Lesson 03

Cost of Capital

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Lesson Outline
Cost of Capital
 Cost of Debt
 Cost of Preferred Stock
 Cost of Common Equity:
• Common Stock
• Retained Earnings
 Weighted Average Cost of Capital
Marginal Cost of Capital

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 Cost of Capital
• The Cost of finance is generally termed as the Cost of Capital
• The individual components of capital may have quite different cost, being
obtained from different financial markets therefore, need to consider
individual components of the capital structure and their cost to determine
the overall cost of capital.
• A firm raises capital through issuance of :
• Bonds
• Preferred Stock
• Common Stock
• Each of these offers a rate of return to investors/creditors.
• This return is a cost to the firm.BBA 2201 CDCE 3
• Cost of capital, generally define as the minimum required rate of return
on invested funds.
• Cost of capital can be further define as the minimum rate of return a
firm earns on its investment in order to satisfy the expectation of the
investors who provide funds to the firm.
• Cost of capital should be calculate for individual components and
overall cost of capital (weighted average cost of capital).
• Overall cost of capital will reflect the required rate of return of the
firms’ assets as a whole.
• The relationship between the required rate return and cost of capital
should be considered in making financing decisions.

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 Importance of Cost of Capital
• Proper capital budgeting decisions require an estimate of the cost of
capital.
• Many other types of decisions, including those related to leasing, to
bond refunding, and to working capital policy, require estimates of the
cost of capital
• Maximizing the value of a firm requires that the costs of all inputs,
including capital, be minimized, and to minimize the cost of capital we
must be able to calculate it.

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 Components of Cost of Capital
Cost of individual components
• Cost of Debt
• Cost of Preference Shares
• Cost of Common Equity
Cost of Retained earnings
Cost of New Common Stock
Overall Cost of Capital- Weighted Average Cost of Capital (WACC)

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 1. Cost of Debt Capital (kd)
• In a companies capital structure, can recognize two types of debt
capital
I. Term loans such as Mortgage Loans and Bank Loans
II. Debt instruments such as Corporate Bonds and Debentures
Redeemable Bonds/Debentures
Bonds/Debentures redeemed or paid off by the issuer prior to the bonds
maturity date.
Irredeemable Bonds/ Debentures
No need to repay back to the lender

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 Cost of Debt Capital (kd) ………con
Cost of Term Loans
• For any loan the interest payment for the debt value will be its cost.
• For the Interest Expense, there is a tax affect.
• Cost of debt should calculate, before tax cost of debt and after tax cost
of debt

Cost of debt before tax (kd BT)= Nominal rate of interest

Cost of debt after tax (kd AT)= kd BT (1 - T)

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 Cost of Debt Capital (kd) …….con
• Interest expense is tax deductible, therefore, when a company pays
interest, the actual cost is less than the expense.
• As an example, consider a company in the 40% marginal tax bracket
that pays Rs.100 in interest. The company’s after-tax cost is only
Rs.60.
Example 01:
A company brought 1 million bank loan from BOC at a 15% annual
interest rate. The company tax rate is 28%. Calculate cost of debt after
tax.

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 Cost of Debt Capital (kd) ……..con

(kd AT)= kd BT (1 - T)
(kd AT)= 15% (1- 0.28)
(kd AT)= 10.8%
Example 02:
• If the company’s interest rate of debt capital is 14% and the tax rate is 30%, the
after-tax cost of debt is;

(kd AT)= kd BT (1 - T)
(kd AT)= 14% (1- 0.3)
(kd AT)= 9.8%
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 Cost of Debt Capital (kd) …..con
Cost of Irredeemable Bonds
Cost of debt before tax (kd BT)= *100

INT= Interest Amount

= Current Market price per bond

Cost of debt after tax (kd AT)= kd BT (1 - T)

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 Cost of Debt Capital (kd) …..con
Cost of Redeemable Bonds

Cost of debt before tax (kd BT)

INT= Interest Amount

= Current Market price per bond
F= Face value/ Nominal value
n= Number of years to maturity

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 Cost of Debt Capital (kd) ….con
• Example 01: a company issued bonds at 14% interest rate for 5 years
period. The nominal value of the bond is Rs. 1000 and the current
market price of the bond is Rs. 950. Applicable tax rate is 25%.
Calculate cost of debt.
kd BT(kd BT)
(kd BT) 15.38%

(kd AT) 15.38% (1-0.25)

