COST

C CAPITAL
OF C
OST OF APITAL
 Definition:
Cost of Capital refers to the required rate of return on various types of financing that will
just satisfy all capital providers.
It reflects the expected average future cost of funds over the long run. It acts as a major link
between the firm’s long-term investment decisions. The overall cost of capital is a weighted
average of the individual required rates of return (costs).

 Factors determining the cost of capital:

There are several factors that impact the cost of capital of any company. This would mean that
the cost of capital of any two companies would not be equal. Rightly, so as these two companies
would not carry the same risk.
a. General economic conditions: These include the demand for and supply of capital within the
economy, and the level of expected inflation. These are reflected in the risk less rate of return
and are common to most of the companies.
b. Market conditions: The security may not be readily marketable when the investor wants to
sell; or even if a continuous demand for the security does exist, the price may vary significantly.
c. A firm's operating and financing decisions: Risk also results from the decisions made within
the company. This risk is generally divided into two classes:
 Business risk is the variability in returns on assets and is affected by the company's
investment decisions.
 Financial risk is the increased variability in returns to the common stockholders as a
result of using debt and preferred stock.
d. Amount of financing required: The last factor determining the company's cost of funds is the
amount of financing required, where the cost of capital increases as the financing requirements
become larger. This increase may be attributable to one of the two factors:
 As increasingly larger public issues are increasingly floated in the market, additional
flotation costs (costs of issuing the security) and under pricing will affect the percentage
cost of the funds to the firm.
 As management approaches the market for large amounts of capital relative to the firm's
size, the investors' required rate of return may rise. Suppliers of capital become hesitant
to grant relatively large amounts of funds without evidence of management's capability to
absorb this capital into the business.

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 Sources of Long-term Capital:
1. Long-term Debt
2. Stockholder’s Equity
 Preferred Stock
 Common Stock Equity
a) New Issue of Common Stock
b) Retained Earnings

 Cost of Long-term Debt:

The cost of long term debt (rp) is the after tax cost today of raising long-term funds through
borrowing. The effective rate that a company pays on its current debt. Most corporate long term
debts are incurred through sale of bonds. The funds those are actually received from such sale
are known as the net proceeds.
Reducing the amount of net proceeds of the sale from the total costs of issuing and selling a
security, we get flotation cost. These costs apply to all public offerings of securities. They
include two components:
 Underwriting cost- compensation earned by investment bankers for selling the security
 Administrative cost- issuer expenses such as legal, accounting, printing etc.

Before-tax Cost of Debt: The before-tax cost of debt (rd) for a bond can be obtained in any of
the three ways: Quotation, Calculation or Approximation.
 Using cost quotations: When the net proceed from the sale of a bond equals the par
value, the before-tax cost just equals the coupon interest rate. For example: a bond with a
10% coupon interest rate that net proceeds equal to the bond’s par value $1000, would
have a before-tax cost of debt (rd) of 10%.
 Calculating the cost: This approach finds the before-tax cost of debt by calculating the
internal rate of return (IRR) on the bond cash flows. From the issuer’s point of view this
value is the cost to maturity of the cash flows associated with the debt. This can be
calculated by financial calculator, electronic spreadsheet or a trial-and-error technique
(repeated varied attempts which are continued until success).
 Approximating the cost: An equation is used in approximating the before-tax cost of
debt:

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 Par Value - Net Proceeds (N d ) I = annual interest amount
I n = number of years to the
n
rd = Par Value  Net Proceeds (N d ) bond’s maturity
2
After-tax Cost of Debt: The specific cost of financing must be stated in an after-tax basis.
Because interest on debt is tax deductible, it reduces the firm’s taxable income. The after-tax cost
of debt (ri) can be found by multiplying before-tax cost (rb) by 1 minus the tax rate (T).

ri = rd × (1-T)

For example: A 9% bond having par value of $1000, maturity period 20 years sold at $980 that
costs $15 for underwriting and $5 for printing. Tax rate is 40%. To calculate its before-tax cost of
debt:
I = $1000 x 9% = $90 Face Value = $1000
Nd = $980 – Floatation cost n = 20 years
= $980 - $20 = $960
1000  960
90 
20
 rd = 1000  960 = 9.4%
2

 ri = 9.4 × (1 - 0.40) = 5.63%

 Cost of Preferred Stock:

Preferred stock represents a special type of ownership interest in the firm. It gives preferred
stockholders the right to receive their stated dividends before the firm can distribute any earnings
to common stockholders. The cost of preferred stock (rp) is the ratio of the preferred stock
dividend to the firm’s net proceeds from the sale of the preferred stock. The net proceeds
represent the amount of money to be received minus any floatation costs. Preferred stock
dividends are paid out of the firm’s after-tax cash flows, a tax adjustment is not required.

