The Cost of

Capital
 Introduction
• The project’s cost of capital is the
minimum required rate of return on funds
committed to the project, which depends
on the riskiness of its cash flows.
• The firm’s cost of capital will be the
overall, or average, required rate of
return on the aggregate of investment
projects.
 Significance of the Cost of
Capital
• Evaluating investment decisions,
• Designing a firm’s debt policy, and
• Appraising the financial performance of
top management.
 The Concept of the
Opportunity Cost of Capital
• The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable
risk. OCC

. Equity shares

. . Preference shares

. . Corporate bonds

Government bonds
Risk-free security

Risk
 General Formula for the
Opportunity Cost of Capital
• Opportunity cost of capital is given by the following
formula:
C1 C2 Cn
I0     
(1  k ) (1  k ) 2 (1  k ) n
where Io is the capital supplied by investors in period
0 (it represents a net cash inflow to the firm), Ct are
returns expected by investors (they represent cash
outflows to the firm) and k is the required rate of
return or the cost of capital.
• The opportunity cost of retained earnings is the rate
of return, which the ordinary shareholders would have
earned on these funds if they had been distributed as
dividends to them.
Weighted Average Cost of Capital
Vs. Specific Costs of Capital
• The cost of capital of each source of capital is known
as component, or specific, cost of capital.
• The overall cost is also called the weighted average
cost of capital (WACC).
• Relevant cost in the investment decisions is the
future cost or the marginal cost.
• Marginal cost is the new or the incremental cost that
the firm incurs if it were to raise capital now, or in the
near future.
• The historical cost that was incurred in the past in
raising capital is not relevant in financial decision-
making.
• Cost of Capital Components
– Debt
– Preferred
– Common Equity
• WACC
Capital components are sources of
funding that come from investors.
Accounts payable, accruals, and
deferred taxes are not sources of
funding that come from investors, so
they are not included in the
calculation of the cost of capital.
We do adjust for these items when
calculating the cash flows of a
project, but not when calculating the
cost of capital.
 Should we focus on before-tax or
after-tax capital costs?

 Tax effects associated with financing can be

incorporated either in capital budgeting cash
flows or in cost of capital.
 Most firms incorporate tax effects in the cost of
capital. Therefore, focus on after-tax costs.
 Only cost of debt is affected.
 Cost of Debt
• Debt Issued at Discount or Premium
n INTt Bn
B0   
t 1 (1  k ) 
t n
d (1 k d )
• Tax adjustment 
After-tax cost of debt  kd (1  T )
• An Approximation 
Kd = Int(1-T) + Bn-B0 divided by Bn+B0/2
n
 Term loans from Financial
Institutions
• Cost of term loan is
» Interest rate(1-tax rate)

Because of the following characteristics

1. They are usually repayable over a period of 8 to 10
years in equal installments
2. The interest is payable on outstanding balance
3. There is hardly any issue expense
4. There is no premium payable when the principal is
repaid
 Cost of Preference Capital
• Irredeemable Preference Share  
PDIV
kp 
P0

• Redeemable Preference Share  

n PDIVt Pn
P0 =  +
t 1 (1  k ) 
t n
p (1 k p )
An Approximation 
Kd = Div + Pn-P0 divided by Pn+P0/2
n
 What are the two ways that companies can
raise common equity?
• Directly, by issuing new shares of
common stock.
• Indirectly, by reinvesting earnings that
are not paid out as dividends (i.e.,
retaining earnings).
 Estimating the investors’ required
rate of return
• Dividend capitalization approach )Zero growth
P0 =D1/(1+ks)1 + …. Till infinite
Where P0 = Current market price per share
D1 = dividend expected at the end of year t
ks = equity shareholders required rate of return
ks = D/P
• With g percent growth in dividends for ever
ks = D1/ P0 + g
– Supernormal growth  
n
DIV0 (1  g s )t DIVn  1 1
P0    
t= 1 (1  ke )t ke  g n (1  ke )n
• Realised Yield approach
Yt = Dt +Pt -1
Pt-1
Dt +Pt is referred to as wealth ratio Wt
Pt-1
 The Capital Asset Pricing Model (CAPM)
• As per the CAPM, the required rate of return
on equity is given by the following
relationship:
ke  R f  ( Rm  R f )  j
• Equation requires the following three
parameters to estimate a firm’s cost of equity:
– The risk-free rate (Rf)
– The market risk premium (Rm – Rf)
– The beta of the firm’s share ()
• Bond Yield plus Risk Premium Approach
Yield on the long term bonds of the firm +
Risk Premium
• Earnings Price Ratio Approach
E1/P
Where E1 = expected EPS for the next year
P= current market price per share
Where E1 is estimated as current EPS x ( 1 +
growth rate of EPS)
 Cost of Equity Capital
• Cost of External Equity: The Dividend—
Growth/Dividend capitalisation Model
DIV1
ke  g
P0
• Earnings–Price Ratio and the Cost of
Equity
• CAPM model
Ke= ks/(1-f)
Where f= underpricing and issue expenses
expressed as a percentage of current
market price
 Cost of Equity: CAPM Vs.
Dividend—Growth Model
• The dividend-growth approach has
limited application in practice
– It assumes that the dividend per share will
grow at a constant rate, g, forever.
– The expected dividend growth rate, g, should
be less than the cost of equity, ke, to arrive at
the simple growth formula.
– The dividend–growth approach also fails to
deal with risk directly.
Cost of Equity: CAPM Vs. Dividend—
Growth Model
• CAPM has a wider application although it is based on
restrictive assumptions:
– The only condition for its use is that the company’s
share is quoted on the stock exchange.
– All variables in the CAPM are market determined
and except the company specific share price data,
they are common to all companies.
– The value of beta is determined in an objective
manner by using sound statistical methods. One
practical problem with the use of beta, however, is
that it does not probably remain stable over time.
The Bond-Yield-Plus-Premium
Approach

