12
The Cost of Capital
©2006 Thomson/South-Western
Introduction

This chapter discusses the concept of the
cost of capital and develops approaches
used to measure it.

Weighted cost of capital

Risk vs. required return trade-off

Individual components
2
Cost of Capital





Determined in the capital markets
Depends on the risk associated with the
firm’s activities
What the firm must pay for capital
The return required by investors
Minimum rate of return required on new
investments
3
Cost of Capital
Is the equilibrium rate of
return demanded by investors
in the capital markets for
securities with the same degree
of risk.
4
Weighted Average Cost
of Capital: ka





Discount rate used when computing the
NPV of a project of average risk
Hurdle rate used in conjunction with the
IRR
Based on the after-tax cost of capital
Obtained from the weighted costs of the
individual components
Weights equal to the proportion of each of
the components in the target capital
structure
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Calculating ka
ka = W(ke) + W(ki) + W(kp)
E
B
Pf
ke  
ki  
kp 
ka 
B  E  Pf
B  E  Pf
B  E  Pf
This method computes the weighted average of the individual
capital costs, with the weights determined by relative values.
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Calculating ka
If a firm has $3 in bonds, $6 in
equity, and $1 in preferred stock
outstanding:
1
6
3
ke  
ki  
kp 
ka 
3  6 1
3  6 1
3  6 1
k = 60%(ke) + 30%(ki) + 10%(kp)
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Which weights? Market or book?

It is generally recommended that market
value weights be used for the various
component costs in the calculation of
weighted cost of capital, especially in the
case of common equity. However, book
values are often used with market values
when market values aren’t available or are
too volatile.
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Required return = rf + Risk premium

rf = risk-free rate
 Real rate of return determined by supply and
demand


Plus a premium for the effects of inflation
Components of the risk premium
 Business risk associated with the amount of operating leverage
 Financial risk associated with the use of financial leverage
 Marketability risk refers to the ability to quickly buy and sell
 Interest rate risk arising from changes in interest rates
 Seniority risk due to the priority of a security’s claim on assets
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Risk-Return Trade-Off of Various
Sources of Funds
Required Return %
x
x Common Stock
x Low Quality Corp Debt
x High Quality P/S
x High Quality Corp Debt
x
L-T Government Debt
S-T Government Debt
rf
Risk
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Component Costs

ki = kd (1 – T)

kp = Dp/Pnet

Cost of internal equity capital

Interest is tax deductible
Dividends are not

ke = D1/P0 + g

ke = rf + j(rm – rf)

Risk premium on debt approach Add %
Cost of R/E using constant dividend g
CAPM
Cost of external equity
ke = D1/Pnet + g
Pnet = P0(1 – f)
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Growth Rate Information

Institutional Brokers Estimate System


Zacks Earnings Estimates


http://www.zacks.com/
Thomson Financial First Call Service


http://www.ibes.com/
http://www.firstcall.com/index.shtml
Dividend growth model

http://www.finplan.com/invest/divgrowmod.ht
m
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CAPM

Check this Web site to see how the CAPM
is used to calculate a firm’s cost of equity:
http://www.ibbotson.com/
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Divisional Costs of Capital




Some divisions of a company have higher
or lower systematic risk.
The discount rates for these divisions
should be higher or lower than the
discount rate for the firm as a whole.
Each division could have its own beta and
discount rate.
Should reflect both the differential risks
and the differential normal debt ratios for
each division.
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MCC Schedule



Step 1: Calculate the cost of capital for
each component
Step 2: Compute the MCC for each
increment of capital raised
Equal to the equilibrium rate of return
demanded by investors in the capital
markets for securities of that degree of
risk
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Determining the Optimal Capital
Budget



Compare the expected project returns to
the company’s MCC schedule.
Accomplished by plotting the returns
expected from the proposed capital
expenditure projects against the
cumulative funds required
Cost of funds may increase with the
amount of financing required.
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Optimal Capital Budget
%
A
B
C
MCC
D
E
F
IRR
$
Optimal capital budget contains all projects for which the
expected return lies above the MCC
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Depreciation Tax Savings

Is a major source of funds

Discounted at the firm’s weighted cost of
capital based on R/E and the lowest cost
of debt

Availability of funds from depreciation
shifts the MCC to the right by the amount
of depreciation.
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The Cost of Capital for
Multinational Firms




Some host countries offer preferential
financing terms.
Multinationals can shop the world for the
lowest capital costs.
Raise majority of equity in home country
Raise substantial amount of debt in
countries where they maintain significant
operations


Is a hedge against exchange rate risk
May insulate the firm from expropriation
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Small Firms



Have a difficult time attracting capital
Issuance costs are high (greater than
20% of issue)
Often issue two classes of stock



One class sold to outsiders paying a higher
dividend.
Second class held by founders with greater
voting power.
Limited sources of debt
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Sources of Debt for Small Firms

Owner’s own funds

Private placement

Loans from friends

Venture capital firms

Loans from financial

Leasing companies
institutions

Creative financing

SBA loans

Warrants

Commercial finance

Convertible debt
company loans
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