Chapter 3

Cost of Capital

Presented by:

Abeba Kelelew

Department of Accounting and Finance

College of Business and Economics
Mekelle University

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 Chapter Outline

Cost of Debt

Cost of Preferred Stock

Cost of Equity

Weighted Average Cost of Capital

Adjusting cost of capital for risk

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 Introduction
• This chapter is key to understanding cost of capital.
Cost of capital refers to the minimum rate of return
a company is expected to earn from a proposed
project so as to make no reduction in the EPS to
equity shareholders and its market price.
If a company is going to maximize wealth of
shareholders, it must earn a return greater or equal
to the weighted average cost of capital (WACC).
Cost of capital is also referred to as cut-off rate,
target rate, hurdle rate, minimum required rate of
return, standard return, etc.
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 Cont…
• There are two approaches to define cost of capital:
1. It is the borrowing rate of the firm, at which it can acquire
funds to finance the proposed project.
2. It is the lending rate which the firm could have earned if
the firm would have invested elsewhere.
• Assumptions:
Constant Business risk – business risk is the potential inability
of a firm to cover fixed operating costs.
Constant Financial risk – financial risk is the potential inability
of a firm to cover required financial obligations such as
interest, preference dividends.
Constant Dividend policy – the dividend payout ratio of the
firm is constant.
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 Cont…
Business Application
– Minimum required return needed on a Project
– Reflects blended costs of raising capital
– Discount rate used to determine Project’s NPV or to
discount FCFs by Hurdle rate
 Cost of Capital is the Opportunity cost or “Hurdle Rate” of
using funds for new projects
 The cost of capital is used primarily to make decisions which
involve raising and investing new capital. So, focus on
marginal (incremental) costs.

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 Cont…

Importance of cost of capital

– Capital Budgeting decisions
– Evaluating Investment proposals
– Designing the Corporate financial structure
– Financial Performance of top management
– Other areas – eg., dividend policy, working capital

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 Cont…
What types of long-term capital do firms use?
• Long-term debt
• Preferred stock
• Common equity
• A/P, accruals, and deferred taxes are not sources of
funding that come from investors (they are short
term as well). Hence they are not included in the
calculation of the cost of capital.
• These items are adjusted for when calculating
project cash flows, not when calculating the cost of
capital.
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Weighted Average Cost of Capital vs. Specific
Costs of Capital
• The cost of capital of each source of capital is known
as component, or specific, cost of capital.
• The overall cost is also called the weighted average
cost of capital (WACC).
• Relevant cost in the investment decisions is the
future cost or the marginal cost.
• Marginal cost is the new or the incremental cost that
the firm incurs if it were to raise capital now, or in
the near future.
• The historical cost that was incurred in the past in
raising capital is not relevant in financial decision-
making.
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 Cost of Debt
Debt is the cheapest form of long-term financing
from the company’s point of view, as:
‘‘It’s the safest form of investment from the point of
view of creditors because they are the first claimants
on the company’s assets at the time of its
liquidation. Likewise they are the first to be paid their
interest.’’
Another, more important reason for debt having the
lowest cost is the tax-deductibility of interest
payments.
• Corporations may issue different types of bonds (e.g., Secured vs.
Unsecured; Registered vs. Bearer; Term vs. Serial Bonds; etc)

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 Cont…

• Cost of debt refers to the interest rate which equates

the present value of the expected future receipts
with the cost of the project.
• Flotation cost is the total cost of issuing and selling
securities.
• The present value of tax-adjusted interest costs plus
repayments of the principal is equated with the
amount received at the time the loan is
consummated.

