Cost of Capital
Cost of Capital
Cost of Capital
Dr Sheeba kapil
The cost of capital represents
• the firm’s cost of financing, and
• is the minimum rate of return that a project must earn to increase firm value.
Financial managers are ethically bound to only invest in projects that they expect to exceed
the cost of capital.
The cost of capital reflects the entirety of the firm’s financing activities.
Most firms attempt to maintain an optimal mix of debt and equity financing.
To capture all of the relevant financing costs, assuming some desired mix of financing, we
need to look at the overall cost of capital rather than just the cost of any single source of
financing.
Cost of Capital: Needed for
• Pre tax cost of debt will be adjusted to calculate post tax cost of debt:
• After-tax cost of debt = Kd x (1 - tax rate)
Example: Tax effects of financing
with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
PAT 264,000 231,000
⚫ Now, suppose the firm pays 50,000 in dividends to
the shareholders
Example: Tax effects of financing
with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
Cost of Debt
Kd = kd (1 - T)
Answer
Kp=10.5/100-4= 10.94%
Cost of Equity: Retained Earnings
• Why is there a cost for retained earnings?
• Earnings can be reinvested or paid out as dividends
• Investors could buy other securities, and earn a
return.
• Thus, there is an opportunity cost if earnings are
retained
• Common stock equity is available through retained
earnings (R/E) or by issuing new common stock:
• Common equity = R/E + New common stock
Cost of Equity:
New Common Stock
• The cost of new common stock is higher than
the cost of retained earnings because of
flotation costs
• selling and distribution costs (such as sales
commissions) for the new securities
Cost of Equity
Rearranging D1
KE = +g
P0
Dividend Growth Model
This model has drawbacks:
kj = Rf + β ( Rm − Rf )
Cost of Co-variance Average rate of return
capital Risk-free of returns against on common stocks
return the portfolio (WIG)
(departure from the average)
B < 1, security is safer than WIG average
B > 1, security is riskier than WIG average
CAPM approach
• Advantage: Evaluates risk, applicable to firms
that don’t pay dividends
• Solutions
• Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques.
• Problem 3 can be lessened by adjusting for changes in business and financial risk.
• Look at average beta estimates of comparable firms in the industry.
What is the appropriate risk-free rate?
Flotation cost is the total cost incurred by a company in offering its securities to the public. They arise from expenses such as under-
writing fees, legal fees and registration fees
Should the company use the composite
WACC as the hurdle rate for each of its
projects?
NO! The composite WACC reflects the risk of an
average project undertaken by the firm.
Therefore, the WACC only represents the
“hurdle rate” for a typical project with average
risk.
Different projects have different risks. The
project’s WACC should be adjusted to reflect
the project’s risk.
Optimum Capital Structure
The optimal (best) situation is associated with the minimum
overall cost of capital:
Optimum capital structure means the lowest WACC
Usually occurs with 30-50% debt in a firm’s capital structure
WACC is also referred to as the required rate of return or the
discount rate
Cost of capital curve