CHAPTER FOUR:

THE COST OF CAPITAL

4.1. The Concept of Cost of Capital
The cost of capital is an extremely important financial concept. It acts as a major link between
the firm’s long-term investment decisions and the wealth of the owners as determined by
investors in the market place. The cost of capital is the ‘magic number’ that is used to decide
whether a proposed investment will increase or decrease the firm’s stock price.
Every business organization has its own risk-return characteristics. Investors (bondholders,
preferred stockholders, and common stockholders) require a minimum rate of return
commensurate with the risk it accepts by investing in the firm. From the standpoint of the
corporation investors provide the capital needed to finance the firm’s investment. The minimum
rate of return that the firm must earn in order to satisfy its investors for a given level of risk is
called cost of capital.
Cost of capital can be also defined as the rate of return that a firm must earn on its investment to
maintain the market value of its stock and satisfy its investors required rate of return. If risk is
held constant, the implementation of projects with a rate of return above the cost of capital will
increase the value of the firm, however, the implementation of a project with a rate of return
below the cost of capital will decrease the value of the firm.
As firms usually use more than one type of financing, cost of capital is thus a weighted average
of the specific costs of several sources. We ought always to use the weighted average cost of
capital, and not an individual cost of funds, as our discount rate for investment decisions. When
we compute a firm’s weighted average cost of capital, we are simply calculating the average of
its cost money from all investors, those being creditors and stockholders.
3.1 Significance of cost of capital
Cost of capital is useful as a standard for:
Evaluating investment decisions (e.g. NPV (+ve or –ve), IRR or PI, etc).
Designing a firm’s debt policy (the proposition of debt and equity in capital structure).
Appraising the financial performance of top management (by comparing the actual earned
rate of return and cost of capital).

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4.2. Specific Cost of Capital
From the shareholder’s point of view, the company’s cost of capital is the rate of return required
by them for financing the company’s investment projects by buying various securities of the
company. The market determines the required rate of return (RRR) through demand and supply
forces by the actions of competing investors.
A company obtains its capital from four basic sources:
Debt Common stock and
Preferred stock Retained earnings
Determining the cost of a specific source of capital is important because of the differences in
risk of various securities.
Debt holders have a prior claim over equity holders on the firm’s assets and cash flows.
Because the firm is under a legal obligation to pay interest and its principal to bond holders.
Preference shareholders have a claim prior to equity holders but after bondholders.
Equity shareholders claim the residual assets and cash flows. They may be paid dividend
from the cash remaining after interest and preference dividends are paid. Thus equity share is
more risky than both securities. Since the securities have risk differences, investors will want
different rates of return.
4.2.1. Cost of Debt
A firm may borrow funds from financial institutions or public center either in the form of public
depositors of bond for specific period of time at a certain rate of return. The firm’s cost of debt is
the investor’s required rate of return (RRR) on debt adjusted for tax and flotation cost. This is
because interest payment on debt is a tax-deductible expense; it reduces the firm’s taxable
income by the amount deductible interest. Flotation cost is the cost incurred in issuing debt
securities that increases the cost of debt. If commissions, legal and accounting fees are incurred
in issuing the security the company will not receive the full market price rather the selling
expenses are deducted from the selling price to give the amount that realizes called Net Proceed
(NP). A bond may be issued at par, at a discount or at a premium as compared to its face value.
The specific cost of debt can be found by the following formulas:

i. Ki = [to compute cost of debt before taxes].

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 ii. Kd = Ki(1−T) ≈ Kd = Interest rate(1−T) [to obtain after tax cost of debt]
Where:
Ki = Cost of debt before taxes FV = Face value of the bond
Kd = After taxes cost of debt MV = Maturity value of the bond
I = Interest Payment n = Maturity period of the bond.
Activity 1: A corporation sold a Br. 20 million bond that mature in 25 years at par value. Each
bond has a Br.1, 000 par values and carries a 12% coupon rate (interest rate). Assume a 45% tax
rate. Compute the specific cost of capital for this bond before and after tax effect.

Activity2: Assume that the above bond in example 1 is discounted and sold for Br.980 per par.
Compute the after tax cost of debt.

