Chapter - 6

The Cost of Capital

Sitaram Dhakal, Kathmandu College of Management[KCM]

Capital
Investment supplied by the investors to the corporation.
Fund raised by corporation from the investors.
Sources of capital are debt, equity, preferred stock and
retained earnings.
Job of financial manager is to raise fund for a corporation,
maximize the wealth of corporation, meet the interest of
investors who supplied capital in the corporation.
Corporation pays cost of debt to the debtors ( in the form of
coupon), cost of equity to the equity holders ( in the form of
dividend and capital gain) cost of preferred stock ( in the form
of fixed dividend) and cost of retained earning ( in the firm of
growth dividend and capital gain)

Capital Structure
Capital structure is the mix of the long term sources of funds
used by the firm.
The primary objective of capital structure decision is to
maximize the market value of the firm through appropriate
mix of long term sources of the funds.
For example:

Source s of Capital

Amount [Rs]

Proportion

Debt
Preferred stock
Retained Earning
Common Stock
Total capital

Rs. 400,000
Rs. 100,000
Rs. 300,000
Rs. 200,000
Rs. 1,000,000

40%
10%
30%
20%
100%

The above example is and specimen of capital structure

showing the mix of 40% debt, 10% preferred stock and 30%
retained earning and the rest i.e. 20 % is common stock.

Cost of capital
Minimum return that must be generated by a corporation from
the use of fund supplied by investors in each source of
capital.
Opportunity cost of capital is given by the following formula:

where Io is the capital supplied by investors in period 0 (it

represents a net cash inflow to the firm), Ct are returns
expected by investors (they represent cash outflows to the
firm) and k is the required rate of return or the cost of capital.
The opportunity cost of retained earnings is the rate of return,
which the ordinary shareholders would have earned on these
funds if they had been distributed as dividends to them.

Cost of Capital
The projects cost of capital is the minimum
required rate of return on funds committed to
the project, which depends on the riskiness of
its cash flows.
The firms cost of capital will be the overall,
or average, required rate of return on the
aggregate of investment projects.
WACC= (Kd) (1-t) (Wd) + (Wps) (Kps) + (Wr) (Kr)+ (We) (Ke)

Significance Merits/Use/Adv./Importance

Investment decisions,
Finance Decision
Dividend Decision
Appraising the financial performance of
top management.

Demerits/ Disadv. /Limitation

Constant Business Risk

Constant Financial Risk
Constant tax rate
Constant dividend Policy

Cost of Component Capital

Components are:
o Debts i.e. bonds, debentures etc.
o Preferred Stocks
o Equity capital & Retained earnings

Bonds /Debt/Debenture:
A long term security or long-term promissory note, promising to
pay interest and principal, on specific date, to the holders of the
bond.
Issuer pays a fixed interest payment each period until the bond
matures. This payment is known as the coupon. At maturity, the
borrower pays back the bondholder the bonds face value
(principal).
Against Future receipts investors pay certain value at present.

For e.g. Rs. 1,000 par, 8%, 5-year annual coupon bonds are
issued by NIC ASIA at Rs. 950.

Features of Bonds

Par Value
Maturity
Coupon Payments
Call Provision
Indenture
Trustee

Par Value
The stated face value of the bond, which is
paid at maturity.
Called maturity value or face value or
principal.
Rs. 1,000 per bond, although multiple of Rs.
1,000 is also used.
It is used to calculate the annul coupon
payments.

Maturity

The specified date on which the principal

amount (par value) is repaid.
It includes original maturity and remaining
maturity.
Remaining years to maturity will be declined
year to year.
Remaining years to maturity is effective to
calculate value of bond and rate of return.

Coupon Payments

A fixed amount of interest paid at the end

of each period (year or six month).
Coupon payment is divided by the par
value is the coupon interest rate.
For e.g. Rs. 1,000 par, 10% bond has
Rs. 100 coupon payments and 10 %
coupon rate.

