The Cost of Capital

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 The Cost of Capital
The principal way value is increased is by
investing in projects that earn more than
their cost of capital.

If a project earns 20%, then it will increase

value of that firm only if its cost of capital is
less than 20%.

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 The Cost of Capital
If the PV of the future cash flows exceeds the
project’s cost, the firm’s value will increase if
the project is accepted.

However, we need a discount rate to find the

PV of the future cash flows, and that discount
rate is the firm’s cost of capital.

Def: The cost of funds used for financing a

business. (Investopedia)
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 Capital Component
One of the types of capital used by firms to raise
funds.

Components:
Debt
Preferred Stock
Common Stock (both retained earnings and new equity)

Cost of each component is called component

cost.
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 WACC
A weighted average of the component
costs of debt, preferred stock, and
common equity.
Why we use Weighted Average Cost of Capital (WACC) ?

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 Components of Cost of Capital

 Cost of Debt, rd
 Cost of Preferred Stock, rp
 Cost of Retained Earnings, rs (internal
equity)
 Cost of New Common Stock, re (External
equity)

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Cost of debt is 10%, Marginal Tax rate is 40%, Preferred
dividend 10 taka, Price of preferred div is 97.5 taka. Next
year expected div 1.25taka & market price of common
stock is 23.06 taka. Expected growth rate is 8.3%.
Flotation cost is 10%......(more info when necessary)
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 Cost of Debt, rd

The interest rate the firm must pay on new

debt.

After Tax cost of debt = rd(1-T)

If X Allied can borrow at an interest rate of

10% and its marginal tax rate is 40%. What
will be its after tax cost of Capital?
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 Cost of Preferred Stock, rp

The rate of return investors require on the

firm’s preferred stock.

Stock would have a 10 taka dividend per

share and it would be priced at 97.50 taka
a share. What would be the cost of
preferred stock?

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 Cost of Retained Earnings, rs
Approaches to find out rs :

 DCF (Discounted Cash Flow) Approach

 CAPM Approach
 Bond Yield Plus Risk Premium Approach
 Averaging the Alternative Estimates

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 Cost of Retained Earnings, rs:
(DCF Approach)
The rate of return required by stockholders on
a firm’s common stock.
D1
rs =Po
 g

Allied’s stock sells for $23.06, its next expected

dividend is $1.25, and analysts expect its
growth rate to be 8.3%
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 Cost of Retained Earnings, rs:
(CAPM Approach)

Assume that in today’s market, rRF = 5.6%,

the market risk premium is RPM = 5.0%, and
Allied’s beta is 1.48.

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 Cost of Retained Earnings, rs:
(Bond Yield Plus Risk Premium Approach)

rs = Bond Yield + Risk Premium

Allied’s bonds yield 10% and risk premium is

4%

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Cost of Retained Earnings, rs:
(Averaging the Alternative Approach)

It is the average of all other approaches.

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Cost of New Common Stock, re:
Flotation Cost, F:
The percentage cost of issuing new
common stock.

D1
re =P0(1  F ) +g

Assume that Allied has a flotation cost of 10%.

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 WACC of Allied Food Products
What is WACC of Allied Food Products
If equity comes from retained Earnings?
If equity comes form selling new stock?

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 Factors That Affect WACC
Factors Firm Cannot Control:
 Interest rate in the economy.
 The general level of stock prices
 Tax rate.

Factors Firm Can Control:

 By changing its capital structure
 By changing its dividend payout ratio.
 By altering its capital budgeting decision.
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 Assignment

Problems: 10-1 to 10-13

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Class Summary

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