COST OF CAPITAL

Prof. Kwame Adom-Frimpong

 Learning Objectives

1. Understand the key assumptions, the basic concept, and the specific
sources of capital associated with the cost of capital.

2. Determine the cost of long-term debt and the cost of preferred stock.

3. Calculate the cost of common stock equity and convert it into the cost
of retained earnings and the cost of new issues of commons stock.

4. Calculate the weighted average cost of capital (WACC) and discuss

alternative weighting schemes.
 Introduction: Cost of Capital
• The cost of capital acts as a link between the
firm’s long-term investment decisions and the
wealth of the owners as determined by
investors in the marketplace.
• the cost of capital is the rate of return that a
firm must earn on the projects in which it
invests to maintain the market value of its
stock.
• Cost of Capital - The return the firm’s
investors could expect to earn if they invested
in securities with comparable degrees of risk
 Cost of Capital
• The cost of capital is the required rate of
return that a firm must achieve in order to
cover the cost of generating funds in the
marketplace.
• The firm must earn a minimum of rate of
return to cover the cost of generating funds to
finance investments; otherwise, no one will be
willing to buy the firm’s bonds, preferred
stock, and common stock
 Cost of Capital
• The Cost of Capital becomes a guideline for
measuring the profitability of different
investments.
• Another way to think of the cost of capital is
as the opportunity cost of funds, since this
represents the opportunity cost for investing
in assets with the same risk as the firm.
The cost of different types of funds
• Where a company uses a mix of equity and
debt capital its overall cost of capital may be
defined as the weighted average of the cost of
each type of capital. The cost of each source
of capital, ie:
a) Ordinary share capital(including retained earning)
b) Debt capital
 Cost of Equity (i.e. Common Stock & Retained Earnings)

• The cost of equity is the rate of return that investors require to

make an equity investment in a firm. Common stock does not
generate a tax benefit as debt does because dividends are paid
after taxes.

• The cost of common stock is the highest. Why?

• Retained earnings are considered to have the same cost of capital

as new common stock. Their cost is calculated in the same way,
EXCEPT that no adjustment is made for flotation costs.
 Cost of Equity
• There are a number of methods used to
determine the cost of equity
• We will focus on two

• Dividend growth Model

• CAPM
 Cost of equity
• The cost of equity could be estimated by means
of a dividend valuation model on the
assumption that the market value of shares is
directly related to expected future dividends on
the shares.
• If the future dividend per share(d) is expected
to be constant then the cost of capital :
• Ke = d
Po
 Cost of equity
• For example, if Constant Ltd is expected to pay
a constant annual net dividend of 25p per
share at the current market price per share is
2 cedis ex div, the cost of equity would be ;

25 =0.125 or 12.5%
200
 Example 2
• ABC plc’s ordinary shares are valued at 247p
ex div. the market expects the company to
continue to pay a dividend of around 39p net
into the foreseeable future. What is the cost
of ABC plc’s equity capital?
 Solution

• r = = 0.158, i.e. 15.8% - say, 16%

 Assumptions in the dividend valuation model

• The dividend valuation model is based on certain assumptions.

• The dividend from projects for which the funds are required will be of the
same risk type or quality as dividends from existing operations currently in
progress.
• There would be no increase in the cost of capital, for any other reason
besides (a) above, from a new issue of shares.
• All shareholders have perfect information about the companies’ future,
there is no delay in obtaining this information and all shareholders
interpret it in the same way; i.e. shareholders have the same certain
knowledge about what future dividends will be.
• Taxation can be ignored.
• All shareholders have the same marginal cost of capital.
• There would be no issue expenses for new shares
 The cost of ordinary share capital: the dividend growth model

