Cost of Capital

By: Kiran Thapa

Cost of Capital

The cost of capital is a very important

element in the capital budgeting process.

The cost of capital is the average return

required by the firms investors and it is the
firms average cost of funds.

Basic Assumptions

Constant business risk

Constant financial risk

Constant tax rate

Constant dividend policy

Conditions for Using Cost of

Capital

The new investments being considered have

the same risk as the average risk of existing
investments.

The financing policy of the firm is not affected

by the investments that are made.

Significance of Cost of Capital

Investment decision

Capital Structure decision

Performance Appraisal

Dividend policy decision

Cost of Specific Sources of

Capital (Component Cost)
Cost of Debt Capital (kd)
Perpetual Debt or Irredeemable Debt
I
kd =
NP
Where,
I
= Interest payment in rupees
NP = Net proceeds or price of the bond

Net proceeds (NP) is the actual amount received from

the sale of bonds. Net proceeds is calculated as follows:
Net proceeds (NP)
= Par value + Premium Discount Flotation cost

contd.

After tax cost of debt is used to compute the

weighted average cost of capital.
Interest is a tax-deductible expense.
After tax cost of debt (kdt) is the interest rate
on debt (kd) less tax savings on interest paid.
The tax saving is equal to the interest rate
times the tax rate.

After tax cost of debt (kdt) is calculated as

follows:
kdt = Interest rate Tax saving

contd.

Redeemable Debt

Approximation Formula Method

M NP
I+
n
kd =
M +2 NP
3

Where,
M = Face value or maturity value
n = Maturity period
NP= Net Proceeds
I = Interest payment on bond
kd = Before tax cost of debt

contd.

Bond Valuation Method

n

Vd =
t=1

I
M
+
(1+kd)t
(1+kd)n

= I PVIFAkd,n + M PVIFkd,n

Solve for kd

kd = Before tax cost of debt (before tax required

rate of return on debt)
The after tax cost of debt is then calculated
using

kdT = kd (1 T)
Where,

Cost of Preferred Stock (kps)

Perpetual Preferred Stock Or
Irredeemable Preferred Stock

Perpetual preferred stock has infinite period.

The component cost of preferred stock (kPS) is
the preferred dividend (DPS) divided by the net
issuing price (Pn) which is the price the firm
receives after deducting flotation costs:
Cost of Preferred Stock

DPS
kPS =
Pn

contd.

Flotation costs are higher for preferred stock

rather than for debt, hence they are
incorporated into the formula for preferred
stocks costs.

Note: No tax adjustments are made when

calculating kPS because preferred dividends,
unlike interest expense on debt, are not tax
deductible as the dividend to preferred stock is
paid only after paying the tax. Hence there are

contd.

Approximation Formula Method

M NP
DPS +
n
kps =
M +2 NP
3
Where,
M = Face value or maturity value
n = Maturity period
NP= Net Proceeds
DPS = Dividends on preferred stock
kPS = Cost of preferred stock

contd.

Bond Valuation Method

DPS
M
Pn =
+
(1+kPS)t (1+kPS)n
= DPS PVIFAk

PS

,n

+ M PVIFk

,n

PS

Cost of Retained Earnings (ks)

The reason we must assign a cost of capital to

retained earnings involves the opportunity cost
principle.
The firms after tax earnings belong to its
stockholders.
Stockholders could have received the earnings
as dividends and invested this money in other
stocks, in bonds, in real restate, or in anything
else.
Thus, the firm should earn on its retained
earnings at least as much as the stockholders
themselves could earn its retained earnings at
least as much as the stockholders themselves

contd.

The cost of retained earnings can be

calculated by using three methods.
Dividend Growth Model
(i)
This model is also called the discounted cash
flow method.
(ii)
The model states that the cost of common
stocks under the assumptions that dividend
grows at a constant rate, is the expected
divided next period dividend by current
market price plus growth rate.

D1
ks = +g
P0

contd.

Capital Asset Pricing Model

The capital asset pricing model (CAPM) states
that the required rate of return (ks) is equal to
risk free rate plus appropriate risk premium for
the level of risk involved. It is calculated as
follows.

ks = kRF + (kM kRF) s

Where,
kRF = Risk free rate of return
= Systematic risk measure

contd.

Bond Yield Plus Risk Premium

Method

The bond yield plus risk premium method

estimates ks by adding a risk premium of three
to five percentage points to the firms own
bond yield. The formula is:

ks = Bond yield + Risk premium

Cost of Newly Issued or

External Common Stock (kN)

The cost of new common equity (kN) is the cost

to the firm of equity obtained by selling new
common stock.
The cost of retained earnings adjusted for
flotation costs. Flotation costs are the costs
that the firm incurs when it issues new
securities.
The funds actually available to the firm for
capital investment from the sale of new
securities is the sales price of the securities
less flotation costs.

contd.

Note that floatation costs consist of (1) direct

expenses such as printing costs and brokerage
commissions, (2) any price reduction due to
increasing the supply of stock, and (3) any
drop in price due to informational
asymmetries.
The cost of new common equity (kN) or
external equity, is higher than the cost of
retained earnings, kS, because of flotation
costs involved in issuing new common stock.

contd.

Mathematically, Cost of External Equity

kN

D1
D1
=
+g =
+g
NP
P0 ( 1 F)
Where
NP = P0 (1 F)

Weighted Average Cost of

Capital

The combined cost of all sources of capital is

called overall, or average, cost of capital.
Costs of individual sources and their proportions
determined the overall cost of capital of the
firm.
Thus the overall cost is also called the weighted
average cost of capital.

WACC = kdT Wd + kPS WPS + kS or, kN WS

Where
Wd = Proportion of bond in the capital structure

Three important points should be noted in above

equation are:
For computational convenience, it is best to
convert the weights to decimal form and leave
the specific costs in percentage terms.
The sum of weights must equal 1.0. Simply
stated, all capital structure components must
be accounted for.
The firms common stock equity weight, W , is
S
multiplied by either the cost of retained
earnings, kS, or the cost of new common stock,
kN. Which cost is used depends on whether the

Marginal Cost of Capital

The marginal cost of capital (MCC) is defined

as the cost of the last rupee of new capital
that the firm raises, and the marginal cost
rises as more and more capital is raised during
a given period.

A firm's marginal cost of capital also known as

weighted marginal cost of capital (WMCC)
reflects the fact that as the volume of total
new financing increases, the costs of the
various types of financing will increase, raising
the firm's cost of capital

contd.

Breaking points, which are found by dividing

the amount of funds available from a given
financing source by its capital structure
weight, represent the level of total new
financing at which the cost of one of the
financing components rises, causing an
upward shift in the weighted marginal cost of
capital.

Break point for retained

earnings
i.e. single
Retained e
arnings
Break point =
fraction
break point is givenEquity
by following
equation:

contd.

The weighted average cost of capital is the

firm WACC associated with its next rupee of
total new financing.

The WMCC schedule relates the WACC to each

level of total new financing.

The marginal cost of capital (MCC) is defined

as the cost of the last rupee of new capital
that the firm raises, and the marginal cost
rises as more and more capital is raised during

Any queries?

Thank You