THE COST OF CAPITAL

OUTLINE
• Some Preliminaries
• Cost of Debt and Preference
• Cost of Equity
• Determining the Proportions
• Weighted Average Cost of Capital
• Weighted Marginal Cost of Capital
• Floatation Costs and the WACC
• Divisional and Project Cost of Capital
• Cost of Capital in Practice
• Determining the Optimal Capital Budget
• Factors Affecting the Weighted Average Cost of Capital
 Centre for Financial Management , Bangalore
 COST OF CAPITAL

The cost of capital of any investment (project, business, or

company) is the rate of return the suppliers of capital would
expect to receive if the capital were invested elsewhere in an
investment (project, business, or company) of comparable risk

• The cost of capital reflects expected return

• The cost of capital represents an opportunity cost

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 WEIGHTED AVERAGE
COST OF CAPITAL (WACC)

WACC = wErE + wprp + wDrD (1 – tc)

wE = proportion of equity
rE = cost of equity
wp = proportion of preference
rp = cost of preference
wD = proportion of debt
rD = pre-tax cost of debt
tc = corporate tax rate

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 KEY POINTS

• Only three types of capital (equity; nonconvertible,

noncallable preference; and nonconvertible, noncallable
debt) are considered.

• Debt includes long-term debt as well as short-term debt.

• Non-interest bearing liabilities, such as trade creditors,

are not included in the calculation of WACC.

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 COMPANY COST OF CAPITAL AND
PROJECT COST OF CAPITAL

• The company cost of capital is the rate of return

expected by the existing capital providers.

• The project cost of capital is the rate of return expected

by capital providers for a new project the company
proposes to undertake

• The company cost of capital (WACC) is the right

discount rate for an investment which is a carbon copy
of the existing firm.

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 COST OF DEBT
n I F
P0 =  +
t = 1 (1 + rD)t (1 + rD)n
P0 = current price of the debenture
I = annual interest payment
n = number of years left to maturity
F = maturity value
rD is computed through trial-and-error. A very close
approximation is:
I + (F – P0)/n
rD =
0.6P0 + 0.4F
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 ILLUSTRATION

Face value = 1,000

Coupon rate = 12 percent
Period to maturity = 4 years
Current market price = Rs.1040

The approximate yield to maturity of this debenture is :

120 + (1000 – 1040) / 4
rD = = 10.7 percent
0.6 x 1040 + 0.4 x 1000

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 COST OF PREFERENCE

Given the fixed nature of preference dividend and principal

repayment commitment and the absence of tax deductibility,

the cost of preference is simply equal to its yield.

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 ILLUSTRATION

Face value : Rs.100

Dividend rate : 11 percent
Maturity period : 5 years
Market price : Rs.95

Approximate yield :
11 + (100 – 95) / 5
= 12.37 percent
0.6 x 95 + 0.4 x 100

 Centre for Financial Management , Bangalore

 COST OF EQUITY

• Equity finance comes by way of (a) retention of earnings

and (b) issue of additional equity capital.

• Irrespective of whether a firm raises equity finance by

retaining earnings or issuing additional equity shares,
the cost of equity is the same. The only difference is in
floatation cost.

• Floatation costs will be discussed separately.

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 APPROACHES TO ESTIMATE
COST OF EQUITY

• Security Market Line Approach

• Bond Yield Plus Risk Premium Approach

• Dividend Growth Model Approach

• Earnings-Price Ratio Approach

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 SECURITY MARKET LINE
APPROACH
rE = Rf + E [E(RM) – Rf ]
rE = required return on the equity of the company
Rf = risk-free rate
E = beta of the equity of the company
E(RM) = expected return on the market portfolio

Illustration
Rf = 7%, E = 1.2, E(RM) = 15%
rE = 7 + 1.2 [15 – 7] = 16.6%

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 INPUTS FOR THE SML
While there is disagreement among finance practitioners, the
following would serve.

• The risk-free rate may be estimated as the yield on long-

term bonds that have a maturity of 10 years or more.
• The market risk premium may be estimated as the
difference between the average return on the market
portfolio and the average risk-free rate over the past 10
to 30 years.
• The beta of the stock may be calculated by regressing the
monthly returns on the market index over the past 60
months or so.
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 BOND YIELD PLUS RISK
PREMIUM APPROACH

Yield on the
Cost of = long-term bonds + Risk
equity of the firm premium

Should the risk premium be 2 percent, 4 percent, or n percent ?

There seems to be no objective way of determining it.

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 DIVIDEND GROWTH MODEL APPROACH

If the dividend per share grows at a constant rate of g percent.

