The Cost of Capital

(Biaya Modal)
Prof. Dr. Kamaludin
Cost of Capital
The firms average cost of funds, which
is the average return required by the
firms investors
What must be paid to attract funds
The use of debt impacts a fims ability to
use equity, and vice versa, so the
weighted average cost must be used to
evaluate projects, regardless of the
specific financing used to fund
a particular project
The Logic of the Weighted
Average Cost of Capital
COC
Cost of Capital Components
Debt
Preferred
Common Equity
WACC

What types of long-term
capital do firms use?

Long-term debt
Preferred stock
Common equity

Basic Definitions
Capital component
types of capital used by firms to raise
money
k
d
= before tax interest cost
k
dT
= k
d
(1-T) = after tax cost of debt
k
ps
= cost of preferred stock
k
s
= cost of retained earnings
k
e
= cost of external equity (new stock)
Basic Definitions
WACC = weighted average cost of
capital
Capital structure
combination of different types of capital
used by a firm
After-Tax Cost of Debt
The relevant cost of new debtits yield
to maturity (YTM)
Taking into account the tax deductibility
of interest
Used to calculate the WACC
k
dT
= bondholders required rate of
return minus tax savings
k
dT
= k
d
- (k
d
T) = k
d
(1-T)
Cost of Preferred Stock
Rate of return investors require on the
firms preferred stock
the preferred dividend divided by the net
issuing price
costs Flotation - P
D
NP
D
k
0
ps ps
ps
= =
s
0
1
RF s
k

P
D

RP k k = + = + = g
Cost of Retained Earnings
Rate of return investors require on the
firms common stock
Three solutions:
1. CAPM
2. Bond yield plus risk premium
3. Discounted cash flow (DCF)
The CAPM Approach

s RF M RF s
k - k k k
The Bond-Yield-Plus-
Premium Approach
Estimate a risk premium above the bond
interest rate
Judgmental estimate for premium

14% 4% 10%
premium Risk yield Bond k
s
= + =
+ =
The Discounted Cash Flow
(DCF) Approach
Price and expected rate of return on a
share of common stock depend on the
dividends expected on the stock

+
=
+
+ +
+
+
+
=
1 t
t
s
t
s s s
k 1
D

k 1
D

k 1
D

k 1
D

P
2
2
1
1
0
DCF Approach
Internal equity, k
s
based on the fact that investors demand the
firm use funds that are retained to earn an
appropriate rate of return
g
P
D

k
0
1
s
Cost of Newly Issued
Common Stock
External equity, k
e
based on the cost of retained earnings
adjusted for flotation costs (the expenses of
selling new issues)
g
F P
D

g
NP
D

k
0
1 1
e
1
Optimal capital structure
percentage of debt, preferred stock, and
common equity that will maximize the
price of the firms stock
Target Capital Structure
Weighted Average Cost of
Capital, WACC
A weighted average of the component costs
of debt, preferred stock, and common
equity

k W k W k W
equity
common
of Cost
equity
common of
Proportion
stock
preferred
of Cost
stock
preferred of
Proportion
debt
of cost
tax - After
debt
of
Proportion
s s ps ps dT d
+ + =
(
(
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What are the two ways that companies
can raise common equity?
Directly, by issuing new shares of
common stock.
Indirectly, by reinvesting earnings that
are not paid out as dividends (i.e.,
retaining earnings).

Why is there a cost for reinvested
earnings?
Earnings can be reinvested or paid out as
dividends.
Investors could buy other securities, earn
a return.
Thus, there is an opportunity cost if
earnings are reinvested.

Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
They could buy similar stocks and earn
r
s
, or company could repurchase its own
stock and earn r
s
. So, r
s
, is the cost of
reinvested earnings and it is the cost of
equity.

Three ways to determine the
cost of equity, r
s
:
1. CAPM: r
s
= r
RF
+ (r
M
- r
RF
)b
= r
RF
+ (RP
M
)b.
2. DCF: r
s
= D
1
/P
0
+ g.
3. Own-Bond-Yield-Plus-Risk
Premium:
r
s
= r
d
+ RP.

Whats the cost of equity
based on the CAPM?
r
RF
= 7%, RP
M
= 6%, b = 1.2.
r
s
= r
RF
+ (r
M
- r
RF
)b.

