11 Cost of Capital

Chapter

McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 11 - Outline

• Cost of Capital
• Cost of Debt
• Cost of Preferred Stock
• Cost of Common Equity:
– Common Stock
– Retained Earnings
• Optimum Capital Structure
• Marginal Cost of Capital
• Summary and Conclusions

2PPT 2-1
 Cost of Capital
• The cost of capital represents the overall cost of future
financing to the firm
• The cost of capital is normally the relevant discount rate to
use in analyzing an investment
– It represents the minimal acceptable return from the investment
– If your cost of funds is 10%, you must earn at least 10% on your investments to
break even!
• The cost of capital is a weighted average of the various
sources of funds in the form of debt and equity

WACC = Weighted Average Cost of Capital

3PPT 2-1
Cost of Debt
• The cost of debt to the firm is the effective yield to
maturity (or interest rate) paid to its bondholders
• Since interest is tax deductible to the firm, the
actual cost of debt is less than the yield to maturity
Kd (cost of debt) = yield/ interest rate x (1 - tax rate)

Example : Prime Finance Ltd. has decided to issue 10 percent coupon bond to
support its financing requirement. Now find out the after tax cost of bond if
corporate tax rate is 40 percent.

4PPT 2-1
Cost of Preferred Stock
Cost of preferred stock Dp
Kp 
Pp  F
Dp : Preferred Dividend
Pp: Price of Preferred Stock
Flotation costs: selling and distribution costs (such as sales commissions) for
the new securities

Example: ABC Bank Ltd. plans to issue preferred stock that pays $10
dividend per share and sells for $100 per share in the market. If the bank
issued new shares of preferred stock, it would incur an underwriting (or
flotation) cost of 2.5 percent or 2.5 percent per share. What will be the
cost of preferred stock?

5PPT 2-1
 Cost of Common Equity
D1
A. Cost of Common Equity/ Retained Earnings Ke  g
P0
D1 = First year common dividend
P0 = price of common stock
g = growth rate

Example: Suppose the market price (P0) of common stock is $50 per
share. The firm expects to pay a dividend (D1) of $ 4 at the end of the
coming year, 1998. The dividend is expected to grow at a rate of 5
percent a year over the foreseeable future. Calculate the cost of
common stock.

6PPT 2-1
 Cost of Common Equity
B. Cost of New Common Stock: D1
Kn  g
D1 = First year common dividend P0  F
P0 = price of common stock
g = growth rate
F = Flotation costs

Example: ABC Co. has decided to issue new common stock. The
current market price of the stock (P0) is $50, the expected dividend
(D1), $4, and the expected growth rate of dividend, (g) is 5%. It is
also found that, the company has to incur underwriting fee of $2.5
per share. Find out the cost of new issues of common stock?

7PPT 2-1
Optimum Capital Structure

The optimum (best) situation is associated with the

minimum overall cost of capital:
– Optimum capital structure means the lowest WACC
– Usually occurs with 40-70% debt in a firm’s capital
structure
– WACC is also referred to as the required rate of return
or the discount rate
– Based upon the market value rather than the book
value of the firm’s debt and equity

8PPT 2-1
Weighted Average Cost of Capital, WACC

 A weighted average of the component costs of debt, preferred stock,

and common equity

 Proportion   After - tax   Proportion   Cost of   Proportion   Cost of 

           
WACC   of 
  cost of 
  of preferred 
  preferred 
  of common 
  common 
 debt   debt   stock   stock   equity   equity 

 Wd  k dT  Wps  k ps  Ws  ks

Example: Suppose Goodwill Technologies has determined that in the

future it will raise new capital according to the following proportions: 40
percent debt, 15 percent preferred stock and 45 percent common equity
(retained earnings plus new common stock). In the preceding sections, it
is found that it’s before tax cost of debt, is 10 percent and the marginal tax
rate is 40 percent; its cost of preferred stock, is 10.5 percent; and its cost
of common equity, is 13 percent if all of its equity financing comes from
retained earnings. Calculate the Goodwill Technologies’ weighted average
cost of capital (WACC)?
 Figure 11-1
Cost of capital curve
Cost of capital Cost of equity
(percent)

Weighted
average cost
of capital
U-shaped
Cost of
debt

Minimum point
for cost of
capital
0 40 80
Debt-equity mix (percent)

10PPT 2-1
Cost of components in the capital structure

1. Cost of debt Kd = Yield (1-T) = 6.55% Yield = 10.74%

T = Corporate tax rate, 39%

Dp
2. Cost of preferred stock Kp   10.94% Dp = Preferred dividend, $10.50
Pp  F
Pp = Price of preferred stock, $100
F = Flotation costs, $4

3. Cost of common equity

(retained earnings) Ke  D1  g  12.0% D1 = First year common dividend, $2
P0
Pc = price of common stock, $40
g = growth rate, 7%

4. Cost of new common stock Same as above, with Pn =$36.00

D1
Kn  g F = Flotation costs, $4,
P0  F
11PPT 2-1
 Summary and Conclusions
•The cost of capital represents the
overall cost of future financing to the
firm
•It is a weighted average of the costs of
the various source of funds available
•It represents the minimum acceptable
return from an investment
•The cost of debt is the effective
interest rate (yield to maturity)
•the cost of preferred stock is the
dividend rate (yield) that must be
paid to investors
•The cost of common shares is the
current dividend rate (yield) plus
the anticipated future rate of
growth
•The cost of capital from retained
earnings is the required rate of
return on the common stock
•The marginal cost of capital is the
cost of the next dollar of financing
required
12PPT 2-1