(kd AT) 11.53%

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 2. Cost of Preference Shares (kp)
• Preference Share Capital is the funds generated by a company through
issuing preference shares
• Preference Shareholders have the first right to receive dividends even
before equity shareholders.
• Preference share considered as a fixed income security.
kp =

=Annual Preferred Dividend

=Current Market price per share
f = Flotation or selling cost
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 Cost of Preference Shares (kp)….con
• Example 01:
An organization issued preference shares for a value of Rs.150 million which
consist of 50,000 preference shares. The annual dividend per share is Rs. 25
and the last traded price of a preference share was Rs. 250. The flotation cost
per share is Rs. 75. Calculate the cost of preference shares.
kp =
kp =
kp = 14.28%

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 3. Cost of Common Equity(ke)
• There are two forms of common equity financing:
1. Reinvested profits (retained earnings); and
2. New issues of common shares.

• The Cost of Common Equity, ke, is the required rate of return on

common stock and, as such, represents the minimum acceptable rate of
return on the equity-financed portion of new projects.

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 3.1 Cost of Return Earnings(ke)
• Earnings in an organization can be reinvested or paid out as dividends.
• Investors could buy other securities to earn a return.
• There is an opportunity cost if earnings are retained.
• The firm may choose to finance new projects using only internally
generated funds (retained earnings).
• These funds are not free because they belong to the common
shareholders (i.e., there is an opportunity cost).
• Therefore, the cost of retained earnings is exactly the same as the cost
of new common equity, except that there are no flotation costs.

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 3.2 Cost of Common Stock (ke)
• The basic rate of return investors require on a firm’s common equity,
(ke) , is a most important quantity. This required rate of return is the
cost of retained earnings, and it forms the basis for the cost of capital
obtained from new stock issues. There are several methods, including;

(1) The Capital Assets Pricing Model (CAPM) approach,

(2) The bond yield plus risk premium approach, and
(3) The dividend yield plus growth rate, or DCF, approach.

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The Capital Assets Pricing Model (CAPM)
Approach
• The CAPM as developed in the above can be used to help estimate
cost of equity. To use the CAPM, we proceed as follows:
Step 1 - Estimate the riskless rate (RF) generally taken to be either the
treasury bond rate or the thirty day treasury bill rate.
Step 2 - Estimate the stock’s beta coefficient (b) and use this as an index
of the stock’s risk.
Step 3 - Estimate the rate of return on “the market”, or on an “average”
stock. Designate this return (kM).
Step 4 - Estimate the required rate of return on the firm’s stock as follows:

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The Capital Assets Pricing Model (CAPM)
approach

CAPM: ke = RF + (kM - RF)β.

Rf = Risk free rate

Km= Return on market portfolio
β = Market risk
• The value (km-RF) is the risk premium on the average stock, while b
is an index of the particular stock’s own risk.

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The Capital Assets Pricing Model (CAPM)
approach
• Example 01:
Eastern Oil company currently sells at Rs. 120 per share. The stockholders
expect to get a dividend of Rs. 6 next year and expect that dividend will grow
at the rate of 5% per annum. The expected return on market is 12% and
riskless rate is 6%. Calculate the cost of equity by using the CAPM approach
if the market risk is 0.667.
ke = RF + (kM - RF)β
ke = 6% + (12% - 6%)0.667
ke = 10%

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 The Bond Yield plus Risk Premium
Approach
• According to this approach the required rate of return by equity
shareholders is equal to:

ke = kd + RP
Kd = Bond Yield
RP= Risk Premium

• The equity investors bear a higher degree of risk than the bond
holders. Therefore equity holders required rate of return should
include an additional premium for this higher risk.
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 The Bond Yield plus Risk Premium
Approach
Example 01:
A company’s equity beta is estimated to be 0.56 and the market expected
returns is 8.5% while the risk free rate is 3.5%. If the required rate of return
of shares are 12%. What is the cost of equity based on bond yield plus risk
premium approach.
ke = kd + RP
ke = 12% + (8.5%-3.5%)
ke =17%

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 The Dividend yield plus growth rate
(DCF Approach)
• The stocks are typically in equilibrium, when the expected rate of return
equal to the required rate. If the firm is expected to grow at a constant rate,
then can estimate kcs by the discounted cash flow (DCF) formula as
follows;
ke = (D1/P0 )+ g

