Topic 07:

Cost of Capital,
Select a combination of
projects
Engineering Economics (IM1027)
Instructor: Dr. Nguyen Vu Quang
Contents

• Capital structure of companies

• Calculate the MARR
• Select the combination of projects

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Capital Structure (sources of capital)

• Debt capital (borrowing money to be repaid, plus interest)

• Equity capital (selling shares to investors, stockholders)
Goods/products
Invetsment services
Capital capital
Money
Lenders Enterprise Investment
Investors
Materials
Return on Return from
capital investment Money

Financial function Investment and production function

Equity capital: owned by company and shareholders (selling stocks to the public)

Borrowed capital: from individuals or banks (loans, bonds,…)

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Capital Structure (sources of capital)
• A company's capital can be short-term debt, bonds, equity, and
retained earnings….
• All of them have the cost of capital

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Where is a debt and debt interest in a
cashflow?

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 Example of cost of debt capital
• No borrowing
• TR = 20%
• EBIT = Earning before income
tax (no interest payment)
• Tax = EBIT*TR
• EAT = Earning after tax
= EBIT – Tax = EBIT(1-TR)
• A borrowing of D, interest rate of
ib=10%
• TR=20%
• EBIT2 = Earning before income tax
with interest payment = EBIT – D*ib
• Tax = EBIT2 *TR
• EAT = EBIT2 – Tax
= (EBIT – D*ib) - (EBIT – D*ib)*TR
= EBIT(1-TR) - D*ib(1-TR)

Example: EBIT = Revenue – Cost = 60, TR = 20%

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Estimating the cost of debt

• Cost of debt capital ib, is the interest rate of money

borrowed (ib is before tax)
• Cost of debt capital after tax: rd = (1-TR)ib = (1-t)ib
• Not easy to assign debt repayment to a specific project,
as debt is determined at the corporate, not the project,
level
• Bonds is a type of debt capital

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Estimating the cost of bonds
• Bonds is a type of debt capital, the cost of bonds i%
determined by the equation::
Po: present value of a bond
F: future value of a bond
A: expense of paying interest
r: annual interest per year
M: number of payments per year
TR: corporate tax rate
S: expense of bond issues
[A + F(r/ M)](1-TR): related to the
interest payment
(1/N)(F-Po+S)(TR): related to tax
savings due to the annual amortization
of the difference F – Po and the cost of
issuing S
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Estimating the cost of equity

• Cost of equity funds, ea, or re is based upon opportunity

costs associated with the best use of those funds within
the firm
• One way is to consider the trend in past values of return
on equity (ROE)
• The other way, base on the return demanded by the
shareholders
•…
• The capital asset pricing model (CAPM) offers an
approach to explain the value of ea
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The Capital Asset Pricing Model (CAPM)
RF : risk-free rate
SML: security market line
RM: return on market where level of risk is M = 1.0
S : risk level of stock S
(RM − RF ) = the market premium for the average stock market risk

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Example of CAPM

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 The Weighted Average Cost of Capital
(WACC)

Generally:
WACC = %D*(1-TR)*rD + %E1*re1 + %E2*re2 + …

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Example of WACC
Consider a large multinational company with an effective income tax
rate of 49.24%. The percentage of long-term debt in its capital
structure is 49%, and its before-tax annual cost is 9.34%. In its capital
structure, the firm also has 13% preferred stock paying 8.22% per year
and 38% common equity valued at 16.5% per year. What is the
weighted average cost of capital for this firm (after taxes)?

WACC = 2.323% + 1.069% + 6.270% = 9.662%

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Cost of capital

• EPS (Earning Per Share)

• When %Debt is increased, ea and ib increase

• When %Debt is increased, the expected value of [EPS] should

be increased

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Cost of capital
r%
re

WACC

rd

%Debt

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Determine MARR

•Based on WACC
•Based on the risk of investment
•Based of opportunity cost:
– Determine MARR by ranking prospective projects of similar risk
according to a ladder of profitability and then establishing a cut-
off point

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Determine MARR by opportunity costs

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MARR determination

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