Cost of capital

Dr Sheeba kapil
The cost of capital represents
• the firm’s cost of financing, and
• is the minimum rate of return that a project must earn to increase firm value.

Financial managers are ethically bound to only invest in projects that they expect to exceed
the cost of capital.

The cost of capital reflects the entirety of the firm’s financing activities.

Most firms attempt to maintain an optimal mix of debt and equity financing.

To capture all of the relevant financing costs, assuming some desired mix of financing, we
need to look at the overall cost of capital rather than just the cost of any single source of
financing.
 Cost of Capital: Needed for

• Good capital budgeting decisions – neither

the NPV rule nor the IRR rule can be
implemented without knowledge of the
appropriate discount rate
• Financing decisions – the optimal/target
capital structure minimizes the cost of capital
• Operating decisions – cost of capital is used by
regulatory agencies in order to determine the
“fair” return in some regulated industries (e.g.
electric utilities)
Cost of Capital

• The cost of capital represents the overall cost of

financing to the firm
• The cost of capital is normally the relevant discount
rate to use in analyzing an investment
• The overall cost of capital is a weighted average of
the various sources:
• Ko=WACC = Weighted Average Cost of Capital
• WACC = After-tax cost x weights
Should our analysis focus on historical
costs or new (marginal) costs?

• The cost of capital is used primarily to make

decisions that involve raising new capital. So,
focus on today’s marginal costs (for WACC).
 Sources of Long-Term Capital

© 2012 Pearson Prentice Hall. All rights reserved. 9-6

Cost of Debt- Kd
• Kd= YTM On bonds
(yield to maturity or interest rate paid to its bondholders)
• Kd= Int paid/Debt
• Kd = Rf + Spread
(Spread is credit default spread)
• The default spreads are obtained from traded bonds. Adding that number
to a riskfree rate should yield the pre-tax cost of borrowing for a firm.

• Pre tax cost of debt will be adjusted to calculate post tax cost of debt:
• After-tax cost of debt = Kd x (1 - tax rate)
 Example: Tax effects of financing
with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
PAT 264,000 231,000
⚫ Now, suppose the firm pays 50,000 in dividends to
the shareholders
 Example: Tax effects of financing
with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
 Cost of Debt

After-tax cost Before-tax cost Tax

of Debt = of Debt - Savings

33,000 = 50,000 - 17,000

OR
33,000 = 50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

Cost of Debt

Kd = kd (1 - T)

.066 = .10 (1 - .34)

 EXAMPLE: Cost of Debt
$1,000 par,(face value)

• A CO issues a 1,000 par, 20 year bond paying

the market rate of 10%. Coupons are annual.
The bond will sell for par since it pays the
market rate. What is the pre-tax and after-tax
cost of debt for the Corporation? but flotation
costs amount to 50 per bond.
EXAMPLE: Cost of Debt

• Pre-tax cost of debt:

950 = 100(PVIFA 20, Kd) + 1000(PVIF 20, Kd)
Kd = 10.61%
• After-tax cost of debt:
Kd = Kd (1 - T)
Kd = .1061 (1 - .34)
Kd = .07 = 7%
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
• Preferred stock is an annuity, so we take the annuity
formula, rearrange and solve for RP
• R P = D / P0

• Cost of preferred stock = dividend

price - flotation cost
Cost of Preferred stock: Example
A co’s preferred stock sells for 100 per share and
co pays an annual dividend of 10.5. if the
flotation cost is 4/share what si the cost of
preference shares.