• Shareholders will normally expect dividends to

increase year by year and not to remain
constant in perpetuity. The fundamental
theory of share values states that the market
price of a share is the discounted future cash
flows of revenues from the share
 the dividend growth model
• It is often convenient, and is reasonably accurate
mathematically, to assume a constant expected dividend
growth in perpetuity
• we get a formula for the ordinary shareholders’ cost of capital
where there is expected dividend growth
r= +g
• This is an important formula, which should be learned. Some
text books give an alternative formula:

r= +g
 The Dividend Growth Model

• Estimating the cost of equity: the dividend growth model

approach
According to the constant growth (Gordon) model,
D1
P0 =
RE - g

Rearranging D1
RE = + g
P0
 The Dividend Growth Model
• Where D is the dividend in year 1, so that

D = Do (1 + g)

• (The growth model is sometimes called

Gordon’s growth model)
 Example-The Dividend Growth Model

• A share has a current market value of 96p, and

the last dividend was 12p. if the expected
growth rate of dividends is 4% per annum,
calculate the cost of equity capital.
 Solution

• Cost of capital = + 0.04

= 0.13 + 0.04
= 0.17
= 17%
 Estimating the growth rate

• If an examination question requires you to

calculate a cost of equity using the growth
model, if it is likely that you will be expected
to predict the future growth rate from an
analysis of historic growth in dividends over
the past few years
Example: Estimating the Dividend Growth
Rate

Percentage
Year Dividend Dollar Change Change

1990 $4.00 - -
1991 4.40 $0.40 10.00%
1992 4.75 0.35 7.95
1993 5.25 0.50 10.53
1994 5.65 0.40 7.62

Average Growth Rate

(10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%
 Dividend Growth Model

This model has drawbacks:

• Some firms concentrate on growth and do not pay

dividends at all, or only irregularly
• Growth rates may also be hard to estimate
• Also this model doesn’t adjust for market risk

• Therefore many financial managers prefer the

capital asset pricing model (CAPM) - or security
market line (SML) - approach for estimating the cost
of equity
 Ks using CAPM (capital asset pricing model)

• The CAPM is one of the most commonly used ways

to determine the cost of common stock. This
“cost” is the discount rate for valuing common
stocks, and provides an estimate of the cost of
issuing common stocks.
• Ks = Krf +  (Km - Krf)

• Where: Krf is the risk free rate is the firm’s beta

Km is the return on the market
 EXAMPLE

• Cowboy Energy Services has a B = 1.6. The

risk free rate on T-bills is currently 4% and the
market return has averaged 15%.
 Solution-CAPM

• Ks = Krf +  (Km - Krf)

• = 4 + 1.6 (15 – 4) = 21.6 %

 Cost of New Preferred Stock

• Preferred stock:
– has a fixed dividend (similar to debt)
– has no maturity date
– dividends are not tax deductible and are expected
to be perpetual or infinite
• Cost of preferred stock = dividend
price - flotation cost
 Cost of Preferred Stock (Kp)
• Preferred stock holders receive a fixed
dividend and usually cannot vote on the firm’s
affairs

preferred stock dividend

• Kp = market price of preferred stock
 Cost of Preferred Stock (Kp)
• preferred stock dividend
• Kp = market price of preferred stock (1 –
flotation cost)
Cost of Preferred Stock
Cost of Preferred
Stock
= What you give. divided by What you get.

Cost of Preferred Price -

Stock = Dividend divided by Underwriting Costs
 Cost of Preferred stock: Example

Baker Corporation has preferred stock that sells for $100 per share and pays an annual
dividend of $10.50. If the flotation costs are $4 per share, what is the cost of new
preferred stock?

$10.50
KP   .1094  10.94%
$100 - 4
 Cost of Preferred stock: Example

• If Cowboy Energy Services is issuing preferred

stock at $100 per share, with a stated dividend
of $12, and a flotation cost of 3%, then:
 Cost of Preferred stock: Example

• Kp = market price of preferred stock (1 –

flotation cost)

$12
• = $100 (1-0.03) = 12.4 %
 COST OF DEBT (Kd)

• Definition: Cost of debt capital is the effective

rate that a company pays on its current debt.
This can be measured in either before- or
after-tax returns; however, because interest
expense is deductible, the aftertax cost is seen
most often. This is one part of the company's
capital structure, which also includes the cost
of equity.
 Why is it important?

