THE COST
OF
CAPITAL
The Cost of Capital
Three broad sources of financing available or raising
capital: debt, common stock (equity), and 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.
Debt – Kd -commercial banks, bond (debenture)
holders
Equity – Ke – common stock holders
Preference – Kp – preferred stock holders
Weighted Average Cost of Capital
• 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.
discount rate for computing NPV.
IRR > WACC for acceptance of project.
• The WACC is estimated by multiplying each
component weight by the component cost and
summing up the products.
Method for finding the WACC
Step 1 - Calculate the individual costs of
capital for the company: for debt,
preferred stock, and
common stock
Step 2 - Calculate the total Market Value for
each type of capital
Step 3 – WACC - weight individual costs by
market values
Step 1
Find
individual
costs of capital
Equity Component
The cost of equity (Ke) is essentially the
rate of return that investors are demanding
or expecting to make on money invested in
a company’s common stock.
Two methods to estimate Ke:
1. the Dividend (Gordon’s) Growth Model
2. the Capital Asset Pricing Model (CAPM).
1. Dividend Growth Model
• Value of a share of stock the present value
of its expected future cash flow…
D0 1 g D0 1 g D0 1 g D0 1 g
1 2 3
P0
1 r 1
1 r 2
1 r 3
1 r
r = required rate of return (Ke)
g = constant growth
P0 = current market price
D0 = current dividend
Dividend Growth Model
Also known as Gordon’s Growth Model - assumes constant
growth rate.
D0 (1 g ) D0 (1 g )
P0 K e g
K e g P0
where D0 = last paid dividend per share;
Po = current market price per share; and
g = constant growth rate of dividend
Ke = cost of equity capital
Example 1: Constant Growth
Gekko Company just paid its shareholders an
annual dividend of $2.00 and has announced
that the dividends will grow at an annual rate of
8% forever. If investors expect to earn an annual
rate of return of 12% on this investment how
much will they offer for the stock?
Capital Asset Pricing Model
The CAPM the expected return of an
investment is a function of
1. The time value of money (the reward for waiting)
2. A reward for taking on risk
3. The amount of risk
K e R f Rm R f e
Ke = expected return on equity shares
Rf = risk free rate of return
(Rm-Rf) = market risk premium
Rm = expected return on the market
βe = beta of the equity investment
Example 2: CAPM
The New Ideas Corporation’s recent
strategic moves have given the company a
beta of 1.2. If the risk-free rate is currently at
4% and the market risk premium (Rm-Rf) is
being estimated at 7%, calculate its
expected rate of return.
Preferred Stock Component
• Preferred stockholders receive a constant
dividend with no maturity point.
• To calculate the price of preferred stock, find the
PV of a perpetuity:
D D
P0 Kp
Kp P0
Example 3: Preferred Stock
The Mid-American Utility Company’s preferred
stock pays an annual dividend of 8% per year on
its par value of $100. If you want to earn 10% on
your investment, how much should you offer for
this preferred stock?
Debt Component
• The cost of debt (Kd) is the rate that firms have to
pay when they borrow money
• Since interest expenses are tax-deductible, the
cost of debt must be adjusted for taxes (t) prior to
including it in the WACC calculation:
I (1 t )
Kd
P0
Example Kellog’s
Kellog’s 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% Debentures
outstanding. They have a face value (par value)
of $1000 and are currently trading at $1075. The
company pays corporation tax at 30%.
Calculate the appropriate cost of debt for the firm.
Example Kellog’s
Kellog’s also has new preferred stock. It will pay
a dividend of $4 per share, the current market
price is $40, par value is $30. What is its cost of
preferred stock?
Example Kellog’s
Kellog’s beta is estimated at 0.65. The risk-free
rate is currently 4%, and the expected return on
the market is 15%. How much should the CEO
put down as one estimate of the company’s cost
of equity?
Example Kellog’s
Kellog’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.
The stock has a par value of $40.
Calculate Kellog’s cost of equity.
Depending on the availability of data, either of
the two models or both can be used to estimate
Ke.
With two values, the average can be used as the
cost of equity.
For example, in Kellog’s case, we have
Ke = (11.15%+11.28%)/211.22%
Step 2
Find
Market Values
Step 2 – calculate the total market
value for each type of capital
• To calculate the WACC of a firm, each
component’s cost is multiplied by its
proportion of the capital mix
• Market Value weights should be used for
proportions because they represent a
company’s current capital structure, which
would be relevant for raising new capital.
Market Value
• Market value weights are determined by:
current market prices of the security
multiplied by
the number outstanding
• to get the weighting:
total value of each security divided by
total market value of the company
Example Kellog’s
Kellogg’s CFO needs to figure out the weights of the various
types of capital sources. He starts by collecting information
from the balance sheet and makes up the table shown below:
Balance Number Current
Component Sheet Value outstanding Market Price Market Value
Debt $150,000,000 $1075
Preferred $45,000,000 $40
Common Stock
Common Stock $180,000,000 $45.57
Step 3
Weight
Individual Costs
by
Market Values
Step 3: Weighted Individual Cost of
Capital by Market Values
E D P
WACC K e K d 1 t K p
V V V
E = Market Value - Equity P = Market Value - Preference
D = Market Value - Debt V = Total Market Value
(E+P+D)
Ke = cost of Equity capital Kp = cost of Preference shares
Kd = cost of Debt capital t = tax
Example Kellog’s
Using the market value weights and the
component costs determined earlier,
calculate Kellog’s WACC.
Using WACC in Budgeting Decision
The WACC can now be used as a discount rate for NPV
calculations, or as the hurdle rate to compare with the project’s
IRR.
The table below presents the incremental cash flow of a
project being considered by Kellog’s. What is the projects NPV
& IRR? Incremental Cash Flow of a $5 Million Project
