University of Technology, Jamaica

Financial Management (FIN3001)

Unit 7: Cost of Capital

For the investor, the rate of return on a security is the reward for the risk involved in investing in
a financial asset. For Financial Managers, the required rate of return for the investor becomes the cost
of raising funds that are needed to operate the firm, ie the cost of raising funds is the firm’s cost of capital.
Firms obtain capital by (i) debt, ie issuing bonds or borrowing from a bank (ii)Issuing Preference
Shares (iii) Issuing Ordinary Shares (iv)Using Retained Earnings – profit that the company makes but does
not pay out to shareholders as dividends. Each of these offers a rate of return to investors. This return is a
cost to the firm.
Cost of capital refers to the weighted cost of capital as a firm can raise capital from different sources having
different costs, and might also have different amounts of each in its capital structure. The cost of capital is
therefore the weighted average cost of financing sources and is referred to as the Weighted Average Cost
of Capital (WACC).
Cost of Debt: For the issuing firm is the rate of return required by investors. As interest on debt securities
is allowable for tax purposes, the cost of debt must be adjusted for the tax benefit. The after-tax position is
what matters.
Cost of Debt after-tax = Before-tax cost of debt x (1 – tax rate) ie. kdAT = kdBT (1 – t)
Cost of Preference Shares: is the investors' required rate of return, kP, on their investment in the
preference shares. This is found from: kp = D/P0 where D = preference dividend, PO= share price
Note, that no after-tax cost adjustment need be made as in the case of debt capital, as preference dividends
are paid from the firm’s after tax income. Dividends are not a tax-allowable expense for the company as
they are considered a distribution of profits to the owners of the company. However, when issuing new
shares, the company will have certain administrative costs, eg investment bank fees and commissions, etc,
known collectively as Flotation Costs. These flotation costs will be subtracted from the issue price, and the
firm will receive the net amount.
Therefore, the cost of issuing new preference shares will be: kp = D/(P0 – F), Where, F = Flotation Costs
Cost of Ordinary Shares
There are two (2) sources of ordinary equity capital: (i) Retained Earnings known as Internal equity, and
(ii) New Issue of Ordinary Shares – known as External equity. Flotation costs (applicable to external
equity) increase the cost of capital and therefore make a new share issue cost more than using retained
earnings. The cost to the firm of using retained earnings is equal to the cost of ordinary shares already in
issue.
To calculate the cost of Internal Equity, two methods may be used:
Ø Dividend Growth Model ksAT = (D1/P0) + g
Ø CAPM formula ksAT = krf + (km – krf)β

To calculate the cost of External Equity, the dividend growth model is used, but the issue price of the shares
will be adjusted for flotation costs.
KeAT = [D1/(P0 – F)] + g
Why is there a cost to the firm for using retained earnings? A firm's net income or profit is what remains
from its earnings after it has paid its expenses. This net income belongs to the shareholders because they
are the owners of the firm. The firm could distribute some or all of it to the shareholders as dividends, or,
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retain all or most of it (retained earnings) for investment in the firm. The shareholders will want some return
on this money that is being invested for them in the company. How much return do they expect? They
expect the same amount as if they had received the retained earnings in the form of dividends and bought
more stock in the company with the funds received. Therefore, the cost of retained earnings to the firm is
the same as the cost of existing ordinary stocks. Financial managers therefore have to ensure that the returns
from invested retained earnings will be sufficient to give the shareholders at least as good a return on the
money as if they had re-invested the money back into the company.
Weighted Average Cost of Capital
The weighted average cost of capital (WACC) can thus be derived as follows:
WACC = wdkdAT + wpkp + wskic
= wdkd(1-T) + wpkp + wskic
kd = the before-tax cost of debt; wd = the weight of debt
T = the tax rate (in decimal)
kdAT = the after-tax cost of debt;
kp = the cost of preferred equity; wp = the weight of preferred equity
wc = the weight (relative amount) of common equity
kic = the cost of retained earnings (internal common equity);
kec = the cost of new common stock (external common equity);
Note also that only the cost of debt requires adjustment for tax.
The cost of capital (WACC) is relevant for capital budgeting decisions. It is the rate of return that
must be achieved on the company’s projects to satisfy the investor’s required rate of return.

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