THE COST OF CAPITAL

CHAPTER 9
 LEARNING OBJECTIVES
2

 Explain the general concept of the opportunity cost of capital

 Distinguish between the project cost of capital and the firm’s
cost of capital
 Learn about the methods of calculating component cost of
capital and the weighted average cost of capital
 Recognize the need for calculating cost of capital for divisions
 Understand the methodology of determining the divisional beta
and divisional cost of capital
 Illustrate the cost of capital calculation for a real company
 INTRODUCTION
3

 The project’s cost of capital is the minimum

required rate of return on funds committed to the
project, which depends on the riskiness of its cash
flows.
 The firm’s cost of capital will be the overall, or
average, required rate of return on the aggregate of
investment projects
 SIGNIFICANCE OF THE COST OF CAPITAL
4

 Evaluating investment decisions

 Designing a firm’s debt policy

 Appraising
the financial performance of top
management
 THE CONCEPT OF THE OPPORTUNITY COST OF
CAPITAL
5

 The opportunity cost is the rate of return foregone

on the next best alternative investment opportunity
of comparable risk.

Risk-return relationships of various securities

 Shareholders’ Opportunities and Values
6

 The required rate of return (or the opportunity cost of capital)

is shareholders is market-determined.

 In an all-equity financed firm, the equity capital of ordinary

shareholders is the only source to finance investment projects,
the firm’s cost of capital is equal to the opportunity cost of
equity capital, which will depend only on the business risk of
the firm.
 Creditors’ Claims and Opportunities
7

 Creditors have a priority claim over the firm’s assets and

cash flows.
 The firm is under a legal obligation to pay interest and
repay principal.
 There is a probability that it may default on its obligation
to pay interest and principal.
 Corporate bonds are riskier than government bonds since
it is very unlikely that the government will default in its
obligation to pay interest and principal.
 General Formula for the Opportunity Cost of
8
Capital
 Opportunity cost of capital is given by the following formula:

 where Io is the capital supplied by investors in period 0 (it

represents a net cash inflow to the firm), Ct are returns
expected by investors (they represent cash outflows to the
firm) and k is the required rate of return or the cost of capital.
 The opportunity cost of retained earnings is the rate of return,
which the ordinary shareholders would have earned on these
funds if they had been distributed as dividends to them
 Cost of Capital
9

 Viewed from all investors’ point of view, the firm’s

cost of capital is the rate of return required by them
for supplying capital for financing the firm’s
investment projects by purchasing various
securities.
 The rate of return required by all investors will be
an overall rate of return — a weighted rate of
return.
 Weighted Average Cost of Capital vs. Specific
Costs of Capital
10

 The cost of capital of each source of capital is known as

component, or specific, cost of capital.
 The overall cost is also called the weighted average cost of
capital (WACC).
 Relevant cost in the investment decisions is the future cost or
the marginal cost.
 Marginal cost is the new or the incremental cost that the firm
incurs if it were to raise capital now, or in the near future.
 The historical cost that was incurred in the past in raising
capital is not relevant in financial decision-making.
 DETERMINING COMPONENT COSTS OF CAPITAL
11

 Generally, the component cost of a specific source

of capital is equal to the investors’ required rate of
return, and it can be determined by using

 But the investors’ required rate of return should be

adjusted for taxes in practice for calculating the
cost of a specific source of capital to the firm.
 COST OF DEBT
12

 Debt Issued at Par

INT
kd = i =
B0

 Debt Issued at Discount or Premium

n INTt Bn
B0 =  +
t =1 (1 + k d ) t (1 + k d ) n

 Tax adjustment

After − tax cost of debt = k d (1 − T)

 EXAMPLE
13

Now,
 Cost of the Existing Debt
14

 Sometimes a firm may like to compute the

“current” cost of its existing debt.

