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Cost of Capital
Financial management and control systems (Lecture 2)
Dr. Mahmoud Otaify
Assistant Professor of Finance

LO1 Understand the basic concept of cost

of capital

LO2 Determine a firm’s cost of equity

capital.

LO3 Determine the cost of long-term debt

LO4 Calculate the weighted average cost

of capital (WACC)
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Source Amount $ Weight

Common Stocks (E) 600,000 E/V=600,000/1000,000=0.6
Preferred Stock (P) 150,000 P/V=150,000/1000,000=0.15
Bonds (D) 250,000 D/V=250,000/1000,000=0.25
Total value of capital 1,000,000 1
structure (V=E+P+D)

Cost of Capital Symbol How Much? %

Cost of Equity RE SML
Cost of Preferred RP DDM
Pre-tax cost of RD YTM
Debt
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Owners Company
+ Use funds
Creditors to receive
more than
Require cost of
rate of funds
return

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• If you want to finance project from banks

and bank requires 10% as interest (return),
the cost of debt capital is 10%
Cost of Debt Capital
Debt • Firm must earn at least 10% to pay the
Financing interest payment. • The return that lenders
require on the firm's debt.
• If you want to finance project from capital
market and investors require 8% return, the
Cost of Equity Capital
cost of equity capital is 8%.
Equity • Firm must earn at least 8% to compensate
investors for the use of the capital needed
• The return that equity
Financing to finance the project. investors require on their
investment in the firm.

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Expected return on the market –

risk-free rate of return
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RF=12%
RE=? E(RM) = 17%

E(RM) – RF
= 17 – 12 = 5%

Beta =
RE = 12%+ (17% - 12%) = 1.2 RE = 12%+ 1.2*(17% - 12%) =
17% 18%

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CAPM 8

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 Compute cost of equity using the

SML
 Risk-free rate, Rf
 Market risk premium, E(RM) – Rf
 Systematic risk of asset, 

Cost of RE Rf E(E(RM)Rf )

Common Stock
(SML) Example:
Company’s equity beta = 1.2
Current risk-free rate = 7%
Expected market risk premium = 6%
What is the cost of equity capital?

R E  7  1.2 ( 6 )  14.2%
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 Reminders
 Preference shares generally pay a
constant dividend every period.
 Dividends are expected to be paid
every period forever.
 Preference share valuation is an
annuity, so we take the annuity
Cost of formula, rearrange and solve for RP.
Preferred
 RP = D/P0
Stocks (Rp)
 Example
 Your company has preference shares that
have an annual dividend of $3. If the current
price is $25, what is the cost of a preference
share?

RP = 3 / 25 = 12%
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Yield on
Treasury
Securities

Risk- Credit
Required Risk
Return by free Premiu
Bondholders
rate m

A bond’s rating is used

to indicate its relative
probability of default
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The cost of debt = the required

return on a company’s debt.

Compute the yield to maturity on

existing Bond

𝑭𝑽 − 𝑩𝑽
𝑪𝒐𝒖𝒑𝒐𝒏 +
𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚
𝒀𝑻𝑴 =
𝑭𝑽 + 𝑩𝑽
𝟐

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Suppose we have a bond issue currently outstanding that has

25 years left to maturity. The coupon rate is 9% and coupons.
The bond is currently selling for $908.72 per $1000 bond.
What is the cost of debt? Tax rate = 40%

Cost of
Debt  Coupon = 1000*0.09 = 90
 Semiannual coupon = 90/2 = 45
(Example)  𝒀𝑻𝑴 =
𝟏𝟎𝟎
𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐
𝟐𝟓
𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐 = 10%
𝟐
 Annual pretax cost = 5*2 = 10%
 After-tax cost of Debt = RD (1- TC) = 10 x
(1 – 0.4 ) = 6%

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Source Amount Weight Cost

Equity (E) 600,000 60% 14.2%

Preferred 150,000 15% 12%
(P)
Debt (D) 250,000 25% 10%
Capital (V) 1,000,000
Tax Rate 40%
WACC WACC= E/V*RE + P/V*RP + D/V*RD(-
TC)
=0.6*14.2 + 0.15*12 + 0.25*10(1-0.4)
=
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