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 Cont…
• Determining Cost of Debt
Step 1. Determine the Net proceeds from sale of each
bond: NPd = Pd – f
Step 2. Compute the effective before-tax cost of the
bond using the formula:
kd = I + (Pn – NPd)
n______
Pn + NPd/2
Step 3. Compute the after-tax cost of debt:
Kdt = Kd (1-T)

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 Cont…
• Illustration
• ABC Company plans to issue 25-year bonds with a face
value of Br.400,000. Each bond has a par value of 1,000
birr and carries an interest rate of 9.5%. The firm’s
marginal tax rate is 34%. Assume that the bonds sell at
par with no flotation costs;
Required: determine the after tax cost of debt.
What if,
• the bonds sell at 98% of par per bond (f=Br.26)
• the bonds are to be sold for 104% of par value and
flotation costs are anticipated to be Br.26 per bond
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Cost of Preferred Stock
• Cost of preferred stock is a function of dividends
paid and flotation costs to issue.
• The cost of preferred stock is determined as follows.
Kps = Dps
P0-f
Where:
Dps = Preferred dividend
P0 = Market price of preferred in Year 0 (now)
f = floatation cost
 There is not tax adjustment here, as preferred
dividends are not tax deductible
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 Cont…
• Example:
Assuming price of preferred stock of Br.125,
preferred dividends of 10.26%, preferred par of
Br.100, and flotation costs of 8.8%, determine the
cost of preferred stock.
• N.B. Flotation costs for preferred stock are significant, so are reflected.
Use net price.
Solution:
Kps = Dps
P0
Kps = Br. 10.26 ;Kps= 9%
Br. 125(1-0.088)
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 Cont…

• Timeline of preferred stock

0 1 2 ∞
kps = ?
...
-114 10.26 10.26 10.26

Dps $10.26
$114.00 = =
kps kps
kps= 9%

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Cost of Common Stock
• Cost of Equity is determined in terms of opportunity cost
of capital
• It is a function of dividends, growth, and net proceeds
after adjusting for flotation costs.
• The cost of common equity is usually determined using
two models.
1) Using the Constant Growth Valuation (Gordon’s) model
• (I) Cost of Existing common stock:
Kcs (also called Ks)= D1 + g
P0
• (II) Cost of Newly issued common stock:
Ke = D1 + g
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 Cont…

Where: D1 = common stock dividend next year ; P0 =

common price now; g = the estimated EPS growth rate;
and F = flotation costs
• Take these data for illustration.
D0 = Birr 1.00; g = 12%; P0 = Birr30
D1 = Birr 1.00 x (1 + g)
= Birr1.12
Accordingly, the cost of existing equity is:
Kcs= Birr1.12 + 12%
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Birr30 17
 Cont…

= 3.73% + 12% Kcs= 15.73%

• Assuming a floatation cost of 7%, the cost of new
equity underwriting is:
• Ke = Birr 1.12 +12%
Birr30(1-7%)
= Birr 1.12 +12%
Birr27.9
= 4.01% +12%
Ke = 16.01%
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 Cont…

2) Using the Capital Asset Pricing Model (CAPM)

• The CAPM explains the behavior of security prices
and provides a mechanism whereby investors could
assess the impact of proposed security investment
on their overall portfolio risk and return. In other
words, it formally describes the risk-return trade-off
for securities.
• According to CAPM, the risk of an
investment/security/asset is assessed in terms of
the beta coefficient.
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 Cont…

• Using CAPM, we may represent the cost of common

stock as follows:

kS = Krf +  (km – Krf)

Where:
– Krf = the rate of return required on a risk free
asset/security/investment
– Km = the expected return in the market
–  = beta for common stock

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 Cont…

• Example:
• Assume the risk-free rate is 7%, the expected return
in the market is 16%, and the beta for the firm’s
common stock is 0.82. Thus, the cost of internal
equity would be estimated as follows:
kS= Krf + (km- Krf )
=7%+0.82(16%-7%)
=14.38%
 Question!
How would you determine the cost of retained earnings, kr?
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 Priority of claim pyramid
• Corporate liabilities have a defined priority of claim
to income and assets in event of liquidation
(bankruptcy).
– Creditors
– 1st mortgage bonds
– 2nd mortgage bonds
– Preferred stock
– Common stock (Residual Equity)
• Notice that common shares have the Lowest Priority
of claim.
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Weighted Average Cost of Capital (WACC)
• WACC- the average cost of capital for a corporation is
the Weighted cost of all long-term capital sources:
LT debt, preferred stock and common stock
(including retained earnings) on an after tax basis.
• WACC is the “Hurdle Rate” for capital budgeting
decisions. WACC therefore influences the ability of a
company to compete effectively.
• Usually, cost of long-term debt is the lowest cost
source of funds and cost of common stock is the
highest source of external capital.

