Financial Mangement (FIN 306)
The Cost of Capital
Chapter 11
Lecture I
Dr. Muhammad Asim Faheem
Department Of Banking and Finance
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Lecture Outline
• The Cost of Capital: A Starting Point
• The WACC Do we know that ???
• The Components of the Weighted Average
Cost of Capital
Debt Component
Preferred Stock Component
Equity Component
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The Cost of Capital: A Starting Point
Money raised and used by entrepreneurs and businesses to
continue its operations.
Various components of capital
Various Sources
Cost is one most important consideration
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The Cost of Capital: A Starting Point
3 broad sources of financing available or raising capital:
Debt
Common stock (equity)
Preferred stock (hybrid equity)
Each has its own risk and return profile and therefore its own rate of
return required by investors to provide funds to the firm.
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The weighted average cost of capital (WACC)
The weighted average cost of capital (WACC) is
estimated by multiplying each component weight by
the component cost and summing up the products.
The WACC is essentially the minimum acceptable rate of
return that the firm should earn on its investments of
average risk, in order to be profitable.
WACC is what we use as
The discount rate for computing NPV and
The hurdle rate with IRR:
IRR > WACC for acceptance of project.
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The weighted average cost of capital (WACC)
Example: Measuring weighted average cost of a mortgage
Jim wants to refinance his home by taking out a single mortgage and paying off all the
other sub-prime and prime mortgages that he took on while the going was good.
Listed below are the balances and rates owed on each of his outstanding home-equity
loans and mortgages:
Lender Balance Rate
First Thrifty Bank $ 150,000 7.5%
Second Consumer Bank $ 35,000 8.5%
Third Prime Mortgage Co. $ 15,000 9.5%
Below what rate would it make sense for Jim to consolidate all these loans and refinance the
whole amount?
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The weighted average cost of capital (WACC)
Jim’s weighted average cost of borrowing
Proportion of each loan x Rate of each loan
Weighted average
= (150,000/200,000)x 0.075 + (35,000/200,000) x 0.085 +
(15,000/200,000) x 0.095
=(0.75 x 0.075) + (0.175 x 0.085) + (0.075 x 0.095)
= 0.05625 + 0.014875 + 0.007125 = 0.07825 or 7.825%
Jim’s average cost of financing his home is 7.825%. Any rate
below 7.825% would be beneficial.
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The weighted average cost of capital (WACC)
To determine a firm’s WACC we need
to know how to calculate:
1.Costs of each source, the debt,
preferred stock, and common stock of a
firm
2.The relative weights
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Debt Component
The cost of debt (Rd) is the rate that firms have to pay when
they borrow money from banks, finance companies, and
other lenders.
It is often measured by calculating the yield to maturity
(YTM) on a firm’s outstanding bonds, as covered in bond
Chapter
Although best solved for by using a financial calculator or
spreadsheet, the YTM can also be figured out as follows:
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Debt Component
YTM on outstanding bonds, indicates what
investors require for lending the firm their
money in current market conditions.
However, new debt would also require payment of
transactions costs(flotation cost) to investment bankers
reducing the net proceeds to the issuer and raising the
cost of debt.
Therefore, we must adjust the market price by
the amount of commissions that would have to
be paid when issuing new debt, and then
calculate the YTM.
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Debt Component
Example: Calculating the cost of debt
Kellogg’s wants to raise an additional $3,000,000 of debt as part
of the capital that would be needed to expand their operations
into the Morning Foods sector.
– They were informed by their investment banking
consultant that they would have to pay a commission of
3.5% of the selling price on new issues.
– Their CFO is in the process of estimating the corporation’s
cost of debt for inclusion into the WACC equation.
– The company currently has an 8%, AA-rated, non-callable
bond issue outstanding, which pays interest semi-annually,
will mature in 17 years, has a $1000 face value, and is
currently trading at $1,075.
Calculate the appropriate cost of new debt for the firm.
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Debt Component
First determine the net proceeds on each bond
= Selling price – Commission
=$1,075.00 - (0.035 x $1,075.00) = $1,037.38
Using a approximation formula:
The appropriate cost of debt for Kellogg’s is 7.6%
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Preferred Stock Component
Typically, preferred stock holders receive a
constant dividend with no maturity point
The cost of preferred (Rp) can be estimated by
dividing the annual dividend by the net proceeds
(after flotation cost) per share of preferred stock.
Recall that this is the perpetuity formula from previous
Chapters
Rp = Dp / Net price
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Preferred Stock Component
Example: Cost of Preferred Stock
Kellogg’s will also be issuing new preferred stock worth $1
million. They will pay a dividend of $4 per share which has a
market price of $40. The flotation cost on preferred will amount
to $2 per share. What is their cost of preferred stock?
ANSWER
Net price on preferred stock = $40.00 - $2.00 = $38.00;
Dividend on preferred = $4.00
Cost of preferred = Rp = $4.00 / $38.00 = 10.53%
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Equity Component
The cost of equity (Re) is essentially the
rate of return that investors are
demanding or expecting to make on
money invested in a company’s common
stock.
The cost of equity can be estimated by
using either the SML approach (covered
in Chapter 8) or the Dividend Growth
Model (covered in Chapter 7).
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Equity Component
The Security Market Line Approach: calculates the cost of equity as
a function of the risk-free rate (rf) the market risk-premium [E(rm)-rf],
and beta (βi).
That is,
Re = rf + βi ([E(rm)-rf ])
So the cost of equity is based on current market conditions and the
respective systematic risk of the company as defined by its beta.
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Equity Component
Example : Calculating Cost of Equity with the SML equation
Ali is expanding his business and will sell common stock for
the needed funds. If the current risk-free rate is 4% and
the expected market return is 12%, what is the cost of
equity for Ali if the beta of the stock is 1.2
ANSWER
Re = rf + βi [E(rm)-rf]
Re = 4% + 1.20 [12%-4%]
Re = 13.6%
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Equity Component
The Dividend Growth Approach to Re: The Gordon
Model, introduced in Chapter 7, is used to calculate
the price of a constant growth stock.
Modified form of Gordon Model
where Div0 = last paid dividend per share;
Po = current market price per share; and
g = constant growth rate of dividend.
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Equity Component
For newly issued common stock, the price must be
adjusted for flotation cost (commission paid to
investment banker)
where F is the flotation cost in percent.
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Equity Component
Example: Applying the Dividend Growth Model to calculate Re
Kellogg’s common stock is trading at $45.57 and
its dividends are expected to grow at a constant
rate of 6%.
The company paid a dividend last year of $2.27.
If the company issues stock they will have to pay a
flotation cost per share equal to 5% of selling
price.
Calculate Kellogg’s cost of equity with and
without flotation costs.
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Equity Component
Cost of equity without flotation cost:
Re = (Div0 x (1+g) / Po) + g
= ($2.27 x (1.06)/ $45.57) + 0.06 = 11.28%
Cost of equity with flotation cost:
Re = [$2.27 x (1.06)/(45.57 x (1-.05)] + 0.06 = 11.56%
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Equity Component
Which value to use???
Depending on the availability of data,
either of the two models, or both, can be
used to estimate Re.
With two values, the average can be used
as the cost of equity.
For consistency we should use flotation costs in both
estimates or estimate both without flotation costs.
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Flotation Costs
Fees charged by investment bankers when a
company raises external equity capital
Range: 2% to 7%
Incorrect way: Increase the cost of equity
Correct way: Adjust initial cash outflow to include
flotation costs when computing NPV
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