Cost of Capital

What is capital?

Money used to start or run a

business
 Where does Capital come from?

1. Borrowing from Banks (Debt)

2. Owners/investors put their own money
in the company (Equity)
 What is cost of Debt?

- Bank interest rate % charged to your

company

Ex. 5%
After-tax Cost of Debt

rd (1 - t)

rd is the before-tax marginal cost of debt

t is the companys marginal tax rate
After-tax Cost of Debt

Raj Burger can borrow at an interest rate of 5% and has a marginal

tax rate of 40%. Compute the after-tax cost of debt.

rd (1 - t) = 0.05(1-0.40)
=0.05(0.6)
=0.03 / 3%
Cost of Preferred Stock

Dp
rp =
Pp

Dd preferred dividend

Pp current price of preferred stock

Cost of Preferred Stock

Suppose a company has preferred stock outstanding that has a

dividend of $1.25 per share and a price of $20. What is the
companys cost of preferred equity?

rp = Dp / Pp
= $1.25 / $20
= 0.0625 / 6.25%
 What is cost of Equity?

- Expected % return of owners/investors

Ex. 10%
Methods of estimating the cost of equity

1. Capital Asset Pricing Model (CAPM)

2. Dividend Discount Model
3. Bond Yield Plus Risk Premium
Capital Asset Pricing Model (CAPM)

Ke = RF + b (RM RF)

where
b is the return sensitivity of stock to changes in the market return
RM is the expected return on the market
Rf risk-free rate
RM RF is the expected market risk premium or risk premium
Dividend Discount Model
DDM assumes that the value of a stock today is the present value of all future dividends,
discounted at the required rate of return.

re = D1 + g
P0

re required rate of return

D preferred dividend
P price
g growth rate [ g = (Retention Rate)(ROE) = (1.0-Payout Rate)(ROE) ]
Dividend Discount Model

re = D1 + g
P0

Suppose the Gadget Company has a current dividend of $2 per

Answer: 15.08%
share. The current price of a share of Gadget Company stock is $40.
The Gadget Company has a dividend payout of 20% and an
expected return on equity of 12%. What is the cost of Gadget
common equity?
Bond Yield Plus Risk Premium

re = bond yield + risk premium

Weighted Average Cost of Capital
WACC = (D/V)rd (1 - t) + (P/V)rp + (E/V)re
where
D/V is the proportion of debt that the company uses when it raises
new funds
rd is the before-tax marginal cost of debt
t is the companys marginal tax rate
P/V is the proportion of preferred stock the company uses when it
raises new funds
Weighted Average Cost of Capital

WACC = (D/V)rd (1 - t) + (P/V)rp + (E/V)re

rp is the marginal cost of preferred stock

E/V is the proportion of equity that the company uses when it

raises new funds
re is the marginal cost of equity
 WACC Example #1

A company wants to raise money, the

company will sell $10 million of common
stock, the expected return is 15%.
Answer: 12.82%
Moreover, the company will issue $5 million
of debt, the cost of debt is 12% and the tax
rate is 30%. Find the WACC.
WACC Example #2

A company wants to raise money, the

company will sell $10 million of common
stock, the expected return is 15%. The
Answer:
company 12.19%
has $3 in preferred stock rate at
9%. Moreover, the company will issue $5
million of debt, the cost of debt is 12% and
the tax rate is 30%. Find the WACC.
Thank you!!!!!!!!