LECTURE-4

TOPIC: THE COST OF CAPITAL

Cost of Capital
The cost of funds used for financing a business. Cost of capital
depends on the mode of financing used it refers to the cost of equity if
the business is financed solely through equity, or to the cost of debt if it
is financed solely through debt.

Many companies use a combination of debt and equity to finance their

businesses, and for such companies, their overall cost of capital is
derived from a weighted average of all capital sources, widely known as
the weighted average cost of capital (WACC). Since the cost of capital
represents a hurdle rate that a company must overcome before it can
generate value, it is extensively used in the capital budgeting process to
determine whether the company should proceed with a project.
Factors Affecting Cost of Capital

General Economic Conditions

Affect interest rates.
Market Conditions
Affect risk premiums.
Operating Decisions
Affect business risk.
Financial Decisions
Affect financial risk.
Amount of Financing
Affect flotation costs and market price of security.
Weighted Cost of Capital Model

Compute the cost of each source of capital

Determine percentage of each source of capital in the optimal
capital structure
Calculate Weighted Average Cost of Capital (WACC)
Compute Cost of Debt

Required rate of return for creditors.

Since interest payments are tax deductible, the true cost of the
debt is the after tax cost.
If the companys tax rate (state and federal combined) is 40%,
the after tax cost of debt
AT kd = 10%(1-.4) = 6%.

A debenture/bond can be issued at par, discount or premium.

Compute Cost of Debt
I
Cost of irredeemable / perpetual debt capital: * 1 T
SV

Cost of redeemable debt capital (Principal is on lump su

n
COIt COPn
m repayment): CI0
t 1 (1 kd ) (1 kd )n
t

Cost of redeemable debt capital (Principal is paid on Inst

n
COI t COP t
allments): CI 0
t 1 (1 k d )
Compute Cost of Debt: Example

A company issues a new 10% debentures of tk. 1,000 face value t

o be redeemed after 10 years. The debenture is expected to be s
old at 5% discount. It will also involve floatation costs of 5% of fa
ce value. The companys tax rate is 35%. What would the cost of
debt be?
Solution:
Years Cash Flow
0 + tk. 900 (tk. 1000-tk.50-tk.50)
1-10 - tk. 100
10 - tk. 1,000

kd
To determine the value of ,10thetkequation
.65 tkturns
.1000to:
tk.900
t 1 (1 kd ) t
1 kd 10
Compute Cost of Debt: Example

Trial and Error Approach:

Year (s) Cash Outflows PV Factor at Total PV at

7% 8% 7% 8%
1-10 Tk. 65 7.024 6.710 Tk. 456.56 436.15
10 1000 .508 .463 508.00 463.00
964.56 899.15
The cost of debt would be 8%
 Compute Cost of Preferred Stock

The cost of preference capital may be defines as the dividend expect

ed by the preference shareholders. Preference stock can be issued
at par, premium or discount.
There are two types of preference shares: (1) irredeemable (2) redee
mable.
Dp
Cost of irredeemable / perpetual preference stock: kp .. (1)
P0(1 f )
Dp 1 Dt
kp ..(2)
P0 (1 f )

Cost of redeemable preference stock: n D pt Pn

P0 (1 f ) (1 k
t 1 ) t

(1 k p ) n
p
Compute Cost of Preferred Stock: Example

ABC Ltd has issued 11% preference shares of the face value of
tk. 100 each to be redeemed after 10 years. Flotation cost is exp
ected to be 5%. Determine the cost of preference shares.