Dp Dp = preferred stock dividend amount

rp = Np Np = net proceeds from the sale of
preferred stock

For example: A 10% preferred stock is expected to sell for its $87 per share value. Cost of
issuing and selling is $5 per share.

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Net proceeds, Np = $5 Dividend Payment, Dp = $87 × 10% = $8.7
8.70
 rp = 82
= 10.60%

 Cost of Common Stock:

The cost of common stock is the return required on the stock by investors in the marketplace.
There are two forms of common stock financing:
1. Retained earnings and 2. New issue of common stock
As a first step in finding each of these costs, we must estimate the cost of common stock equity.
The cost of common stock equity (rp) is the rate at which investors discount the expected
dividends of the firm to determine its share value. Two techniques are used to measure the cost
of common stock equity.

 Constant-growth Valuation Model: This technique assumes that value of a share of

stock equals the present value of all future dividends (assumed to grow at a constant
rate) that it is expected to provide over an infinite time horizon. It is also known as
Gordon Model. Cost of Common stock equity is expressed as follow:
rs = required rate on common stock
D1 = per share dividend expected at the end
D1 of 1 year
o rs = P0 + g P0 = value of common stock
g = constant rate of growth in the dividend

 Capital Asset Pricing Model (CAPM): Basically it link risk and returns for all assets
and describes the relationship between the expected return and nondiversified risk of
the firm as measured by the beta coefficient (β). The basic CAPM is:
rs = required rate on common stock
o rs = Rf + [β × (rm – Rf)] RF = risk-free rate of return
rm = return on market portfolio of assets

Using the CAPM indicates that the cost of common stock equity is the return required by
investors as compensation for the firm’s nondiversifiable risk, measured by beta.

 Cost of Retained Earnings:

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Dividends are paid out of a firm’s earning and this is made in cash to common stockholders,
reduces the firm’s retained earnings. Basically retained earning is the undistributed profit portion
of shareholders. For example: A firm needs common stock equity of a certain amount. Either it
can issue new additional common stock or it can do this by retaining the earnings, i.e. not paying
the cash dividend. The retention of earnings increases common stock equity in the same way that
the sale of additional common stock does. Thus,
Cost of retained earnings (rr) to the firm is the same as the cost of an equivalent fully subscribed
issue of additional common stock. Stockholders find the firm’s retention of earnings acceptable
only if they expect that it will earn at lest their required return on the reinvested funds.
So we can set the firm’s cost of retained earnings equal to the cost of common stock equity.

 rs = rr
It should be noted that, it is not necessary to adjust the cost of retained earnings for flotation
costs. Because the firm raises equity by retaining earnings without incurring such cost.

 Cost of New Common Stock:

The purpose in finding the firm’s overall cost of capital is to determine the after-tax cost of new
funds required for financing projects. The cost of new issue of common stock (rn) is determined
by calculating the cost of common stock, net of underpricing and associated flotation costs.
Normally, for a new issue to sell, it has to be underpriced – sold at a price below its current
market price (P0). The reasons of underpricing are:

 When the market is in equilibrium, i.e. the demand for shares equals the supply of
shares, additional demand for shares can be achieved at a lower price.

 When additional shares are issued, each share percentage of ownership in the firm is
diluted, thereby justifying a lower share value.

 Many investors view the issuance of additional shares as a signal that management is
using common stock equity financing because it believed that shares are currently
overpriced.
We can use the constant-growth valuation model expression for the cost of existing common
stock as a starting point. If we let N n represent the net proceeds from the sale of new common
stock after subtracting underpricing and flotation costs, the cost of the new issue, rn can be
expressed as follow:

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 D1
o rn = Nn
-g

The cost of new common stock is normally greater than any other long-term financing cost.
Because common stock dividends are paid from after-tax cash flows, no tax adjustment is
required.

 Constant-growth Valuation vs CAPM Techniques:

 The CAPM technique differs from the constant-growth valuation model in that it
directly consider the firm’s risk, as reflected by beta, in determining the cost of
common stock equity or required return.
The constant-growth model doesn’t look at risk; it uses the market price as a
reflection of expected risk-return preference of investors in marketplace.
The both approaches are theoretically equivalent for finding rs. It is difficult to
demonstrate that equivalency because of measurement problem associated with
growth, beta, the risk-free rate and the market return.
 When the constant-growth model is used to find the cost of common stock equity it
can easily be adjusted for flotation costs to find the costs of new common stock.
The CAPM doesn’t provide a simple adjustment mechanism. The difficulty in
adjusting the cost of common stock equity calculated by using CAPM occurs
because its common form model doesn’t include the market price.
Although CAPM has a stronger theoretical foundation, the computational appeal of the
traditional constant-growth valuation model justifies its use throughout this text to measure
common stock costs.