• Estimating a risk premium above the

bond interest rate
• Judgmental estimate for premium
• “Ballpark” figure only
k  Bond yield  Risk premium
s
 10%  4%  14%
 The Weighted Average Cost of Capital

• The following steps are involved for calculating the firm’s WACC:
– Calculate the cost of specific sources of funds
– Multiply the cost of each source by its proportion in the capital
structure.
– Add the weighted component costs to get the WACC.
ko  kd (1  T ) wd  kd we
D E
ko  kd (1  T )  ke
DE DE
• WACC is in fact the weighted marginal cost of capital (WMCC); that
is, the weighted average cost of new capital given the firm’s target
capital structure.
 Weighted Cost of Capital

Capital
Source Cost Structure

debt 6% 20%
preferred 10% 10%
common 16% 70%
 Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)

• Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16)
= 13.4%
Book Value Versus Market Value
Weights
• Managers prefer the book value weights
for calculating WACC:
– Firms in practice set their target capital structure
in terms of book values.
– The book value information can be easily
derived from the published sources.
– The book value debt—equity ratios are analysed
by investors to evaluate the risk of the firms in
practice.
 Book Value Versus Market Value Weights

• The use of the book-value weights can

be seriously questioned on theoretical
grounds:
– First, the component costs are opportunity rates
and are determined in the capital markets. The
weights should also be market-determined.
– Second, the book-value weights are based on
arbitrary accounting policies that are used to
calculate retained earnings and value of assets.
Thus, they do not reflect economic values.
 Book Value Versus Market Value
Weights
• Market-value weights are theoretically
superior to book-value weights:
– They reflect economic values and are not
influenced by accounting policies.
– They are also consistent with the market-
determined component costs.
• The difficulty in using market-value
weights:
– The market prices of securities fluctuate
widely and frequently.
– A market value based target capital structure
means that the amounts of debt and equity are
continuously adjusted as the value of the firm
changes.
 Flotation Costs, Cost of Capital and Investment
Analysis
• A new issue of debt or shares will invariably involve
flotation costs in the form of legal fees, administrative
expenses, brokerage or underwriting commission.
• One approach is to adjust the flotation costs in the
calculation of the cost of capital. This is not a correct
procedure. Flotation costs are not annual costs; they
are one-time costs incurred when the investment
project is undertaken and financed. If the cost of capital
is adjusted for the flotation costs and used as the
discount rate, the effect of the flotation costs will be
compounded over the life of the project.
• The correct procedure is to adjust the investment
project’s cash flows for the flotation costs and use the
weighted average cost of capital, unadjusted for the
flotation costs, as the discount rate.
Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock; derived from same formula as a perpetuity.

Dividend (Dp)
Required rate kp =

Net Price (MP – F)

 Example: You can issue preferred stock for $45
(Market Price). However, if Flotation costs are $3,
then the firm only gets $42 and if the preferred
stock pays a $5 dividend, then
 The cost of preferred stock:

kp = $5.00 = 11.90%
$45.00 – 3.00
 Compute Cost of Common Equity
• Cost of External Equity - New Common Stock
– Must adjust the Dividend Growth Model
equation for Flotation costs of the new
common shares.
D1
kn = + g
P0 - F

Example:
If additional shares are issued floatation costs will
be 12% of the Market Price. D0 = $3.00 and
estimated growth is 10%, Price is $60 as before.
 3. Compute Cost of Common Equity
• Cost of External Equity - 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. (Flotation =12% x $60 = $7.20)

kn = 3.00(1.10) + .10 = .1625 = 16.25%

60.00 – 7.20
 The Cost of Capital for Projects
• A simple practical approach to incorporate
risk differences in projects is to adjust the
firm’s WACC (upwards or downwards), and
use the adjusted WACC to evaluate the
investment project.
• Companies in practice may develop policy
guidelines for incorporating the project risk
differences. One approach is to divide
projects into broad risk classes, and use
different discount rates based on the
decision-maker’s experience.
The Cost of Capital for Projects
• For example, projects may be classified
as:
– Low risk projects
discount rate < the firm’s WACC
– Medium risk projects
discount rate = the firm’s WACC
– High risk projects
discount rate > the firm’s WACC
 Marginal cost of capital
• The marginal cost of capital is simply the
weighted average cost of capital at the
margin. The marginal cost of capital tends
to rise as the firm obtains more and more
financing.
Determining the weighted marginal
cost of capital schedule
• Procedure
• 1. estimate the cost of each source of financing for various levels of
its use through an analysis of current market conditions and an
assessment of the expectations of investors and lenders.
• Identify the levels of total new financing at which the cost of the new
components would change, given the capital structure policy of the
firm. These levels are called breaking points.
– Breaking point of financing source j = total new financing from source j
at breaking point Divided by the proportion of financing source j in the
capital structure
• Calculate the weighted average cost of capital for various ranges of
total financing between the breaking points
• Prepare the weighted marginal cost of capital schedule which
reflects the weighted average cost of capital for each level of total
new financing