Chapter 11
Cost of Capital
Costs in raising capital
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Firm can raise money by issuing different
types of financial instruments such as …
The costs involved in raising capital are
different across the various types of
instruments
Because investors require different rates of
return from different types of instruments
Getting the required rate of return
from the market
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Normally market information will provide
the price of each type of instruments
We need to derive the required rate of
return from the market price of the
instrument
How to derive the rate of return
from market price
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Use the formulae such as
Bond price = AxPVIFA(n,i)+FxPVIF(n,i)
i or Kd is the required rate of return of the
bond
Price of preferred share = D/Kp
Price of common stock assuming constant
dividend growth = D1/Ke-g
Another way to determine Ke of
common stock
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Ke = required rate of return for individual stock
Ke = riskfree rate + risk premium
Hence, risk premium of individual stock
= Ke - riskfree rate
Similarly risk premium of the market
= market rate of return - riskfree rate
According to the Capital Asset Pricing Model,
the risk premium of individual stock is
determined by the market risk premium
CAPM cont’
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There are two reasons – market risk cannot be
reduced by diversification and individual stock
price moves according to the market.
When the market (return) rises, most of the stock
prices (return) will rise - some rise more while
other less. It all depends on the value of beta.
Ke - Rf =  [Rm - Rf] Or Ke = Rf +  [Rm - Rf]
Rf=risk free rate, T-Bill rate is a good
approximation,  = Share’s systematic risk,
[Rm - Rf] = Market risk premium
Internal Source of Capital
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Retained earnings constitute to one-third of the
equity financing
Based on opportunity cost consideration, the cost
of retained earnings is equivalent to the rate of
return on the firm’s common stock, Ke
However, the cost of new common share is higher
than the cost of retained earnings because of the
additional issuing costs (flotation costs)
Capital Structure
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It is too risky to have a single source of
financing
Normally capital structure would involve
several different sources of financing
Example, a mix of debt, preferred stock,
equity financing and retained earnings
How does a firm determine its
overall cost of capital?
F in an ce
S o u rce
D eb t
M arket
V alu e
1 000 000
R equ ired
R ate
6%
A m o un t of
C o st
6 000 0
P referred
shares
C om m on
shares
T o tal
5 000 00
12%
6 000 0
5 000 00
20%
1 000 00
2 000 000
11%
2 200 00
Alternative way - WACC
F in an ce
S o u rce
D eb t
M arket
V alu e
1M
P referred 5 000 00
shares
C o m m o n 5 000 00
shares
T o tal
2M
% o f R equ ired W eigh ted
T o tal R ate
A verage
50% 6%
3%
25%
12%
3%
25%
20%
5%
1 00 %
11%
Calculating Cost of Capital
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WACC
= Kd x MV of Debt/MV of Total Financing
+ Kp x MV of Preferreds/MV of Total Financing
+ Ke x MV of Commons/MV of Total Financing
MV = Market Value
Since the required rate is derived from the market
price of each financial instrument, we have to use
the market value (not the book value) to calculate
the cost of each instrument
Reasons for using MV of
financial instrument
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The return required by investors is based
on the market value of the investment
The cost of capital will be used to assess
future investments (future potential returns
must be assessed against current costs, not
historical costs)
Hence historical book values are not
relevant
Other Costs
 Returns
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on investment earned by investors
are only part of costs of each source of
capital
 Additional costs to the firm involve
allowances for costs of issuing securities
(flotation costs) and taxes
We have to adjust kb, kp , ke so that they reflect
 (a) tax considerations and
 (b) costs of issuing (flotation costs)
After-tax Cost of Capital
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So far, we have not considered the impact
of tax on cost of capital
Since interest payments on bonds are tax
deductible, the after-tax cost of Debt is
Kd (1 - t)
where t = Corp. tax rate
Since dividend payments on preferred and
common shares are not tax deductible, their
after-tax costs will be the same as before
Issuing Costs - Flotation Costs
Flotation Costs include prospectus printing
cost, underwriters fee, commissions to
investment banks and selling groups, legal
and accounting fees, etc
Flotation Costs as a percentage of fund being
raised
 Funds raised by Bonds: 2-4 %
 Funds raised by Preferreds: 3-6%
 Funds raised by Common shares: 4-9 %
Flotation Costs Adjustment
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Let F = Flotation Cost per bond or share
For preferred shares, P = D/Kp
Actual amount received per unit = (P - F)
Hence, (P - F) = D/Kp
That is, Kp = D / (P - F)
Flotation Costs Adjustment cont’
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For corporate bond, the after-tax cost of
debt is Kd (1 - t)
The flotation cost adjusted cost of debt
Knd = Kd (1 - t)/ 1 - F (approximate)
For common stock, the cost adjusted rate
Kne = Ke [P/(P - F)]
where P = Price per share
Optimal Capital Structure
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Since the cost of debt (especially after-tax cost) is
lower than the cost of preferred/common share,
why not have a single source of financing (i.e.
debt financing only)
A high D/E ratio implies the threat of bankruptcy
Initially debt reduces the cost of capital but as
more debt is used, the threat of bankruptcy will
erase the benefits. (Figure 11-1)
FIF T H
5
Foundations of Financial PPT 11-2
Management
th
CANADIAN
ED ITIO N
Figure 11-1
Cost of capital curve
Cost of equity
Cost of capital
(percent)
Weighted
average cost
of capital
U-shaped
Cost of debt
Minimum point
for cost of capital
Block
Hirt
Short
0
McGraw-Hill R yerso n
40
Debt-equity mix (percent)
80
©McGraw-Hill Ryerson Limited 2000
Usage of Cost of Capital
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Cost of Capital is the yardstick against
which new projects are measured
Projects must earn at least the cost of
capital to be financially viable
WACC is a technique to determine the cost
of capital
WACC is subject to certain limitations
Limitations of WACC
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WACC is an appropriate discount rate only
if the project risk is similar to the
company’s risk
The firm’s capital structure remains stable
so that WACC is consistent with the project
life
Book values instead of WACC will be used
when there are lack of market values
Marginal Cost of Capital
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The marginal cost of debt ( the cost of the
last amount of debt financing) will rise as
more debt financing is used. (e.g. when
D/E ratio exceeds a reasonable level)
The marginal cost of equity also rises when
the shift from retained earnings to external
equity financing (i.e. new common stock
issuance) is necessary (Figure 11-4)
FIF T H
5
Foundations of Financial PPT 11-8
Management
th
CANADIAN
ED ITIO N
Figure 11-4
Marginal cost of capital and Baker Corporation investment
alternatives
Percent
12.0
-
10.0
-
8.0
-
16.0
14.0
A
B
11.06%
C
11.46%
Kmc Marginal
cost of
capital
10.26%
D
E
F
4.0 2.0 0.0 -
G
H
6.0
Block
Hirt
Short
10 15 19
McGraw-Hill R yerso n
39
50
70
Amount of capital ($ millions)
85
95
©McGraw-Hill Ryerson Limited 2000