CHAPTER FOUR

COST OF
CAPITAL
 The Cost of Capital
 The Cost of Capital is the required return for a
capital budget/long-term investments.
 It is the opportunity cost of funds tied up in the
project.
 It is the rate of return at which investors are
willing to provide financing for the project
today.
 It reflects the risk of the project.
The specific (component) cost of capital is the
 minimum rate of return that the business firm must
earn for its resource providers in order to
maintain the market value of the firm’s equity.
 Economics and Accounting meaning
of cost of Capital
In Economics and Accounting, the cost
of capital is
the cost of a company's funds, or,
"the required rate of return on a
portfolio company's existing securities".
It is used to evaluate new projects
of a company.
 Components of capital
Debt
Preferred Equity
Common Stock Equity:
 Internal- retained earnings
 External- new issues of common
stock
N.B. Non interest bearing sources like A/P
and Accruals are not components of
capital.
The cost of debt tends to be
the least expensive of the other
forms of financing sources for
two reasons:
Bond holders have greater
security than preferred or
common stockholders
Interest is tax deductible.
 1. Cost of Debt (Kd)
is the after-tax cost today of raising funds through
borrowing.
Steps
1st step, determine the net proceeds per debt(bond) to the firm
issuing the value of the bond (usually 1000 birr) after the cost
of selling the bond to the firm is deducted.
2nd step, determine the effective before-tax-cost-of-debt (bond)
use the net proceeds from the bond issue as a time zero cash
inflows. i.e, interest rate that equalize NPV=0 (present value of
interest + principal=Ki) = Net proceed. Ki=using present value of annuity
Ki = pmt (

3rd, Determine the after-tax-cost-of-debt= Kd = Ki(1-T)

 Example
Assume that the Ethiopian Government
(NBE) sells bond issues for 20 million Birr
that is to mature in 25 years time.
Each bond is expected to have a par value of
1000 Birr and carries a coupon interest rate of
12 percent.
The income tax rate is assumed to be 40
percent. The government (NBE) nets for 985
Birr per bond.
Compute the specific (component) cost of
debt (bond) capital to the government.
The annual interest payment equals 1000x12% = 120 Birr per bond per
year. Thus, the 120 Birr will be paid as an interest per bond for the
coming 25 years. In addition, the principal (face) value of the bond
(i.e. 1000Birr) will be paid at the end of the 25 years at maturity).
Net present value= (Proceed from sale of bond). (Present value of
interest payments annuity)-(present value of principal payment at
maturity)
 