Answer

Kp=10.5/100-4= 10.94%
Cost of Equity: Retained Earnings
• Why is there a cost for retained earnings?
• Earnings can be reinvested or paid out as dividends
• Investors could buy other securities, and earn a
return.
• Thus, there is an opportunity cost if earnings are
retained
• Common stock equity is available through retained
earnings (R/E) or by issuing new common stock:
• Common equity = R/E + New common stock
Cost of Equity:
New Common Stock
• The cost of new common stock is higher than
the cost of retained earnings because of
flotation costs
• selling and distribution costs (such as sales
commissions) for the new securities
Cost of Equity

• There are a two methods used to determine the

cost of equity

• Dividend growth Model

• CAPM
 The Dividend Growth Model
Approach
• Estimating the cost of equity: the dividend growth model
approach
According to the constant growth (Gordon) model,
D1
P0 =
KE - g

Rearranging D1
KE = +g
P0
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
 Advantages and Disadvantages of Dividend
Growth Model
• Advantage – easy to understand and use
• Disadvantages
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth rate
– an increase in g of 1% increases the cost of
equity by 1%
– Does not explicitly consider risk
 Capital Asset Pricing Model (CAPM)

kj = Rf + β ( Rm − Rf )
Cost of Co-variance Average rate of return
capital Risk-free of returns against on common stocks
return the portfolio (WIG)
(departure from the average)
B < 1, security is safer than WIG average
B > 1, security is riskier than WIG average
CAPM approach
• Advantage: Evaluates risk, applicable to firms
that don’t pay dividends

• Disadvantage: Need to estimate

• Beta
• the risk premium (usually based on past data, not
future projections)
• use an appropriate risk free rate of interest
Estimation of Beta: Measuring Market
Risk

• Market Portfolio - Portfolio of all assets in the

economy
• In practice a broad stock market index, such as the
NIFTY, SENSEX, is used to represent the market
• Beta - sensitivity of a stock’s return to the return on
the market portfolio
 Estimation of Beta

• Theoretically, the calculation of beta is straightforward:

• Problems Cov ( Ri , R M ) σ iM
β= = 2
1. Betas may vary over time.
2. The sample size may be inadequate.
Var ( R M ) σM
3. Betas are influenced by changing financial leverage and business risk.

• Solutions
• Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques.
• Problem 3 can be lessened by adjusting for changes in business and financial risk.
• Look at average beta estimates of comparable firms in the industry.
 What is the appropriate risk-free rate?

• Use the yield on a long-term bond if you are analyzing cash

flows from a long-term investment

• For short-term investments, it is entirely appropriate to use

the yield on short-term government securities

• Use the nominal risk-free rate if you discount nominal cash

flows and real risk-free rate if you discount real cash flows
Survey evidence: What do you use for
the risk-free rate?

Corporations Financial Advisors

90-day T-bill (4%) 90-day T-bill (10%)

3-7 year Treasuries (7%) 5-10 year Treasuries (10%)

10-year Treasuries (33%) 10-30 year Treasuries (30%)

20-year Treasuries (4%) 30-year Treasuries (40%)

10-30 year Treasuries (33%) N/A (10%)

10-years or 90-day; depends

(4%)
Source: Bruner et. al. (1998)
N/A (15%)
Weighted Average Cost of Capital (WACC)
https://www.investopedia.com/terms/w/wacc.asp

• WACC weights the cost of equity and the cost of debt

by the percentage of each used in a firm’s capital
structure
• WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
• (E/V)= Equity % of total value
• (D/V)=Debt % of total value
• (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-
tax rate must be considered because interest on corporate
debt is deductible
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.
 • The WACC is not constant
• It changes in accordance with the risk of the
company and with the floatation costs of
new capital

Flotation cost is the total cost incurred by a company in offering its securities to the public. They arise from expenses such as under-
writing fees, legal fees and registration fees
Should the company use the composite
WACC as the hurdle rate for each of its
projects?
 NO! The composite WACC reflects the risk of an
average project undertaken by the firm.
Therefore, the WACC only represents the
“hurdle rate” for a typical project with average
risk.
 Different projects have different risks. The
project’s WACC should be adjusted to reflect
the project’s risk.
Optimum Capital Structure
 The optimal (best) situation is associated with the minimum
overall cost of capital:
 Optimum capital structure means the lowest WACC
 Usually occurs with 30-50% debt in a firm’s capital structure
 WACC is also referred to as the required rate of return or the
discount rate
Cost of capital curve