Topic 7

Cost of Capital
After studying this topic, you should be able
to:
Understand the concept of cost of capital
Understand the specific sources of capital associated with the cost of
capital
Determine the cost of long-term debt
Determine the cost of preference share
Determine the cost of equity
Calculate the weighted average cost of capital
What is Cost of Capital ?
Cost of capital
To the company:
It is the cost of a company's source of funds (both debt and equity).
It is the rate of return that a firm must earn on the projects in which it invests to maintain or
increase the market value of its stock.
This can only be achieved if company undertakes projects that provide returns in excess of
the firms overall weighted average cost of capital.

To investor
It is the required rate of return on a investment (company's existing securities)
It is the minimum return that investors expect for providing capital to the company

Opportunity cost of capital, required rate of return, or weighted average cost of

capital are used interchangeably.
Source of Funds
Sources of long-term capital used by a normal company can include:
Long-term debt
Preferred stock
Common stock
New common stock
Retained earnings
Weighted Average Cost of Capital (WACC)

= + + 1

ke: Cost of Equity weights of equity financing

kps: Cost of Preferred Stock weights of preference share financing

kd: Before tax Cost of Debt weights of debt financing

t: Marginal corporate tax rate

Weight of Source of Financing
Example:
A project costs $1 million. If the money is raised from (1) common stock
$500,000, (2) preferred stock $200,000, and (3) bonds $300,000, then the
weightage would be as follows:

$500,000
Common Stock = = 0.5 50%
$1,000,000

$200,000
Preferred Stock = = 0.2 20%
$1,000,000

$300,000
Bond = = 0.3 30%
$1,000,000
Cost of Debt
For the issuing firm, the cost of debt is:
the rate of return required by investors (YTM),
adjusted for flotation costs (any costs associated with issuing new bonds), and
adjusted for taxes.

After-tax cost of debt = Before-tax cost of debt x (1-Marginal tax rate)

= kd x (1-t)
Cost of Debt
Recall
1
1
1+
= +
1+

0
[ + ]
=
20 +
3
Cost of Debt
Example:
Ambassador Corporation plans to issue a new 20-year bond that has a
$1,000 par value, carries a 13 percent coupon rate, and pays interest
annually. The firm expects to receive $1,000. The firm is currently at
40% marginal tax bracket.
Calculate the after-tax cost of debt.
Cost of Debt
N=20 0
[ + ]
Face Value: $1,000 =
Price: $1,000 20 +
3
Coupon: 13%
10001000
Coupon Payment : [ 130+
20
]
= $1,000 x 0.13 = $130 = 2(1000)+1000 = 13%
3

Tax: 40% After-tax cost of debt

= kd x (1-t)
= (0.13) x (1-0.4)
= 7.80%
Cost of Debt
Example:
ABC issues bonds with $1,000 face value, paying coupon rate of 10%
annually, with 15 years to maturity. The bond is selling at par with
flotation costs of 5% of par. Tax rate is 35%.
Calculate the before-tax cost of debt and after-tax cost of debt.
Cost of Debt
Before-tax cost of debt:
N = 15 0
Face value = $1,000 [ + ]
=
P0 = $1,000 20 +
Coupon: 10% 3
Coupon payment: $100 [ 100+
1000950
]
15
Tax: 35% = 2(950)+1000 = 10.69%
3
Flotation Cost: 5% x $1000 = $50
After-tax cost of debt:
= kd x (1-t)
= (0.1069) x (1-0.35)
= 6.95%
Cost of Preferred Stock
Finding the cost of preferred stock is similar to finding the rate of
return, except that we have to consider the flotation costs associated
with issuing preferred stock
Dividends on preferred stock are paid out of after-tax earnings, no tax
adjustment is required.
Recall

0 =


=
0
Cost of Preferred Stock
Example:
If Ambassador is planning to issue a $50 par preferred stock that pays
$6 in dividends per year and the firm expects to realize $48 per share
(meaning, the flotation cost associated with the issuance of the
preferred stock is $2 per share).
Calculate the cost of the preferred stock.
Cost of Preferred Stock
D = $6
Par: $50
Net Price = $48

=
0

$6
= = 12.5%
$48
Cost of Common Equity
Like the cost of debt and preferred stock, the cost of equity capital,
Ke, is also a function of the returns expected by investors.
There is no need to adjust for taxes, because cash dividends on
common stock are paid out of after-tax earnings.
The two approaches for estimating the cost of common equity:
1. The dividend valuation approach,
2. The capital asset pricing model, CAPM,
Cost of Common Equity
1. The Dividend Valuation Model

Recall:
1
0 =
( )

1
= +
0
Cost of Common Equity
Example:
Assume the present market price on ambassadors common stock is
$25, dividends to be paid in 1 year are $1.75, and the expected growth
in dividends is 9 percent per year.
Calculate the Cost of Common Equity.
Cost of Common Equity
D1: $1.75
P0: $25
g: 9%
1
= +
0

$1.75
= + 0.09
$25

= 16%

This 16% is considered the cost of existing common stock.

Cost of Common Equity
Example:
Consider the earlier example, but now company is issuing new
common stock with flotation cost of 10%.
Calculate the Cost of Equity for these new issue.
Cost of Common Equity
D1: $1.75
P0: $25
g: 9%
Flotation cost: 10%

= 1 +
0

$1.75
= + 0.09
$25 (10.1)

= 16.78%

This 16.78% is considered the cost of existing common stock.

Cost of Common Equity
2. Capital Asset Pricing Model Approach
the investors required rate of return = the cost of common equity

k = rf + (rm rf)

Example:
Assume Ambassadors beta is 0.95, the risk-free rate is 11%, expected rate of
return the market is 18%. Calculate the cost of common equity.

k = rf + (rm rf)
= 11% + 0.95(18% -11%)
=17.65%
Cost of Common Equity
Compare the Cost of Equity:
For Ambassador, we have two estimates of its cost of common equity:

Approach Estimated Ke
Dividend Valuation 16%
CAPM 17.65%

They differ slightly, but they are close. Taking everything into account,
we would estimate Ambassadors cost of common equity is between
16 and 17.65%.
Weighted Average Cost of Capital (WACC)
Putting all together, from our earlier calculation
Cost (After-tax)
Debt 7.8%
Preferred Stock 12.5%
Common Equity 17.65%

Lets assume the market value proportions of financing to be employed

are 30% debt, 10% preferred stock, and 60% common equity.
Calculate the WACC for the company.
Weighted Average Cost of Capital (WACC)
After-tax Cost Weight
Debt 7.8% 0.3
Preferred Stock 12.5% 0.1
Common Equity 17.65% 0.6

= + + 1

= 0.1765 0.6 + 0.125 0.1 + (0.078)(0.3)

= 0.1059 + 0.0125 + 0.0234

= 14.18%
Divisional Opportunity Costs Of Capital
When different divisions in a company and their respective risks are different
Different discount rates may need to be employed

What happened if a firm employs a firm-wide opportunity cost of capital when

differences in risk exist?
Setting too high a required return for low-risk projects, and
Too low a return for high-risk projects.
The result is to under allocate capital to low-risk divisions and to over allocate funds to high-
risk divisions.

Example:
Lets say the WACC is 15%.
Project A: a low-cash-flow low-return low-risk project @ 10%.
If 15% is used to discount Project As cash flow, the PV may be negative. Thus, it would be rejected.
Project B: a high-cash-flow high return high risk project @ 20%.
If 15% is used to discount Project Bs cash flow, the PV would be positive. Thus, it would be accepted.