Cost of Capital

What is cost of capital?

 The minimum rate of return required to remain in business.

 The minimum rate of return that the firm should earn on its investment of average
risk, in order to be profitable.
 Firm/Company

Finances
Earn profit Operations Assets
(Money)
There are three options of financing:

 Debt, common equity, and preferred equity (hybrid equity).

Debt Financing Hybrid Equity Equity Financing

(kd) (kp) (ks)
• Commercial • Preferred • Common
banks stockholders stockholders
• Bond holders (external funds)
• Suppliers • Retained
• Non-bank earnings
lenders (Internal funds)

Each has its own risk and return profile and therefore its own rate of return required by
investors to provide funds to the firm.
1. Measuring Cost of Debt 5

 The cost of debt (kd) is the rate that firms have to pay when they
borrow money from banks, finance companies, and other lenders.
 Generally measured as Interest paid on long-term debts or bond
yield to maturity on a firms outstanding bonds.
 e.g. Suppose that a company issues bonds with a before tax cost of
10%.
 Since interest payments are tax deductible, the true cost of the debt
is the after tax cost.
 If the company’s tax rate (state and federal combined) is 40%, the
after tax cost of debt AT kd = 10%(1- 0.4) = 6%.
Example 1: The Zee Company’s currently outstanding bonds have a 10% coupon and a
12% yield to maturity. The company believes it could issue new bonds at par that would
provide a similar yield to maturity. If its marginal tax rate is 35%, what is Zee’s after-tax
cost of debt?

 YTM is considered as before tax cost of debt (kd) = 12%

 After tax cost of debt = Kd(1 – t)
 After tax cost of debt = 0.12 (1 – 0.35)
 After tax cost of debt = 0.078 or 7.8%
Measuring Cost of Debt

 However, new debt would also require payment of transaction costs to investment
bankers, thereby reducing the net proceeds to the issuer and raising the cost of
debt.
 We must adjust the market price by the amount of commissions that would have
to be paid when issuing new debt, and then calculate the YTM.
 Example 2: Zee Company wants to raise an additional Rs.3,000,000 of debt as
part of the capital that would be needed to expand its operations into the business.
The company was informed by its investment banking consultant that they would
have to pay a commission of 3.5% of the selling price on new issues. The
company currently has an 8%, AA-rated, non-callable bond issue outstanding,
which pays interest semiannually, will mature in 17 years, has a Rs.1,000 face
value, and is currently trading at Rs.1,075. Calculate the appropriate cost of debt
for the firms.
Solution:
 Step 1: Determine the net proceeds on each bond = (Selling price – Commission
cost)
 Commission cost = Rs.1075 x 0.035 = Rs.37.62
 Step 2: Net proceed on each bond = 1075 – 37.62 = Rs.1037.38

Maturity (Duration) 17
Coupon rate 8.00%
Coupon payment Rs. 80
Par value Rs.1,000
YTM 7.60%
Present value (Rs.1,037.38)
Example 3: Measuring weighted average cost of bank loans

Lender Loan Balance

NBP 6,000,000
MCB 8,000,000
UBL 10,000,000
Total Loan 24,000,000
Example 3: Measuring weighted average cost of bank loans

Lender Loan Balance Rate

NBP 6,000,000 9.50%
MCB 8,000,000 8.25%
UBL 10,000,000 8.00%
Total Loan 24,000,000  
Example 3: Measuring weighted average cost of bank loans

Lender Loan Balance Rate Weight

NBP 6,000,000 9.50% 25%
MCB 8,000,000 8.25% 33%
UBL 10,000,000 8.00% 42%
Total Loan 24,000,000    
Example 3: Measuring weighted average cost of bank loans

Lender Loan Balance Rate Weight Cost

NBP 6,000,000 9.50% 25% 2.38%
MCB 8,000,000 8.25% 33% 2.75%
UBL 10,000,000 8.00% 42% 3.33%
Total Loan 24,000,000     8.46%

Weighted average cost of debt = (6,000,000/24,000,000) 9.50% +

(8,000,000/24,000,000) 8.25% + (10,000,000/24,000,000) 8.00% = 8.46%

If Tax rate = 40%

After tax cost of debt kd (1 – t) = 5.08%
2. Compute Cost Preferred Stock

 Cost to raise a money(Rs. / $) of preferred stock.

 Preferred stockholders receive a constant dividend with no maturity point.
 The cost of preferred stock (kp) can be estimated by dividing the annual dividend
by the net proceeds (after flotation cost) per share of preferred stock.
2. Compute Cost Preferred Stock 16

Dividend (Dp)
Required rate kp =

Market Price (PP) - F

 Example: You can issue preferred stock for a net price of
Rs.42 and the preferred stock pays a Rs.5 dividend.

