Chapter Five

5.1. The Meaning of Cost of Capital

The cost of capital is the rate of return that the enterprise must pay to satisfy the
providers of funds, and it reflects the riskiness of providing funds.

The cost of capital has two aspects to it.

(a) The cost of funds that a company raises and uses
(b) The return that investors expect to be paid for putting funds into the company
It is therefore the minimum return that a company should make on its own
investments, to earn the cash flows out of which investors can be paid their return.

The cost of capital can therefore be measured by studying the returns required by
investors. The cost of capital can then be used to derive a discount rate for DCF
analysis and investment appraisal.
Each form of capital has its own cost. For example, equity has a cost and each
bank loan or bond issue has a different cost. A company must make sufficient
returns from its investments to satisfy the requirements for return of all the
different finance providers.

Cost of capital represents the return a company needs to achieve in order to justify
the cost of a capital project, such as purchasing new equipment or constructing a new
building.

Cost of capital encompasses the cost of both equity and debt, weighted according to
the company's preferred or existing capital structure. This is known as the weighted
average cost of capital (WACC).

A company's investment decisions for new projects should always generate a return
that exceeds the firm's cost of the capital used to finance the project. Otherwise, the
project will not generate a return for investors.
The focus of this topic is the weighted cost of capital and the measurement of the cost of individual
capital components (debt, common equity, and preferred stock) and its use in the capital budgeting
process.

The cost of capital and risk

The cost of capital can be analyzed into three elements.

Risk free rate of return +
 Premium for business risk +
Premium for financial risk
= COST OF CAPITAL
(a) Risk-free rate of return
This is the return which would be required from an investment if it were completely free from
risk. Typically, a risk-free yield is the yield on government securities.
(b) Premium for business risk
This is an increase in the required rate of return due to the existence of uncertainty about the
future and about a firm's business prospects. The actual returns from an investment may not be
as high as they are expected to be. Business risk will be higher for some firms than for others,
and some types of project undertaken by a firm may be more risky than other types of project
that it undertakes.
(c) Premium for financial risk
This relates to the danger of high debt levels (high gearing). The higher the gearing of a
company's capital structure, the greater will be the financial risk to ordinary shareholders, and
this should be reflected in a higher risk premium and therefore a higher cost of capital.
Because different companies are in different types of business (varying business risk) and have
different capital structures (varying financial risk) the cost of capital applied to one company
may differ radically from the cost of capital of another.
The relative costs of sources of finance
The cost of debt (the rate a firm pays on its current loans, bonds and other debts) is likely to be
lower than the cost of equity (the return paid to its shareholders). This is because debt is less
risky from the debthodlers' viewpoint. In the event of liquidation, the creditor hierarchy
dictates the priority of claims and debt finance is paid off before equity. This makes debt a safer
investment than equity and hence debt investors demand a lower rate of return than equity
investors.
Debt interest is also corporation tax deductible (unlike equity dividends) making it even cheaper
to a tax paying company. Arrangement costs are usually lower on debt finance than equity
finance and once again, unlike equity arrangement costs, they are also tax deductible.
The creditor (payables) hierarchy
1. Creditors with a fixed charge
 2. Creditors with a floating charge
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders
This means that the cheapest type of finance is debt (especially if secured) and the most
expensive type of finance is equity (ordinary shares).

5.2 The Components of the Cost of Capital

The overall cost of capital of a firm is comprised of the costs of the various components of financing.
Techniques for determining the specific costs of each of these sources, i.e., debt, preferences shares,
equity shares and retained earnings are presented as follows:

5.2.1. The cost of debt and preferred stock

A. Cost of Debt:

Cost of debt is the after tax cost of long term funds through borrowing. The cost of capital for debt is the
return that potential investors require of the firm’s debt securities; such as its bonds. The cost of debt has
two basic components. These are:

a. The annual interest.

b. The cost that arises from the amortization of discounts or premiums paid or received when the debt
is initially issued.
Interset
Cost of Debt (Kd) =Pr incipal x 100%

Kd (1- Tax) = After tax cost of debt

Example: Assume that xy company issue £100 par value bonds with a coupon rate of 12% paid annually.
The bonds, which are currently trading at £93, are redeemable at par in 20 years time. Find the cost of the
bond assuming a taxation rate of 30 per cent.