NPV 12% = 985 – [120 (PVIFA12%,25)] – 1000 (PVlF 12%,25)
=985 – 941.17 – 58.80 = 985 – 1000
= -15
NPV 13% = 985 – [120 (PvlFA 13%,25) – 1000 (PVlF 13%,25)
=985 – 879.60 – 47 = 985 –927
= +58
Hence, the cost of debt before-tax = Kd = 12% + 15/73%
=12% + 0.21% = 12.21%, or
Kd = 13% -58/73%
= 13% - 0.79% = 12.21%
After-tax specific cost of capital of debt=Kd(1-T)
=12.21% (1-0.40)
=7.33%
 Therefore, the Ethiopian Government is required to pay an effective
cost-of-capital of debt after-tax of 7.33 percent on the bond it has
issued.
If the Ethiopian Government sells the bonds at a net proceed of
1000Birr per bond which is equal to the principal (par value) of the
bond, the sum of the present values of the series payments and the
present value of the principal payment at maturity of the bond is equal
to the proceed at time zero at the discounting rate that is equal to the
bond’s coupon rate, that is 12 percent.
Net, present value (12%) = 1000 – [120 (PVIFA 12%25)] – 1000 (PVIF
12%,25)
= 1000 – [120(7.8431)] – 1000 (0.0588)
= 1000 – 1000 = 0
After-tax specific cost of debt (bond)of capital = Kd-KdT
= 12% - (12%)(0.40)
 2. Cost o f preferred stock (Kp)
The cost of preferred stock is the today’s cost of using
preferred stock to raise funds.
Kp = Dp/Pn
Eg. X Company is contemplating issuance of a 10% preferred
stock that is expected to sell for its $87 per share par value.
The cost of issuing and selling the stock is expected to be $5
per share. What is the cost of the stock?
Pd=10% * 87 =8.7
Kp= 8.7/82 = 10.61%
No tax adjustments are made when calculating the specific
cost capital of preferred stock (Kps) because preferred
dividend unlike interest expenses on debt, are non-tax deduct
able, hence there are not tax saving associated with use of
preferred stock as a source of capital.
 3. The cost of common stock
Two sources:
1. Internal – Retained earnings
2. External - new issues of common stock
Three methods:
A. The discounted cash flow (DDM)
approach
B. The CAPM= Ks = KRF + β(Km –KRF)
C. The bond-yield-plus-premium approach
Ks = Co.’s own bond yield + Risk Premium on
common stock over Co. bonds (3 to 5%)
Comparison:
CAPM: helps to directly incorporate risk in the cost of capital.
DCF: helps to incorporate floatation costs
When the firm sells its common stock issue and
nets for Pn Birr amount per share, it can set
the net proceeds equal to the stocks’ intrinsic
value because investors have been willing to
acquire the security at the price that nets the
firm an amount of Pn Birr.
The intrinsic value of common stock is estimate by using
an equation:
V = Do (1+g) Where Do = Current dividend per share
 K-g g = Compound dividend growth rate
 K = the rate of return required by common
stockholders(investors).
 This equation is used to compute the intrinsic value of the
share of common stock that returns an indefinite dividend
stream. In addition, dividends on common shares are
assumed to grow at a given growth compound rate each year.
Then the market interest (discount) rate (k) is a measure of
specific (component) cost of capital of common stock is given by
the symbol Ke.
To determine the value of Ke, we equate Pn and v; Pn=V
Pn = Do (1+g) because V = Do (1+g)
 
K-g Ke = D (1+9) + 9
o K- g
P
Substituting Ke K in the above equation, you get;
n

Pn = Do (1+g)
Ke-g
Solving for specific cost of capital of common stock (ke)
from the above equation, you arrive at:
Pn (Ke – g) = Do (1+g)  

Ke = Do (1+g) + g
Ke –g =Do (1+ g)
Pn Pn
 4. Specific Cost of Retained Earnings
There are two difficulties with computing the specific
(component) cost of capital of retained earnings.
Both of these difficulties arise from the nature of the
retained earnings.
Retained earnings are an internal, as opposed to
external source of funds.
First, retained earnings are not securities, like that of stocks and
bonds. Thus, they do not have market values/prices that can be
used to compute their specific cost of capital.
Second, since retained earnings do not represent funds provided
directly by common stock holders (investors), there may be a
tendency to equate the specific cost of capital of retained earnings
with zero.
Therefore, it is reasonable to estimate the specific cost of capital of
retained earnings based on the market value of common share (Po),
current dividend per common share (Do), and compound dividend
growth rate per year (g) but ignoring the selling (flotation) costs since
retained earnings are not marketable securities.
Hence, Specific cost of capital of retained
earnings = Kr = Do (1+g)
+g
Po
Where, Do = Current dividend per common share
G = Compound dividend growth rate
Po = Current market price of the firm’s common share
Kr = Specific cost of capital of retained earnings.
WEIGHTED AVERAGE COST OF
CAPITAL
It reflects, on the average, the firm’s
cost of long-term financing.
WACC= (Wd x Kd) + (Wp x Kp) +
(WRE x KRE)+(WE x KE)
Weights may be based on:
target capital structure
 market value or
 book value.
Example : The following relates to XY Company.
Source of Cost (after Book Value Market
Finance tax) value
Debt 5.6% 100,000 100,000
Preferred stock 10.6% 75,000 100,000
Retained 13% 125,000 300,000
Earnings
Common Stock 14% 100,000

Required: Determine the WACC for XY Co.

assuming that weights are based on:
a)Book value
b)Market value