 The cost of preferred stock:

kp = Rs.5.00 11.90%
Rs.42.00
2. Compute Cost Preferred Stock 17

Dividend (Dp)
Required rate kp =

Market Price (PP) - F

 Example: You can issue preferred stock for a price of Rs.42
and the preferred stock pays a Rs.5 dividend. The company also
paid Rs. 2 flotation cost on the issuance of new share.

 The cost of preferred stock:

kp = Rs.5.00 12.50%
Rs.42.00 – Rs.2
 19
3. Compute Cost of Common Equity
 Two Types of Common Equity Financing
 Retained Earnings (internal common equity)
 Issuing new shares of common stock (external common equity)
 20
3. Compute Cost of Common Equity
 Cost of Internal Common Equity
 Management should retain earnings only if they earn as much as stockholder’s
next best investment opportunity of the same risk.
 Cost of Internal Equity = opportunity cost of common stockholders’ funds.
 Two methods to determine
Dividend Growth Model
Capital Asset Pricing Model
 21
3. Compute Cost of Common Equity
 Cost of Internal Common Stock Equity
 Dividend Growth Model

D1
kS = + g
P0
 22
3. Compute Cost of Common Equity
 Cost of Internal Common Stock Equity
 Dividend Growth Model

D1
kS = + g
P0
Example:
The market price of a share of common stock is Rs.
60. The dividend just paid is Rs.3, and the expected
growth rate is 10%.
 23
3. Compute Cost of Common Equity
 Cost of Internal Common Stock Equity
 Dividend Growth Model

D1
kS = + g
P0
Example:
The market price of a share of common stock is Rs.60.
The dividend just paid is Rs.3, and the expected
growth rate is 10%.

kS = 3(1+0.10) + .10 =.155 = 15.5%

60
 24
3. Compute Cost of Common Equity
 Cost of Internal Common Stock Equity
 Capital Asset Pricing Model

kS = kRF + (kM – kRF)

 25
3. Compute Cost of Common Equity
 Cost of Internal Common Stock Equity
 Capital Asset Pricing Model

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
 26
3. Compute Cost of Common Equity
 Cost of Internal Common Stock Equity
 Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

kS = 5% + 1.2(13% – 5%) = 14.6%

 27
3. Compute Cost of Common Equity
 Cost of New Common Stock
 Must adjust the Dividend Growth Model equation for floatation costs of the
new common shares.

D1
ke = P0 - F + g
 28
3. Compute Cost of Common Equity
 Cost of New Common Stock
 Must adjust the Dividend Growth Model equation for floatation costs of the
new common shares.

D1
ke = P0 - F + g
Example:
If additional shares are issued floatation costs will
be 12%. D0 = Rs.3.00 and estimated growth is 10%,
Price is Rs.60 as before.
 29
3. Compute Cost of Common Equity
 Cost of New Common Stock
 Must adjust the Dividend Growth Model equation for floatation costs of the
new common shares.

D1
kn = P0 - F + g
Example:
If additional shares are issued floatation costs will
be 12%. D0 = Rs.3.00 and estimated growth is 10%,
Price is Rs.60 as before.

ke = 3(1+0.10) + .10 = .1625 = 16.25%

52.80
Weighted Average Cost of Capital (WACC)

 The weighted average cost of capital (WACC) is estimated by multiplying each

component weight by the component cost of summing up the products.
 WACC is the minimum acceptable rate of return that the firm should earn on its
investments of average risk, in order to be profitable.
 WACC is the discount rate for computing NPV.
 IRR > WACC for acceptance of project.
Zee Company use the following components in its capital
structure:

  Amount in Rs.
Debt 40,000,000
Preferred equity 10,000,000
Common equity 50,000,000
Total value 100,000,000
Weightage of each capital component:

  Amount in Rs. Weightage

Debt 40,000,000 40%
Preferred equity 10,000,000 10%
Common equity 50,000,000 50%
Total value 100,000,000 100%
Weighted Average Cost of Capital 33

Zee Company estimates the following costs for

each component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15.5%
New Shares ke = 16.25%

Zee’s tax rate is 40%

Weighted Average Cost of Capital 34

 If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (Wd x AT kd ) + (Wp x kp ) + (Ws x ks)

Weighted Average Cost of Capital 35

 If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (Wd x AT kd ) + (Wp x kp ) + (Ws x ks)

 Assume that the company’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
Weighted Average Cost of Capital 36

 If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

 Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9% + .50 x 15.5% = 11.34%
Weighted Average Cost of Capital 37

 If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (Wd x AT kd ) + (Wp x kp ) + (Ws x ks)

Weighted Average Cost of Capital 38

 If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = .40 x 10% (1-.4) + .10 x 11.9% + .50 x 16.25% = 11.72%

 Projects Rate of Return
WACC = 11.34%
A 13.65% Accept

B 12.52% Accept

C 11.30% Reject

D 11.90% Accept