Solution:

The before-tax cost of the bond can be calculated by finding its internal rate of return (IRR). The
nominal cash flows to an investor who purchased the bond now at £93 would be as follows:
 Year Cash flow (£)

0 (93)

1–20 12

20 100

The investor would have a cash outlay now of £93, followed by cash inflows of £12 per year interest for
20 years, plus the par value of the bond on redemption 20 years from now.

We therefore want a discount rate which can be applied to the future cash flows, over the 20-year term to
maturity of the bond, gives a present value of £93.

The before-tax cost of the bond, kd, is determined as:

We can determine a close approximation of the actual cost by interpolating as follows:

Where, r1 = lower discount rate used

r2 = higher discount rate used

NPV1 = the NPV of the cash flows at r1

NPV2 = the NPV of the cash flows at r2%

Kd approximately determined as;

Gross cost of the bond to the company is 13 per cent, approximately: it is the investor’s
required rate of return.

With a marginal tax rate of 30 per cent, the after-tax cost of the debt, kd(1−T), would be:
kd(1−T)=13(1−0.30) = 9.1%

The tedium of interpolating can be avoided by using the Hawanini and Vora (1982) yield
approximation formula as follows:

 where, I =annual interest or coupon rate

P =par value of bond at maturity

NPD = net proceeds from sale, or market value of debt instrument

n = number of periods (years) to maturity

 Applying it to our present example the cost of debt, kd, would be calculated as:
And the after-tax cost of debt, kd(1−T), is given as:

kd(1−T)=12.89(1−0.3) = 9.02%

B. Cost of Preference Capital:

A Preference share, being a hybrid security, has neither the ownership privilege of equity nor the legally
enforceable provisions of debt. The cost of preference share is found by dividing annual preference share
divided by net proceeds from the sale of preference share. The net proceed represents the amount of
money to be received minus floatation cost.

D
P −F
Cost of preference share (K ) = p
p

Where: Kp: Cost of preference share

D: The preference share dividend

Pp: The market price of preference share

F: The floatation or selling cost

Example: To illustrate, KMI has just issued 3 million shares of a preferred stock that pay an annual

dividend of $4.05. The preferred stock was sold to the public at a price of $52 per share. With issuance

costs of $2 per share, the marginal cost of preferred stock is calculated as follows:

$ 4 . 05
Kp = $ 52−$ 2 = 0.081 or 8.1%

5.2.2. The cost of common equity capital

The cost of equity can be generally stated as the rate at which investors discounted the expected dividend
by the firm in order to determine the market price of an ownership interest in the firm.

D1
Cost of Common Equity shares (K ) = P o −F +g
e

Where: D1: Dividend paid in year 1.

Ke: cost of common equity

Po: the price of share

F: The floatation or selling cost

g: growth rate by which the dividends are expected to grow per year at constant compound rate.

Example: To illustrate, consider NICOR Corporation. Its current stock price is $39 per share. NICOR
pays a current annual dividend of $1.68 per share. The consensus forecast from security analysts is that
earnings and dividends will grow at an annual rate of 6.5% per annum for the foreseeable future. The
floatation cost of the share is $2. The cost of external equity capital for NICOR using a constant growth
dividend valuation model is:

$ 1 . 68(1+0 . 065)
Ke = $ 39−$ 2 + 0.065 = 0.113 or 11.3%

5.2.3. The cost of retained earnings and new common stock

A. Cost of Retained Earnings:

The cost of retained earnings is closely related to the cost of equity share which excludes floatation costs.
If earnings are not retained they will be paid out to the equity shareholders as dividends. The cost of
retained earnings must therefore be viewed as the opportunity cost of the foregone dividend to the
existing equity shareholders. The cost of funds obtained by retained earnings can be defined as the rate of
return shareholders require on the firm’s equity shares.

D1
Cost of retained earnings (K ) = P o +g
r

Where, Kr: The required rate of return.

Example: To illustrate, suppose KMI’s common stock is currently selling for $56 a share. Its present
dividend, D0, is $0.20 a share, and the expected long-term earnings and dividend growth rate is 10.0%.
The cost of internal equity capital, kr, is calculated as follows:

$ 0. 2(1+0 . 1)
Kr = $ 56 +0.1 = 0.104 or 10.4%

5.3. The meaning and use of the weighted average cost of capital (WACC)

The weighted average cost of capital (WACC) is the average cost of capital for all the
company’s long term sources of finance, weighted to allow for the relative proportions of each
type of capital in the overall capital structure.
The WACC represents the return that the company should make on its investments to be able to
provide the returns required by its finance providers.
The WACC is calculated by weighting the costs of the individual sources of finance according to
their relative importance as sources of finance.

