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 costs 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 (e.g. LT-bank loans , Bonds )

Preferred Stock
Common Equity

The cost of capital is used primarily to make decisions that

involve raising new capital. $100
How the Firm can raise Capital?

• Bonds or Bank loan

• 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
A B
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)?
• rd=Kd=YTM =i
• PV=Price
• N=15*2=30

• Remember, the bond pays a semiannual coupon, so rd = 5.0% x 2 = 10%

• Pmt= coupon rate * Face value
• = 0.12*1000= $120 /2 = 60
• or 0.06*1000=60

INPUTS 30 -1153.72 60 1000

N I/YR PV PMT FV
OUTPUT 5%
A 15-year, 12% quarterly coupon bond sells
for $1,153.72. What is the cost of debt (rd)?

• N= 15*4= 60
• I=??? 2.5024 * 4 = 10.0096
• PV= -1153.72
• PMT= 0.03 *1000 = 30 OR 0.12*1000=120/4 =
30
• FV= 1000
 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 = Dp/Pp
 Kp = Dp / Po(1-F) = $4/$40 = 10%
 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 k c.
• Therefore, kc is the cost of retained earnings.
 To determine the cost of common
equity, ks
• CAPM: kc = kRF + (kM – kRF) βc
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
Discounted CashFlow Approach.
DCF: kc = (D1 / P0 )+ g =???
• D1= D0 (1+g)
• D2= D1 (1+g)
• D3=D2 (1+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) = (1-0.65)*15

OR
g = (Retention Rate) (ROE)
Retention Rate = (1 - payout)
= (0.35) (15%)
= 5.25%

• Very close to the g that was given before.

• EBIT
• -I
• EBT
• -Tax
• NI = $100
• R.E = $35
• DIV=$65
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 + wck c=???
• WACC = w d k d (1 – T) + 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 10% 20%
preferred 10% 10%
common 14% 70%
 Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)

Weighted cost of capital =

.20 (10%)(1-0.4) + .10 (10%) + .70
(14%)
= 12%
 What factors influence a
company’s composite WACC?
• Market conditions (Int rate, tax rate)
• The firm’s capital structure policy , dividend policy and
investment policy.
• Investment policy- Firms with riskier projects generally
have a higher WACC.
 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.