• The cost of debt is usually based on the cost of the

company's bonds. Bonds are a company's long-
term debt and are little more than the company's
long-term loans. The cost of newly issued bonds is
the best rate to use if possible when calculating the
cost of debt. If a company has no publicly-traded
bonds, then the business owner can look at the
cost of the debt of other firms in the same industry
in order to get an idea of the cost of debt.
 Cost of debts
• We use the after tax cost of debt because
interest payments are tax deductible for the
firm.

• Kd after taxes = Kd (1 – tax rate)

 Cost of debts

• Kd = interest on a firm’s new debt and not old debt

or capital (called cost of debt). It is a before tax
cost of debt.

• Kd(1-T) = after-tax cost of debt = interest – tax

savings where tax savings = KdT. The tax
deductibility of debt provides a great incentive for
corporations to use debt rather than equity
 EXAMPLE-COST OF DEBT
If the cost of debt for Cowboy Energy Services is
10% (effective rate) and its tax rate is 40% then:

• Kd after taxes = Kd (1 – tax rate)

= 10 (1 – 0.4) = 6.0 %

We use the effective annual rate of debt based on

current market conditions (i.e. yield to maturity
on debt). We do not use historical rates (i.e.
interest rate when issued; the stated rate).
 EXAMPLE-COST OF DEBT

• The after tax cost of irredeemable debt capital is:

• Kd =
• Where kd is the cost of debt capital
• I is the annual interest payment
• Po is the current market price of the debt capital ex-interest (i.e. after
payment of the current interest)
• t is the rate of corporation tax
• Therefore if a company pays ¢10,000 per annum interest on irredeemable
debenture stock with nominal value of ¢100,000 and a market price of
¢80,000 and the rate of corporation tax is 35% the cost of the debentures
would be:
• = 10,000 (10.350
• 80,000
• = 0.08125 or 8.0125%
 Other Factors
• There are a number of other factors that might affect the costs of debt capital for a
business Including:

(i)The bargaining power of the business

(ii) The availability of government assistance - for example, the special government
assistance (grants or reliefs) available in deprived areas

(iii)The conditions at any particular moment of the financial markets

(iv)Interest rates in the markets

(v)The availability of internal sources of finance available

(vi) The record of debt repayment for the business concerned

 IrredeemableDebt
The formula for calculating the cost of irredeemable debt is:

Kd = 1(1-t)
Po
Kd = Cost of debt capital
I = annual interest payment
Po = Current market price od debt capital
t = the rate of company applicable

Taxation is considered because the interest can be offset

against taxation, which will lower its Nominal rate, and thus
its cost. The higher the rate of corporation tax payable by the
Company, the lower will be the after-tax cost of debt capital.
 Example-Irredeemable Debt
• Clown plc. has £10,000 of 8% irredeemable debentures in
issue which have a current market Price of £92 per £100 of
nominal value. If the corporation tax rate is 33% what is the
cost of the debt capital?

• The annual interest payment will be based on the nominal

value, i.e. 8% of £10,000 or £800,
 Solution-Irredeemable Debt
• So using the above formula:

Kd = 800( 1-0.33) = 0.0583 = 5.83%

92/100 × 10.00

Or 8(1-0.33) × 100 =
92
 Cost of Fixed Rate Bank Loans

The cost of this major source of finance is given

by:
Cost = Interest rate = (1-t)

• Cost of Short-term Funds and Overdrafts

• The cost of short-term bank loans and
overdrafts is the current interest rate being
charged on the capital lent.
 WEIGHTED AVERAGE COST OF CAPITAL
(WACC
• The firm’s WACC is the cost of Capital for the firm’s mixture of debt and stock in their
capital structure.

• WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)

So now we need to calculate these to find the WACC!

wd = weight of debt (i.e. fraction of debt in the firm’s capital structure)

ws = weight of stock

wp = weight of prefered stock

 Steps in calculating WACC
• 1. Calculate capital proportion-the proportion
of total financing obtained from each source.

