2022

THE COST OF CAPITAL

PART 01
PRESENTED BY: KIMBEARLY CHENG, MBA
 01

DEFINITION
The cost of capital represents the firm’s cost of financingand is the minimum rate
of return that a project must earn to increase firm value. (Gitman, 2018)
WHAT DOES THIS MEAN?
It's the cost of the next dollar of financing necessary to finance a new
investment opportunity
Investments with a rate of return above the cost of capital will increase
the value of the firm, and projectswith a rate of return below the cost of
capital will decrease firm value.

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 BASIC CONCEPTS
a.
A firm’s cost of capital is estimated at a given point in time and reflects the expected average future cost
of funds over the long run. Although firms typically raise money in lumps, the cost of capital reflects the
entirety of the firm’s financing activities, and they tend to toward some desired mix of financing.

b.
We need to look at the overall cost of capital rather than just the cost of any single source of financing to
capture all the relevant financing costs.
EXAMPLE:
A firm is currently faced with an investment
opportunity. Assume the following:

Imagine that 1 week later a new investment

opportunity is available:
BUT WHAT IF...
What if instead the firm used a combined cost of financing? By weighting
the cost of each source of financing by its relative proportion in the firm’s
target capital structure, the firm can obtain a weighted average cost of
capital.

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 OUR
GOALS
There are four basic sources of long-term capital for firms: long-term debt, preferred stock,
common stock, and retained earnings (see right-hand side of balance sheet).
Not every firm will use all of these sources of financing, but most firms will have some mix of
funds from these sources in their capital structures.
Although a firm’s existing mix of financing sources may reflect its target capital structure, it is
ultimately the marginal cost of capital necessary to raise the next marginal dollar of financing
that is relevant for evaluating the firm’s future investment opportunities. 06
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TERMS TO REMEMBER
FLOTATION COST
FLOTATION COMPONENTS
NET PROCEEDS UNDERWRITING COSTS:
COSTS Compensation earned by investment
bankers for selling the security
Funds that the firm Total costs of issuing ADMINISTRATIVE COSTS:
receives from the sale and selling securities issuer expenses such as legal,
accounting, and printing.
 COST OF LONG-TERM DEBT

COMPONENTS OF COST OF PREFERRED STOCKS

THE COST OF
CAPITAL COST OF COMMON EQUITY

(PART 01)
USING THE BOND YIELD+RISK
PREMIUM APPROACH AND
CAPM 08
 EXAMPLE:
A 5-YEAR CORPORATE BOND WITH A PAR VALUE
OF $1,000 HAS A COUPON RATE OF 8% WITH
THE INTEREST PAID SEMI-ANNUALLY. SUPPOSE
IT IS SELLING FOR $1,050; CALCULATE YIELD TO
MATURITY (COST OF DEBT BEFORE TAX) AND
THE AFTER-TAX COST OF DEBT IF THE
CORPORATE TAX RATE IS 21%.
COST OF LONG-TERM DEBT
Description The financing cost associated with
new funds raised through long-term
borrowing. Typically, the funds are
raised through the sale of corporate
bonds.
Simply put, this is the bond's Yield to Maturity (YTM)!
BEFORE TAX:
AFTER TAX:
 COST OF PREFERRED STOCKS
Description The ratio of the preferred stock dividend
to the firm’s net proceeds from the sale EXAMPLE 02
of the preferred stock. The net proceeds
represent the amount of money to be
received minus any flotation costs.

NOTES:
Present Value of the stock can be
computed using this formula, wherein:
rp = required return on the
preferred stock
NOTES:
Likewise, we can compute for the
Required Return on the Preferred
Stock by using this formula:

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COST OF COMMON EQUITY

1 2 3 4 5 6 7
Most important Basic equity Common Claim comes Because of this, Estimating cost Common stock
component of security of the stockholders ONLY AFTER it's the riskiest of equity is dividends are not
the Cost of firm. have a residual Bondholders and among the challenging fixed and in many
Capital claim on the Preferred sources of because it's the cases, not paid at
form. Stockholders capital and has last in the all, because if
have been paid the highest cost. pecking order! there's no money
(in this particular left, then there's no
order) money left!
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METHODS FOR ESTIMATING COST OF

COMMON EQUITY

01 02 03
Bond Yield + Discounted Cash Flow
Risk Premium CAPM (DCF): Earnings/Dividend
Approach Growth
BOND YIELD + RISK PREMIUM APPROACH

PROBLEM:

SOLUTION:
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THE CAPM METHOD

EXAMPLE:
Consider a well-diversified portfolio has an expected
return of 11.5% and a Beta of 1.70. If the Risk-free interest
rate is 5%, what is the cost of common equity using the
CAPM Method?
ENDE