The Cost

of Capital

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Learning objectives
• To explain the Sources of capital
• To calculate the Cost of each type of funding
• To Calculate the weighted average cost of capital (WACC)
• To Construct and use of the marginal cost of capital schedule (MCC)

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• According to the definition of John J. Hampton “ Cost of
capital is the rate of return the firm required from investment in
order to increase the value of the firm in the market place”.

• According to the definition of Solomon Ezra, “Cost of capital

is the minimum required rate of earnings or the cut-off rate of
capital expenditure”.
• According to the definition of James C. Van Horne, Cost of capital is “A
cut-off rate for the allocation of capital to investment of projects. It is the
rate of return on a project that will leave unchanged the market price of the
stock”.

• According to the definition of William and Donaldson, “Cost of capital

may be defined as the rate that must be earned on the net proceeds to
provide the cost elements of the burden at the time they are due”.
• Assumption of Cost of Capital
• Cost of capital is based on certain assumptions which are closely associated while calculating
• and measuring the cost of capital. It is to be considered that there are three basic concepts:
• 1. It is not a cost as such. It is merely a hurdle rate.
• 2. It is the minimum rate of return.
• 3. It consist of three important risks such as zero risk level, business risk and financial risk.
• Cost of capital can be measured with the help of the following equation.
• K = rj + b + f.
Where,
• K = Cost of capital.
• rj = The riskless cost of the particular type of finance.
• b = The business risk premium.
• f = The financial risk premium.
Cost of Debt (kd)

• Debt may be perpetual or redeemable debt. Moreover, it may be issued

at par, at premium or discount.
• The cost of debt is the return that a company provides to its debt
holders and creditors. These capital providers need to be compensated
for any risk exposure that comes with lending to a company
• Since observable interest rates play a big role in quantifying the cost of
debt, it is relatively more straightforward to calculate the cost of debt
than the cost of equity. Not only does the cost of debt reflect the
default risk of a company, but it also reflects the level of interest rates
in the market. In addition, it is an integral part of calculating a
company’s Weighted Average Cost of Capital or WACC
Cost of Preferred Stock

• The cost of preferred stock is the stated dividend amount paid annually
on each share of preferred stock, divided by the current market price
of the stock. These dividends are not tax deductible, so the cost of
preferred stock is always higher than the cost of debt – for which
interest payments are tax deductible. The cost of preferred stock is
usually less than the cost of common stock, for which investors
demand an even higher return on investment.
Cost of Equity

• The cost of equity is the return that an investor expects to receive from
an investment in a business. This cost represents the amount the
market expects as compensation in exchange for owning the stock of
the business, with all the associated ownership risks.
• Cost of equity is the percentage of returns payable by the company to
its equity shareholders on their holdings. It is a parameter for the
investors to decide whether an investment is rewarding; otherwise,
they may shift to other opportunities with higher returns.
Factors Affecting the Cost of Capital
• General Economic Conditions
• Affect interest rates
• Market Conditions
• Affect risk premiums
• Operating Decisions
• Affect business risk
• Financial Decisions
• Affect financial risk
• Amount of Financing
• Affect flotation costs and market price of security

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Weighted average cost of capital (WACC)
• Weighted average cost of capital (WACC) represents a firm’s average
after-tax cost of capital from all sources, including common stock,
preferred stock, bonds, and other forms of debt. WACC is the average
rate that a company expects to pay to finance its assets.
 Weighted Cost of Capital Model
• Compute the cost of each source of capital
• Determine percentage of each source of capital in the
optimal capital structure
• Calculate Weighted Average Cost of Capital (WACC)

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1. Compute Cost of Debt
• Required rate of return for creditors
• Same cost found in Chapter 12 as yield to maturity
on bonds (kd).
• e.g. Suppose that a company issues bonds with a
before tax cost of 10%.
• Since interest payments are tax deductible, the true
cost of the debt is the after tax cost.
• If the company’s tax rate (state and federal
combined) is 40%, the after tax cost of debt
• AT kd = 10%(1-.4) = 6%.

