Corporate Finance

Cost of Capital

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 Contents and Introduction
1. Introduction

2. Cost of Capital

3. Costs of the Different Sources of Capital

4. Topics in Cost of Capital Estimation

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 1. Introduction
• A company grows by investing in projects that are profitable and
survives by its revenue streams.

• All investments have associated costs and the most critical is the cost of capital.

• The cost of capital is an important ingredient in both investment decision

making by company’s management and also its valuation by investors

• Cost of capital estimation is a complex undertaking which requires

many assumptions and, factors that need to be taken into account.

• Investments that alter a company’s capital structure require project specific

cost of capital adjustments

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2. Cost of Capital
Lenders/Bondholders Cost of capital is the rate of
return that the suppliers of
capital require as
compensation for their
contribution of capital

Invest if return > cost of capital

Owners/ Equity holders
Riskier projects will have a
higher cost of capital

Marginal cost of capital

(MCC)

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 Weighted average cost of capital
(WACC)

WACC = wd rd (1-t) + wp rp + were

wd = proportion of debt that the company uses when it raises new funds
rd = before tax marginal cost of debt
t = company’s marginal tax rate
wp= proportion of preferred stock the company uses when it raises new
funds
rp= marginal cost of preferred stock
we= proportion of equity that the company uses when it raises new funds
re = the marginal cost of capital

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 Example
IFT has the following capital structure: 30 percent debt, 10 percent preferred
stock and 60 percent equity. The before tax cost of debt is 8 percent, cost of
preferred stock is 10 percent and cost of equity is 15 percent. If the marginal
tax rate is 40%, what is
the WACC?.
WACC = (0.3)(0.08)(1-0.40) + (0.1)(0.1) + (0.6)(0.15) = 11.44 percent

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 Example
Machiavelli Co. has an after tax cost of debt capital of 4%, a cost of preferred
stock of 8%, a cost of equity capital of 10% and a weighted average cost of
capital of 7%. MC intends to maintain its current capital structure as it raises
additional capital. In making its capital budgeting decisions for the average risk
project the relevant cost of capital is
A. 4%
B. 7%
C. 8%
Answer: B
The WACC using weights derived from the current capital structure, is the best estimate of the cost of
capital for the average risk project of a company.

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 Taxes and Cost of Capital
Payments to owners (dividends) are not tax deductible
Interest costs are tax deductible, which means that they provide tax savings
Example: Debt = 100, interest rate = 10%, tax rate = 40%
Calculation of net income Calculation of net income
assuming interest is tax assuming interest is NOT tax
deductible deductible

Revenue 100 Revenue 100

Operating Expenses 50 Operating Expenses 50
Interest 10 EBT 50
EBT 40 Tax Expense (40%) 20
Tax Expense (40%) 16 Interest expense 10
Net Income 24 Net Income 20

After-tax cost of debt = Before-tax cost of debt (1- tax rate)

www.ift.world Example 8
 Weights of the Weighted Average
Weights should be based on:
• Market values
• Target capital structure

In the absence of explicit information about a firm’s target capital structure, use:
• Current capital structure based on market values
• Trend in the firm’s capital structure
• Average of comparable companies

Example 3

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 Example
You gather the following information about the capital structure and
before-tax component costs for a company. The company’s marginal tax
rate is 40 percent. What is the cost of capital?

Capital component Book Value (000) Market Value (000) Component cost
Debt $100 $90 8%
Preferred stock $20 $20 10%
Common stock $100 $300 14%

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MCC and IOS

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 Role of WACC (MCC)
• For average risk projects use WACC to compute NPV

• Adjustments to the cost of capital are necessary when a project

differs in risk from the average risk of a firm’s existing projects

• The discount rate should be adjusted upward for higher risk

projects and downwards for lower risk projects

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 3. Costs of the Different Sources of Capital
• Each source of capital has a different cost because of
differences in seniority, contractual commitments, and potential
value as a tax shield

• Three primary source of capital are:

 Debt
 Preferred equity
 Common equity

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 3.1 Cost of Debt
• Cost of debt is the cost of debt financing to a
company when it issues a bond or takes out a
bank loan

• Two methods of estimating before tax cost of debt:

 The yield to maturity approach

 Debt rating approach

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 Yield to Maturity Approach
The yield to maturity (YTM) is the annual return that an investor
earns if he purchases the bond today and holds it until maturity

Example: A company issues a 10-year, 8% semi-annual coupon bond. Upon

issue, the bond sells for $980. If the marginal tax rate is 30%, what is the
after-tax cost of debt?

Example 4

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 Debt Rating Approach
• Use the debt rating approach when a reliable current market
price for a company’s debt is not available can be use

• Estimate before-tax cost of debt based on comparable bonds

 Similar rating
 Similar maturity

• Use the company’s marginal tax rate to determine after-tax cost

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 3.2 Cost of Preferred Stock
The cost of preferred stock is the cost that a company has committed
to pay preferred stockholders and preferred dividend

Cost of preferred stock = preferred dividend / current price

Example: A company issues preferred stock with a par value = 100 and
preferred dividend = 5 per share. The current share price is 125 and the
marginal tax rate is 33%. What is the cost of preferred stock?

Examples 5 and 6

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 3.3 Cost of Common Equity
• Cost of equity is the rate of return required by a company’s common
shareholders

• Estimation of cost of equity is challenging because of the uncertain nature of

future cash flows

• Commonly used approach for estimating cost of equity are:

 Capital asset pricing model
 Dividend discount model
 Bond yield plus risk premium method

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 Capital Asset Pricing Model
Expected return = risk free rate + premium for stock’s market

risk re = Rf + β [E(Rmkt ) – Rf]

Example: In a developing market the risk free rate is 10% and the equity risk
premium
is 6%. The equity beta for a given company is 2. What is the cost of equity
using the CAPM approach?

Risk free rate: use long term government bonds

Equity risk premium can be calculated using historical returns
Examples 7 and 8

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 Pre-Requisites for Understanding the DDM
Present value of a perpetuity

Present value of a growing perpetuity

Value of a financial asset, such as a stock,

is the present value of future cash flows
(dividends)

Gordon growth model is one example of a

DCF model
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 Dividend Discount Model
P0= D1 / (re-

g) re = D1 / P0

+g

g= (retention rate)(return on equity) = (1- payout rate) (ROE)

Cost of equity is the same as cost of retained earnings

Gordon growth model is also called the constant-growth dividend discount
model

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 Example
You have gathered the following information about a company and the market
• Current share price = 30
• Most recent dividend paid = 2
• Expected dividend payout rate = 40%
• Expected ROE = 15%
• Equity beta = 1.5
• Expected return on market = 15%
• Risk free rate = 8%

Using the DCF approach, what is the cost of

retained earnings?

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Thank you

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