INTRODUCTION
Capital components are sources of funding
that come from investors.
Accounts payable, accruals, and deferred
taxes are not sources of funding that come
from investors, so they are not included in
the calculation of the cost of capital.
We do adjust for these items when
calculating the cash flows of a project, but
not when calculating the cost of capital.
 When
we talk about the “cost” of capital,
we are talking about the required rate of
return on invested funds
 It is also referred to as a “hurdle” rate
because this is the minimum acceptable rate
of return
 Any investment which does not cover the
firm’s cost of funds will reduce shareholder
wealth (just as if you borrowed money at
10% to make an investment which earned 7%
would reduce your wealth)
The Cost of Capital
A firm will invest only if the expected rate of return
exceeds the cost of capital. For a firm under rate-ofreturn regulation, if the permitted rate of return is set
above the cost of capital (or the required rate of
return), the firm will over-invest; conversely, if the
permitted rate is set below the cost of capital, the firm
will under-invest.
“A cut-off rate for the allocation of capital to
investment of projects. It is the rate of return on a
project that will leave unchanged the market price of
the stock.”
JAMES C. VAN HORNE
4
1.
2.
3.
4.
As an acceptance
criterion in capital
budgeting
As a determinant of
capital mix in capital
structure decisions
As a basis for
evaluating the
financial performance
As a basis for taking
other financial
decisions.
SIGNIFICANCE OF THE COST OF
CAPITAL
1)
2)
3)
4)
5)
Conceptual
controversies regarding
the relationship
between the cost of
capital & the capital
structure
Historic cost & future
cost.
Problems in computation
of cost of equity
Problems in computation
of cost of retained
earnings
Problems in assigning
weights.
DETERMINATION OF COST OF
CAPITAL
1. HISTORICAL
COST- BOOK COSTS
RELATED TO PAST.
2. FUTURE COSTESTIMATED COST
FOR THE FUTURE
8. IMPLICIT COSTOPPORTUNITY
COST.
7. EXPLICIT COSTSDISCOUNT RATE
WHICH EQUATES
PRESENT VALUE OF
INFLOW &OUTFLOW
3. SPECIFC COSTCOST OF SECIFIC
SOURSE OF CAPITAL
4. COMPOSITE
COST-COMBINED
COST OF VARIOUS
SOURCES, WACC
6. MARGINAL COSTADDITION TO THE
AVERAGE COSTOF
CAPITAL
5. AVERAGE COSTCOMBINED COST OF
VARIOUS
CORPORATE
SECURITIES









1. COST OF DEBT
COST OF REDEEMABLE DEBT
2. COST OF PREFERENCE
CAPITAL
COST OF REDEEMABLE
PREFERENCE CAPITAL
3. COST OF EQUITYSHARE
CAPITAL
DIVIDEND YIELD METHOD
DIVIDEND YIELD PLUS GROWTH
IN DIVIDEND METHOD.
EARNING YIELD METHOD
4. COST OF RETAINED
EARNINGS
COST OF SPECIFIC SOURCE OF
FINANCE
WEIGHTED AVERAGE
COST OF CAPITAL
 MARGINAL COST OF
CAPITAL
 CAPITAL ASSET
PRICING MODEL

WEIGHTED AVERAGE COST OF
CAPITAL

The cost of debt is the rate of interest
payable on debt. The cost of debt is
generally easier to calculate
 Equals the current interest cost to borrow
new funds
 Current interest rates are determined from
the going rate in the financial markets
 The market adjusts fixed debt interest
rates to the going rate through setting debt
prices at a discount (current rate > than
face rate) or premium (current rate < than
face rate)
 BEFORE
TAX COST OF DEBT
In case debt issued at parIn case debt issued at premium or discount
NP IN CASE OF PREMIUM= P+ %PREMIUM
NP IN CASE OF DISCOUNT = P - %DISCOUNT
 AFTER TAX COST OF DEBT
 interest expense is tax deductible
Therefore, when a company pays interest, the
actual cost is less than the expense, than the
formula will be

The debt is issued to be redeemed after a certain period
during the life time of a firm. Such a debt is known as
redeemable debt. The formula to calculate the
redeemable amount to be given to debenture holder is :-
Kdb= cost of debt before tax Kda= cost of debt after tax
 I= interest
N= no. of years
 RV= redeemable value of debt
 NP= net proceeds
 T= tax rate

