.0
•E 1 Million 10.7
•F 1 Million 10.3
•G 1 Million 10.2
• Projects A, B, C, D, and E would be accepted since each project’s
return is greater than the firm’s WACC.