D1 = Expected dividend
D1 = D0 (1+g) where D0 is the dividend just paid/last divided payment
P0 = Current market price per share
g = dividend growth rate
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 The Dividend yield plus growth rate
(DCF Approach)
Example 01:
The common stock for Carter & Sons is selling for Rs. 129 a share and
paid a dividend of Rs.6. if the growth rate of dividends is 12% what is
the cost of equity?
ke = (D1/P0 )+ g
ke = (D0 (1+g) /P0 )+ g
ke = (6 (1+12%) /129 )+ 12%
ke = 17.209

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 Weighted Average Cost of capital
• The target proportions of debt, preferred and common equity, along with
the component costs of capital, are used to calculate the firm’s overall or
weighted average cost of capital, ka .
• So the Weighted Average Cost of Capital (WACC), ka, reflects the expected
average future cost of funds.
• WACC is computed using the following formula:
∗
𝐖𝐀𝐂𝐂 ( 𝐤𝐚)=𝐤 𝐝 𝐰 𝐝 + 𝐤 𝐩 𝐰 𝐩+ 𝐤 𝐞 𝐰 𝐞
wd = proportion of long-term debt in capital structure
wp = proportion of preferred equity in capital structure
we = proportion of common equity in capital structure
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 Weighted Average Cost of capital
• Example 01:
To illustrate, suppose Firm M has a target capital structure calling for 30%
debt, 10% preferred stock and 60% common equity. Its cost of debt, kd, is
10%; its cost of preferred stock, kp, is 12%; its cost of common equity from
retained earnings, ke , is 15%; and its marginal tax rate is 40%. Calculate
WACC.

WACC= 10%(1-0.4)*30% + 12%*10% + 15%*60%

WACC= 12%

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 Marginal Cost of Capital
• The marginal cost of any item is the cost of another unit of that item; for
example, the marginal cost of labor is defined as the cost of adding one
additional worker.
• The marginal cost of labor might be Rs.25 per person if ten workers are
added, but Rs.35 per person if the firm tries to hire 100 new workers,
because it would be harder to find that many people willing and able to
do the work. The same concept applies to capital.
• As the firm tries to attract more new rupee, the cost of each rupee will,
at some point, rise. Thus, the marginal cost of capital is defined as the
cost of obtaining another rupee of new capital, and the marginal cost
rises as more and more capital is raised.
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 Marginal Cost of Capital
• We can use Firm M to illustrate the marginal cost of capital concept.
The company’s market value capital structure and other data are given
below.
Debt Rs.3,000,000 30%
Preferred Rs.1,000,000 10%
Common equity
(300,000 shares* Rs.20 per share) Rs.6,000,000 60%

Total value Rs.10,000,000 100

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 Marginal Cost of Capital
• P0 = Rs.20 D0 = Rs.1.495
• D0 has already been paid, so someone purchasing this stock today
would not receive D0. Rather, he or she would receive D1 the next
dividend. g = 7%, and it is expected to retain constant
ke = (D0 (1+g) /P0 )+ g
ke = (1.495 (1+7%) /20 )+ 7%
ke =14.99%= 15%
• Suppose that Kd= 10% and Kp= 12% and tax rate 40%
• Based on the data Weighted average cost of capital is,
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 Marginal Cost of Capital

• Since the firm’s optimal capital structure calls for 30% debt, 10% preferred and
60% equity each new (or marginal) rupee will be raised as 30 cents of debt, 10
cents of preferred and 60 cents of common equity.
• Otherwise, the capital structure would not stay on target. As long as Firm M’s debt
has an after –tax cost of 6%, its preferred has a cost of 12%, and its common equity
has a cost of 15%, then its weighted average cost of capital will be 12%. Thus, each
new rupee will be raised as 30 cents of debt, 10 cents of preferred, and 60 cents of
equity and each new (or marginal) rupee will have a weighted average cost of 12%.
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 Summary
• The cost of capital concept is of vital significance in decision-making. It is used:
(1) as a discount, or cutoff rate for evaluating investment projects,
(2) for designing the firm’s debt-equity mix,
(3) for appraising the top management’s financial performance.
• Firms obtain their supply of capital for financing their investments in the form of equity
or debt or both. Also, in practice, they maintain a target debt-equity mix. Therefore, the
firm’s cost of capital means the weighted average cost of debt and equity.
• Three steps are involved in calculating the firm’s weighted cost of capital. First, the
component of debt and equity are calculated. Second, weights to the each component of
capital are assigned in proportion of its amount in the capital structure. Third, the
product of component costs and weights is summed up to determine WACC. The
weighted average cost of new capital is called the marginal cost of capital (MCC).

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