CHAPTER 1

Cost of Capital

Lecturer: B Taruvinga

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Topics in Chapter
 Computations of various elements of
cost of capital
 Cost equity
 Cost of retained earnings
 Cost of debt
 Cost of preffered shares

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Topics in Chapter (continued)
 Weighted average cost of capital
(WACC)
 Weighted Marginal Cost of Capital
(WMCC) and Investment Opportunity
Schedule (IOS)

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 Why is cost of capital
important?
 Primary objective for shareholders is to
maximise shareholder value.
 Invest in projects that earn more than
the cost of capital

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Basic Definitions
 Capital Components: Types of long term
capital used by firms

 Long-term debt
 Preferred stock
 Common equity

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Symbols identifying
component costs of capital
 Kd: interest rate on the firm’s new
before-tax component cost of debt.
 kd(1 - T): after-tax component cost of
debt, where T is the firm’s marginal tax
rate. kd(1 -T) is the debt cost used to
calculate the weighted average cost of
capital.

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Symbols identifying component
costs of capital (continued)
 Kp: component cost of preferred stock.

 Equity capital is raised in two ways:

 Ks: component cost of retained earning(internal equity)
 Ke: component cost of new common stock (external
equity)

WACC: the weighted average cost of

capital
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WACC
 Why should the cost of capital used in
capital budgeting be calculated as a
weighted average of the various types
of funds the firm generally uses, not the
cost of the specific financing used to
fund a particular project?

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Cost of Debt: kd(1-T)
 It is the interest rate on debt, kd, less
the tax savings that result because
interest is deductible.

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Example:
ABC limited has earnings before interest and
taxes of $200 million. It has interest-bearing
debt of $50 million carrying 8% interest rate.
The company's marginal tax rate is 35%. Find
the after tax cost of debt in dollar and in
percentage terms.

Solution: In class

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Cost of Preferred Stock, kp
 The rate of return investors require on
the firms’ preferred stock.

 Kp = Dp/Pp

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Example: Calculating kp
 Find the componet cost of preferred
stock given that the par value is $100
per share, the preferred dividend rate is
8%, and the current market price is
$80.

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Cost of retained earnings, ks
Though there are no direct costs
associated with retained earnings, this
capital still has a cost:
Opportunity cost principle

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Why is there a cost for
reinvested earnings?
 Earnings can be reinvested or paid out
as dividends.
 Investors could buy other securities,
earning a return.
 Thus, there is an opportunity cost if
earnings are reinvested.

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Three ways to determine
the cost of equity, rs:

1. CAPM: rs = rRF + (rM – rRF)b

= rRF + (RPM)b.

2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Judgmental-
Risk Premium: ks = kd + Bond RP.

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 Example:Calculating ks
using CAPM
 Assume rrf=8%,rm=13%, bi=0.7 for a
given stock. Calculate the cost of
retained equity

 Had bi been 1.8, indicating that the

stock was riskier than average, what
would be the cost of retained equity?

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DCF Cost of Equity, Ks:

D1 D0(1 + g)
rs = +g= +g
P0 P0

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 Example: ks using DCF
approach

 Given D0 = $3.12; P0 = $50; g = 5.8%

Calculate ks using the DCF approach

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Estimating the Growth Rate
 Use historical growth rate if believe
future be like past.

 Use earnings retention model.

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Earnings Retention Model
 Suppose a company has been
earning 15% on equity (ROE = 15%)
and been paying out 62% of its
earnings.
 If expected to continue as is, what’s
the expected future g?

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Earnings Retention Model
(Continued)
 Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.

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The Own-Bond-Yield-Plus-Judgmental-Risk-
Premium Method: kd = 10%, RP = 3.2%

 ks = kd + Judgmental risk premium

 ks = 10.0% + 3.2% = 13.2%

 This over-own-bond-judgmental-risk
premium  CAPM equity risk premium,
RPM.
 Produces ballpark estimate of rs.
Useful check.
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Final estimate of ks?
Method Estimate
CAPM
DCF
Bond Yld + risk prem

Average

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Cost of new common stock:
ke
Floatation costs should be taken into
account as follows:

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Example:
 Assume ABC stock is currently selling
for $23,the next expected dividend is
$1.24 and its expected growth rate is is
8%. If floatation costs are 10%,
Calculate:
 a) ks and ke

b)Comment on the difference between
ks and ke
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WACC

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Calculating the weighted
average cost of capital

WACC = wdkd(1-T) + wpkp + wsks

 The w’s refer to the firm’s capital

structure weights.
 The k’s refer to the cost of each
component.
Example
 Suppose ABC company has a target
capital calling for 45% debt, 2%
preferred stock, and 53% common
equity. If kd =10%, kp=10.3%;
ks=13.4%; marginal tax rate=40%;
Calculate WACC.

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 What if you are not given the target
capital structure? Use market values to
determine the weights

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Example: WACC Calculation
In 2014, Tbag plc was considering the
acquisition of a chain of extended care
facilities and wanted to estimate its own
WACC as a guide to the cost of capital for
the acquisition. Tbags’s capital structure
consists of the following:

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Example continued
 Tbag, through its CFO, contacted the firm’s
investment banker to get estimates of the
firm’s current cost of financing and was told
that if the firm were to borrow the same
amount of money today, it would have to pay
lenders 8%; Preferred stockholders currently
demand a 10% rate of return, and common
stockholders demand 15%. The company’s tax
marginal tax rate is 25%. Calculate Tbag’s
WACC
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Example 2
 After completing her estimate of Tbag’s WACC, the
CFO decided to explore the possibility of adding more
low-cost debt to the capital structure. With the help
of the firm’s investment banker, the CFO learned that
Tbag could probably push its use of debt to 37.5% of
the firm’s capital structure by issuing more debt and
retiring (purchasing) the firm’s preferred shares.
This could be done without increasing the firm’s costs
of borrowing or the required rate of return demanded
by the firm’s common stockholders. What is your
estimate of the WACC for Tbag under this new
capital structure proposal?
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WACC=MCC
 MCC represents the cost of obtaining
another dollar of new capital
 As long as the target capital structure is
maintained and the component costs do
not change : WACC=MCC
 But,if a huge project is undertaken
resulting in a change in capital
structure, then WACC in not equal to
MCC 35
Four Mistakes to Avoid
 Current vs. historical cost of debt
 Mixing current and historical measures
to estimate the market risk premium
 Book weights vs. Market Weights
 Incorrect cost of capital components

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Current vs. Historical Cost of
Debt
 When estimating the cost of debt, don’t
use the coupon rate on existing debt,
which represents the cost of past debt.
 Use the current interest rate on new
debt.

(More…)
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Estimating Weights
 Use target cap structure to determine wts.
 If don’t know target wts, use market values.
 If don’t know MV of debt, then use BV of
debt.

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Factors affecting WACc
 Level of interest rates
 Tax rates
 Capital structure policy
 Dividend policy
 Investment policy

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