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 Cont…
 WACC Calculation:
• WACC = (Weight of Debt)(After-tax cost of Debt) + (Weight
of Equity)(Cost of Equity) + (Weight of Preferred stock)(Cost
of Preferred stock)
• Management may use book value, market value or target
weights to determine the weight of each source of capital.
• Usually, management uses book value of assets.
• Example: capital structure (book value based)
Debt 30% (Br.6,000) cost of debt, kdt=8%
Preference shares 30% (Br.6,000) cost of p.stk, kps=13%
Equity 40% (Br.8,000) cost of c.s, ks=14%
Instruction: Compute WACC.
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 Cont…
Solution:
WACC= Σwiki
=(30%*8%)+(30%*13%)+(40%*14%)
=2.4%+3.9%+5.6%
=11.9%

Increased use of debt decreases WACC but increases

risk.
This is called “financial leverage”.

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 Adjusting Cost of Capital for Project Risk
The two assumptions we made in the preceding
sections in computing the firm’s WACC as a cutoff
rate for new capital investments (constant business
risk and constant financial risk) do not hold in
practice.

In determining a fair or appropriate rate of return for

a project given its level of risk, we assume that the
firm’s investors hold a diversified portfolio of
investments and that we want our measure of risk
to indicate the incremental risk the project adds to
the investor’s diversified portfolio.
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 Cont…

In this situation, the CAPM gives us a way to

evaluate a project. Using the CAPM, the required
rate of return for the jth project may be expressed as
follows:
KS= Krf + (Km-Krf )

• Where j identifies the volatility of the jth project

returns relative to the investor’s widely diversified
portfolio.

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 Cont…
• Example:
• Suppose a firm is considering a capital investment
with an expected return of 16%. Management
believes that the riskiness of the project should be
analyzed in terms of its contribution to the risk of a
diversified investor’s portfolio.
• The expected return for a diversified portfolio of
assets, km, is 14% and the risk free rate, Krf, is 6%.
Management has estimated the beta for the project
to be 1.12.
• Instruction: Estimate the appropriate required rate of return
for the project.
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 Cont…

• Solution:
kj = Rf + j (km – krf)
= 0.06+1.12(0.14-0.06)
=0.1496 OR 14.96%

Attention here!
• Because the 16% expected return for the investment
exceeds the required rate of return of 14.96%, the
investment should be undertaken.
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 Chapter-end Exercises
1. Define the term cost of capital?

2. How does cost of capital link investment and financing decisions?

3. Why is cost of debt considered the lowest cost source of finance?

4. Internally generated funds are cost free sources of capital for a

firm. Do you agree? Explain.

5. Which capital components are affected by flotation costs? How?

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 Self-test problems
1. Given that a bond with par value of Br 1,000 and 20 years term to
maturity has been issued by Hibret PLC, calculate the cost of debt under
each of the following situations. Assume a 40% tax rate.
i) the bonds pay 9% interest annually, flotation costs are 2%.
ii) the bonds pay 8% interest annually, flotation costs are 3%.
iii) the bonds pay Br 100 interest annually, flotation costs are 2%.
2. LYN corporation has 8 million shares of common stock outstanding, 1
million shares of 6% preferred stock outstanding, and 100,000 9%
annual bonds outstanding, par value of $1,000 each. The common stock
currently sells for $35 per share and has a beta of 1.0, the preferred
stock currently sells for $60 per share, and the bonds have 15 years to
maturity and sell for 90% of the par. The market risk premium is 8%,risk
free rate is 5% and the company's tax rate is 35%.
Required: Calculate WACC of LYN corporation?