 In such a case, the cost of debt should be

approximated by the current market yield of the
debt.
 COST OF PREFERENCE CAPITAL
15

 Irredeemable Preference Share

PDIV
kp =
P0
 Redeemable Preference Share

n PDIV t Pn
P0 =  +
t =1 (1 + k p ) t (1 + k p ) n
 Example
16
 COST OF EQUITY CAPITAL
17

 IsEquity Capital Free of Cost? No, it has an

opportunity cost.
 Cost of Internal Equity: The Dividend-Growth
Model DIV1
P0 =
 Normal growth (k e − g)

n
DIV0 (1+g s ) t DIVn +1
Supernormal growth 
 1
P0 = + 
(1+k e ) t k e − g n (1+k e ) n
t =1

 Zero-growth DIV1 EPS 1

ke = = (since g = 0)
P0 P0
 COST OF EQUITY CAPITAL
18

 Cost
of External Equity: The Dividend Growth
Model
DIV1
ke = +g
P0

 Earnings–Price Ratio and the Cost of Equity

EPS 1 ( 1 − b )
ke = + br (g = br)
P0
EPS 1
= (b = 0)
P0
 Example
19
 Example: EPS
20

A firm is currently earning Rs 100,000 and its share is selling

at a market price of Rs 80. The firm has 10,000 shares
outstanding and has no debt. The earnings of the firm are
expected to remain stable, and it has a payout ratio of 100 per
cent. What is the cost of equity?
 We can use expected earnings-price ratio to compute the cost
of equity. Thus:
 THE CAPITAL ASSET PRICING MODEL (CAPM)
21

 Asper the CAPM, the required rate of return on

equity is given by the following relationship:

k e = R f + (R m − R f ) j
 Equation requires the following three parameters
to estimate a firm’s cost of equity:
 The risk-free rate (Rf)
 The market risk premium (Rm – Rf)
 The beta of the firm’s share ()
 Example
22

 Suppose in the year 2002 the risk-free rate is 6 per

cent, the market risk premium is 9 per cent and beta
of L&T’s share is 1.54. The cost of equity for L&T
is:
 COST OF EQUITY: CAPM VS. DIVIDEND–
23
GROWTH MODEL
 The dividend-growth approach has limited
application in practice
 It assumes that the dividend per share will grow at a
constant rate, g, forever.
 The expected dividend growth rate, g, should be less than
the cost of equity, ke, to arrive at the simple growth
formula.
 The dividend–growth approach also fails to deal with risk
directly.
 Cost of equity under CAPM
24
 COST OF EQUITY: CAPM VS. DIVIDEND–
25
GROWTH MODEL
 CAPM has a wider application although it is based on
restrictive assumptions.
 The only condition for its use is that the company’s share is
quoted on the stock exchange.
 All variables in the CAPM are market determined and
except the company specific share price data, they are
common to all companies.
 The value of beta is determined in an objective manner by
using sound statistical methods. One practical problem with
the use of beta, however, is that it does not probably remain
stable over time .
 THE WEIGHTED AVERAGE COST OF CAPITAL
26

 The following steps are involved for calculating the firm’s WACC:
 Calculate the cost of specific sources of funds
 Multiply the cost of each source by its proportion in the capital
structure.
 Add the weighted component costs to get the WACC.
k o =k d (1 − T ) w d + k d w e
D E
k o =k d (1 − T ) + ke
D+E D+E

 WACC is in fact the weighted marginal cost of capital (WMCC);

that is, the weighted average cost of new capital given the firm’s
target capital structure.
 Cost of Equity: Two stage growth
27

 Example: Assume that a company’s share is

currently selling for Rs 134. Current dividends,
DIV0 is Rs 3.50 per share and are expected to grow
at 15% over the next years and then at a rate of 8%
forever. Find the company’s cost of equity.
 Solution
28

𝐷𝑖𝑣 1+𝑔 𝑡 𝐷𝑖𝑣𝑛+1 1

𝑃0 = σ𝑛𝑡=1 0 𝑠
+ 𝑘 −𝑔 ∗
1+𝑘𝑒 𝑡 𝑒 𝑛 1+𝑘𝑒 𝑛

6 3.5 1.15 𝑡 𝐷𝑖𝑣7 1

134 = σ𝑡=1 + 𝑘 −0.08 ∗
1+𝑘 𝑡
𝑒 𝑒 1+𝑘𝑒 6
 n
DIV0 (1+g s ) t DIVn +1

1
Solution P0 =
t =1 (1+ k e ) t
+
k e − g n

(1+ k e ) n

29

We need to find ke. We will use Trial and error method. Assume
Ke and then find PVIF for years 1 to 6 Assume ke=10%
Year Dividend Discount factor