Steps in computation of the overall cost of capital

The computation of the overall cost of capital (represented symbolically by Ka):

1. Determine specific cost of capital for each funds

2. Assigning weights to specific costs (the capital structure weights)

3. Multiplying the cost of each of the sources by the appropriate weights.

4. Sum each of specific weighted costs to get Ka.

The crucial part of the exercise is the decision regarding appropriate weights and the related
aspects.

Ka = Weight of Debt x Cost of Debt + Weight of Preferred share x Cost of Preferred Share +
Weight of Common Share x Cost of Common Share + Weight of Retained Earning x Cost
of Retained Earning

Ka = Wd x Kd +Wp x Kp + We x Ke + Wr x Kr

Illustration:
Kinder Morgan, Inc. (KMI) has a target capital structure consisting of 47% common equity, 51%
debt, and 2% preferred stock. The company plans to finance future capital investments in these
proportions. All common equity is expected to be derived internally from additions to retained
earnings. The marginal cost of internal common equity has been estimated to be 10.4% using the
dividend valuation approach. The marginal cost of preferred stock is 8.1% and the pretax
marginal cost of debt is 8%. The marginal tax rate is 4%. The weighted cost of capital for KMI
can be computed as follows:

Ka = 0.47 x 10.4% + 0.51 x 8.0% (1 – 0.4) + 0.02 x 8.1% = 7.5%

This is the rate that KMI should use to evaluate investment projects of average risk over the
coming year.

Source of Capital After-Tax Target proportion of Capital Weighted Cost

Cost

common equity 10.4% 0.47 4.89%

capital

Debt 4.8 0.51 2.45

Preferred stock 8.1 0.02 0.16

1.00 7.50%

5.4. Adjusting cost of capital for project risk

Marginal cost of capital approach
The marginal cost of capital approach involves calculating a marginal cut-off rate for
acceptable investment projects by:
(a) Establishing rates of return for each component of capital structure, except retained
earnings, based on its value if it were to be raised under current market conditions.
(b) Relating dividends or interest to these values to obtain a marginal cost for each component.
(c) Applying the marginal cost to each component depending on its proportionate weight
within the capital structure and adding the resultant costs to give a weighted average.
It can be argued that the current weighted average cost of capital should be used to evaluate
projects.
Where a company's capital structure changes only very slowly over time, the marginal cost of
new capital should be roughly equal to the weighted average cost of current capital.
Where gearing levels fluctuate significantly, or the finance for new project carries a significantly
different level of risks to that of the existing company, there is good reason to seek an alternative
marginal cost of capital.
5.6 Example: Marginal cost of capital
Georgebear has the following capital structure:
Source After-Tax Market Value After-Tax Cost x
Cost % Market Value
$Million

Equity 12 10 1.2

Preference 10 2 0.2

Bonds 7.5 8 0.6

20 2.0

Weighted average cost of capital = 2x100%

20
= 10%
Note that this is a simplified calculation of WACC. The full calculation will give the same
answer of 10%.
Georgebear's directors have decided to embark on major capital expenditure, which will be
financed by a major issue of funds. The estimated project cost is $3,000,000, 1/3 of which will
be financed by equity, 2/3 of which will be financed by bonds. As a result of undertaking the
project, the cost of equity (existing and new shares) will rise from 12% to 14%. The cost of
preference shares and the cost of existing bonds will remain the same, while the after tax cost of
the new bonds will be 9%.
Required
Calculate the company's new weighted average cost of capital, and its marginal cost of capital.
Solution
New weighted average cost of capital
Source After-Tax Market Value After-Tax Cost x
Cost % Market Value
$Million

Equity 14 11 1.54

Preference 10 2 0.2

Existing Bonds 7.5 8 0.6

New Bonds 9 2 0.18

23 2.52

Weighted average cost of capital = 2.52x100%

23
= 11%
Adjusted Marginal cost of capital = (2.52-2)x100%
(23-20)
= 17.3%