= 7.0% + (6.0%)1.2 = 14.2%.
Whats the DCF cost of equity, r
s
?
Given: D
0
= $4.19;P
0
= $50; g = 5%.
( )
g
P
g D
g
P
D
r
s
+
+
= + =
0
0
0
1
1
( )
= +
= +
=
$4. .
$50
.
. .
.
19 105
0 05
0 088 0 05
13 8%.
Estimating the Growth Rate
Use the historical growth rate if you
believe the future will be like the past.
Use the earnings retention model,
illustrated on next slide.

Suppose the company has been earning
15% on equity (ROE = 15%) and
retaining 35% (dividend payout = 65%),
and this situation is expected to continue.

Whats the expected future g?
Retention growth rate:

g = ROE(Retention rate)
= ROE (1 DPR)

g = 0.15(35%) = 5.25%.

Could DCF methodology be applied
if g is not constant?
YES, nonconstant g stocks are expected
to have constant g at some point,
generally in 5 to 10 years.

Find r
s
using the own-bond-yield-
plus-risk-premium method.
(r
d
= 10%, RP = 4%.)
r
s
= r
d
+ RP
= 10.0% + 4.0% = 14.0%
This RP = CAPM RP
M
.
Whats a reasonable final estimate
of r
s?

MethodEstimate
CAPM 14.2%
DCF 13.8%
r
d
+ RP 14.0%
Average 14.0%

Estimating Weights
Suppose the stock price is $50, there are
3 million shares of stock, the firm has $25
million of preferred stock, and $75
million of debt.

V
ce
= $50 (3 million) = $150 million.
V
ps
= $25 million.
V
d
= $75 million.
Total value = $150 + $25 + $75 = $250
million.
w
ce
= $150/$250 = 0.6
w
ps
= $25/$250 = 0.1
w
d
= $75/$250 = 0.3

Whats the WACC?
WACC = w
d
r
d
(1 - T) + w
ps
r
ps
+ w
ce
r
s

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
What factors influence a companys
WACC?
Market conditions, especially interest
rates and tax rates.
The firms capital structure and dividend
policy.
The firms investment policy. Firms with
riskier projects generally have a higher
WACC.

Marginal Cost of Capital
MCC
the cost of obtaining another dollar of new
capital
the weighted average cost of the last dollar
of new capital raised
MCC Schedule
Marginal cost of capital schedule
a graph that relates the firms weighted
average of each dollar of capital to the total
amount of new capital raised
reflects changing costs depending on
amounts of capital raised
Weighted Average Cost of Capital (WACC) (%)
New Capital Raised
(millions of dollars)
100 150
11.5 -
11.0 -
10.5 -
WACC
1
=10.5%
WACC
2
=11.0%
WACC
3
=11.5%
MCC Schedule
Break Point
BP
the dollar value of new capital that can be
raised before an increase in the firms
weighted average cost of capital occurs
Point
structure capital the in capital of type this of Proportion
type given a of capital cost lower of amount Total Break
=
Weighted Average Cost of Capital (WACC) (%)
New Capital Raised
(millions of dollars)
100 150
11.5 -
11.0 -
10.5 -
WACC
1
=10.5%
WACC
2
=11.0%
WACC
3
=11.5%
BP
RE
BP
Debt

MCC Schedule
MCC Schedule
Schedule and break points depend on
capital structure used
Weighted Average Cost of Capital (WACC) (%)
Dollars of New Capital Raised
0 -
WACC
Smooth, or Continuous,
Marginal Cost of Capital
Schedule
MCC Schedule
Combining the MCC and
Investment Opportunity Schedules
Use the MCC schedule to find the cost of
capital for determining whether a project
should be purchased
Investment Opportunity Schedule (IOS)
graph of the firms investment
opportunities ranked in order of the
projects rates of return

Percent
New Capital Raised and invested (millions of dollars)
20 40 60 80 100 120 140 160 180
12.0 -
11.5 -
11.0 -
10.5 -
MCC
IOS
WACC
1
=10.5%
WACC
2
=11.0%
WACC
3
=11.5%
Return
C
= 12.0%
Return
B
= 11.6%
Return
D
= 11.5%
Return
E
= 11.3%
IRR
A
= 10.8%
Optimal Capital
Budget - $139
Combining the MCC and
Investment Opportunity Schedules

15/07/2014 43
and
SEKIAN