Activity 3: ABC Company sold Br.100 par value bond that mature in 7 years. The rate of
interest is 15% per year, and the bond will be redeemed at 5% premium on maturity. The firm’s
tax rate is 35%.

Cost of preferred stock

It is the rate of return that must be earned on the preferred stockholders’ investment to satisfy
their requirement (fixed dividend payment). When a corporation sells preferred stock, it expects
to pay dividends to investors in return for their money capital. The dividend payments are costs
to the firms issuing preferred stock. In order to express this dividend cost as yearly rate, the firm
uses the selling price it receives after deducting flotation costs incurred in issuing the preferred
stocks. The cost of preferred stock can be estimated by dividing the annual preference dividend
by the current market price per share or net proceed; as the dividend can be considered a
continuous (stable) level of payment.
Preferred stock dividends are either expressed as a stated birr amount or annual percentage.
Preference capital is never issued with an intention not to pay dividends.
The cost of preferred stock is not adjusted for taxes, because preference dividend is paid after
corporate tax is paid.
The cost of preferred stock (Kp) can be estimated through the following formula;

Kp =

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Activity 1: A preferred stock selling for Br.500 with an annual stated dividend per share of Br.50
requires a flotation cost of Br.10 per share. Determine the specific cost of the preferred stock if the
corporate tax rate is 40%.

4.2.2. The Cost of Common Stock

Cost of common stock is a minimum rate of return that the corporation must earn for its common
stock holders in order to maintain the market value of the firm’s equity. However, cost of equity
share is more difficult to calculate than the cost debt or the cost of preferred shares because there
are no fixed contractual payments for equity shares. The cost of equity share capital is
determined by the present value of all future dividends expected to be paid on their share. In case
of equity shares, it is difficult to determine the expected future value. This occurs due to that
many firms do not pay dividends for long period of time either because they choose to finance
their investment or they are not profitable enough.
There are two important techniques to estimate the cost of common stock.
A. The Dividend–Growth Model
a) Normal dividend-growth: whose dividends are expected to grow at a constant rate of g. In
this case the cost of common stock (Kc) can be found by applying the following formula.

Kc = +

Where:
Kc = cost of common stock g = dividend growth rate
Do = current dividend per share D1 = dividend at the end of 1st year
NP = Net Proceed
Dividend for n period with normal growth rate can be estimated using the formula
Dn = Do (

Activity 1: a company’s common stock has recent dividend per share of Br.12. It is found that
the company dividend per share should continue to increase at 6% growth rate. What is the cost
of common stock if a market price of Br.100 with a flotation cost of per share Br.8 is expected
up on selling the stocks?

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Activity 2: suppose that the current market price of company’s share is Br.90 and the expected
dividend per share next year is Br.4.50. If the dividends are expected to growth at a constant rate
of 8%, the shareholders’ required rate of return is
b. Zero-Growth Rate: - The dividend valuation method can also be used to estimate the cost of
equity of no-growth. The growth rate will be zero if the firm does not retain any of its earnings;
i.e. the firm follows a policy of 100% pay out dividend policy. In this case,

Kc = = which implies that in a no-growth situation, the expected earnings-price

(E/P) ratio may be used as the measure of the cost of equity (where, EPS = Earnings Per
Share).
Activity: a firm is currently earning Br.100,000 and its share is sold at a market price of Br.80.
the firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to
remain stable, and it has a payout ratio of 100%. What is the cost of equity? If the firm’s payout
ratio is assumed to be 60% and that it earns 15% of rate of return on its investment opportunities,
then what would be the firm’s cost of equity?

b) The Capital Asset Model (CAPM):- as per the CAPM, the required rate of return on equity
is given by Kc = Rf + (Rm − Rf)βj.
Where:
Kc = cost of equity Rm = market return
Rf = Risk free rate βj = beta of firm’s share
Risk free rate (Rf) is the rate obtained on the government treasury securities.
Market risk premium (Rm −Rf) is measured as the difference between long-term historical
arithmetic averages of market return and the risk free rate.
Beta j (βj) is the systematic risk of an ordinary share in relation to the overall market.

Activity: Assume that the risk free rate is 7%, the expected return in the market is 16% and the
beta for the firm’s common stock is 0.82. Compute the cost of equity using CAPM.

