Calculation of Cost of Capital

(CoC)
Compiled by Dr Showkat Ahmad Busru
 Risk

 In finance, risk refers to the degree of uncertainty and/or potential

financial loss inherent in an investment decision. 

 Total risk = systematic risk + unsystematic risk

 The standard deviation of returns is a measure of total risk.

 For well-diversified portfolios, unsystematic risk is very small.

 Consequently, the total risk for a diversified portfolio is essentially equivalent

to the systematic risk.
 Risk: Systematic and Unsystematic
We can break down the total risk of holding a stock into
two components: systematic risk and unsystematic risk:
2
R  R U
Total risk
becomes
 R  R  m 
where
Nonsystematic Risk: 
m is the systematic risk
Systematic Risk: m  is the unsystematic risk

n
 The Cost of Equity Capital
Shareholder
invests in
Firm with
Pay cash dividend financial
excess cash
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets, the
expected return on a capital-budgeting project should be at least as great as the
expected return on a financial asset of comparable risk.
 The Cost of Equity Capital
 From the firm’s perspective, the expected return is
the Cost of Equity Capital:
RS = RF +  (RM – RF)
 To estimate a firm’s cost of equity capital, we need to
know three things:
1. The risk-free rate, RF
2. The market risk premium, R M  RF
Cov(Ri ,RM )  i,M
3. The company beta, i   2
Var(RM ) M
 Example – I
 Suppose the stock of Stansfield Enterprises, a
publisher of online presentations, has a beta of
1.5. The firm is 100% equity financed.
 Assumea risk-free rate of 3% and a market risk
premium of 7%.
 Whatis the appropriate discount rate for an
expansion of this firm?

RS = RF +  (RM – RF)
RS = 3% + 1.5 × 7%
RS = 13.5%
 Example – II
Suppose Stansfield Enterprises is evaluating the following
independent projects. Each costs $100 and lasts one year.

Project Project b Project’s IRR NPV at

Estimated Cash 13.5%
Flows Next
Year
A 1.5 $125 25% $10.13

B 1.5 $113.5 13.5% $0

C 1.5 $105 5% -$7.49

 Using the SML

Good SML
IRR
Project
A
project

13.5% B

C Bad project
3%
Firm’s risk (beta)
1.5
An all-equity firm should accept projects whose IRRs exceed
the cost of equity capital and reject projects whose IRRs fall
short of the cost of capital.
 The Risk-Free Rate

 Treasury securities are close proxies for the risk-

free rate.
 The CAPM is a period model. However, projects are
long-lived, so average period (short-term) rates
need to be used.
 The historic premium of long-term (20-year) rates
over short-term rates for government securities is
in the range of 1-2%.
 So, the risk-free rate to be used in the CAPM could
be estimated as 2% below the prevailing rate on 20-
year Treasury securities.
 Market Risk Premium

 Method 1: Use historical data

 Method 2: Use the Dividend Discount Model

𝐷1
𝑅 𝑠= +𝑔
𝑃0
 Market data and analyst forecasts can be used to implement the DDM
approach on a market-wide basis.
 Estimation of Beta
Market Portfolio – Portfolio of all assets in the economy. In
practice, a broad stock market index, such as the S&P 500, is
used to represent the market.
Beta – Sensitivity of a stock’s return to the return on the
market portfolio.
Beta (β) is a measure of the volatility—or systematic risk—of a
security or portfolio compared to the market as a whole
(usually the S&P 500).
Beta = 1.0: stock just as volatile as the market
Cov(Ri ,RM )  i,M
i   2
Var(RM ) M
https://www.wallstreetmojo.com/beta-formula/
 Estimation of Beta
 Problems
1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.
 Solutions
1. Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
2. Problem 3 can be lessened by adjusting for changes in business and
financial risk.
3. Look at average beta estimates of comparable firms in the industry.
 Stability of Beta

 Most analysts argue that betas are generally stable for

firms remaining in the same industry.
 That is not to say that a firm’s beta cannot change.
 Changes in product line
 Changes in technology
 Deregulation

 Changes in financial leverage

 Determinants of Beta

 Business Risk
 Cyclicality of Revenues
 Operating Leverage
 Financial Risk
 Financial Leverage
 Operating Leverage – I

