The Cost of Capital

Chapter Objectives

• Learn about the methods of calculating

component cost of capital and the weighted
average cost of capital.
 Component Cost of Capital
• Cost of Debt
• Cost of Preference Share
• Cost of Equity
 Cost of Debt
• Debt Issued at Par
INT
kd  i 
B0

• Debt Issued nat Discount or Premium

INTt Bn
B0   
t 1 (1  k ) 
t n
d (1 k d )

• Tax adjustment  
After-tax cost of debt  kd (1  T )
Debt Issued at Par

INT
kd  i 
B0
 Debt Issued at Par
Where:
kd= Cost of Debt
INT= Interest
B0= Issue price of Bond
 Illustration: 1
• A company decides to sell a new issue of 7
year 15 per cent bonds of Rs. 100 each at par.
If the company realizes the full face value of
Rs. 100 bond and will pay Rs. 100 principal to
bondholders at maturity, compute the before
tax cost of debt.
 Illustration: 1
Where:
INT= 15
B0= 100

kd= 15/100=0.15 or 15%

 Illustration: 1
• Assuming that a firm pays tax at a 50% rate.
Compute after tax cost of capital in the last given
case.

Solution:

• After tax Cost of Debt = kd (1-T)

• After tax Cost of Debt = 0.15 (1- 0.5) = 0.075
or 7.5%
 Cost of Preference Capital
• Irredeemable Preference Share  
PDIV
kp 
P0

• Redeemable Preference
n PDIV P
Share  
P0 =  t
+ n
t 1 (1  k p )t (1  k p ) n
 Illustration: 2
• A company issues 10 % irredeemable preference
shares. The face value per share is Rs. 100, but the
issue price is Rs. 95. What is the cost of a preference
share? What is the cost if the issue price is Rs. 105?
• Solution:
• If issue price is Rs. 95:
• k p= PDIV/P0 = 10/95 = 0.1053 OR 10.53%
• If issue price is Rs. 105:
• k p= 10 / 105 = 10 / 105 = 0.0952 or 9.52%
Cost of Equity Capital (Dividend
Growth Model)

– Cost of Internal Equity:

DIV1
– Normal growth   P0 
( ke  g )
n
DIV0 (1  g s )t DIVn  1 1
– Supernormal growth  P0   (1  ke )t
 
ke  g n (1  ke )n
t=1

DIV1 EPS1
– Zero-growth ke   (since g  0)
P0 P0
 Cost of Equity Capital
• Is Equity Capital Free of Cost? No, it
has an opportunity cost.
• Cost of Internal Equity: The Dividend
—Growth Model
– Normal growth  

– Supernormal growth  

– Zero-growth
 Cost of Equity Capital
• Is Equity Capital Free of Cost? No, it has an
opportunity cost.
• Cost of Internal Equity: The Dividend—Growth
Model
– Normal growth   DIV1
P0 
( ke  g )
 Cost of Internal Equity:

• Where:
• k e = cost of equity
• P0 = Market Price of equity share capital
• g = growth rate = ROE * b
(where b= retention ratio)
• DIV 1 = DIV 0 (1+ g)
 Cost of Equity Capital
• Cost of External Equity: The
Dividend—Growth Model
DIV1
ke  g
P0
 Illustration : 3
• An ordinary share selling at a current
market price of Rs. 120 and paying a
current dividend of Rs. 9 per share, which
is expected to grow at a rate of 8%.
• k e = DIV 1 / P0 + g = [9 (1.08) / 120 ]* 0.08
= 16.1%
 The Weighted Average Cost of
Capital
• The following steps are involved for calculating the firm’s
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.
ko  kd (1  T ) wd  kd we
D E
ko  kd (1  T )  ke
DE DE
• WACC is in fact the weighted marginal cost of capital
(WMCC); that is, the weighted average cost of new
capital given the firm’s target capital structure.
Book Value Versus Market Value
Weights
• Managers prefer the book value weights
for calculating WACC:
– Firms in practice set their target capital structure
in terms of book values.
– The book value information can be easily
derived from the published sources.
– The book value debt—equity ratios are analysed
by investors to evaluate the risk of the firms in
practice.
 Book Value Versus Market
Value Weights
• The use of the book-value weights can be seriously
questioned on theoretical grounds:
– First, the component costs are opportunity rates
and are determined in the capital markets. The
weights should also be market-determined.
– Second, the book-value weights are based on
arbitrary accounting policies that are used to
calculate retained earnings and value of assets.
Thus, they do not reflect economic values.
 Book Value Versus Market
Value Weights
• Market-value weights are theoretically superior to
book-value weights:
– They reflect economic values and are not
influenced by accounting policies.
– They are also consistent with the market-
determined component costs.
• The difficulty in using market-value weights:
– The market prices of securities fluctuate widely
and frequently.
– A market value based target capital structure
means that the amounts of debt and equity are
continuously adjusted as the value of the firm
changes.
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.