Call Provision

The right to call the bonds prior to maturity to an issuer to protect

from interest rate risk.

Call period and call price can be used to calculate the value of the
bond and return of the bond.

Call price is par value plus call premium.

Call period is always less than remaining years to maturity.

Indenture

A legal document or contract that contains

terms and conditions of bond issue.
Includes details of debt issue, description of
property pledged (if any), the methods of
principal repayment, restrictions (or
covenants) placed on the firm by the lenders,
rights and responsibilities of both borrower
and lender.

Cost of Debt
For Perpetual Bond

For Pure Discount Bond

Bond with maturity for annual coupon

Here, Kd can be calculated using trial and error approach

Bond with Maturity and semi annual Coupon

Here, Semi-kd can be calculated using trial and error approach

Callable Bond: Yield to call is the cost of debt

To calculated YTC, yield to call, call period & call price can be used,

After tax cost of debt

Tax adjustment for cost of Debt is made by
calculating cost of debt,

Note - If flotation cost are given than it is

reduced to find net proceeds, NP, of the bond

Example - 1
Calculate the after tax cost of debt of the following assuming 35
percent tax bracket:
a.Rs. 1000 par, 10-year perpetual bond selling at Rs. 1250.
b.Rs. 1000 par, 10-year zero coupon bond selling at Rs. 350.
c.Rs. 1000 par, 10%, 10-year annual coupon bond selling at Rs.
950.
d.Rs. 1000 par, 9%, 12-year semi-annual coupon bond selling at
Rs. 1050.
e.Rs. 1000 par, 12%, 15-year annual coupon bond selling at Rs.
1090. The bond has call provision to make a call at the end of 5
year at 10 percent premium.
f.Rs. 1000 par, 9%, 12-year semi-annual coupon bond selling at
Rs. 1100. The bond has call provision to make a call at the end of
4 year at 9 percent premium.

Thank You

The Cost of Capital

Cost of preferred stock

Cost of equity and retained earning

Preferred Stock
The long-term source of financing.
An intermediate position between long-term debt and common stock.
Claim on assets comes after that of creditors but before that of common
stockholders.
Income preferred stock dividend is distributed after payment of interest
but before distribution of common stock dividend.
A hybrid form of financing with combined futures of both debt (and bond)
and common stock.
May be perpetual and redeemable.
Perpetual preferred stock does not have maturity period and pays
coupon forever.
Redeemable preferred stock has stated maturity and pays fixed dividend
and repay the par at the end of maturity.
Valuation and calculating returns of preferred stock is similar with bonds.

Cost of Preferred Stock

For redeemable or callable preferred stock.

Example - 2
Calculate the after tax cost of the following assuming 35 percent
tax bracket:
a.Rs. 100 par, 10-year perpetual preferred stock selling at Rs.
120.
b.Rs. 100 par, 11%, 10-year preferred stock selling at Rs. 90.
c.Rs. 100 par, 12%, 15-year preferred stock selling at Rs. 109.
The bond has call provision to make a call at the end of 5 year at
15 percent premium.

Common Stock
Common stock holders wont receive fixed divided from their
investment.
The valuation on common stock is similar to the valuation of other
securities such as bonds and preferred stocks.
The value of a share of common stock is equal to the present value
of all future benefits it is expected to provide.
Valuation of a share of common stock is more difficult than the
valuation of bond due to the lack of fixed dividend and par value
repayment and maturity.
Investors expect dividends after the observation of past dividends
and expect value of security to be received at the end of holding
period.
As per investors expectation, stock may be classified zero growth,
constant growth and non-constant and supernormal growth.

Concept of Equity:
Concept of stocks or shares or equity
A security issued by a company to raise equity capital.
The major sources of long-term (permanent) capital.
Funds provided by equity are used to finance major portion of the firms fixed
assets such as land and building, plant and machinery, vehicle, etc.
No fixed dividend.
No maturity.
Equity holders are real owner of the corporation.
They enjoy from right to right to right share, right to dividend, right to vote.
Residual claim.
Includes common stock and preferred stock.

