BUSINESS FINANCE

Lecture 2:
Cost of Capital

By: Sana Tauseef

Assistant Professor, Department of Finance
Institute of Business Administration, Karachi
Email: sasghar@iba.edu.pk
 Cost of capital is the
weighted average of the
costs of different

Cost of Capital
components of firm’s
financing mix…

2
Why the cost of capital is important???

• It is used in evaluating the long-term projects.

cost of capital provides us the hurdle rate-the
minimum acceptable return on the capital
projects.

Cost of Capital
• Since the WACC is the weighted average of cost
of equity and cost of debt, we can vary the
WACC by changing the mix of debt and equity.
The optimal capital structure is the structure
with the lowest possible WACC.
3
Some important points about the cost
of capital include…
• Using WACC in capital evaluation does not imply
that each investment is financed using the mix
of all financing sources.
• WACC is a forward-looking concept.

Cost of Capital
• WACC is calculated on an after-tax basis.
• WACC includes the cost of financing the long-
term funds only.
• WACC does not remain constant for all levels of
required financing. 4
Cost of debt equals the current interest
cost to borrow new funds…

• Cost of debt is not the coupon rate on the

already outstanding debt issue of the firm.
• Cost of debt is estimated by computing the YTM

Cost of Capital
on the existing debt issue.
• We may also need to adjust the current YTM
based on the bond rating we expect when we
issue new debt.
• Cost of debt needs to be adjusted for taxes.
5
Suppose we have a bond issue currently outstanding
that has 20 years left to maturity. The coupon rate is
11% with annual payments. The bond is currently
selling for $950. If the par value is $1000 per bond
and the tax rate is 40%, calculate the after-tax cost

Cost of Capital
of debt?

6
Cost of equity is the return required by the
equity holders of the firm…

Two major methods for determining the cost of equity

are:
• Dividend growth model

Cost of Capital
For Common Equity P0 = D1 / KCE – g
For Preferred Equity P0 = D / KPE

• CAPM (for common equity only)

KCE = KRF + β (KM - KRF)
7
Retained earnings represent the internal
source of common equity funds…
• As the income is retained in the firm for
reinvestment, it represents a source of
equity capital as supplied by current
stockholders.

Cost of Capital
• These internal funds should not be
considered as free in nature.
• We assume the stockholders could earn the
return equivalent to that provided by their
present investment in the firm. 8
Your company has an outstanding preferred equity
that has an annual dividend of $10.5. If the preferred
stock is selling for $100, and each new share issued
will carry a floatation cost of $4, calculate the cost of
preferred equity?

Cost of Capital
Suppose that your company is expected to pay a
common dividend of $1.50 per share next year. There
has been a steady growth in dividends of 7% per year
and the market expects that to continue. The current
price is $30 and the floatation cost is $3 per common
share. What is the cost of common equity (retained
earnings and new common shares)? 9
Based on the market values of debt, preferred equity
and common equity, your firm’s financing mix is 30%
debt, 10% preferred equity and 60% common equity.
The firm has $23.4 million of retained earnings.
Calculate the WACC for your company?

Cost of Capital
10
WACC for financing $1-$39 million…

Weight Cost
Debt 0.3 6.99
Preferred Equity 0.1 10.94

Cost of Capital
Common Equity 0.6 12
WACC 10.39%

Total available retained earnings is utilized if

the firm’s financing need is $39 million.
11
WACC will increase if the firm needs
additional funds above $39 million…
Weight Cost
Debt 0.3 6.99
Preferred Equity 0.1 10.94

Cost of Capital
Common Equity 0.6 12.6
WACC 10.75%

WACC will not be 10.75% for all financing needs

above $39 million. Assuming that debt financing
becomes expensive (8.6% on after-tax basis) if
company borrows above $15 million…
12
WACC will increase if the firm needs
additional funds above $50 million…

Weight Cost
Debt 0.3 8.6

Cost of Capital
Preferred Equity 0.1 10.94
Common Equity 0.6 12.6
WACC 11.23%

13
Table of MCC shows the WACC for
different levels of financings…

Amount of financing WACC

$1 - $39 million 10.39%

Cost of Capital
> $39 million - $50 million 10.75%
> $50 million 11.23%

14