COST OF CAPITAL

Prof. Vanita Patel.

Prof.Vanita Patel 1
 What sources of long-term capital
do firms use?

Long-Term Capital
Long-Term Capital

Long-Term Debt
Long-Term Debt Preferred Stock
Preferred Stock Common Stock
Common Stock

Retained Earnings
Retained Earnings New Common
New Common Stock
Stock

Prof.Vanita Patel 2
 Capital Components
• These are called as capital components.
• Each of them has a cost called as component
cost.
• This cost of all components calculated
together is called as weighted average cost of
capital, WACC.

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 Definition
• Cost of capital of a company is the minimum
expected rate that a company requires to
meet its obligations and sustain in the market.
• A project’s cost of capital is the minimum
acceptable rate of return on funds committed
to the project.

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 Introduction
• Operationally it is a discount rate that is used
in determining present value of future cash
flows.

• Conceptually it is a minimum rate of return

that a firm must earn on its investments to
keep its market value unchanged.

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 Introduction
• This minimum acceptable rate or the required
rate or the hurdle rate is a compensation for
time and risk in the use of capital by the
project.

• Since the investment in projects may differ in

risk, each one of them will have its own
unique cost of capital.

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 Introduction
• We can use the firm’s cost of capital for
discounting the cash flows of capital
expenditure only if the project which is under
consideration has the same risk class that of
the firm,
or
• it should be adjusted to account for
differential riskiness of investment projects.

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 Should our analysis focus on
historical (embedded) costs or new
(marginal) costs?

• The cost of capital is used primarily to make

decisions that involve raising new capital. So,
focus on today’s marginal costs (for WACC).

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 Types of project risks
• Stand alone risk

• Corporate risk

• Market or beta risk

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 Cost of capital
• We pay for assets using debt (liabilities) and owners
money (equity).
• We pay for fixed assets (capital assets) using long-
term debt and equity.
• To assess whether a capital asset will have a positive
return (make a profit) we need to know the cost of
the financing used to pay for the asset.

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 Cost of capital
• Capital components are sources of funding that
come from investors.
• Accounts payable, accruals, and deferred taxes are
not sources of funding that come from investors, so
they are not included in the calculation of the cost of
capital.
• We do adjust for these items when calculating the
cash flows of a project, but not when calculating the
cost of capital.

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 Sources of long term capital
• Debt

• Preferred Stock

• Equity (Common Stock and Retained Earnings)

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 COST OF CAPITAL
• Different components have different costs.
• A firm could finance all projects with equity,
then the cost of capital would equal the cost
of capital (The firm would have no debt).
• There is a limit to the amount of money a firm
can borrow, therefore debt is limited.

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 COST OF CAPITAL
• Rather than look at how individual capital
projects are financed, we look at the firm as a
going concern.
• Therefore, all projects are viewed as being
financed with a composite of the firms capital
structure.
• To determine the cost of capital in individual
projects, we take the Average Cost of Capital
for the firm.

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 1. COST OF DEBT
• The company can raise debt in variety of
ways,
• Individuals
• Financial institutions
• Corporate houses
• Banks
• Associated companies
• Issue of debentures, bonds etc….

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 COST OF DEBT (kd)
• Since interest payments on debt are tax
deductible, we must adjust the cost of
debt to account for this tax deduction.

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 COST OF DEBT
• After tax cost of debt = interest – tax savings.

• After tax cost of debt = kd(1 – T)

• kd = before tax cost of debt

• T = tax rate

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 COST OF DEBT
• If the company borrows at an interest rate of
12% and if the tax rate is 40%,then its after tax
cost is,
• After tax cost of debt = kd(1 – T)
• kd = .12
• T = .40
• kd(1 – T) = .12(1 - .40) = .072

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 Continued..
• The reason for using the after-tax cost of debt
in calculating the weighted average cost of
capital is, because interest is tax deductible
expense, it gives tax savings that reduce the
net cost of debt, making the after tax cost of
debt less than the before cost.

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 COST OF PREFERRED STOCK (kp)
• Preferred Stock is a no growth stock.
• P0 = D1/(ke – g)
• P = D/k or Pp = Dp/kp
• kp = Dp/Pp
• kp = Dp/Pp where Dp is preferred
dividend and Pp is current price.

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 COST OF PREFERRED STOCK
• For example if the company pays dividend of Rs.10 per share
and sells the share in the open market for Rs.120,its cost
would be,
• Dp = Rs.10
• Pp = Rs.120
• kp = 10/120 = .0833 or 8.33%

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 Cost of retained earnings, Ks
• Retained earnings are not free, as it has
opportunity cost.
• It should earn at least as much as the
stockholder’s themselves could earn on
alternative investment of comparable risk.
• It means it should equate required rate of
return to its expected rate of return.