• 2. Determine the required rate of return for

each source of financing

• 3. Calculate a weighted average

 EXAMPLE -WACC
• Wait Ltd has ordinary share capital with a
market value of c450,000 and a cost of 20%
per annum. It has debenture with a market
value of c150,000 and a cost of 10% per
annum.
• Calculate the WACC
 Determining the Weights to be Used:
• My example above gives you the weights to use in calculating the WACC.
How do you calculate the weights yourself?

• The firm’s balance sheet shows the book values of the common stock,
preferred stock, and long-term bonds. You can use the balance sheet
figures to calculate book value weights, though it is more practicable to
work with market weights.

• Basically, market value weights represent current conditions and take into
account the effects of changing market conditions and the current prices
of each security. Book value weights, however, are based on accounting
procedures that employ the par values of the securities to calculate
balance sheet values and represent past conditions
 Breakpoints (BP) in the WACC:

• Breakpoints are defined as the total financing that can be done

before the firm is forced to sell new debt or equity capital.
Once the firm reaches this breakpoint, if they choose to raise
additional capital their WACC increases.

• For example, the formula for the retained earnings breakpoint

below demonstrates how to calculate the point at which the
firm’s cost of equity financing will increase because they must
sell new common stock. (Note: The formula for the BP for
debt or preferred stock is basically the same, by replacing
retained earnings for debt and using the weight of debt
 Breakpoints (BP) in the WACC

• BPRE = Retained earnings

Weight of equity
 Example:

• Cowboy Energy Services expects to have total earnings of

$840,000 for the year, and it has a policy of paying out half
of its earnings as dividends. Thus, the addition to retained
earnings will be $420,000 during the year. We now want to
know how much total new capital – debt, preferred and
retained earnings – can be raised before the $420,000 of
retained earnings is exhausted and the company is forced to
sell new common stock. We are seeking the amount of
capital which represents the total financing that can be
done before Cowboy Energy Services is forced to sell new
common stock to maintain their target weights in their
WACC.
 Solution
• Let’s assume that Cowboy Energy Services maintains a capital structure of 60% equity, 40%
debt. Using the formula above:

• BPRE = Retained earnings

Weight of equity

= $420,000/0.60 = $700,000

• Thus, Cowboy Energy Services can raise a total of $700,000 in new financing, consisting of
0.6($700,000) = $420,000 of retained earnings and 0.40($700,000) = $280,000 of debt,
without altering its capital structure. The BPRE = $700,000 is defined as the retained
earnings break point, or the amount of total capital at which a break, or jump, occurs in
the marginal cost of capital.

• Can there be other breaks? Yes, there can – depending on if there is some point at which
the firm must raise additional capital at a higher cost.
 WACC Illustration

ABC Corp has 1.4 million shares common valued at $20 per
share =$28 million. Debt has face value of $5 million and trades
at 93% of face ($4.65 million) in the market. Total market value
of both equity + debt thus =$32.65 million. Equity % = .8576
and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18%
Tax rate is 40%
Current yield on market debt is 11%
 WACC Illustration

WACC = (E/V) x RE + (D/V) x RD x (1-Tc)

= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
 Final notes on WACC

• WACC should be based on market rates and

valuation, not on book values of debt or equity
• Book values may not reflect the current
marketplace
• WACC will reflect what a firm needs to earn on a
new investment. But the new investment should
also reflect a risk level similar to the firm’s Beta
used to calculate the firm’s RE.
– In the case of ABC Co., the relatively low WACC of 8.81%
reflects ABC’s β=.74. A riskier investment should reflect a
higher interest rate.
 Final notes on WACC

• The WACC is not constant

• It changes in accordance with the risk of
the company and with the floatation costs
of new capital
Determinants of the cost of capital

• Investment policy or capital budgeting policy.

• dividend policy
• capital structure policy
• level of interest rates
• tax rates