D1
P0 =
rE – g
D1
So, rE = +g
P0
Thus, the expected return of equity shareholders, which in
equilibrium is also the required return, is equal to the dividend
yield plus the expected growth rate

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 GETTING A HANDLE OVER g

• Analysts’ forecasts of growth rate.

• Average annual growth rate in the preceding 5 - 10

years.

• (Retention rate) (Return on equity)

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 EARNINGS-PRICE RATIO APPROACH
Cost of equity = E1 / PO
where E1 = the expected EPS for the next year
PO = the current market price
This approach provides an accurate measure in the
following two cases:
• When the EPS is constant and the dividend payout
ratio is 100 percent.
• When retained earnings earn a rate of return equal to
the cost of equity.
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 DETERMINING THE
PROPORTIONS OR WEIGHTS

• The appropriate weights are the target capital structure

weights stated in market value terms.

• The primary reason for using the target capital structure

is that the current capital structure may not reflect the
capital structure expected in future.

• Market values are superior to book values because in

order to justify its valuation the firm must earn
competitive returns for shareholders and debtholders on
the current (market) value of their investments.

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 WACC

Source of Capital Proportion Cost Weighted Cost

(1) (2) [(1) x (2)]
Debt 0.60 16.0% 9.60%
Preference 0.05 14.0% 0.70%
Equity 0.35 8.4% 2.94%
WACC = 13.24%

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 WEIGHTED MARGINAL COST OF CAPITAL
SCHEDULE
The procedure for determining the weighted marginal cost of
capital involves the following steps:

1. Estimate the cost of each source of financing for various levels

of its use through an analysis of current market conditions and
an assessment of the expectations of investors and lenders.

2. Identify the levels of total new financing at which the cost of

the new components would change, given the capital structure
policy of the firm. These levels, called breaking points, can be
established using the following relationship.

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 WEIGHTED MARGINAL COST OF CAPITAL
SCHEDULE

TFj
BPj =
wj
where BPj is the breaking point on account of financing source
j, TFj is the total new financing from source j at the breaking
point, and wj is the proportion of financing source j in the
capital structure.

3. Calculate the WACC for various ranges of total financing

between the breaking points.

4. Prepare the weighted marginal cost of capital schedule which

reflects the WACC for each level of total new financing.
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 DETERMINING THE OPTIMAL
Return,
CAPITAL BUDGET
Cost (%)
A
18 Investment Opportunity Curve
B
17

16 C
15 14.6%

14 14.0%
13.2% D

13
E
12 Marginal Cost of Capital Curve
11
10 Optimal Capital Budget

10 20 30 40 50 60 70 80 90 100 110 120 130 140

Amount (in million rupees)
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 DIVISIONAL AND PROJECT COST
OF CAPITAL
• Using WACC for evaluating investments whose risks are
different from those of the overall firm leads to poor
decisions. In such cases, the expected return must be
compared with the risk-adjusted required return, as
calculated by the security market line.

• Multidivisional firms that have divisions characterised

by differing risks may calculate separate divisional costs
of capital. Two approaches are commonly employed for
this purpose:
• The pure play approach
• The subjective approach

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 FLOATATION COSTS
• Floatation or issue costs consist of items like
underwriting costs, brokerage expenses, fees of
merchant bankers, underpricing cost, and so on.

• One approach to deal with floatation costs is to adjust

the WACC to reflect the floatation costs:
WACC
Revised WACC =
1 – Floatation costs

• A better approach is to leave the WACC unchanged but

to consider floatation costs as part of the project cost.

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 SOME MISCONCEPTIONS
Several misconceptions characterise the calculation and
application of cost of capital in practice.

• The concept of cost of capital is too academic or

impractical.

• The cost of equity is equal to the dividend rate or return

on equity.

• Retained earnings are either cost free or cost

significantly less that the external equity.

• Share premium has no cost

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 SOME MISCONCEPTIONS

• Depreciation has no cost

• The cost of capital can be defined in terms of an

accounting-based measure.

• A company must apply the same cost of capital to all

projects.

• If a project is financed heavily by debt, its WACC is low.

 Centre for Financial Management , Bangalore

 SUMMING UP
• A company’s cost of capital is the weighted average cost of the
various sources of finance used by it, viz., equity, preference and
debt.
• Since debt and preference entail more or less fixed payments,
estimating their cost is relatively easy.
• Three approaches are commonly used to estimate the cost of
equity : security market line approach, bond yield plus risk
premium approach, and dividend growth model approach.
• The appropriate weights in the WACC calculation are the target
capital structure weights stated in market value terms
• In multidivisional firms, it is advisable to calculate divisional costs
of capital.
• Floatation costs may be considered as part of project cost.
• Several misconceptions characterise cost of capital in practice.
 Centre for Financial Management , Bangalore