CBMBA Cost of Capital

ASB9032: Corporate Finance
Cost of Capital
Professor Aziz Jaafar

Bangor Business School
Bangor University
(email: a.jaafar@bangor.ac.uk)
Chartered Banker MBA Programme
Outline
• Sources of capital
• Cost of each type of funding
• Calculation of the weighted average cost of capital
(WACC)
• Construction and use of the marginal cost of capital
schedule (MCC)
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Overall Cost of Capital of the Firm
Cost of Capital is the required rate of return on

the various types of financing. The overall cost
of capital is a weighted average of the
individual required rates of return (costs).
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Factors Affecting the Cost of Capital

• General Economic Conditions
– Affect interest rates
• Market Conditions
– Affect risk premiums
• Operating Decisions
– Affect business risk
• Financial Decisions
– Affect financial risk
• Amount of Financing
– Affect flotation costs and market price of security
Weighted Cost of Capital Model
• Compute the cost of each source of capital

• Determine percentage of each source of
capital in the optimal capital structure
• Calculate Weighted Average Cost of Capital
(WACC)
Cost of Debt
• Required rate of return for creditors
• Same as yield to maturity on bonds (rd).
• 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
• After Tax rd = 10%(1-.4) = 6%.
Cost Preferred Stock
• Cost to raise a dollar of preferred stock.

Dividend (Dp)
Required rate rp =
Market Price (PP) - F

• Example: You can issue preferred stock for a
net price of $42 and the preferred stock pays a
$5 dividend.
• The cost of preferred stock:
$5.00
rp =
$42.00
= 11.90%
Cost of Common Equity
• Two Types of Common Equity Financing

– Retained Earnings (internal common equity)
– Issuing new shares of common stock (external
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

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

D1
re = + g
P0
Example:
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is
10%.
re = 3(1+0.10) + .10 =.155 = 15.5%

60

– Capital Asset Pricing Model
re = rRF + (rM – rRF)

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

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
re = 5% + 1.2(13% – 5%) = 14.6%

• Cost of New Common Stock

– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
D1
rne = + g
P0 - F

– Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.
D1
rne = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.

– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
D1
rne = +g
P0 - F
Example:
If additional shares are issued floatation costs will
be 12%. D = $3.00 and estimated growth is 10%,
0
Price is $60 as before.
rne = 3(1+0.10) + .10 = .1625 = 16.25%

52.80 www.charteredbankermba.co.uk18
Weighted Average Cost of Capital

Gallagher Corporation estimates the following
costs for each component in its capital structure:
Source of Capital Cost
Bonds rd = 10%
Preferred Stock rp = 11.9%
Common Stock
Retained Earnings re = 15%
New Shares rne = 16.25%
Gallagher’s tax rate is 40% www.charteredbankermba.co.uk19


 If using retained earnings to finance the
common stock portion the capital structure:
WACC= (WTd x AT rd ) + (WTp x rp ) + (WTs x rs)
 Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
 If using retained earnings to finance the

WACC= (WTd x AT rd ) + (WTp x rp ) + (WTs x rs)
 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% = 11.09%
 If using a new equity issue to finance the

WACC= (WTd x AT rd ) + (WTp x rp ) + (WTne x rne)
WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%
Marginal Cost of Capital

• Gallagher’s weighted average cost will change if one
component cost of capital changes.
• This may occur when a firm raises a particularly large
amount of capital such that investors think that the
firm is riskier.
• The WACC of the next dollar of capital raised in called
the marginal cost of capital (MCC).
Graphing the MCC curve

• Assume now that Gallagher Corporation has
$100,000 in retained earnings with which to
finance its capital budget.
• We can calculate the point at which they will need
to issue new equity since we know that
Gallagher’s desired capital structure calls for 50%
common equity.

• Assume now that Gallagher Corporation has
$100,000 in retained earnings with which to
finance its capital budget.
• We can calculate the point at which they will need
to issue new equity since we know that
Gallagher’s desired capital structure calls for 50%
common equity.
Breakpoint = Available Retained Earnings

Percentage of Total

Breakpoint = ($100,000)/.5 = $200,000
Making Decisions Using MCC
Marginal weighted cost of capital curve:

Weighted Cost of Capital
13%
12% 11.72%
11.09%
11%
Using
Usinginternal
internal Using
Usingnew
new
10% common
commonequity
equity common
commonequity
equity
0 100,000 200,000 300,000 400,000
Total Financing

• Graph MIRRs of potential projects

12%
11% Project 1
MIRR = Project 2 Project 3
10% 12.4% MIRR = MIRR =
12.1% 11.5%
9%
0 100,000 200,000 300,000 400,000

Total Financing
• Graph IRRs of potential projects

Graph MCC Curve
11.72%
12%
11.09%
11% Project 1
IRR = Project 2 Project 3
10% 12.4% IRR = IRR =
12.1% 11.5%
9%
0 100,000 200,000 300,000 400,000

Total Financing

• Graph IRRs of potential projects
• Graph MCC Curve
 Choose projects whose IRR is above the weighted
marginal cost of capital
11.72%
12%
11.09%
11% Project 1
IRR = 12.4% Project 2 Project 3
10% IRR = 12.1% IRR = 11.5%
9% Accept Projects #1 & #2

0 100,000 200,000 300,000 400,000
Total Financing
Thank you

CBMBA Cost of Capital

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CBMBA Cost of Capital

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ASB9032: Corporate Finance

Professor Aziz Jaafar

Overall Cost of Capital of the Firm

Cost of Capital is the required rate of return on

Factors Affecting the Cost of Capital

Weighted Cost of Capital Model

• Compute the cost of each source of capital

Cost Preferred Stock

• Cost to raise a dollar of preferred stock.

Market Price (PP) - F

Cost of Common Equity

• Two Types of Common Equity Financing

Cost of Common Equity

Cost of Common Equity

Cost of Common Equity

Cost of Common Equity

• Cost of Internal Common Stock Equity

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

Cost of Common Equity

• Cost of Internal Common Stock Equity

re = rRF + (rM – rRF)

Cost of Common Equity

• Cost of Internal Common Stock Equity

re = rRF + (rM – rRF)

Cost of Common Equity

• Cost of Internal Common Stock Equity

re = rRF + (rM – rRF)

re = 5% + 1.2(13% – 5%) = 14.6%

Cost of Common Equity

• Cost of New Common Stock

Cost of Common Equity

Cost of Common Equity

Price is $60 as before.

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

Weighted Average Cost of Capital

Source of Capital Cost

Gallagher’s tax rate is 40% www.charteredbankermba.co.uk19

Weighted Average Cost of Capital

WACC= (WTd x AT rd ) + (WTp x rp ) + (WTs x rs)

 Assume that Gallagher’s desired capital

Weighted Average Cost of Capital

 If using retained earnings to finance the

WACC= (WTd x AT rd ) + (WTp x rp ) + (WTs x rs)

 Assume that Gallagher’s desired capital

Weighted Average Cost of Capital

 If using a new equity issue to finance the

WACC= (WTd x AT rd ) + (WTp x rp ) + (WTne x rne)

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

Marginal Cost of Capital

Graphing the MCC curve

Graphing the MCC curve

Breakpoint = Available Retained Earnings

Graphing the MCC curve

Making Decisions Using MCC

Marginal weighted cost of capital curve:

Making Decisions Using MCC

Marginal weighted cost of capital curve:

0 100,000 200,000 300,000 400,000

Making Decisions Using MCC

• Graph IRRs of potential projects

0 100,000 200,000 300,000 400,000

Making Decisions Using MCC