The Cost

of Capital
 Learning Goals

Understanding cost of capital

Significance of cost of capital
Cost of each source of capital funding
Approaches used to estimate the cost of common equity?
Optimal Capital Structure Optimal Capital Structure
Calculation of the weighted average cost of capital
(WACC), (which is the firms Required Rate of Return =
K)
Marginal Cost of Capital (MCC) and its application in
decision making
Exercises
Understanding Cost of Capital
The term capital is used by the firms for funds
needed for investment purposes, its cost is the
key input to calculate a firms or divisions
economic value added (EVA).
The required return necessary to make a
capital budgeting project, such as building
a new factory, worthwhile. Cost of capital
includes the cost of debt and the cost of
equity capital.
 Significance of Cost of Capital

Managers estimate and use the cost of capital when

deciding if they should lease or purchase assets.
It is the key input used to calculate a firms or
divisions economic value added.
To properly evaluate investment decisions, the firm
must know how much it will cost them to raise
capital funds.
This capital carries a cost because the investors want
a return on their investment (fixed assets, technology,
etc.)
 Sources / Components of Capital

Debt capital / Borrowing, such as Bonds, bank loans,

etc.
Issuing Preferred stock
Issuing Common stock
Net Income (retained earnings)
Each of these sources carries a different cost based on
the required rate of return of each provider (source) of
these funds.
 Optimal Capital Structure
The capital structure of a firm is, how the firm
has selected / decided to finance its assets.
Firm must decide the level or percentage of total
assets financed by debt, preferred stock and
common equity (common stock and retained
earnings) to minimizing the costs and increasing
the value of the firm.
Each firm has an optimal level of debt and
equity at which it can operate most efficiently
and profitability.
 Stages of Weighted Cost of Capital
Compute the cost of each source of capital;
debt, preferred stock, common stock, and
earnings.
Determine percentage to total assets of each
source of capital in the optimal capital
structure
Multiply each components weight or ratio with
its cost and adding the costs the find Weighted
Average Cost of Capital (WACC).
Approaches used to estimate the cost
of common equity?

1. The CAPM Approach

Ks = KRF +(KM - KRF )

o 2. Dividend growth model

Ks= D1/ Po +g
Po= D1/ (Ks- g) Here, D1= Do* (1+g)

o 3. Bond Yield Plus Risk premium approach

Ks = Bond yield + Risk premium
 1. Compute Cost of Debt

Required rate of return for creditors

e.g. Suppose that a company issues bonds with a
before tax cost (interest) of 10%.
Since interest payments are tax deductible, the
true cost of the debt to the company is the after
tax cost. AT kd = K(1-T), where T = tax rate, K=
interest rate
If the companys tax rate (state and federal
combined) is, say, 40%, the after tax cost of
debt AT kd = 10%(1-.40) = 6%.
Flotation Costs cost of issuing securities

Accounting
Legal
Printing (prospectus)
Underwriting (investment banker)
Filing Fees (SEC)
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock;
derived from same formula as a perpetuity.

Dividend (Dp)
Required rate kp =
Net Price (MP F)

Example: You can issue preferred stock for $45

(Market Price). However, if Flotation costs are $3,
then the firm only gets $42 and if the preferred
stock pays a $5 dividend, then
The cost of preferred stock:

kp = $5.00 = 11.90%
$45.00 3.00
3. Compute Cost of Common Equity

Two Types of sources of Common

Equity Financing
Retained Earnings (internal common
equity) ; symbol is Ks
Issuing new shares of common stock
(external common equity) ; symbol is
Ke
 3. Compute Cost of Common
Equity
3.1 Cost of Internal Common Equity
Management should retain earnings only
if they can earn as much as stockholders
next best investment opportunity at the
same level of risk.
Method to determine stockholders next best
investment opportunity:
Dividend Growth Model
Internal retained earnings
External new common stock
3. Compute Cost of Common
Equity
Cost of Internal Common Equity
Dividend Growth Model

D1
kS = P0
+ g

Ks = cost of internal common equity

D1 = the next dividend to be paid
Po = the current market price of the stock
g = the projected rate of growth of the company
 3. Compute Cost of Common
Equity
Cost of Internal Common Equity
Dividend Growth Model

kS = D1 + g
P0
Example:
The market price (Po) of a share of common
stock is $60. The prior dividend paid (D0) was
$3, and the expected growth rate (g) is 10%.
(Discuss D0 vs D1 )
 3. Compute Cost of Common
Equity
Cost of Internal Common Equity
Dividend Growth Model

D1
kS = + g
P0

Example: The market price of a share of common

stock is $60. The prior dividend is $3, and the
expected growth rate is 10%. Use the growth rate
to calculate D1. D1 = Do (1 + g)

3.00(1.10) + .10
kS = =.155 15.5%
60
 3. Compute Cost of Common
Equity
3.2 Cost of External Equity - New Common
Stock
Must adjust the Dividend Growth Model
equation for Floatation costs of the new
common shares.
D1
kn = P0 - F
+ g
Example:
If additional shares are issued floatation costs will
be 12% of the Market Price. D0 = $3.00 and
estimated growth is 10%, Price is $60 as before.
3. Compute Cost of Common Equity
Cost of External Equity - New Common Stock
Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
kn = + g
P0 - F
Example: If additional shares are issued floatation
costs will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before. (Flotation =12% x
$60 = $7.20)

kn = 3.00(1.10) + .10 = .1625 = 16.25%

60.00 7.20
Weighted Average Cost of Capital
Gallagher Corporation estimates the following
costs for each component in its capital structure:

Source of Capital Cost

Bonds (After-tax) kd = 6.0%

Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15.5%
New Shares kn = 16.25%
Weighted Average Cost of Capital

If using retained earnings (Internal Equity) to

finance the equity portion:

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = weighted average cost of capital

WT = the weight, or percentage of each element of capital
(% of debt, preferred and common stock to total assets)
ATkd = after tax cost of debt
Kp = Cost of preferred stock
Ks = Cost of equity (Internal retained earnings)
Weighted Average Cost of Capital

If using retained earnings (Internal Equity) to

finance the equity portion:

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

Assume that Gallaghers desired capital

structure is 40% debt, 10% preferred
and 50% common equity.
WACC =
Cost of Debt .40 x 6% = 2.40%
+ Cost of Preferred .10 x 11.9% = 1.19%
+ Cost of Common .50 x 15.5% = 7.75%
= 11.34%
 Weighted Average Cost of Capital
If using new common stock (External Equity) to
finance the common stock portion:

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

Then we must use the cost of stock adjusted

for the Flotation costs
WACC =
Cost of Debt .40 x 6.0% = 2.40%
+ Cost of Pref .10 x 11.9% = 1.19%
+ Cost of common .50 x 16.25% = 8.13%
= 11.72%
 Marginal Cost of Capital

The WACC of the next dollar of capital

raised is called the marginal cost of
capital (MCC).
Gallaghers weighted average cost will
change if any component (debt,
preferred or common equity) cost of
capital changes.
This may occur when a firm raises a
particularly large amount of capital such
that investors think that the firm is
riskier.
 Raising/Spending Capital
The assumption is that the capital money is
spent or raised in direct proportion to the
optimal capital structure.
If we raise or spend $100,000, it would be in
the following proportions:

Capital Structure Raise Spend

Debt 40% 40,000 40,000
Preferred 10% 10,000 10,000
Common 50% 50,000 50,000
Calculating the Breakpoint

Assume now that Gallagher Corporation has

$100,000 in retained earnings with which to
finance its capital budget.
We can calculate the point at which they will
need to issue new equity (common stock)
since we know that Gallaghers desired
capital structure calls for 50% common
equity.

Breakpoint = Available Retained Earnings (RE)

Percentage of RE to Total Capital
 the Calculating Breakpoint

Breakpoint = ($100,000)/.5 = $200,000

What this means is that once we spend $200,000 total on capital

projects, we will have used up our retained earnings of $100,000
(internal equity).
Therefore, if we spend over $200,000, we will need additional
financing from the issue of new shares of stock since 50% of our
spending must come from Equity.
The cost of new shares is greater than internal equity due to
flotation costs.
 Making Decisions Using MCC

Marginal weighted cost of capital curve:

Weighted Cost of Capital

12%

11% 11.72%
11.34%
10%
Using external
Using internal (new) common
9% common equity equity
0 100,000 200,000 300,000 400,000
Total Financing
Making Decisions Using MCC

Graph IRRs of potential projects

Marginal weighted cost of capital curve:

Weighted Cost of Capital

12%

11% Project 1
$100,000 Project 2 Project 3
10% IRR = $150,000 $100,000
12.4% IRR = IRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing
Making Decisions Using MCC
Graph IRRs of potential projects
Graph MCC Curve

Marginal weighted cost of capital curve:

11.72%
Weighted Cost of Capital

12%
11.34%
11% Project 1
$100,000 Project 2 Project 3
10% IRR = $150,000 $100,000
12.4% IRR = IRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing
Making Decisions Using MCC
Graph IRRs of potential projects
Graph MCC Curve

Choose projects whose IRR is above the weighted

marginal cost of capital
Marginal weighted cost of capital curve:
Accept Projects #1 & #2
Weighted Cost of Capital

12% 11.72%
11.34%
11% Project 1
$100,000 Project 2 Project 3
10% IRR = $150,000 $100,000
12.4% IRR = IRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing
 WACC
A calculation of a firm's cost of capital in
which each category of capital is
proportionately weighted. All capital
sources - common stock, preferred stock,
bonds and any other long-term debt - are
included in a WACC calculation. All else
equal, the WACC of a firm increases as
the beta and rate of return on equity
increases, as an increase in WACC notes a
decrease in valuation and a higher risk.
Review Questions

What is cost of capital ?

Discuss the significance as well as objectives of cost
of capital.
What are the approaches used to estimate the cost
of common equity?
What is Optimal Capital Structure?
How are weight determined?
What factors influence a companys composite
weighted Average cost of Capital?
Why is a cost for retained earnings?
Is preferred stock more or less risky to investors?
How many ways cost of common equity is
determined?
Problems for Practice
Contd.
Contd.
Solution -10.1
We are given, debt = 40% (Wd)
Equity = 60% (We)
kd= 9%.
Tax rate 40%, WACC = 9.965
Ke= ?

We know, WACC = {wd*kd(1-T)+ (We*Ke)}

Or 0.996= 0.40*0.09(1-0.40+ 0.60*Ke)
Or 0.0996= 0.0216+ 0.60Ke
Or 0.078= 0.6Ke
Or Ke= 13%