 The degree of operating leverage measures how

sensitive a firm (or project) is to its fixed costs.
 Operating leverage increases as fixed costs rise and
variable costs fall.
 Operating leverage magnifies the effect of cyclicality
on beta.
 Financial Leverage and Beta
 Operating leverage refers to the sensitivity to the
firm’s fixed costs of production.
 Financial leverage is the sensitivity to a firm’s fixed
costs of financing.
 The relationship between the betas of the firm’s debt,
equity, and assets is given by:

bAsset = Debt × bDebt + Equity × bEquity

Debt + Equity Debt + Equity
 Levered and Un Levered Beta

 Beta is a measure of market risk. Unlevered beta (or

asset beta) measures the market risk of the company
without the impact of debt.
 'Unlevering' a beta removes the financial effects
of leverage thus isolating the risk due solely to
company assets. 
 Cost of Debt
 The cost of debt is the return that a company provides to its debtholders and
creditors. These capital providers need to be compensated for any risk exposure
that comes with lending to a company.
 Interest rate required on new debt issuance (i.e., yield to maturity on
outstanding debt)
 Adjust for the tax deductibility of interest expense
 Cost of Redeemable Debt

 Where, I = Annual interest payment,

 NP = Net proceeds from issue of debenture or bond,
 t = Tax rate.
 Market Value/FV/Par Value
 Cost of Preferred Stock
 Preferred stock has the benefit of not diluting the ownership
stake of common shareholders, as preferred shares do not
hold the same voting rights that common shares do.
 Preferred stock (Irredeemable/perpetuity)
 RP = D / PV
Suppose a share of the preferred stock of Polytech, Inc., is
selling at $17.16 and pays a dividend of $1.50 per year.
=1.50/17.16 = 8.7%
Redeemable
 The Weighted Average Cost of
Capital
 The Weighted Average Cost of Capital is given by:

Equity Debt
RWACC = × REquity + × RDebt × (1 – TC)
Equity + Debt Equity + Debt

S B
RWACC = × RS + × RB × (1 – TC)
S+B S+B

 Because interest expense is tax-deductible, we

multiply the last term by (1 – TC).
 Illustration
 Consider a firm whose debt has a market value of
40,00,000 and whose stock has a market value of
60,00,000 (300000 outstanding shares of stock, each
selling for $20 per share).
 The firm pays a 5 percent rate of interest on its new debt
and has a beta of 1.41. The corporate tax rate is 34
percent. Assume that the security market line [SML]
holds, that the risk premium on the market is 9.5 percent
[somewhat higher than the historical equity risk
premium], and that the current Treasury bill rate is 1
percent.)
 What is this firm’s WACC?
 Solution

 The pretax cost of debt is 5 percent, implying an

after-tax cost of 3.3 percent [5%* 3 (1-.34)].
 Rs= Rf+(Beta*(RM-Rf))
 COE = 14.40%
 WACC= 9.96%
Param ltd. Has the following book value capital structure.
 Equity Capital (Rs. 10 each, fully paid up) Rs. 2000000
 10% Preference shares (Rs. 100 each fully paid up) Rs. 500000
 Retained earnings Rs. 200000
 12% Debentures (Rs. 100 each) Rs. 100000
 12% Term loans Rs. 125000
The next expected dividend on equity shares is Rs. 2.40, it is expected to grow at the rate of 5%.
Market price of shares is Rs. 52 
Preference stock redeemable after 8 years is currently selling at Rs. 66 per share.
Debentures redeemable after 5 years are selling at Rs. 78 per debenture
Income tax rate is 30%. Calculate the WACC using book value proportions.
Calculate the CoC if the company is planning to raise 20 lakh next year in the following proportion:
1.The amount will be raised by equity and debt in equal proportion 10 lakh each.
2.The company expects to retain Rs. 3 Lakh earnings next year.
3.The additional issue of equity shares will result in the net price per share being fixed at Rs. 36
4.The debt capital raised by way of term loans will cost 13% for the first Rs.5 lakh and 14% for the next
Rs. 5 lakhs