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 Cost of retained earnings Ks
• Required rate of return= Expected rate of
return
• kRF+RP=D1/P0+g
• kRF=risk free rate
• RP= risk premium
• Dividend yield=D1/P0
• g= growth rate

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 COST OF EQUITY (Ke)
• Equity is composed of common stock and retained
earnings.
• Common stock has a slightly higher cost due to the
cost of issuing the stock (flotation costs).
• In the big picture, flotation costs are very minor.
• For our purposes, we will assume that the cost of
common stock and the cost of retained earnings is
the same.

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 COST OF EQUITY ke
• There are a number of methods used to
determine the cost of equity like,
• CAPM –Capital Asset Pricing Model.
• Bond-yield-plus-risk-premium approach
• Dividend-yield-plus-growth-rate or Discounted
cash flow (DCF) approach

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 CAPM Method
• Step1- Estimate the risk-free rate, kRF, generally taken to
be either the Treasury bond rate or the short-term (30
days) Treasury bill rate.

• Step-2 Estimate the stock’s beta coefficient, bi, and use it as

a index of the stock’s risk. The I signifies the ith company’s
beta. bi

• Step-3 Estimate the expected rate of return on the market,

or on an average stock, Km.

• Step-4 Substitute the preceding values into the CAPM

equation to estimate the required rate of return on the
stock.
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 Continued..

• The CAPM equation is,

• ks = kRF + (km – kRF)bi
• Which can be explained as follows,
• kRF- risk free rate
• Km-expected rate of return
• Bi-beta coefficient

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 CAPM

• kRF = .06 or 6%
• km = .18 or 18%
• bs = 1.2
• ks = .06 + (.18 - .06)1.2 = .204 or 20.4%.

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 Bond-Yield-Plus-Risk-Premium
approach
• It is an ad hoc way to estimate a firm’s cost of
common equity.
• A judgmental risk premium of 3 to 5
percentage points are added to the interest
rate on the firm’s long term debt.
• It does not produce a precise cost of equity
and used as ‘ballpark’ figure.

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 Dividend yield plus growth rate or
discounted cash flow approach
• Both price and the expected rate of return on
a share of a common stock depend ultimately
on the dividends expected on the stock.
• Ks=D1/Po +expected g
• Ks-expected rate of return
• D1/Po- is dividend yield
• g-projected growth rate

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 DCF method
• Example- if company A’s stock sells for
Rs.23,its next expected dividends is Rs.1.24
and expected growth rate is 8% its expected
and required rate of return is as under,
• Ks=1.24/23+8%
• Ks=13.4%

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 Cost of new common stock (ke)
• It is the cost of external equity based on the
cost of retained earnings but increased for
flotation costs.
• Ke= D1/Po(1-F)+g
• In our earlier example if the flotation cost is
10% then,
• Ks=1.24/23(1-0.10)+8%=14%

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 WEIGHTED AVERAGE COST OF
CAPITAL
• We look at the Capital Structure of a firm.
• Determine the weight /portion of each
element in the Capital Structure.
• Multiply the cost of the element by its
portion/ weight and sum the products of the
individual elements.

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 WEIGHTED AVERAGE COST OF
CAPITAL
WACC = Wdkd (1-T) + Wpkp + Weke
Where, Wd is- weight/portion of debt
and, Kd is cost of debt
1.First calculate the weight.
2.Calculate individual cost of capital
components.
3.Put the values in the said equation.
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 WEIGHTED AVERAGE COST OF
CAPITAL

Long term debt 10,000,000

Preferred Stock 2,000,000
Equity 18,000,000
30,000,000
Tax rate- 40%,

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 WEIGHTED AVERAGE COST OF
CAPITAL

Weight of Long term debt =

10,000,000/30,000,000 = .3333

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 WEIGHTED AVERAGE COST OF
CAPITAL

Weight of Preferred stock=

2,000,000/30,000,000 = .0666

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 WEIGHTED AVERAGE COST OF
CAPITAL

Weight of Equity =

18,000,000/30,000,000 = .60

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 WEIGHTED AVERAGE COST OF
CAPITAL
Cost of debt

Before tax cost of debt = .12 or 12%

Tax rate = .40 or 40%

kd = .12(1 - .40) = .072 or 7.2%

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 WEIGHTED AVERAGE COST OF
CAPITAL
Cost of Preferred stock

kp = Dp/Pp

Dp = 12

Pp = 100

kp = 12/100 = .12

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 WEIGHTED AVERAGE COST OF
CAPITAL
Cost of Equity

ke = (D1/P0) + g

D1 = 2

P0 = 22

g = .16

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 WEIGHTED AVERAGE COST OF
CAPITAL
Cost of Equity

ke = (D1/P0) + g

ke = (2/22) + .16 = .25

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 WEIGHTED AVERAGE COST OF
CAPITAL
WACC = Wdkd + Wpkp + Weke
WACC = (.3333)(.072) + (.0666)(.12) +(.60)(.25) = .182
or 18.2%

This firm should only invest in projects which

have a projected return greater than 18.2%.

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 Factors that affect the WAAC
• Non-Controllable- interest rate, tax rate,
inflation rate.

• Controllable-capital structure policy, dividend

policy, investment policy

The End

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