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Cost of Retained Earnings
Retained Earnings (RE) represents profit available to common stockholders that the corporation
chooses to reinvest. The cost of RE costly related to the use of equity shares. If earnings were not
retained, they will be paid out to the common stockholders in dividend form. The cost of retained
earnings is the opportunity cost forgone dividends to the existing shareholders. Thus, its cost is
the same as that of equity shares. Since retained earnings represent the internal source of capital,
it is not necessary to adjust the cost of it for flotation costs. So, specific cost of RE (K RE) is
equated in the same way as the cost of equity was equated. That is,

KRE , where MP = market price of existing common stock.

Activity: a company’s common stock has recent dividend per share of Br.12. It is found that the
company dividend per share should continue to increase at 6% growth rate. What is the cost of
retained earnings if a market price of Br.100 with a flotation cost of per share Br.8 is expected
up on selling the common stocks?

4.3. The Weighted Average Cost of Capital (WACC)

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WACC estimates the cost of capital structure financed from different sources of finance
like debt, common stock, preferred stock or retained earnings. It is a function of the
individual cost of capital and the percentage of funds provided by different securities
holders. The capital structure weights can be estimated from book value, market value,
historical weight or target weight.
Book value weight- uses accounting book value to measure the proportion of each
type of capital in the firm’s capital structure.
Market value weight- measures the proportion at its market value.
Historical weights-can be either book value or market value weights based on actual
capital structure proportion. Such weights however, would represent actual rather
than desired proportions of various types of capital in the capital structure.
Target weights- can be either book value or market value weights that reflect the
firm’s desired capital structure proportion. However, from strictly theoretical point of
view, the target market value weighting scheme (program) should be preferred.
The following steps are involved for calculating the firm’s WACC.
a) Calculate the cost of specific sources of funds.
b) Multiply the cost of each source by its proportion in the capital structure.
c) Add the weighted component costs to get the WACC.
Thus, WACC = W1K1 + W2K2 + … + WnKn =

Where: Ki = cost of capital for the ith source.

Wi = percentage of total capital supplied by ith source.
n = number of long-term capital sources.
Example: assume that you are provided with the following information regarding the
capital structure of a corporation found in your locality.
Source of finance Market value Specific cost of capital
Debt Br.300,000 8%
Preferred stock 100.000 11%
Common stock 450,000 18%
Retained earnings 150,000 15%
Total Br.1,000,000
 Debt =

Preferred stock =

Common stock =

Retained earnings =
WACC = 0.3(0.08) + 0.1(0.11) + 0.45(0.18) + 0.15(0.15) = 13.85%
Interpretation – to satisfy its shareholders or creditors the corporation should get at least
13.85% annual return from the investment.
4.4. The Weighted Marginal Cost of Capital (WMCC)
It is the cost of additional (new) capital raised by a firm from different sources of finance.
WMCC is simply the firm’s WACC associated with its next birr of total new financing. It
reflects the WACC of the last birr raised by the firm. The WMCC increases as more and
more capital is raised during a period. Increases in the component financing costs result
from the fact that at a given point in time, the larger the amount of new financing, the
greater the risk to the fund suppliers. Risk rises in response to the increased uncertainty as
to the outcomes of the investments financed with these funds. In other words, fund
suppliers require greater returns in the form of interest, dividend, or growth as
compensation for the increased risk introduced as larger volumes of new financing are
incurred.
Example: the corporation in your locality (see the previous example) wanted to raise
additional funds of Br.100,000 to finance its plant. The corporation raised the Br.100,000
from different sources such as: Br.20,000 debt, Br.30,000 common stock, Br.30,000
preferred stock and Br.20,000 retained earnings. The specific cost of capital of each
source remains the same. Compute the WMCC.

Debt = = 20% Preferred stock = = 30%

Common stock = = 30% Retained earnings = = 20%

WMCC = WdKd + WpKp + WcKc + WREKRE

= 0.2(0.08) + 0.3(0.11) + 0.3(0.18) + 0.2(0.15) = 13.3%
Interpretation – to satisfy its shareholders or creditors the corporation should earn at
least 14.5% annual return from the investment financed by additional raised funds.