 Weighted Average Cost of Capital:

Upto above discussions, the cost of specific sources of financing have been calculated. A firm
generally uses more than one type of funds to finance its assets, and the costs of, or the returns
associated with, those funds usually are not the same.
Weighted Average Cost of Capital (rd) reflects the expected average future cost of funds over the
long run. It is found by weighting the cost of each specific type of capital by its proportion in the
firm’s capital structure. All sources of capital, including common stock, preferred stock, bonds

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and any other long-term debt, are included in a WACC calculation. A firm’s WACC increases as
the beta and rate of return on equity increase, as an increase in WACC denotes a decrease in
valuation and an increase in risk.

 Calculation of WACC: Calculating the weighted average cost of capital is

straightforward: Multiply the specific cost of each form of financing by its
proportion in the firm’s capital structure and sum the weighted values. As an
equation the weighted average cost of capital can be specified as follows:
ra = (wt × rt) + (wp × rp) + (ws × rn or rr)
here, wt = proportion of long-term debt in capital structure
wp = proportion of preferred stock in capital structure
ws = proportion of common stock equity in capital structure
wt + ws + wp = 1.0

Three important points should be noted:

1. For computational convenience, it is best to convert the weights into decimal form
and leave the specific costs in percentage term.
2. The sum of the weights must equal 1.0, i.e. all capital structure components must be
accounted for.
3. The firm’s common stock equity weight (ws) is multiplied by either the cost of
retained earnings (rr) or the cost of common stock (rn). Which cost is used depends
on whether the firm’s common stock equity will be financed using retained earnings
or new common stock.

Important Uses of WACC:

It is important for companies to make their investment decisions and evaluate projects with
similar and dissimilar risks. Calculation of important metrics like net present values and
economic value added requires WACC. It is equally important for investors for arriving at
valuations of companies. The following points will explain why WACC is important and how it
is used by investors and the company for their respective purposes:
 Investment decision by Company: WACC is widely used for making investment
decisions in the corporate by evaluating their projects. Let us categorize the investments in
projects in the following 2 ways:
o Evaluation of Projects with the Same Risk
o Evaluation of Projects with Different Risk

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  Discount Rate in Net Present Value Calculations: Net present value (NPV) is the widely
used method of evaluating projects to determine the profitability of the investment. WACC
is used as discount rate or the hurdle rate for NPV calculations. All the free cash flows and
terminal values are discounted using the WACC.
 Valuation of Company: Any rational investor will invest time before investing money in
any company. The investor will try to find out the valuation of the company. Based on the
fundamentals, the investor will project the future cash flows and discount them using the
WACC and divide the result by no. of equity shareholders. He will get the per-share value
of the company. He can simply compare this value and the current market price

Weighting Schemes:
Firms can calculate weights on the basis of either book value or market value and using either
historical or target proportion:
 Book value weights use accounting values to measure the proportion of each type of
capital in the firm’s financial structure.
 Market value weights measure the proportion of each type of capital at its market value.
These values are appealing because the market values of securities closely approximate
the actual amount to be received from their sale.
 Historical Weights can be either market or book value weights based on actual capital
structure proportions. Such a weighting scheme would, therefore, be based on real –
rather than desired – proportions.
 Targeting weights reflect the firm’s desired capital structure proportions Firms using
targeting weights establish such proportions on the basis of the “optimal” capital structure
they wish to achieve.

An example for calculating WACC:

A firm’s cost of common stock equity is 13%, cost of debt 5.6% and cost of preferred stock
10.6%. The firm uses the following weight in calculating its weighted average cost of capital.
Sources of Capital Weight
Long-term debt 40%
Preferred stock 10%
Common Stock Equity 50%
Total 100%

Find out its weighted average cost of capital.

Calculation:
Sources of Capital Weight (1) Cost (2) Weighted Cost (1×2)

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 Long-term debt 0.40 5.6% 2.2%
Preferred stock 0.10 10.6% 1.1%
Common Stock Equity 0.50 13.0% 6.5%
Total 1.00 9.8%

Weighted average cost of capital of that firm is 9.8%.

 Marginal Cost of Capital:

The marginal cost of capital is the cost needed to raise the last dollar of capital, and usually this
amount increases with total capital.
 When raising extra capital, firms will try to stick to desired capital structure, but once
sources are depleted they will have to issue more equity. Since this tends to be higher
than other sources of financing, we see an increase in marginal cost of capital as capital
levels increase.
 Since an investment in capital is logically only a good decision if the return on the capital
is greater than its cost, and a negative return is generally undesirable, the marginal cost of
capital often becomes a benchmark number in the decision making process that goes into
raising more capital.