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 2. Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock.
Dividend (Dp)
Required rate kp =
Market Price (PP) - F

Example: You can issue preferred stock for a net

price of $42 and the preferred stock pays a
$5 dividend.
 The cost of preferred stock:

$5.00
kp =
$42.00
= 11.90%
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 3. Compute Cost of Common
Equity
• Two Types of Common Equity Financing
• Retained Earnings (internal common equity)
• Issuing new shares of common stock (external common
equity)

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3. Compute Cost of Common Equity
• Cost of Internal Common Equity
• Management should retain earnings only
if they earn as much as stockholder’s
next best investment opportunity of the
same risk.
• Cost of Internal Equity = opportunity
cost of common stockholders’ funds.
• Two methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model

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3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Dividend Growth Model

D1
kS = + g
P0

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3. Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

• Dividend Growth Model

D1
kS = + g
P0

Example:
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is
10%.

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3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Dividend Growth Model

D1
kS = + g
P0
Example:
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.

kS = 3(1+0.10) + .10 =.155 = 15.5%

60
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3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Capital Asset Pricing Model

kS = kRF + (kM – kRF)

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 3. Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

• Capital Asset Pricing Model (Chapter 7)

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.

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3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
• Capital Asset Pricing Model

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.

kS = 5% + 1.2(13% – 5%) = 14.6%

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3. Compute Cost of Common Equity

• Cost of New Common Stock

• Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
kn = + g
P0 - F

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3. Compute Cost of Common Equity
• Cost of New Common Stock
• Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs will
be 12%. D0 = $3.00 and estimated growth is 10%,
Price is $60 as before.
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 3. Compute Cost of Common Equity
• Cost of New Common Stock
• Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs will be
12%. D0 = $3.00 and estimated growth is 10%, Price is
$60 as before.

kn = 3(1+0.10) + .10 = .1625 = 16.25%

52.80 25
Weighted Average Cost of Capital
Kumar Corporation estimates the following costs for
each component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%

Kumar’s tax rate is 40% 26

Weighted Average Cost of Capital
If using retained earnings to finance the
common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

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Weighted Average Cost of Capital

If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.

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Weighted Average Cost of Capital

If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

Assume that Gallagher’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09%
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Weighted Average Cost of Capital

If using a new equity issue to finance the common

stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

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Weighted Average Cost of Capital

If using a new equity issue to finance the common stock

portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%

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 Marginal Cost of Capital
• Kumars’s weighted average cost will change if one
component cost of capital changes.
• This may occur when a firm raises a particularly large
amount of capital such that investors think that the
firm is riskier.
• The WACC of the next dollar of capital raised in
called the marginal cost of capital (MCC).

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Graphing the MCC curve
• Assume now that Kumar Corporation has $100,000
in retained earnings with which to finance its
capital budget.
• We can calculate the point at which they will need
to issue new equity since we know that Kumar’s
desired capital structure calls for 50% common
equity.

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Graphing the MCC curve
• Assume now that Kumar Corporation has $100,000
in retained earnings with which to finance its
capital budget.
• We can calculate the point at which they will need
to issue new equity since we know that Kumar’s
desired capital structure calls for 50% common
equity.

Breakpoint = Available Retained Earnings

Percentage of Total
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Graphing the MCC curve

Breakpoint = ($100,000)/.5 = $200,000

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 Making Decisions Using MCC

Marginal weighted cost of capital curve:

Weighted Cost of Capital

13%

12% 11.72%
11.09%
11%
Using internal Using new
10% common equity common equity

0 100,000 200,000 300,000 400,000

Total Financing

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Making Decisions Using MCC
• Graph MIRRs of potential projects

Marginal weighted cost of capital curve:

12%
Weighted Cost of Capital

11% Project 1
MIRR = Project 2 Project 3
10% 12.4% MIRR = MIRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing 37
 Making Decisions Using MCC
• Graph IRRs of potential projects
Graph MCC Curve
Marginal weighted cost of capital curve:
11.72%
Weighted Cost of Capital

12%
11.09%
11% Project 1
IRR = Project 2 Project 3
10% 12.4% IRR = IRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing 38
Making Decisions Using MCC
• Graph IRRs of potential projects
• Graph MCC Curve
 Choose projects whose IRR is above the weighted marginal cost
of capital
Marginal weighted cost of capital curve:
11.72%
Weighted Cost of Capital

12%
11.09%
11% Project 1
IRR = 12.4% Project 2 Project 3
10% IRR = 12.1% IRR = 11.5%

9% Accept Projects #1 & #2

0 100,000 200,000 300,000 400,000
Total Financing 39