Cost of internal equity retained earning

1. Dividend discount model:

a. For zero growth stock:
b. For constant or perpetual growth:

Where,
g = constant growth rate i.e. % increase in
DPS, MPS & EPS.

g can be calculated as using following equations:

c. For non-constant or supper normal growth:

There are different growth rates, higher

growths are supper growth rates, constant
growth at the end of maturity or terminal
date is constant growth i. e. gn and the
ending period of higher growth rate is
maturity period i. e. n.
The cost of equity can be calculated using
trial and error approach as below:

The value of stock would be:

2. Capital assets pricing model:

Under CAPM, Ke can be calculated as:

3. Bond Yield Plus Risk Premium Approach

D. Cost of new/marginal/external equity

Example - 3
The earnings, dividends, and stock price of Carpet to
Technologies Inc. are expected to grow at 7 percent per year
in the future. Carpet's common stock sells for $23 per share,
its last dividend was $2.00, and the company will pay a
dividend of $2.14 at the end of the current year.
a.Using the discounted cash flow approach, what is its cost of
common equity?
b.If the firms beta is 1.6, the risk-free rate is 9 percent, and
the average return on the market is 13 percent, what will be
the firms cost of common equity using the CAPM approach?
c.If the firms bonds earn a return of 12 percent, what will k,
be using the bond yield plus risk premium approach?

Example - 4
The Bouchard Companys EPS was $6.50 in
2002 and $4.42 in 1997. The company pays out
40 percent of its earnings as dividends, and the
stock sells for $36.
a. Calculate the past growth rate in earnings.
b. Calculate the next expected dividend per share,
D1. Assume that the past growth rate will
continue.
c. What is the cost of retained earnings, ks for the
Bouchard Company?

Thank You

Weighted average Cost of Capital, WACC

The following steps are involved for

calculating the firms WACC:
Calculate the cost of specific sources of
funds
Multiply the cost of each source by its
proportion in the capital structure.
Add the weighted component costs to
get the WACC.
Calculate using the following equation.

Factors affecting WACC

The level of interest rates

Tax rates
Capital structure policy
Dividend Policy
Investment Policy

Weighted average Cost of Capital, WACC

Example - 6

Percy Motors has a target capital structure of

40 percent debt and 60 percent equity. The
yield to maturity on the companys outstanding
bonds is 9 percent and the companys tax rate
is 40 percent. Percys CFO has calculated the
companys WACC as 9.96 percent. What is the
companys cost of common equity?

Example - 7
The Manx Company was recently formed to manufacture a
new product. It has the following capital structure in market
value terms:
Debentures
Preferred stock
Common stock (320,000 shares)

$ 6,000,000
2,000,000
8,000,000
$16,000,000

The company has a marginal tax rate of 40 percent. A study of

publicly held companies in this line of business suggests that the
required return on equity is about 17 percent. (The CAPM
approach was used to determine the required rate of return.) The
Manx Companys debt is currently yielding 13 percent, and its
preferred stock is yielding 12 percent. Compute the firms present
weighted average cost of capital.

Example - 8
The capital structure of the S. Hotel, consists of,
(i) 9% coupon, 20,000 bond of Rs.1000 each, 20 years
maturity, currently selling at a discount of 10%.
(ii) 12%, 100,000 preferred stock of Rs.100 each, selling at
Rs.110 each.
(iii) 500,000 common stock of Rs.50 each, selling at per,
expected dividend Rs.2.50 per share and growth rate is
expected to be 8%.
(iv) The retained earning balance is Rs.4000,000, with
brokerage charge of 7%.
The corporate tax rate of the Hotel is 50% and the majority
of shoulders personal tax liability is 25%.
Required: a) Calculate the cost of each source of capital
b) Calculate the weighted average cost of capital.

Thank You