1 3.5 ∗ 1.151 = 4.03 0.909

3.65909
2 3.5 ∗ 1.152 = 4.63 0.826
3.82541
3 3.5 ∗ 1.153 = 5.32 0.751
3.99930
4 3.5 ∗ 1.154 = 6.12 0.683
4.18108
5 3.5 ∗ 1.155 = 7.04 0.621
4.37113
6 3.5 ∗ 1.156 = 8.10 0.564
4.56982
7 3.5 ∗ 1.156 ∗ 1.08 = 8.74 0.564
8.74/(0.10-0.08)= 437.168 246.77021
271.37604
30

14% 10%
87.178 134 271.376

By Interpolation

271.376 − 134
∗ 4 = 2.98
273.376 − 87.178
 n
DIV0 (1+g s ) t DIVn +1

1
Solution P0 =
t =1 (1+ k e ) t
+
k e − g n

(1+ k e ) n

31

We need to find ke. We will use Trial and error method. Assume
Ke and then find PVIF for years 1 to 6 Assume ke=14%
Year Dividend Discount factor

1 3.5 ∗ 1.151 = 4.03 0.877 3.52993

2 3.5 ∗ 1.152 = 4.63 0.769 3.55951
3 3.5 ∗ 1.153 = 5.32 0.675 3.59307
4 3.5 ∗ 1.154 = 6.12 0.592 3.62394
5 3.5 ∗ 1.155 = 7.04 0.519 3.65363
6 3.5 ∗ 1.156 = 8.10 0.456 3.69164
7 3.5 ∗ 1.156 ∗ 1.08 = 8.74 0.456
8.74/(0.10-0.08)= 437.168 66.44961
88.10133
 32

Problem 9.1 Assuming that a firm pays tax at a 50% rate, compute
the after-tax cost of capital in the following cases:
(i) A 8.5% preference share sold at par.
(ii) A perpetual bond sold at par, coupon rate of interest being 7%.
(iii) A ten-year, 8%, Rs1000 par bond sold at Rs950 less 4%
underwriting commission.
(iv) A preference share sold at Rs100 with a 9% dividend and a
redemption price of Rs110 if the company redeems it in five years.
(v) An ordinary share selling at a current market price of Rs120, and
paying a current dividend of Rs 9 per share, which is expected to
grow at a rate of 8%.
(vi) An ordinary share of a company, which engages no external
financing, is selling for Rs50. The earnings per share are Rs7.50 of
which 60% is paid in dividends. The company reinvests retained
earnings at a rate of 10%.
 Soln: 9.1
33

(i) The after-tax cost of the preference issue will be

8.5%

(ii) The after-tax cost of bond is

Kd(1-T) = 0.07(1-0.5) = 0.035=3.5%
 Soln: 9.1
34

 iii) after tax cost of bond (approximation method)

1
1 − 𝑇 [𝐼𝑛𝑡 + 𝑛 (𝐹 − 𝐵0 )
1
2 (𝐹 + 𝐵0 )

1
1−0.5 [80+ (1000−950)
10
1 =4.36%
(1000+950)
2
 Soln: 9.1
35

 iv) preference share

𝐷𝑖𝑣 𝑃𝑛
𝑃0 = σ𝑛𝑡=1 𝑡 + 𝑛
1+𝑘𝑝 1+𝑘𝑝

9 110
100 = σ5𝑡=1 5 + 5
1+𝑘𝑝 1+𝑘𝑝
By trial and error kp = 10.06
We find kp=10.6% by Trial and error
 Soln: 9.1
36

