Chapter 8: Cost of capital

The minimum required rate of return

expected by investors for providing funds
to a business organization is called cost of
capital. It is the minimum rate of payments
from the part of business organization
against raising of funds and the minimum
rate of receipts from the part of the
suppliers of funds. Generally cost of capital
means weighted average cost of capital.
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Chapter 8: Cost of capital

It is the sum of multiplicative results of
proportion of different sources of funds
and respective percentage cost of each
source. For calculating WACC the weight
of each is required and for this if there is
no specific requirement then generally
market
value
of
all
sources
is
considered. It is determined by applying
the following formula:
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Chapter 8: Cost of capital

WACC= Wd Kd + WP KP + We Ke + Wr Kr
Wd = proportion / weight / percentage of debt fund to total
fund; Wp = proportion / weight / percentage of fund from
preferred stock to total fund; We = proportion / weight /
percentage of fund from common stock to total fund; Wr =
proportion / weight / percentage of fund retained earnings
to total fund.
Kd= percentage cost of debt financing; Kp = percentage cost
of financing from preferred stock; Ke = percentage cost of
financing from common stock; Kr = percentage cost of
financing from retained earnings.
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(a) Kd = [Kb (1-Tc)] / (1-f); % form of

floatation
borrowing
rate and
tax rate
1
. Costcost,
of debt
capital
(bonds
/
are given
debentures / long term loans):
(b) Kd = I (1- Tc) / Po (1-f); Amount form of
interest and % form of floatation cost and
tax rate are given
(c) Kd = I (1-Tc) / (Po-F); Amount form of
interest and floatation cost and tax rate are
given
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2.
Cost of preferred
(a) stock:
Kp = Dp / Po (1-f); % form of
floatation cost is given
(b) Kp = Dp / (Po-F); amount form of
floatation cost is given

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3. Cost of common stock:

(a) Ke = D0 / P0 (1-f); Constant amount of
dividend and % form of floatation cost
(b) Ke=Do /(P0-F); Constant amount of dividend
and amount form of floatation cost
(c) Ke = [D1/ (P0-F)] + g; Constant growth rate of
dividend and amount form of floatation cost
(d) Ke = [D1/ P0 (1-f)] + g; Constant growth rate
of dividend and % form of floatation cost
* Ke = Rf + (Rm - Rf) (according to CAPM
approach)
8-6

4. Cost of Retained Earnings:

Cost of retained earnings is equal to
cost of common stock in absence of
floatation cost
(a) Ke = D0 / P0 Constant amount of
dividend
(b) Ke = [D1/ P0] + g; Constant growth rate
of dividend
* Ke = Rf + (Rm - Rf) (according to CAPM
approach)
8-7

If Wild Widgets Inc. (WWI) were an all-equity firm, it

would have a beta of 0.9. WWI has a target debt-to-equity
ratio of 0.50. The expected return on the market portfolio
is 16 percent, and Treasury bills currently yield 8 percent
per annum. WWI one-year $1000 par value bonds carry a
7 percent annual coupon and are currently selling for
$909.73. The yield on WWIs longer term debt is equal to
the yield on its one-year bonds. The corporate tax rate is
34 percent.
(a) What is WWIs cost of debt?
(b) What is WWIs cost of equity?
What is WWIs weighted average cost of capital?
8-8

Solution:
Beta = 0.9
D/E = 0.50
Tax rate = 34%
(a) Bonds par value = 1000 Selling price (Bo) = 909.73
FV
1000
Bo = or, 909.73 = or, Kd= 10%
1 kd
1 kd
(b)D/E = 0.50
V = D+E = 0.5+1 = 1.5
+0.9 (0.16- 0.08) = 0.152
K = =R0.08
f beta ( Rm R f )
(c) We = E/V = 1/1.5 = .667
Wd = D/V = .5/1.5 =.333
WACC = We*Ke +Wd*Kd*(1-Tc) = 0.667*0.152+0.333*0.10*0.66
= 12.33%
e

8-9

Example of WACC

Weighted Average Cost of Capital is the weighted

average of individual sources of capital. With the
following capital structure, the WACC of Ciba is 7.57%.

Source
Equity

Amoun Weight
t
200
0.40

Cost

Wi.ki

0.093

0.0372

Debt

200

0.40

0.060

0.0240

Pref. Cap.

100

0.20

0.073

0.0145

Total

500

1.00

0.0757
8-10

Problem # 1
Hilishia Ltd. is currently paying Tk.12 dividend on its
common stock and is expected to grow @3.5% forever.
The current market price per share is Tk.120 and it has
50000 shares in the market. Related issuing cost is
Tk.2.5 per share. It is paying 10% preferred dividend of
Tk.500 par value stock thats market price is Tk.525
per share and it has 20000 preferred shares in the
market with 2% floatation cost. It has also Tk.3000000
long-term bank loan @9.5% interest rate along with
0.8% loan processing fee. The corporate tax rate in the
country is 35%. The balance in retained earnings
account is Tk.2000000.Determine the WACC for the
firm.
8-11

Marginal cost of capital

The weighted average cost of capital of the last
unit of fund raised by the business is called
marginal cost of capital. The new percentage of
required cost for raising one unit additional fund
is also marginal cost of capital. For example,
when total financing is Tk.10 lac then weighted
average cost of capital is 13%. But when total
financing is Tk.11 lac then weighted average
cost of capital is 14%. Here marginal cost of
capital is 14%.
8-12