Chapter

11 Cost of Capital

© 2003 McGraw-Hill Ryerson Limited

Chapter 11 - Outline 2PPT 2-1

 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

© 2003 McGraw-Hill Ryerson Limited

 Cost of Capital 3PPT 2-1

 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!
 Thecost 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

© 2003 McGraw-Hill Ryerson Limited

Cost of Debt 4PPT 2-1

 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.

© 2003 McGraw-Hill Ryerson Limited

Cost of Preferred Stock 5PPT 2-1

Dp
Cost of preferred stock 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?

© 2003 McGraw-Hill Ryerson Limited

 6PPT 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.

© 2003 McGraw-Hill Ryerson Limited

 Cost of Common Equity 7PPT 2-1

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?

© 2003 McGraw-Hill Ryerson Limited

Optimum Capital Structure 8PPT 2-1

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

© 2003 McGraw-Hill Ryerson Limited

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)?
© 2003 McGraw-Hill Ryerson Limited
Figure 11-1
Cost of capital curve 10PPT 2-1

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)

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 Table 11-7
Cost of components in the capital 11PPT 2-1
structure
1. Cost of debt Kd = Yield (1-T) = 6.55% Yield = 10.74%
T = Corporate tax rate, 39%

2. Cost of preferred stock Dp = Preferred dividend, $10.50

Dp
Kp   10.94% Pp = Price of preferred stock,
Pp  F
$100
3. Cost of common equity F = Flotation costs, $4
(retained earnings)
D1 D1 = First year common
Ke   g  12.0%
P0 dividend, $2
Pc = price of common stock, $40
D1 g = growth rate, 7%
4. Cost of new common stock Kn  g
P0  F
Same as above, with Pn =$36.00
F = Flotation costs, $4,
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 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
12PPT 2-1
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
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