 v) Ordinary share
𝑫𝒊𝒗𝟏
𝒌𝒆 = 𝑷𝟎
+𝒈

𝟗(𝟏.𝟎𝟖)
𝒌𝒆 = 𝟏𝟐𝟎
+ 𝟎. 𝟎𝟖 = 𝟏𝟔. 𝟏
 Soln: 9.1
37

 vi)ordinary share
𝑬𝑷𝑺(𝟏−𝒃)
𝑷𝟎 = 𝒌𝒆−𝒃𝒓

𝑬𝑷𝑺(𝟏−𝒃)
𝒌𝒆 = 𝑷𝟎
+ 𝒃𝒓

𝟕.𝟓(𝟏−𝟎.𝟒)
𝒌𝒆 = 𝟓𝟎
+ 𝟎. 𝟒 ∗ 𝟎. 𝟏 =13%
 38

 Problem 9.2 : A firm finances all its investments by

40% debt and 60% equity. The estimated required
rate of return of equity is 20% after-taxes and that
of the debt is 8% after taxes. The firm is considering
an investment proposal costing Rs40,000 with an
expected return that will last forever. What amount
(in rupees) must the proposal yield per year so that
the market price of the share does not change?
Show calculations to prove your point.
 Soln: 9.2
39

 Minimum required rate of return is:

 Debt 0.4*0.08 = 0.032
 Equity 0.6*0.20 = 0.120
 Weighted average 0.152

 Hence, proposal must earn 0.152*40,000 = 6080/year

 Soln: 9.2
40

 Annual return before tax 6080

 Less: Interest 0.08*0.4*40000 1280
 Return on equity 4800

 After-taxrate of return on equity:

 Rs 4800 (0.6*40,000)
 Rs 4800/24000 = 0.20
41

 Problem 9.3: The Kay Company has the following capital structure
at 31 March 2014 which is considered to be optimum.
Rs
14% Debentures 300,000

11% Preference 100,000
Equity (1,00,000 shares) 1,600,000
2,000,000

 The company's share has a current market price of Rs23.60 per

share. The expected dividend per share next year is 50% of the
2014 EPS. The following are the earnings per share figure for the
company during the preceding ten years. The past trends are
expected to continue.
42

Year EPS (Rs) Year EPS(Rs)

2011 1.00 2016 1.61
2012 1.10 2017 1.77
2013 1.21 2018 1.95
2014 1.33 2019 2.15
2015 1.46 2020 2.36

The company can issue 16% new debentures. The

company's debenture is currently selling at Rs96.
The new preference issue can be sold at a net price
of Rs9.20, paying a dividend of Rs1.1 per share. the
company's marginal tax rate is 50%.
43

(a) Calculate the after-tax cost (i) of new debt, (ii) of new preference
capital and (iii) of ordinary equity, assuming new equity comes from
retained earnings.
(b) Find the marginal cost of capital, again assuming no new ordinary
shares are sold.
(c) How much can be spent for capital investment before new ordinary
shares must be sold? Assume that retained earnings available for next
year's investment are 50% of 2014 earnings.
(d) What is the marginal cost of capital (cost of funds raised in excess of
the amount calculated in part (c), if the firm can sell new ordinary
shares to net Rs20 a share? The cost of debt of preference capital is
constant.
44

Solution 9.3

 The existing capital structure of the firm is assumed

to be optimum. Thus, the optimum proportions are:
Rs
14% Debentures 300,000 0.15
11% Preference 100,000 0.05
Equity (1,00,000 1,600,000 0.80
shares)
2,000,000 1.00
45

(a) (i) After-tax cost of debt:

16
𝑘𝑑 = 96 = 0.1667

𝑘𝑑 1 − 𝑇 = 1 − 0.5 0.1667 = 0.0833

(ii) after-tax cost of preference capital

1.1
𝑘𝑝 = 9.2 = 0.12
46

(iii) after-tax cost of retained earnings:

𝐷𝑖𝑣1 1.18
𝑘𝑒 = +𝑔 = + .10 = 0.05 + 0.10
𝑃0 23.60
= 0.15
Calculation of g = It can be observed that it is
growing at an annual compound rate of 10%.
𝐸𝑡 = 𝐸0 (1 + 𝑔)𝑡
2.36 = 1(1 + 𝑔)9

Solving the above we get g=10%

47

Proportion Specific cost Product

14% Debentures 0.15 0.0833 0.0125
11% Preference 0.05 0.1200 0.0060
Equity (1,00,000 0.80 0.1500 0.1200
shares)
Marginal cost 1.00 0.1385
of capital

(b) the marginal cost of capital (MCC) is the weighted

average cost of new capital. The firm would maintain its
existing capital structure. Therefore, new capital would
be raised in proportion to the existing capital structure.
48