Solution: 10
tk . 11 tk . 100
tk. 95 =
t 1

(1 k p ) t (1 k p )10

Year (s) Cash Outflows PV Factor at Total PV at

11% 12% 11% 12%
1-10 Tk. 11 5.889 5.65 Tk. 64.78 62.15
10 100 .352 .322 35.15 32.20
99.93 94.35
Compute Cost of Common Equity
Two Types of Common Equity Financing
Issuing new shares of common stock (external common equit
y).
Retained Earnings (internal common equity).
Cost of Common Equity
Management should fulfill the expectation of earnings of the sh
areholders of their invested funds.
The opportunity costs of funds determine the expectation of ea
rnings.
Three methods to determine
Dividend Valuation Model
Capital Asset Pricing Model
Bond-Yield-Plus-Premium Approach
Compute Cost of Common Equity
Dividend Valuation Model:

Zero growth model: D1

kS =
P0

Constant Growth Model:

D1
kS = + g
P0
Example: The market price of a share of common stock is $6
0. The dividend just paid is $3, and the expected growth rat
e is 10%.
Compute Cost of Common Equity

Capital Asset Pricing Model (CAPM) Approach:

kS = kRF + (kM kRF)

Example: The estimated Beta of a stock is 1.2. The risk-free r

ate is 5% and the expected market return is 13%.
 Compute Cost of Common Equity

Bond-Yield-Plus-Premium Approach: This is a simple, ad hoc

approach to estimating the cost of retained earnings. Simply ta
ke the interest rate of the firm's long-term debt and add a risk p
remium (typically three to five percentage points):

Example: The interest rate on Newco's long-term debt is 7% an

d our risk premium is 4%. What is the cost of retained earnings
for Newco using the bond-yield-plus-premium approach?
 Compute Cost of Common Equity

Cost of Retained Earnings: the cost of retained earning is con

sidered to be equal to the cost of equity when there is no reinvest
ment cost and personal income tax rate. Otherwise, Cost of retain
ed earnings would be
k e (1-f) (1-t).
Example: A company's share are currently selling for $ 120. The ex
pected dividend and the growth rate are $5.20 and 6% respectively
. The flotation costs are 10% and personal tax rate is 15%. Then c
alculate the cost of retained earning.
Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the rate that

a company is expected to pay on average to all its security hold
ers to finance its assets.

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

Assume that Gallaghers desired capital structure is 40% debt, 1

0% preferred and 50% common equity. The corporate tax rate is
40% and the costs of each sources of capital are debt=10%, pre
ferred stock=11.9%, equity (retained earnings) =15% and equity
(new issue)= 16.25%
Marginal Cost of Capital (MCC)

The WACC of the next dollar of capital raised in called the margi
nal cost of capital (MCC).
This may occur when a firm raises a particularly large amount of
capital such that investors think that the firm is riskier.
Graphing the MCC curve

Assume now that Gallagher Corporation has $100,000 in retaine

d earnings with which to finance its capital budget.
We can calculate the point at which they will need to issue new e
quity since we know that Gallaghers desired capital structure c
alls for 50% common equity.
The breakpoint is $100,000/.5 = $200,000
Making Decisions Using MCC

Marginal weighted cost of capital curve:

Weighted Cost of Capital

12%

11% 11.72%
11.09%
10%
Using Using
Usingnew
new
Usinginternal
internal
9% common common
commonequity
equity
commonequity
equity
0 100,000 200,000 300,000 400,000
Total Financing
Making Decisions Using MCC

Graph MIRRs of potential projects

Marginal weighted cost of capital curve:

Weighted Cost of Capital

12%

11% Project 1
MIRR = Project 2 Project 3
10% 12.4% MIRR = MIRR =
12.1% 11.5%
9%

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

Total Financing
 21

Making Decisions Using MCC

Graph IRRs of potential projects

Graph MCC Curve
Marginal weighted cost of capital curve:
Weighted Cost of Capital

12% 11.72%
11% 11.09%
Project 1
IRR = Project 2 Project 3
10% 12.4% IRR = IRR =
12.1% 11.5%
9%

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

Total Financing
 23

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:
11.72%
Weighted Cost of Capital

12%
11.09%
11% Project 1
IRR = 12.4% Project 2 Project 3
10% IRR = 12.1% IRR = 11.5%

9% Accept Projects #1 & #2

0 100,000 200,000 300,000 400,000
Total Financing