 Financial
institutions requires principal to be
amortized in installments. A company may
issue a bond or debenture to be redeemed
periodically. The amount of interest goes on
decreasing each period as it is calculated on
the outstanding amount of debt. Formula will
be :-
 Vd=
present value of debt,
 INTEREST 12…n=annual interest, Pn= periodic
payment for 1,2,n , n numbers of years for
maturity, Kd= cost of debt.
:Kd
installment
expected
dividend
D1
D2
D3
PV= (1 + r) + (1 + r)2 + (1 + r)3 + ...
discounted rate, cost of equity
capital
Dt
]
PV=  [
t
(1 + r)
Assume D1 grows at constant rate of g:
D1
D1(1+g) D1(1+g)2
+
+ ...
PV= (1 + r) +
(1 + r)2 (1 + r)3
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Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
Most firms incorporate tax effects in
the cost of capital. Therefore, focus
on after-tax costs.
Only cost of debt is affected.
A fixed rate of dividend is payable on preference
shares. The cost of preference capital is a
function of dividend expected by its investors.
The cost of preference capital can be calculated
as follows:In case PC issued at parIn case PC issued at premium or discount

NP IN CASE OF PREMIUM= P+ %PREMIUM
NP IN CASE OF DISCOUNT = P - %DISCOUNT
Kp = Cost of preference capital, D= Annual
preference dividend, P= Preference share
capital proceeds, NP= Net proceeds.
 Redeemable
preference shares are issued
which can be redeemed or cancelled on
maturity date. The cost of redeemable
preference share capital can be calculated
as:-
 Kpr
= cost of redeemable preference shares,
D= annual preference dividend, MV= Maturity
value of preference shares, NP= Net
proceeds of preference shares.
.the cost of equity is the maximum rate of
return that the company must earn on equity
financed portion of its investments in order to
leave unchanged the market price of its stock.
The cost of equity share capital can be
computed as follows: 1. DIVIDEND YIELD METHOD:
or
Ke= cost of equity capital, D= expected dividend
per share, NP= Net proceeds, MP= market price
per share.
 3(b)
DIVIDEND YIELD PLUS GROWTH IN DIVIDEND
METHOD :-When the dividends of the firm are
expected to grow at a constant rate & the dividend
pay out ratio is constant.
3© EARNING YIELD METHOD
Assumptions
There are few assumptions behind the
method:
(a) future dividends are expected to grow at
a constant rate perpetually;
(b) future dividends can be discounted at a
constant cost of equity capital;
(c) future dividends remain a constant
proportion of earnings over time;
(d) the firm is an all-equity-financed firm, or
it has a constant level of leverage (or a
constant debt-equity ratio).
 The
firm may choose to finance new projects
using only internally generated funds (retained
earnings)
 These funds are not free because they belong to
the common shareholders (i.e., there is an
opportunity cost)
 Therefore, the cost of retained earnings is
exactly the same as the cost of new common
equity, except that there are no flotation costs:
FORMULA OF COST OF
RETAINED EARNINGS
Kr = COST OF RETAINED
EARNINGS
D = EXPECTED DIVIDEND
NP = NET PROCEEDS OF
SHARE ISSUE
G = RATE OF GROWTH
FORMULA OF COST OF RETAINED EARNINGS
TO MAKE ADJUSTMENTS OF TAX & COST OF
PURCHASING NEW SECURITIES
Kr = COST OF RETAINED EARNINGS
D = EXPECTED DIVIDEND
NP = NET PROCEEDS OF SHARE ISSUE
G = RATE OF GROWTH
T = TAX RATE
b = COST OF PURCHASING NEW
SECURITIES, OR BROKERAGE COSTS
A
firm’s overall cost of capital must
reflect the required return on the firm’s
assets as a whole
 If a firm uses both debt and equity
financing, the cost of capital must include
the cost of each, weighted to proportion
of each (debt and equity) in the firm’s
capital structure
 This is called the Weighted Average Cost
of Capital (WACC)
1. WEIGHTED AVERAGE COST OF CAPITAL
 As we have seen, a given firm may have
more than one provider of capital, each with
its own required return
 In addition to determining the weights in the
calculation of the WACC, we must determine
the individual costs of capital
 To do this, we simply solve the valuation
equations for the required rates of return
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
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



We now need a general way to determine the minimum
required return
Recall that 40% of funds were from debt. Therefore, 40%
of the required return must go to satisfy the debt holders.
Similarly, 10% should go to preferred shareholders, and
50% to common shareholders
This is a weighted-average, which can be calculated as:
Wd ,Kd =weights & cost of debt
Wp,Kp= weights & cost of preference capital
Wcs,Kcs= weights & cost of common shareholders
WACC  w d k d  w p k p  w csk cs
The
weights that we use to
calculate the WACC will
obviously affect the result
Therefore, the obvious question
is: “where do the weights come
from?”
There are two possibilities:


Book-value weights
Market-value weights
 One
potential source of these weights is the
firm’s balance sheet, since it lists the total
amount of long-term debt, preferred equity,
and common equity
 We can calculate the weights by simply
determining the proportion that each source
of capital is of the total capital
The problem with book-value weights is that the
book values are historical, not current, values
 The market recalculates the values of each type
of capital on a continuous basis. Therefore,
market values are more appropriate
 Calculation of market-value weights is very
similar to the calculation of the book-value
weights
 The main difference is that we need to first
calculate the total market value (price times
quantity) of each type of capital

 It
is important to note that market-values is
always preferred over book-value
 The reason is that book-values represent the
historical amount of securities sold, whereas
market-values represent the current amount
of securities outstanding
 For some companies, the difference can be
much more dramatic than for RMM
 Finally, note that RMM should use the WACC
in its decision making process
The Cost of Equity may be derived from the dividend
growth model as follows:
P = D / RE – g
Where the price of a security equals its dividend (D)
divided by its return on equity (RE) less its rate of
growth (g). We can invert the variables to find RE as
follows:
RE = D / P + g
But this model has drawbacks when considering that
some firms concentrate on growth and do not pay
dividends at all, or only irregularly. Growth rates may
also be hard to estimate. Also this model doesn’t adjust
for market risk.
Therefore many financial managers prefer the security
market line/capital asset pricing model (SML or CAPM)
for estimating the cost of equity:
RE = Rf + βI x (RM – Rf)
or Return on Equity = Risk free rate + (risk factor x risk
premium – risk free rate of return)
Advantages of SML: Evaluates risk, applicable to firms
that don’t pay dividends
Disadvantages of SML: Need to estimate both Beta and
risk premium (will usually base on past data, not future
projections.)
 Stand-alone
risk
 Corporate risk
 Market risk
 Stand-alone
risk is easiest to calculate.
 Market risk is theoretically best in most
situations.
 However, creditors, customers, suppliers, and
employees are more affected by corporate
risk.
 Therefore, corporate risk is also relevant.
Unique Risk (also called “diversifiable risk”):




Unique risk associated with the assets owned by the company
Industry risks, e.g. competition, innovation, R&D dependence,
etc.
Risk related to outstanding debt (financial leverage)
Age, size and stability of the organization
Market Risk (also called “systematic risk”):




Economic volatility
Inflation
Political or other events that impact stability or the value of
assets
Changes in interest rates
example Capital asset pricing model (CAPM):
Cost of equity capital = risk-free rate +beta (market rate - riskfree rate)
Re = Rf +  (Rm - Rf)
Therefore, if we use the CAPM to estimate a firm’s cost of equity
capital (Re, or the required rate of return), we have to estimate a
firm’s beta, the risk-free rate of return, and the market risk
premium (the difference between Rm and Rf).
In the CAPM, the measure of market risk is
known as beta (). For example, the returns from an asset with a
beta of 0.5 will fluctuate by 5% for each 10% fluctuation in the
market’s returns. It has been shown that the required risk
premium for an asset is directly proportional to its beta.
Therefore, the holder of an asset with a beta of 0.5 will require a
risk premium only half as large as that offered by the market as a
whole. If the market is efficient, the cost of equity capital will
be equal to the expected rate of return.
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 When
a company sells securities to the public, it
must use the services of an investment banker
 The investment banker provides a number of
services for the firm, including:


Setting the price of the issue, and
Selling the issue to the public
 The
cost of these services are referred to as
“flotation costs,” and they must be accounted for
in the WACC
 Generally, we do this by reducing the proceeds
from the issue by the amount of the flotation
costs, and recalculating the cost of capital
 The
amount of flotation costs are generally
quite low for debt and preferred stock (often
1% or less of the face value)
 For common stock, flotation costs can be as
high as 25% for small issues, for larger issue
they will be much lower
 Note that flotation costs will always be given,
but they may be given as a dollar amount, or
as a percentage of the selling price
 Optimal
capital structure is achieved by
finding the point at which the tax benefit of
an extra dollar of debt = potential cost of
financial distress. This is the point of:




Optimal amount of debt
Maximum value of the firm
Optimal debt to equity ratio
Minimal cost of WACC
 This
will obviously vary from firm to firm and
takes some effort to evaluate. No single
equation can guarantee profitability or even
survival
Firms with greater risk of financial distress must
borrow less
 The greater volatility in EBIT, the less a firm should
borrow (magnify risk of losses)
 Costs of financial distress can be minimized the
more easily firm assets can be liquidated to cover
obligations
 A firm with more liquid assets may therefore have
less financial risk in borrowing
 A firm with more proprietary assets (unique to the
firm, hard to liquidate) should minimize borrowing

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