(c) the company can spend the following amount

without increasing its MCC and without selling the
new shares:

Retained earnings – (0.5)(2.36*100,000) = 118,000

The ordinary equity (retained earnings in this case) is
80% of the total capital. Thus
Investment before issue of equity
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 118,000
= 𝑃𝑒𝑟 𝑐𝑒𝑛𝑡 𝑒𝑞𝑢𝑖𝑡𝑦
= 0.80
= 147,500
49

(d) If the company spends more than Rs 147,500, it

will have to issue new shares. The cost of new issue
of ordinary shares is:

1.18
𝑘𝑒 = + 0.10 = 0.059 + 0.10 = 0.159
20
50

 The marginal cost of equity in excess of Rs

147,000
Proportion Specific cost Product
14% Debentures 0.15 0.0833 0.0125
11% Preference 0.05 0.1200 0.0060
Equity (1,00,000 0.80 0.1590 0.1272
shares)
Marginal cost 1.00 0.1457
of capital
 Book Value Versus Market Value Weights
51

 Managers prefer the book value weights for

calculating WACC
 Firms in practice set their target capital structure in terms of
book values.
 The book value information can be easily derived from the
published sources.
 The book value debt-equity ratios are analysed by investors
to evaluate the risk of the firms in practice.
 Book Value Versus Market Value Weights
52

 Theuse of the book-value weights can be seriously

questioned on theoretical grounds;
 First, the component costs are opportunity rates and are
determined in the capital markets. The weights should also
be market-determined.
 Second, the book-value weights are based on arbitrary
accounting policies that are used to calculate retained
earnings and value of assets. Thus, they do not reflect
economic values
 Book Value Versus Market Value Weights
53

 Market-value weights are theoretically superior

to book-value weights:
 They reflect economic values and are not influenced by
accounting policies.
 They are also consistent with the market-determined
component costs.
 The difficulty in using market-value weights:
 The market prices of securities fluctuate widely and
frequently.
 A market value based target capital structure means that the
amounts of debt and equity are continuously adjusted as the
value of the firm changes.
 FLOTATION COSTS, COST OF CAPITAL AND INVESTMENT
ANALYSIS
54

 A new issue of debt or shares will invariably involve flotation costs in the
form of legal fees, administrative expenses, brokerage or underwriting
commission.

 One approach is to adjust the flotation costs in the calculation of the cost of
capital. This is not a correct procedure. Flotation costs are not annual costs;
they are one-time costs incurred when the investment project is undertaken
and financed. If the cost of capital is adjusted for the flotation costs and
used as the discount rate, the effect of the flotation costs will be
compounded over the life of the project.

 The correct procedure is to adjust the investment project’s cash flows for
the flotation costs and use the weighted average cost of capital, unadjusted
for the flotation costs, as the discount rate.
 DIVISIONAL AND PROJECT COST OF CAPITAL
55

A most commonly suggested method for

calculating the required rate of return for a division
(or project) is the pure-play technique.
 The basic idea is to use the beta of the comparable
firms, called pure-play firms, in the same industry
or line of business as a proxy for the beta of the
division or the project
 DIVISIONAL AND PROJECT COST OF CAPITAL
56

 Thepure-play approach for calculating the divisional cost of

capital involves the following steps:
 Identify comparable firms

 Estimate equity betas for comparable firms:

 Estimate asset betas for comparable firms:

 Calculate the division’s beta:

 Calculate the division’s all-equity cost of capital

 Calculate the division’s equity cost of capital:

 Calculate the division’s cost of capital

 Firm’s cost of capital
57
 Example
58
 The Cost of Capital for Projects
59

A simple practical approach to incorporate risk differences in

projects is to adjust the firm’s WACC (upwards or
downwards), and use the adjusted WACC to evaluate the
investment project:

 Companies in practice may develop policy guidelines for

incorporating the project risk differences. One approach is to
divide projects into broad risk classes, and use different
discount rates based on the decision maker’s experience.
 The Cost of Capital for Projects
60

 For example, projects may be classified as:

 Low risk projects
discount rate < the firm’s WACC
 Medium risk projects
discount rate = the firm’s WACC
 High risk projects
discount rate > the firm’s WACC