Weighted Marginal Cost of Capital (WMCC): The weighted average cost of capital may vary
over time depending on the volume of financing that the firm plans to rise. As the volume of
financing increases, the costs of the various types of financing will increase, It will cause raising
the firm’s WACC.
Therefore, it is useful to calculate the weighted marginal cost of capital which is the firm’s
weighted average cost of capital associated with its next amount of total new financing.
There are two main reasons of such increase are:
 The costs of financing components rise as large amounts are raised. Suppliers of funds
require greater returns for the increased risk introduced. The WMCC is therefore an
increasing function of the level of total new financing.
 Another reason is the use of common stock financing. New financing provided by
common stock equity will be provided by retaining earnings until this supply is exhausted
and then it will be obtained through new common stock financing. As retained earnings
are less expensive then the other, the weighted average cost of capital will rise with the
addition of new common stock.

Calculation of WMCC:

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To calculate WMCC, we must calculate break points that reflect the level of total new financing
at which the cost of one of the financing components rises. The formula of calculating break
points is: BPi = break point for financing source i
AFi AFi = amount of funds available from
BPi  financing source i at a given cost
wi
wi = capital structure weight for financing source j

Once we have determined the break points, the next step is to calculate the weighted average cost
of capital over each range of total new financing between break points. For each of the ranges of
total new financing between breakpoints certain component capital costs will increase. This will
cause the WACC to increase to a higher level than that over the preceding range.
These data can be used to prepare a WMCC schedule – a graph that relates the weighted average
cost of capital to the level of total new financing.

Investment Opportunities Schedule (IOS):

At any given time, a firm has certain investment opportunities available to it. These opportunities
differ with respect to the size of investment, risk and return. The firm’s investment opportunities
schedule is a ranking of investment possibilities from best to worst, i.e. highest return to lowest
return.

Combining WMCC & IOS to make Financing Decisions:

As long as a project’s internal rate of return (IRR) is greater than the weighted marginal cost of
new financing, the firm should accept the project. The return will decrease with te acceptance of
more projects and the weighted marginal cost of capital will be increased because greater amount
of financing will be required. An example will be effective for this discussion.
Following tables of calculations are drawn from related info given about a farm.

WACC for ranges of total new financing:

Range of total new Weighted Cost

Source of Capital Weight Cost
financing
Debt .40 5.6% 2.2%
$0 to $600,000 Preferred .10 10.6% 1.1%
Common .50 13.5% 6.5%
Weighted Cost of Capital 9.8%
Debt .40 5.6% 2.2%
$600,000 to $1,000,000 Preferred .10 10.6% 1.1%
Common .50 14% 7.0%
Weighted Cost of Capital 10.3%

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 Debt .40 8.4% 3.4%
$1,000,000 to above Preferred .10 10.6% 1.1%
Common .50 14% 7.0%
Weighted Cost of Capital 11.5%

Weighted Marginal Cost of Capital Schedule:

11.5%

11.5
WMCC
11.0
(%)
ital
10.5
Cap
of 10.3%

9.8%
Cost
rage 10.0
Ave
d 9.5
ghte
Wei

500 1000 1500

Total New Financing ($000)

Investment Opportunities Schedule:

Investment Internal Rate of Initial Cumulative

Opportunity Return Investment Investment
(%) ($) ($)
A 15.0 100,000 100,000
B 14.5 200,000 300,000
C 14.0 400,000 700,000
D 13.0 100,000 800,000
E 12.0 300,000 11,00,000
F 11.0 200,000 13,00,000
G 10.0 100,000 14,00,000

WMCC & IOS Combined Schedule:

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 A
15
B
14.5
C
14

13.5
D
13

12.5
E 11.5%
12
(%)
IRR 11.5 WMCC
al and F
Capit 11
of
10.5 10.3%
G
Cost
ge 10 9.8% IOS
Avera
hted 9.5
Weig
0

500 1000 1100 1500

Total New Financing or Investment ($000)

The decision rule would be: Accept the projects upto the point at which the marginal return on an
investment equals its weighted marginal cost of capital. Beyond that point its investment return
will be less than its capital cost. This approach is consistent with the maximization of net present
value (NPV) for conventional project for two reasons.
 The NPV is positive as long as the IRR exceeds the weighted average cost of capital, ra.
 The larger the difference between the IRR and ra, the larger the resulting NPV.
Therefore, the acceptance of projects beginning with those that have greatest positive difference
between IRR and ra, down to the point at which IRR just equals ra should result in the maximum
total NPV for all independent projects accepted.
Such an outcome is completely consistent with the firm’s goal of maximizing owner wealth.

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