THE COST OF CAPITAL

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

 WEIGHTED AVERAGE
COST OF CAPITAL (WACC)

WACC = wErE + wDrD (1 – tc)

wE = proportion of equity
rE = cost of equity
wD = proportion of debt
rD = pre-tax cost of debt
tc = corporate tax rate
 WEIGHTED AVERAGE
COST OF CAPITAL (WACC)

WACC = wErE + wprp + wDrD (1 – tc)

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

• 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.
 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.
 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.

 APPROACHES TO ESTIMATE
COST OF EQUITY

• CAPM

• Dividend Growth Model

 CAPM
rE = Rf + βE [E(RM) – Rf ]
rE = required return on the equity of the company
Rf = risk-free rate
βE = beta of the equity of the company
E(RM) = expected return on the market portfolio

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

 INPUTS FOR CAPM
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
stock returns against market returns.

βL = βu (1+ ((1-t)D/E))

βL = βu (1+ ((1-t)D/E)) - βdebt (1-t) (D/E)

 Cost of Debt
The two most widely used approaches to estimating cost of debt are:
– Looking up the yield to maturity on a straight bond outstanding from the firm.
The limitation of this approach is that very few firms have long term straight
bonds that are liquid and widely traded
– Looking up the rating for the firm and estimating a default spread based upon
the rating. While this approach is more robust, different bonds from the same
firm can have different ratings. You have to use a median rating for the firm
 DETERMINING THE
PROPORTIONS OR WEIGHTS

• Use Market Value weights AND NOT Book Value

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